Source: https://benefitsattorney.com/articles/tobacco-2/
Timestamp: 2019-04-19 16:21:22+00:00

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The above book is out of print. However, the chapter on legal issues is available below, or as a Microsoft Word document by clicking here.
G. Daniel Miller and Carol V. Calhoun, Esqs.
In recent years, many fiduciaries of pension funds have considered whether they can consider social concerns along with financial ones in selecting investments for the funds. This trend has been particularly noticeable among plans of governmental entities, churches, and other nonprofit organizations, as well as among plans that cover employees whose terms and conditions of employment are the subject of collective bargaining (“collectively bargained plans”). Simultaneously, the ongoing debate on whether some portion of the Social Security trust fund should be invested in the stock market has heightened the controversy about such policies. Several Members of Congress have claimed that state retirement systems have pursued social concerns to the detriment of their participants’ financial interests, and have used such claims to argue against investment of Social Security funds in the stock market.
This report provides a background on social investment policies. Although the focus is on tobacco-free investment policies, the report recognizes that fiduciaries often implement such policies as part of a broader policy of socially screened investments. The report also analyzes the legal constraints that may apply to various types of pension funds and nonpension assets in carrying out a socially screened investment policy.
A trustee has a fiduciary responsibility to manage investments for the exclusive benefit of participants or beneficiaries. The question analyzed in this report is whether, and to what extent, it may consider the social consequences of its investments when it provides a collateral benefit to a prudent investment process.
Divestiture. At first, this involved selling stocks in companies that invested in South Africa, a practice that changes in the South African political situation have eliminated in recent years. However, it has also been proposed as one way of decreasing a fund’s investment in tobacco stocks, although it is not, at least as yet, in common use.
Over the past 20 years, many individual and institutional investors have begun considering the social consequences of their investment strategies. For example, thirteen states have at one point had some sort of limitation or ban on investment in South Africa by state pension funds. Although these bans were repealed after the fall of apartheid, a variety of other social investing strategies are still in effect. For example, 17 states and the District of Columbia have passed laws requiring some sort of use of state pension investment strategy to oppose religious discrimination in Northern Ireland. Other states have restricted investment in Iran, Cuba, or companies that complied with the Arab League’s boycott of Israel.
Although the South African ban has ended, pension funds and non-pension funds continue not only to maintain but to increase their level of social screening. For example, the Social Investment Forum reported on November 4, 1999 that assets invested in socially responsible portfolios grew 82 percent between 1997 and 1999, roughly twice as fast as all assets under management.
Policies concerning social investing have commonly been based on one of two theories. The first is that avoiding certain types of investments (e.g., investment in companies that did business in South Africa) was prudent, because the unsettled political situation there made companies that did business there inherently more risky than those that did not. Most entities that avoid investments in tobacco stocks justify the policy on this basis. The second was that society as a whole benefited if each investor used its financial power not only to make profits for itself, but to further social goals.
The first theory has not been controversial. No one would question the right of a pension fund to avoid investment in tobacco stocks based on the trustees’ reasonable belief that the risks associated with tobacco stocks, in relationship to their returns, make them a poor investment.
The second theory has generated much more controversy, since it impliedly involves a tradeoff under which the potential investment returns for an individual might suffer at least to some extent to benefit the rest of society. While no one has questioned the right of individuals to make such tradeoffs in their private affairs, questions have arisen about whether a fiduciary charged with managing assets held for the beneficial ownership of others is entitled to make such a tradeoff on their behalf.
Since the 1950s, the tobacco industry has been subject to increasing challenges at the federal and state level, in both the courts and legislatures. In the 1950s, when the first tobacco litigation was instituted, the industry won all of the cases. However, as set forth below, the history since then has been of greater statutory restrictions, and greater success of plaintiffs in litigation.
In 1967, the Federal Communications Commission (FCC) ruled that the Fairness Doctrine applies to cigarette advertising. Stations broadcasting cigarette commercials therefore had to donate air time to smoking prevention messages.
In 1970, Congress enacted the Public Health Cigarette Smoking Act of 1969. This Act banned cigarette advertising on television and radio effective in 1971. It also required a stronger health warning on cigarette packages: “Warning: The Surgeon General Has Determined that Cigarette Smoking is Dangerous to Your Health.” However, this Act also resulted in an end to the requirement that stations broadcast smoking prevention messages.
In 1972, under a consent order with the FTC, six major cigarette companies agreed to include a “clear and conspicuous” health warning in all cigarette advertisements. Because federal law already prohibited such advertisements on television and radio, this order affected primarily print and billboard ads.
In 1973, the Civil Aeronautics Board first required no-smoking sections on all commercial airline flights.
