Investment Matters
Prudent Person Rule v Environment, Social and
Governance (ESG) considerations in investment
decisions
Is there a convergence of Environmental, Social and
Governance concerns with the investment rules based on
the “Prudent Person Principle”?
November 2015
Private Portfolio Managers, Level 3, 2 Martin Place, Sydney NSW 2000, +61 2 8256
3777
www.ppmfunds.com Australian Financial Services Licence No. 241058
Is there a convergence of Environmental, Social and
Governance concerns with the investment rules based on
“Prudent Person”?
This paper considers whether the Prudent Person Principle excludes Environmental, Social
and Governance (ESG) consideration in investing or whether the Principle require ESG
issues to be considered by trustees, boards or committees charged with fiduciary
responsibilities. This paper compares the situation in the United States to that in Australia.
In Australia generally, trustees, boards or committee members of Trusts, Not-For-Profits
(NFP) organisations and Superannuation Funds have followed the prudent person principle
as the bench mark for investment policies based on the various Trustee Acts,
superannuation and charity legislation and the common law requirement s for the actions of
fiduciaries.
As background the “Prudent Person Principle” reflects changes that took place in NSW (and
other states) following the amendments to the Trustee Act 1925 by the Trustee Amendment
(Discretionary Investments) Act 1997, while ESG has evolved out of the socially responsible
investment movement.
The US experience
The phrase “prudent person” or “prudent man” seems to have first appeared in the US in
1830 in the case Harvard College v Amory 26 Mass (9Pick) 446, when a Massachusetts
Court ruled “All that can be required of a trustee is that he conduct himself faithfully and
exercise a sound discretion. He is to observe how men of prudence, discretion and
intelligence manage their own affairs, not in regard to speculation but in regard to the
permanent disposition of their funds, considering the probable income, as well as the
probable safety of capital to invest”. This became known as “The Massachusetts Rule which
represented a great advance by abandoning the attempt to specify approved types of
investment”i available to a trustee. The approved list of investment concept came from the
English law where it was developed by the Chancellor after the South Sea investment
“Bubble” burst causing trustees to lose considerable trust funds following the collapse of
very speculative investments. Following the Massachusetts case the prudent person
concept was incorporated into US law, notably via the Employee Retirement Income
Security Act of 1974(ERISA) and later the Uniform Prudent Investor Act of 1994 which
reflected the American Law Institute’s (ALI) Restatement of Trusts approved in 1991. The
Act states that the trustee is under a duty: “To invest and manage the funds of the trust as a
prudent investor would, in light of the purpose, terms, distribution requirements and other
circumstances of the trust”.
The relationship between social responsibility in investment policy and the prudent man
rule was covered in a paper in the California Law Review in 1980. The paper explored the
limitation of the “two traditional investment objectives: attainment of an adequate return
and preservation of the trust corpus” and “examined whether a trustee who invests trust
funds to foster political, social or non-traditional objects complies with the prudent man
rule.”ii The paper cites several cases involving pension funds where members took action
against the trustee in relation to investments made for the funds. The outcome from
Blankenship and Boyleiii and Withers v Teachers’ Retirement Systemiv left the position
unclear as to a trustee’s ability to invest in non- traditional investments. The paper draws on
Scott’s The Law of Trusts and quotes “trustee in deciding whether to invest in or retain, the
securities of a corporation may properly consider the social performance of the corporation.
They may….invest in or retain the securities of corporations whose activities or some of
them are contrary to fundamental and generally acceptable ethical principles. The article
quotes pollution, race discrimination, fair employment and consumer responsibility as
matters that a trustee may consider..v The article concludes that the trustee principle
obligations under the prudent man standard…. will continue to be to obtain an adequate
return and protect corpus, but that courts will permit some deviation from this norm.
Thirty five years after the Law Review was published ,in a decision of the United States
Court of Appeal for the Ninth Circuit in the case of Tibble v Edison International it was held
that the provisions of the Employee Retirement Income Security Act of 1974 (ERISA) is
“derived from the common law of trusts and as such the trustee failed to adequately
consider the trust law duty to monitor the investments of a trust and remove imprudent
investmentsvi. The Court found that ERISA fiduciaries also have a continuing duty to monitor
the suitability and prudence of an ERISA plan's investments …which provides that a trustee
has a continuing duty- separate and apart from the duty to exercise prudence in selecting
investments at the outset-to monitor and remove imprudent, trust investments. Further a
fiduciary must discharge his responsibilities “with the care, skill, prudence and diligence”
that a prudent person “acting in a like capacity and familiarity with such matters” would
use.
This judgement was summarised by the Responsible Investor Magazine and in an article by
Jay Youngdahl June 8th 2015 who writes “that the case provides a powerful opening for
social investments advocates.” He suggests “ trustees must consider what effects climate
change has on their investments now, not what effect it had at some time in the past when
fund investments were initially purchased”vii and that trustees that fail to regularly monitor
for these risks(those associated with ESG issues) may constitute a breach of their fiduciary
duty.
