The core duty of a trustee is to act exclusively in the best interests of the trust and importantly, trustees have a duty to balance the interests of different beneficiaries and to act fairly when making investment decisions which could have different outcomes for beneficiaries with competing interests. We are experiencing a new generation of beneficiaries who are increasingly pushing for investment strategies which respond to global pressures and trends (such as climate change-driven extreme weather events, biodiversity loss and inequality). As markets increasingly take account of the materiality of ESG considerations to financial value, today, trustees must be mindful of and regularly address ESG issues and be seen to be doing so, otherwise they could be exposed to business and reputational – and, increasingly, legal – risks.
Who cares wins
The term environment, social and governance (ESG) is a product of the world of investment, rather than the world of trusts. The term ESG was first coined in 2005 in a landmark study entitled: Who Cares Wins. Global ESG assets surpassed $30 trillion in 2022 and are on track to surpass $40 trillion by 2030 – over 25% of projected $140 trillion assets under management (AUM) according to a latest ESG report from Bloomberg Intelligence (BI). Among many findings, this study found that the majority of investors (85%) reported that ESG leads to better returns, resilient portfolios and enhanced fundamental analysis.
Responsible investing is thus widely understood as the integration of ESG factors into investment processes and decision-making business owners and SMEs. Trustees and investors, however, do not undertake identical roles. A trust is a legal arrangement for managing assets. Assets are held and managed by one person or people (trustee) to benefit another person or people (the beneficiary). In effect, it places things of value into the care of a third party, with that third party accepting obligations of careful stewardship. How and to what extent does a trustees’ duty of stewardship (to act with due care, skill and diligence) today include the duty to consider ESG factors when acting in the beneficiary’s best financial interests? Furthermore, to what extent can trustees take into account ethical considerations when choosing between investments that might not be of equal financial merit?
There is now indisputable evidence that many ESG factors (notably good corporate governance and climate risk) have a material financial impact on investments. As such, it is now being viewed as essential for trustees of discretionary trusts to factor ESG considerations into their business’s investment decisions. This includes appointing investment managers, making decisions as to investment objectives and asset allocation, and in voting on company and shareholder resolutions. Similarly, as activist shareholding is on the rise, it might be expected that socially conscious beneficiaries who wish for their trustees to take into account ESG considerations will increasingly push them to do so. The risk for the trustees is whether in considering such investments, they make themselves vulnerable to claims by other beneficiaries that they have acted in breach of trust – particularly if financial returns decrease as a result.
Factors for trustees to take into account
Unless the terms of a particular trust deed provide otherwise, a trustee’s primary duty is to act in the best financial interests of the beneficiaries and to exercise a duty of prudence when investing (Cowan v Scargill [1985]).
In acting in accordance with these duties when making investment decisions, a prudent trustee should therefore take ESG factors into account, as it is now generally accepted that businesses and their owners with poor ESG ratings are at considerably higher risk of financial losses. A negative ESG report or incident can have significant adverse impact and can affect a business’s sales, customer loyalty and reputational value.
It seems likely that we will increasingly see future litigation involving trustees who have invested in companies with poor ESG indices where the value of these companies subsequently declines due to ESG failures. In an important 2014 report, the Law Commission reviewed the investment duties of trustees and considered that trustees may take ESG considerations into account. The report was focused on pensions but considered that there were other types of trusts, such as family trusts and charities, to which the general principles outlined would be applicable. Ultimately, it concluded that it was “not helpful to suggest that trustees should only maximise financial returns”. Rather, it was necessary to balance returns against risk, judged at the time of the decision and distinguish between those factors that are relevant to increasing returns and reducing risks and those which are not. The Law Commission did not conclude, however, that trustees were obliged to take into account ESG factors:
“Given that ESG is a ‘portmanteau’ concept, covering so many different factors, and used in so many different ways, it would not make sense to say that trustees must take an ESG approach. However, bearing in mind the comments from ShareAction and others, we think it would be helpful to make clear that trustees should take account of risks to their investments. When investing in long-term equities, this includes risks to the long-term sustainability of a company’s performance. It is a matter for trustees and their financial advisers to consider what these risks might be and how they should be valued. In doing so, they should bear in mind that both ‘ESG’ and ‘ethical’ factors may, in any given case, be material to the performance of an investment.”