In 1975, Minnesota enacted the first comprehensive clean indoor air act, which restricts smoking in most buildings open to the public. This has been followed by tobacco-related legislation in many cities and states. Typical provisions include banning tobacco advertisements on any billboard, streetcar sign, streetcar, or bus; prohibiting the distribution of free cigarettes; smoking restrictions in private work places; banning tobacco advertising in sports stadiums; and earmarking part of the state cigarette excise tax to support smoking prevention programs.
In 1983, Rose Cipillone’s lawsuit alleging that her cancer (and subsequent death) had been the result of smoking became the first time that a court found in favor of a plaintiff in smoking-related litigation. The jury awarded her estate $400,000. However, the case was overturned on appeal, and sent back to the lower court for further consideration. Her heirs finally dropped the suit in 1992.
In 1984, Congress enacted the Comprehensive Smoking Education Act. This Act required the rotation of several different health warnings on cigarette packages and advertisements.
In 1987, Congress imposed a ban on smoking on domestic airline flights scheduled to last two hours or less. In 1989, Congress extended the ban to flights scheduled for six hours or less. Some airlines have voluntarily banned smoking on all flights.
In 1992, the Synar Amendment to the Alcohol, Drug Abuse, and Mental Health Administration (ADAMHA) Reorganization Act was the first Federal legislation enacted to require states to adopt and enforce restrictions on tobacco sales to minors. The Act set forth penalties to be imposed on state substance abuse funding if a state did not engage in proper enforcement activities.
In 1994, the Pro-Children Act prohibited smoking in facilities (in some cases portions of facilities) in which certain federally funded children’s services are provided on a routine or regular basis. This included schools, day care facilities, etc.
In 1994, Mississippi became the first state to sue the tobacco industry to recover Medicaid costs for tobacco-related illnesses. Early lawsuits had often run into difficulties based on tobacco-industry arguments that smokers had been as well informed as tobacco companies about the risks of smoking, and therefore had voluntarily assumed those risks. However, because this case involved a plaintiff that was not a smoker, it avoided some of the problems of other litigation, and was finally settled with a cash payment to the state.
A rash of lawsuits by other states followed the filing of the Mississippi lawsuit. In 1995, the state of Minnesota brought Minnesota v. Philip Morris, C1-94-8565, 2d Judicial District (May 8, 1998). The Minnesota suit not only resulted in a $6 billion settlement, but caused public disclosure of hundreds of thousands of tobacco industry documents dealing with the effects of tobacco that the industry had sought to keep confidential. During this litigation, Liggett Group, Inc. also turned over documents allegedly showing that the tobacco industry knew of health problems and misled customers.
In 1995, the Department of Justice reached a settlement with Philip Morris to remove tobacco advertisements from the line of sight of TV cameras in sports stadiums. The Department’s position was that the federal ban of tobacco ads on TV also covered placement of cigarette billboards in a position in which viewers would see them during game broadcasts.
In 1995, Brown & Williamson filed suit against Jeffrey Wigand, a former employee, for theft, fraud, and breach of contract. Mr. Wigand counterclaimed for invasion of privacy and holding him in a false light. Wigand v. Brown & Williamson (Kentucky). The company claimed that Mr. Wigand had breached employee confidentiality agreements by providing information regarding the tobacco company’s research and business operations to the Washington Post and to plaintiffs in a products liability suit. Mr. Wigand had provided information to CBS’s “60 Minutes” for a segment that the network chose not to air because of the risk of being sued. On November 29, 1995, Mr. Wigand gave a sworn deposition describing numerous tobacco industry practices. A court order sealed his testimony, but it was leaked to the Wall Street Journal and formed the basis of the Journal’s January 26, 1996 article, “Cigarette Defector Says CEO Lied to Congress About View of Nicotine,” by Alix M. Freedman. In the wake of the publication of the Wall Street Journal article, on February 4, 1996, CBS aired the previously canceled segment.
In 1996, the Liggett Group, the smallest of the nation’s five major tobacco companies, settled its liability in the Castano v. The American Tobacco Company, Inc. (Fifth Circuit) class action lawsuit, the biggest and most visible tobacco liability case. This represented the first time that a tobacco company had taken financial responsibility for tobacco-related diseases and death.
In 1996, the American Medical Association called for divestment of tobacco stocks by mutual funds. This resolution increased the interest of some organizations, pension plans, and individuals in divesting themselves of tobacco stocks, or in investing in tobacco-free mutual funds.
In 1996, in Grady Carter v. Brown & Williamson Tobacco Corp., a Florida jury awarded Carter $750 million based on his claim that he had contracted lung cancer from smoking Lucky Strike cigarettes. The case was overturned on appeal in 1998.