The position in the US has shifted from the approved list of investments to prudent person
and expanded the fiduciary duties to include the effects that ESG issues may have on the
long term suitability of certain investments.
The Australian Experience
What is the position in Australia?
Similar to the US in relation to Trusts but slightly different in relation to superannuation
funds, charities and not-for-profit organisations.
For trusts there is the common law and legislation. Using NSW as an example the NSW
Trustee Act 1925, (the Act), which prior to 1998, contained in section 14 a list of approved
investments that trustee could use for trust funds. As in the US this originated from the
Chancellors “Court approved list of Investments”. In NSW, the Trustee Act was changed in
1998 by the Trustee Amendment (Discretionary Investments) Act 1997 moving Australia
towards the US model in abandoning the approved list and replacing it with the concept of
prudent person. Under the amendments trustees were given unlimited powers provided
they acted according to the procedures prescribed in the Act.
In the Act, law and equity are preserved by S14B in that:
(1) Any rules and principles of law or equity that impose a duty on a trustee exercising a
power of investment continue to apply except to the extent that they are inconsistent with
this or any other Act or the instrument (if any) creating the trust.
(2) Without limiting the generality of subsection (1), a duty imposed by any rules and
principles of law or equity includes the following:
(a) a duty to exercise the powers of a trustee in the best interests of all present and future
beneficiaries of the trust,
(b) a duty to invest trust funds in investments that are not speculative or hazardous,
(c) a duty to act impartially towards beneficiaries and between different classes of
beneficiaries,
(d) a duty to take adviceviii .
Section 14A of the Act requires trustees to exercise care, skill and diligence in investing. The
standard of care, skill and diligence is determined according to whether the trustee is a
professional trustee or not. Professional trustees are held up against a professional standard
of care (ie, how a prudent professional trustee would act). Non-professionals are held up
against a normal standard of care (i.e., how a prudent normal person would act)ix.
Matters that trustee must take into account are listed in section 14, particularly S14 A(4),
which states that a trustee must, at least once in each year, review the performance
(individually and as a whole) of trust investments. This is in line with the verdict in the US in
the Tibble case where it was held that the trustee has an ongoing responsibility to review
investment at least once a year.
In addition the Act sets out matters that trustees must take into account in exercising their
power of investment in section 14C.
Section 14C states inter alia:
1) Without limiting the matters that a trustee may take into account when exercising a
power of investment, a trustee must, so far as they are appropriate to the circumstances of
the trust, if any, have regard to the following matters:
(a) the purposes of the trust and the needs and circumstances of the beneficiaries,
(d) the need to maintain the real value of the capital or income of the trust,
(e) the risk of capital or income loss or depreciation,
(f) the potential for capital appreciation,
(g) the likely income return and the timing of income return,
(m) the likelihood of inflation affecting the value of the proposed investment or other trust
property,
(3) A trustee is to comply with this section unless expressly forbidden by the instrument (if
any) creating the trust.
It would seem from the Trustee Act that provided the trustee follows these rules by taking
into account the nature of the trust, the preservation of assets, the minimization of risk and
at the same time generating income and investing for the long term, that they have carried
out their obligations. The rules are a procedure to be followed by trustees and, provided
they are, the trustee is protected no matter the financial outcome.
ESG consideration would seem to fit under the selection criteria for individual investments
along with P/E ratios, dividend policy, estimated future earning etc. Provided the
investment selected is not speculative or hazardous and complies with the requirements of
matters that a trustee must take into consideration, the trustee is able to select or favour
Investments based on ESG considerations. It could be argued however that if the
predominate driver was ESG considerations and the maintenance of the value of capital or
the income of the trust was secondary that the trustee could be in breach of the Act.
To overcome this, it has been argued that ESG considerations work in favour of the investor
since companies that manage their affairs and the impact that the company is having, both
in a positive and negative way on the environment, its attitude to employees, consumers
and the communities it operates in and its own governance are most likely to have a better
financial outcome. This approach is supported by the Responsible Investment Association
Australasia’s 2014 report fact sheet which states “Core responsible investments Australian
equities fund strongly out preformed both the ASX300 and the average Large Cap Australian
equities funds in all times periods across 1,3,5 and 10 years. Similar results occurred for
international equities and multi-sector growth funds. “The report found once again that the
myth of underperformance of responsible funds is unfounded”x . This approach is different
from the earlier US approach which challenged and succeeded in widening the Prudent Man
test to allow “institutional funds …to be employed to further worthy social goals”. Based
on these finding there does not seem to be a conflict but trustees must take cognisance of
the principles regarding income and capital growth.
What is the situation for trustees that are governed by particular legislation or by
investment policy statements?