The law still does not provide a clear framework for trustees, and they may still find themselves conflicted between their legal obligations and increasing pressure to take into account ESG considerations, neither of which are fully aligned. ESG considerations have recently been the subject of claims for permission to bring derivative actions. In ClientEarth v Shell’s Board of Directors [2023] EWHC 1137, the environmental law charity, ClientEarth, lodged a derivative action against Shell’s directors. This was for not complying with their duties under the Companies Act 2006, in relation to their failure to adopt policies capable of achieving the company’s target of becoming a net zero business by 2050, resulting in the breach of their duties of “reasonable are, skill and diligence”, under section 174 of the Act. The judge concluded that ClientEarth’s witness evidence did not amount to expert evidence. It had not brought the case in good faith, and there was no universally accepted methodology as to how Shell might be able to achieve the targeted reductions referred to in its energy transition strategy. Obtaining permission to bring derivative claims can be very difficult, and it remains to be seen whether a more straightforward breach of trust claim by a beneficiary would yield a different result.
In Butler-Sloss v The Charity Commission for England And Wales [2022] EWHC 974 (Ch) (“Butler-Sloss”), two charitable trusts sought a declaration that they were entitled to adopt an investment policy which excluded investments inconsistent with the Paris Climate Agreement, notwithstanding the fact that this strategy might be detrimental to the anticipated rate of return. The High Court held that trustees’ powers to invest must be exercised to further a charity’s purposes (in this case, “environmental protection” and the “improvement and relief of poverty”). Although the court ruled that this would normally mean maximising financial returns, it held that trustees had a discretion as to whether to exclude investments which they reasonably believed were in conflict with their charity’s purposes. The decision in Butler-Sloss is significant because it establishes that charitable trustees have a considerably wider latitude in determining a suitable investment policy than previously thought. Significantly, the court re-emphasised that in considering the “financial effect” of a decision, trustees are entitled to take into account the risk that failing to divest could damage their charity’s reputation and decrease support amongst its supporters or the public at large. If consumer pressure for ESG action continues to mount, this factor will undoubtedly take on increasing significance.
Practical considerations for settlors, trustees and beneficiaries
If a settlor wishes for ESG factors to be taken into account in investment of trust funds, this should be included in the trust deed – either in the form of an express limitation on the trustee’s investment power or by express permission. This may cover circumstances where ESG factors can be taken into account even at the risk of significant financial detriment to the trust fund.
Where there is no such express power, then trustees should try to obtain the consent of all the beneficiaries. This would be particularly suitable in the case of small family trusts.
Additionally, beneficiaries may choose to incorporate ESG into the investment policy. The content of such a policy is dependent on many factors and with regard to ESG issues, many are global – climate change, resource scarcity and demographic shifts, for example, affect all asset owners, influencing activity in the SME sector.
Even if a breach of trust claim is brought against trustees, they may be able to rely on the difficulties, due to the inherent risk and uncertainty in choosing investments that a disappointed beneficiary will face in proving loss to the trust fund.
If there is genuine uncertainty as to which investment a trustee should proceed with and the beneficiaries are not in agreement (when each course of action seems to be of equal financial benefit), then a court application may be appropriate.
Conclusion
The current state of the law in the UK suggests that trustees of ordinary discretionary trusts should only take into account non-financial factors in their investment decisions if: this would not involve a significant risk of financial detriment to the trust fund, and, if they consider that the beneficiaries would support their decision.
A prudent trustee will therefore ensure that all of its investment decisions are based on financially material considerations and will not rely only upon non-financial considerations. In practice, most ESG factors will be financially material on close analysis given the potentially huge financial impact of an ESG failure. However, it remains the case that trustees are more restricted than investment managers in their ability to take into account ESG considerations, being bound by important safeguards, such as the trust deed, the Trustee Act 2000, and the common law.
There is clearly still a slight tension between a trustee’s obligations under the law and the pressure to comply with the increasing number of ESG rules and regulations. There is also increasing demand for exploration of how trustees can, or indeed if they should, positively influence ESG outcomes. This is likely to be increasingly relevant where the interests of beneficiaries extend many decades into the future, perhaps requiring trustees to take a proactive interest in issues such as demographic change, climate change and other environmental pressures. As trustees become more progressive in implementing ESG policies and considerations, they will need to ensure that they are acting with integrity and honesty and within the current constraints of the law to avoid accusations of greenwashing from regulators, beneficiaries and other key stakeholders.
Freeths has a long track record of assisting clients in matters discussed in this article and our ESG team are on hand to steer businesses, boards, individuals, funds, investors, and other stakeholders through the changing route map of national and regional policies, regulations and frameworks.