In 1997, the parties reached a settlement in Mangini vs. R.J. Reynolds Tobacco Company, San Francisco Civil Number 939359. The plaintiffs alleged that use of Joe Camel advertising constituted an unfair business practice by allegedly targeting youth. The settlement resulted in a $10 million payment by the company to fund youth anti-smoking advertisements in California and the release of certain documents referring to minors and the Joe Camel advertising campaign.
In 1997 and 1998, the states of Mississippi, Florida, Texas and Minnesota settled their Medicaid lawsuits with the tobacco industry in exchange for industry payments totaling $40 billion over 25 years, plus other industry concessions on marketing and lobbying activities.
In 1998, in Roland Maddox v. Brown & Williamson Tobacco Corp., a Florida jury awarded the estate of Roland Maddox $952,000 based on his claim that he had contracted lung cancer from smoking Lucky Strike cigarettes. For the first time, the jury award included punitive damages totaling $450,000. The case is on appeal.
In 1998, nonsmoking flight attendants settled Broin v. Philip Morris Companies, Inc., a lawsuit based on allegations of damages from second-hand smoke. Under the settlement, Phillip Morris set aside $300 million to research the effects of second-hand smoke. Damages to individuals could be obtained only in individual suits. However, the settlement allowed individual plaintiff suits — even those whose statute of limitations had expired — to continue against the tobacco industry.
On November 16, 1998, eight state Attorneys General announced that they had negotiated a national settlement that imposed sweeping bans on the marketing of tobacco products and provided $206 billion to the states to settle their suits. All 46 states and territories subject to the settlement have received approval in their respective courts. Under the settlement, the tobacco companies are required to make the first payment to the states when 80 percent of the states, representing 80 percent of the total allocation, have received court approval and their appeal periods have expired.
In February 1999, in Patricia Henley v. Philip Morris, a San Francisco jury awarded $50 million in punitive damages to a former heavy smoker who lit her first cigarette at a high school dance and went on to develop inoperable lung cancer at age 51. The case is on appeal.
In March 1999, in Jesse Williams v. Philip Morris, an Oregon jury ordered Philip Morris to pay the heirs of a former three-pack-a-day smoker $81.5 million. Most of the award represented punitive damages and is the largest ever amount awarded in a tobacco case brought on behalf of an individual plaintiff.
In August 1999, Engle, et al. v. R.J. Reynolds Tobacco, et al. (Dade County, Florida, Eleventh Judicial Circuit) entered the damages phase of this three-phase trial. This is the first class action brought on behalf of smokers to go to trial. The plaintiffs are Florida residents alleging injury from smoking cigarettes; a damage award could range as high as $200 billion or more. In October, a Florida appeals court ruled that damages could be awarded in a lump sum, rather than on the basis of individual assessments. The ruling sent tobacco stocks plummeting to their lowest levels in years.
In September 1999, President Clinton announced that the Justice Department is bringing a lawsuit to recover the federal government’s costs of treating sick smokers. The government estimates that is spends $25 billion annually in health claims paid to veterans, military personnel, federal employees and elderly on Medicare who have contracted smoking-related illnesses.
In addition to the lawsuit brought by the U.S. government, the governments of Bolivia, Brazil, Guatemala, Nicaragua, Panama and Venezuela have filed lawsuits in U.S. courts patterned on suits filed by U.S. states. The Marshall Islands and British Columbia have filed similar actions in their home courts. Several individual smokers also have filed lawsuits overseas in Argentina, Brazil, Canada, Italy, Japan, Scotland and Turkey. Class action suits have been filed in Australia, Brazil, Canada and Nigeria. It is expected that other foreign governments and individuals will also sue, as state governments did following the Mississippi litigation discussed above.
More restrictions on print ads, including elimination of the use of figures, such as the Marlboro Man, whom anti-smoking groups perceive as glamorizing cigarettes.
Restrictions on the retail display of cigarette advertising.
Penalties against the tobacco industry if youth smoking does not drop.
Additional restrictions on tobacco-industry sponsorships of athletic events, which are limited but not entirely banned under the proposed settlement.
Stronger health warnings on cigarette packs.
Restrictions on the tobacco industry’s activities abroad.
Limiting the amount of tar and carbon monoxide to 10 milligrams per cigarette, and the amount of nicotine to 1 mg per cigarette.
Revising health-warning labels on cigarettes, with “Smoking Kills” warnings printed in clear and bigger typeface.
Requiring tobacco companies to provide national authorities with a list of ingredients and their quantities in the products they sell.
Protecting children and adolescents from exposure to and promotion of tobacco products and their promotion.
Promoting smoke-free environments, and preventing and treating tobacco dependence.