For superannuation fund trustees the SUPERANNUATION INDUSTRY (SUPERVISION) ACT
1993 SECT 52B contains covenants that must be included in the governing rules of a selfmanaged superannuation fund. These covenants are, that each trustee of the fund:
(a) act honestly in all matters concerning the fund;
(b) exercise, in relation to all matters affecting the fund, the same degree of care, skill and
diligence as an ordinary prudent person would exercise in dealing with property of another
for whom the person felt morally bound to provide.
Charities and Not-for-Profit organisations are governed by the Australian Charities and NotFor–Profit Commission Act and Regulations 2012 (ACNC). According to the commissions fact
sheet each director, trustee or committee member is a “responsible person” and under
Governance Standard 5 -Duties: (2) (a) a registered entity must ensure that its responsible
entities (persons) discharge their duties “with the degree of care and diligence that a
reasonable individual would exercise…”xi This is similar wording to the Trustee Act with a
similar outcome.
In these organisations their deeds and/or investment policy statements would be drafted to
overcome any conflict. Several universities in their Investment policies cover both the care,
skill, prudence and diligence requirement with the ESG considerations. Deakin University in
its published Investment Management Policy states “The University will endeavour that its
investments are undertaken in a manner that befits a contemporary university
incorporating appropriate Environmental, Social and Governance (ESG) considerations with
the ultimate aim of meeting its stated investment objectives. These considerations will be
part of an ESG investment plan that balances financial outcomes with ESG imperatives.”xii
The balance sought is to achieve long term investment objectives at appropriate levels of
risk, with ESG principles considered in conjunction with financial factors.
Part of that duty is to ensure the rate of return from the investment is in line with the risks
involved, including possible capital loss. This aspect seems, from results provided in the fact
sheet, to be covered and, provided fiduciaries are not distracted by seeking non-financial
outcomes instead of financial outcomes, ESG considerations considered alongside financial
outcomes are acceptable.
In conclusion: Do trustees, board or committee members of trusts, not-for profit
organisation or superannuation funds have to take Environmental, Social and Governance
issues into consideration when making investment decisions on behalf of their
organisations?
Following the point highlighted in the Responsible Investor Magazine article by Jay
Youngdahl “that the case (Tibble v Edison) provides a powerful opening for social
investments advocates” it would seem both in the US and Australia, as a first step, that
consideration of ESG factors may be made. This can be done when undertaking the yearly
portfolio review of portfolios, especially in light of development in regards to investors
changed attitude towards social responsible investing.
Are Prudent Person and ESG parallel principles or is there simply a convergence of both?.
The Responsible Investment Association Australasia’s 2014 report, fact sheet concludes
“There is currently a convergence of factors that are resulting in a very compelling case to
invest responsibly, from consumers demanding investments that do no harm through to the
evidence that investment value is inextricably tied to ESG factors”xiii
With the spotlight now on social responsibility and greater scrutiny of investments trustee,
board or committee members who disregard ES G for initial investments or reviews may
leave them open to adverse public scrutiny.
Stanley Rickert M.Bus., CPA. SF FIN, FICS
Marketing & Client Development
PPM Funds
(02) 8256 3777
i
Langbein. John H., “The Uniform Prudent Investor Act and The Future of Trust Investing (1996) Faculty
Scholarship Series Paper 486. https://digitalvommon.law.yale.edu/fss/486
ii
Ronald R Ravikoff and Myron P Curzan, Social responsibility in Investment Policy and the Prudent Man Rule
iii
iv
BLANKENSHIP v. BOYLE, 337 F.Supp. 296, United States District Court, District of Columbia., January 7, 1972.
Withers v. TEACHERS' RETIREMENT SYSTEM, ETC., 447 F. Supp. 1248 (S.D.N.Y. 1978)
v
Ronald R Ravikoff and Myron P Curzan, Social responsibility in Investment Policy and the Prudent Man Rule.
rd
A Scott The law of Trusts (3 ed. Sup 1978)
vi
Supreme Court of the United States No 13-550 [May 18 2015]
vii
Jay Youngdah, Responsible Investor-US Supreme Court clears way for actions against fiduciaries who do not
monitor their investments June 15 2015. https://www.responsibleinvestor.com/home/article/youngdahl_tibble
viii
Trustee Act 1925 s14B
ix
http://www.unistudyguides.com/wiki/Duties_of_Trustees
x
Responsible Investment Association Australasia 2015 Benchmark Report Fact Sheet
xi
Australian Charities and Not for Profit Commission. Fact sheet “Responsible persons-board or committee
members” http://www.acnc.gov.au/ACNC/FTS/FS_RespPers
xii
Investment Management Policy. This policy was approved by Council on 24 September 2012 and
incorporates all amendments to 13 May 2015. https://theguide.deakin.edu.au/TheGuide/TheGuide2011.nsf/
xiii
Responsible Investment Association Australasia 2015 Benchmark Report Fact Sheet
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Private Portfolio Managers Pty Limited ABN 50 069 865 827, AFS Licence No. 241058.
Private Portfolio Managers, Level 3, 2 Martin Place, Sydney NSW 2000
Australian Financial Services Licence No. 241058 ACN 069 865 827