Improving knowledge and the exchange of information at the national and international levels.
Setting specific obligations to address advertising, packaging, labeling and prices.
As noted earlier, investment managers have considered the social impact of their investments in two contexts. First, to what extent does the controversy surrounding certain industries cause stocks of companies in those industries to be riskier, relative to their potential return, than other available investments? For example, to what extent can a fiduciary that is considering the prudence of investing in a tobacco-free fund take into account the trend of increasing regulation of tobacco products, and the possibility of future settlements or judgments that may impose financial burdens on the tobacco industry?
Second, to what extent can a fiduciary take into account social aspects of investing, other than the strictly financial aspects? This second question arises in two contexts. In some instances, a fiduciary believes that stocks in a particular industry represent an investment that is equal to that available from other available investments, but wishes to avoid investing in stocks in that industry, based on nonfinancial concerns. For example, a fiduciary might believe that a tobacco-free fund was equal in potential risks and returns to other unscreened funds, but chooses the tobacco-free fund over other funds because of its opposition to smoking. In other instances, a fiduciary believes that excluding stocks in a particular industry from its portfolio might increase risks relative to returns (by causing less diversification of the portfolio), decrease returns relative to risks (by excluding stocks that have historically been profitable), or increase transaction costs (by requiring the divestiture of existing tobacco stocks and the purchase of other investments), but wishes to exclude such stocks based on social concerns. For example, it might avoid investing in tobacco stocks even if it felt that such stocks were likely to outperform the market generally.
This letter discusses these questions presented above. In doing so, we are aware that the Investor Responsibility Research Center (“IRRC”) is primarily interested in the propriety of excluding tobacco stocks from a fund’s investments. However, historically some fiduciaries that have wanted to exclude tobacco stocks have wanted to use their portfolios for other social purposes as well. Thus, this report discusses the legal issues surrounding social investment generally, as well as the specifics of tobacco-free investments.
In reviewing this report, the first point to note is that different types of funds are subject to differing legal standards. Plans that are subject to the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), i.e., most plans other than governmental or church plans, are subject to a uniform federal standard. Governmental and church plans, and internal investments of tax-exempt organizations, are typically governed by state law. Different states phrase their standards in different ways, and the differences can be important.
A second point to remember is that the case law, either under ERISA or under state law, has not been particularly instructive when it comes to socially responsible investing. Thus, we have often had to examine cases and other authorities that deal with fiduciary standards generally. Court cases have typically dealt with situations involving reckless or grossly imprudent investment choices, rather than situations in which a fund might lose a few basis points of investment return due to consideration of social factors. Thus, the language of case law is often quite broad and sweeping. However, in actual practice, trustees have not to date been held liable for damages incurred due to consideration of social factors in instances in which the difference in return between a socially screened fund and other available funds is small.
Socially screened investments by pension funds and endowments, like any other investments they make, are subject to fiduciary standards. If the fiduciaries exercise both the substantive and the procedural component of their fiduciary duties (see paragraph 2, below), a court is likely to give deference to their investment decisions, even if those decisions later prove to have been less than optimal.
Fiduciary duties have both a substantive and a procedural component. It is important to be able to show both that the fiduciaries took adequate steps to analyze risks and returns (the procedural component), and that their ultimate decisions were in accordance with the results of the prudence investigation (the substantive component).
In determining the risk and return ratio of a socially screened investment option versus one that is not socially screened, fiduciaries should consider risk factors specific to the particular screened industry. For example, in determining the risk and return ratio of a tobacco-free fund, fiduciaries should take into account the risks presented by tobacco litigation and regulation.
Fiduciaries of pension plans must consider the consequences of their investments to future retirees as well as current retirees. For example, they should take into account societal shifts that may affect investments over the long term, even if not in the short term.
When considering divestment, fiduciaries must consider transaction and market impact costs as well as the theoretical value of investments. Thus, for example, situations may arise in which it would be prudent not to invest further in tobacco stocks, but in which it would not be prudent to divest all tobacco-related investments immediately.
The depth of the social investing screen will in many instances have an impact on the above factors. For example, any “tobacco-free” fund would presumably not invest in Philip Morris, the business of which is primarily tobacco-related. However, other companies such as Eastman Chemical and H.B. Fuller make such items as cigarette filters and adhesives, but are not involved in the production or sale of tobacco as such. Thus, some tobacco-free funds might invest in them, while others would consider them off-limits. Typically, the deeper the screen, the more likely it is to affect returns and/or diversification of the fund as a whole.
We have reviewed a companion report from BARRA Rogers Casey (see Chapter 3) concerning the financial impact of tobacco-free investments. Assuming a limited-depth tobacco screen, the report indicates that because tobacco companies represent a small percentage of companies available for investment, eliminating tobacco company stocks from an indexed portfolio typically has minimal effect on returns. Thus, the concerns are greatest in three situations: (a) for actively managed funds that are less diversified than indexed funds, (b) for funds that currently own tobacco stocks, and must incur transactional or market impact costs to dispose of them, or (c) for funds that screen for multiple social concerns in addition to tobacco. The more stocks that the screens exclude, the more effect the exclusions are likely to have on returns. However, even a de minimis reduction in expected investment returns relative to risks can pose problems, particularly for plans subject to ERISA.
If an investment option that is socially screened is at least as prudent, taking into account the balance between risk and likely investment return, as other investments a pension plan or nonprofit entity could make, avoiding certain investments based on nonfinancial factors is not a fiduciary violation. This is true regardless of whether the investor is a pension plan subject to ERISA, a pension plan not subject to ERISA, or another type of nonprofit entity.
Suppose that even after considering risks specific to the screened-out industry or industries, a socially screened fund appears likely to produce lower returns in relationship to its risks, or higher risks in relationship to its returns, than other investments available to a pension fund. If the difference is de minimis, as discussed below, at least one state court has held that the investment does not violate common law fiduciary standards applicable to non-ERISA pension plans or Constitutional standards applicable to governmental plans. (Unfortunately, even that case does not indicate how large a variance would be considered de minimis.) The Department of Labor has taken the opposite position under ERISA. And even under state law, the issue is much less clear than if the risks and returns were at least as great for the socially screened fund as for other investments.
Despite the comments in paragraph 9, above, a governmental pension fund that is not subject to state Constitutional provisions that affect investments can typically avoid fiduciary issues if an applicable statute specifically permits a fund to avoid the screened-out investments, regardless of what language appears in the trust. However, such language is rare; more typically, statutes make a preference for avoiding certain types of investments subsidiary to general fiduciary standards. If the trust instrument of such a fund provides for investment in such a manner, and no applicable state statute voids such trust provision, the trust instrument investment directives control. This contrasts with an ERISA plan, in which neither state statutory nor plan language can eliminate fiduciary issues.
Despite the comments in paragraph 9, above, a church pension fund can typically avoid fiduciary issues if the trust instrument provides for socially screened investments, and no applicable state statute voids such trust provision. Moreover, First Amendment issues could arise if a state statute attempted to void a church’s preference for socially screened investments. This contrasts with an ERISA plan, in which similar plan language cannot eliminate fiduciary issues.
Even if a pension fund’s fiduciaries cannot be certain to be free from liability in making a decision to invest in a socially screened fund, they can often by following certain standards permit plan participants to choose among a variety of funds, which include a number of funds that would be prudent without regard to social considerations, as well as socially screened funds, without incurring fiduciary liability.
For nonprofit entities, the permissibility of investing in a socially screened fund — even if the fund appears likely to produce lower returns, in relationship to its risks, than other available investments — depends on specific state law. In some cases, nonprofit corporations are subject to a “prudent investor” standard similar to ERISA; in others, they are subject to a lesser “business care” standard that would allow the consideration of social objectives equally with financial ones.
The major types of plans of taxable employers that might consider investment in socially screened funds are qualified plans, and nonqualified deferred compensation arrangements for management and highly compensated employees (“top hat plans”). ERISA governs any pension plan maintained by an employer or union that affects interstate commerce, other than (1) a governmental plan, (b) a church plan, (c) a plan maintained outside of the United States primarily for the benefit of nonresident aliens, or (d) an unfunded excess benefit plan. ERISA section 4. Thus, ERISA is the major source of federal law dealing with plans of taxable employers.
ERISA was enacted in response to a variety of weaknesses in the pension system. Some employers required unrealistically lengthy periods of participation, and penalized employees for even brief breaks in employment. Even those employees who qualified for pensions sometimes found that pension assets were insufficient to cover benefits. These problems were exacerbated by imprudent or even dishonest investment practices. These problems were highlighted by the collapse of the Studebaker Corp. in 1964. When the company declared bankruptcy, even fully vested, long service employees lost substantial pension benefits. Congress then began hearings that culminated 10 years later in the passage of ERISA, which contained a variety of initiatives to prevent similar occurrences in the future. These initiatives included funding standards, reporting and disclosure requirements, plan termination insurance, and minimum coverage requirements. They also included a variety of fiduciary rules. These fiduciary rules are typically of the greatest concern to pension funds that are considering investment in socially screened funds.
For qualified plans of ERISA-covered employers, the Internal Revenue Code of 1986 (“Code”) and ERISA represent the major statutory constraints on investments. Section 404 of ERISA (dealing with fiduciary standards) and sections 406 through 408 (dealing with prohibited transactions, self-dealing, and limitations of the percentage of plan assets that can be invested in certain kinds of investments) are the primary sections of ERISA relevant to socially screened investing. Similar restrictions are found in the exclusive benefit rule of Code section 401(a)(2) and the prohibited transaction rules of Code section 4975.
To the extent that a qualified plan permits participants to select the investments of their accounts, and that the investments from which they can make the selections include a variety of funds that would be prudent regardless of social considerations, ERISA section 404(c) would provide certain additional protections to fiduciaries if the plan’s investment selection procedures meet its standards. Conversely, for those qualified plans that cover collectively bargained employees (both single employer plans and multiemployer plans), the provisions of the Taft-Hartley Act and collective bargaining agreements could impose terms that constrain or permit socially screened investments. We discuss each of these issues below.
Because specific precedents concerning socially screened investment funds are sparse, the following sections of this report deal with not only socially screened investments in particular, but social investment, divestment, screening, and economically targeted investments (“ETIs”) in general. In addition, we have spoken informally with staff of the relevant legislative committees, and officials at each of the relevant federal agencies (the Internal Revenue Service and the Department of Labor), to ascertain the current views of the Hill and the agencies on the issues presented.
ERISA contains several provisions governing plan investments. ERISA sections 403(c)(1) and 404(a) (set forth in Appendix A) impose the general fiduciary prudence and diversification standards. Thus, the question presented is whether investing in socially screened funds would be considered a violation of the fiduciary standards of ERISA sections 403 and 404.
ERISA Reg. § 2550.404a-1 sets forth the applicable regulatory interpretation of the statutory standards. Under the standards set forth in that regulation, a fiduciary could clearly decide to invest in a socially screened fund if the fiduciary had complied with both its procedural and substantive fiduciary duties, and believed that the return of that fund, relative to the risk, was greater than that otherwise available. For example, if a fiduciary under such circumstances believed that tobacco-related litigation lowered the expected returns while increasing the risk of tobacco investments to the point that tobacco stocks were not as good an investment as other investments available to the fund, the fiduciary could decide to exclude tobacco stocks from the portfolio.
The question then becomes whether the “exclusive purpose” standard of ERISA section 404 means that a fiduciary cannot take into account any purposes other than financial returns, even in deciding between two investments with equal return/risk characteristics. The primary guidance on these points is ERISA Reg. § 2509.94-1, which is set forth in Appendix B. In essence, it permits the consideration of nonfinancial factors in selecting investments to the extent, and only to the extent, that the investments chosen involve a risk/return ratio at least as favorable as other available investments.
By its terms, ERISA Reg. § 2509.94-1 deals only with (and guidance is therefore limited to) ETIs. However, the Department of Labor has applied similar reasoning to social investments, such as investment in socially screened funds.
Thus, ERISA as currently interpreted by the Department of Labor would permit ERISA-covered fiduciaries to consider the social consequences of alternative investments, to the extent that such fiduciaries, after taking the proper steps to assure compliance with both the procedural and substantive components of their fiduciary duties, decided that the socially screened investment was equal to or better than available alternative investments on an economic basis. However, it would not permit fiduciaries to choose a socially screened investment that was not at least equal to available other investments.
H.R. 1594, supra, did not pass the Senate, and has not been reintroduced in the current Congress. However, social investing has again become a hot topic on the Hill due to the discussion in the current Congress of modifying Social Security. In a March 3, 1999 hearing of the House Ways & Means Committee Subcommittee on Social Security, the experience of public plans with social investing and ETIs was often cited negatively, as an argument against permitting the Social Security trust fund to invest in the stock market.
For example, the Honorable Maureen M. Baronian discussed her experience as a former trustee of the Investment Advisory Council for the State of Connecticut. She cited the Connecticut plans’ experience in investing in the Firearms Division of Colt Industries, to shore up a local employer, and then having the firm file for bankruptcy. Peter J. Sepp, Vice President for Communications of the National Taxpayers Union, cited the Kansas Public Employee Retirement Systems’ investment losses under its ETI program, and the Pennsylvania systems’ investment in a Volkswagen plant.
Other witnesses argued that, even in the absence of lowered investment returns, governmental entities should not be “meddling” in the affairs of private corporations. (By analogy, this argument could apply to state and local governmental retirement systems.) For example, Fred T. Goldberg, Jr., a former Commissioner of Internal Revenue, stated that, “All human experience shows that government is certain to misuse its ownership of private capital.” Michael Tanner of the Cato Institute cited efforts by the California Public Employees’ Retirement System (CalPERS) and New York systems in influencing the election of the board of directors of General Motors as evidence of such meddling.
Perhaps even more telling about the prevailing view of ETIs and social investing, even proponents of having Social Security assets invested in the stock market often did not respond to the negative comments made about the experience of state retirement systems with respect to ETIs and social investing. For example, Deputy Treasury Secretary Lawrence H. Summers defended the Administration’s proposal to have some Social Security funds invested in the stock market, not by defending the record of state systems, but by arguing that the Social Security proposal involves safeguards against the kind of activity engaged in by the states.
Robert Reischauer of the Brookings Institution testified at that same hearing that experience suggests that, “concerns about political influence are exaggerated and that institutional safeguards can be constructed that would reduce the risk of interference to a de minimis level.” The Century Foundation submitted written testimony that noted that, “CalPERS’s energy is usually focused on maximizing shareholder value rather than imposing politically based demands on companies.” The implication of both of these statements was that imposing politically based demands would be unacceptable, and that safeguards needed to be constructed to reduce the risk of such conduct.
Ironically, the one specific analysis presented at the hearing on the effect of social investing on plans’ investment returns suggested that it was small or even nonexistent. Deputy Treasury Secretary Lawrence H. Summers noted that over the period 1990-1995, public plans actually received returns that slightly exceeded those of private plans (although the differences were not statistically significant). Over the period 1968-1993, the performance of public plans was slightly inferior to that of private pension funds, but again the difference was not significant.
Economically targeted investments account for no more than 2.5 percent of total state and local holdings.
Whereas early forays into ETIs resulted in some loss of returns, more recent examples show competitive returns.
In only three states have public plans seriously engaged in shareholder activism.
The only significant divestiture to date has been related to South Africa.
In view of the above, if the likely returns, relative to risk, of a socially screened fund are less than those of otherwise available investments, fiduciaries interested in investing in a socially screened fund may wish to consider ways of insulating themselves from liability. The most practical approach is typically through ERISA section 404(c), which insulates the fiduciaries from liability for certain participant-directed investments, if they follow its standards. We discuss ERISA section 404(c) in the following section of this report.
The section 404(c) regulations would not provide full protection to a fiduciary that allowed investment only in socially screened funds that had lower returns, relative to risks, than other available investments. The preamble to these regulations emphasized that the act of designating investment alternatives in an ERISA section 404(c) plan is a fiduciary function to which the limitation on liability provided by section 404(c) is not applicable. ERISA Advisory Opinion 98-04A made clear that in designating investment alternatives, non-economic factors could be considered only if the investment alternatives chosen, when judged solely based on economic value, would be equal to or superior to alternative available investments.
Nevertheless, section 404(c) provides protection for fiduciaries who follow it to the extent that participants’ own choices, rather than the fiduciaries’ conduct, result in the losses. Thus, for example, a fiduciary that offered only socially screened investments, each of which offered economic benefits lower than those of comparable non-socially screened investments, would not be protected by section 404(c). However, provided the provisions of the regulations were followed, they arguably would protect a fiduciary that offered the same portfolio of investments, plus a broad range of other investments (socially screened or otherwise) which offered economic benefits equal or superior to those of alternative available investments. Such a fiduciary would presumably not be liable for an economic detriment that occurred because of a particular participant’s choice of the socially screened funds.
Code section 503(b) imposes prohibited transaction rules on governmental and church qualified plans. However, like the prohibited transaction rules of Code section 4975 applicable to other qualified plans, the Code section 503(b) rules apply only if a pension plan is involved in a transaction with a related party, and thus would not typically be an issue with respect to socially screened investments.
In Withers v. Teacher’s Retirement System, 447 F. Supp. 1248 (S.D.N.Y. 1978), aff’d. memo 595 F.2d 1210 (2d Cir. 1979), beneficiaries of the New York City Teacher’s Retirement System argued that the trustees of the System had acted imprudently in deciding to purchase highly speculative New York City bonds to avert the City’s threatened bankruptcy. However, the court declined to treat averting the City’s bankruptcy as a nonfinancial social purpose, reasoning that the solvency of the System depended on the City’s ability to make continuing contributions to it, which would be jeopardized if the City became bankrupt.
At least one case has, however, explicitly dealt with whether trustees who exercised overall prudence in the selection of investments could take into account social objectives, even if doing so reduced the benefits of plan participants. Board of Trustees v. City of Baltimore, 317 Md. 72, 562 A.2d 720 (1989), cert. denied sub nom. Lubman v. Mayor et al., 110 S. Ct. 1167, 107 L.Ed.2d 1069 (1990). In that case, various Baltimore City pension systems provided both fixed and variable benefits. The trustees of the systems argued that an ordinance that called for divestiture of stock in companies that did business in South Africa impaired the city’s contractual obligations to the systems’ participants, in violation of the Contract Clause of the U.S. Constitution. (Art. I, § 10.) They argued that to the extent the systems provided variable benefits, divestiture would reduce the participant’s ultimate benefits, and that to the extent the systems provided fixed defined benefits, divestiture disturbed the participants’ expectations that benefits would be well secured.
Thus, while little authority exists at the state level on social investing, we believe that in the absence of a statute, at least the majority of courts would not hold social investment goals to be per se forbidden. However, courts may well vary as to whether they would simply require that fiduciaries not pursue them to the extent that they would have more than a de minimis negative effect on investment returns, or whether they would require that the socially screened funds be equal to or better than available nonscreened funds, after considering transaction and market impact costs.
Moreover, at common law a trustee is generally entitled to rely on the terms of a trust document specifying the types of investments in which the trust may invest or is forbidden from investing. Restatement of Trusts § 227, comments q and r. The only exceptions are if the trust terms are impossible or illegal, or if owing to circumstances unknown to the settlor of the trust and not anticipated by him, compliance would defeat or substantially impair the accomplishment of the purposes of the trust. Thus, to the extent that a trust under a church pension plan specifically provides for investment in socially screened funds, the trustee would normally be entitled to rely on such provision as a matter of the state common law of trusts.
Restatement of Trusts 3d § 216. These rules are quite similar to the rules set forth in the regulations under ERISA section 404(c), and we believe that they should be interpreted in a similar manner. Thus, for example, the fiduciaries would want to make sure that plan participants and beneficiaries were aware of any historical information that might suggest that a socially screened investment would likely produce a lower rate of return than a non-screened alternative.
Church retirement plans facing a legal challenge to their decision to invest in socially screened investments have a defense they can offer that is not available to other types of retirement plans namely, that their decision to select plan investments based on their respective religious beliefs is a decision protected by the First Amendment of the U.S. Constitution (or by a similar provision contained in a state constitution).
This issue (First Amendment protection for a church retirement plan’s socially screened investment decisions) has not been directly addressed by a court. However, in one case, the Minnesota Court of Appeals (that state’s highest level appellate court) determined that, under the First Amendment and a broader “Freedom of Conscience” Clause contained in the State of Minnesota’s Constitution, Minnesota courts should not entangle themselves in reviewing issues of church doctrine and organization. Basich v. Board of Pensions, Evangelical Lutheran Church in America, 540 N.W. 2d 82 (1995). In this case, Rev. Basich and other plaintiffs complained of his denomination’s determination that, in the absence of a participant’s direction to the contrary, the participant’s retirement plan accounts would be invested in a fund that had been divested of companies doing business in South Africa, under the denomination’s South Africa divestment policy.
Because no case law has interpreted this legislative history, practitioners generally assume that the exclusive benefit rule under Code section 403(b)(9) is identical to that which applies to qualified plans under Code section 401(a)(2), discussed above. And as discussed above, at least one private letter ruling has held that a socially screened default investment option will not impair the 403(b)(9) status of a church retirement fund.
For those churches that use 403(b)(7) custodial accounts, or variable annuities under Code section 403(b) in which the segregated asset account is invested in a mutual fund, the Code does not provide a specific exclusive benefit rule. Code section 403(b)(1)(C) does provide that benefits under a 403(b) plan must be “nonforfeitable.” However, it seems highly unlikely that a court would determine that social screening of investments would be considered a forfeiture for purposes of section 403(b).
The Constitutional provisions, and the interpretation of those provisions, will obviously vary from state to state. Moreover, it is unclear how broadly the Sgaglione case should be interpreted. That case dealt with a situation in which the Systems were being required to purchase highly risky New York City bonds, at a time when New York City was staving off bankruptcy. The case of Board of Trustees v. City of Baltimore, supra, analyzed a similar provision under the Maryland Constitution. The court there found that the Maryland Constitutional provision in question would not preclude a de minimis reduction in benefits and/or benefit security to foster the social purposes involved in divestment of stock in companies that did business in South Africa.
Thus, trustees of governmental plans should bear the Constitutional issues in mind in determining the permissibility of applying social screens to the investments of a particular government plan. However, to the extent that application of such screens would have no more than a de minimis effect on returns (after taking into account transaction and market impact costs), the Board of Trustees v. City of Baltimore case, supra, provides an argument that such a purchase would not be prohibited by state or federal Constitutional provisions dealing with impairment of contracts.
Most state statutes would not bar the application of social screens to a plan’s investments as such, except to the extent that the application of such a screen, or combination of screens, might in a particular instance be “imprudent.” However, they might in some instances have an indirect effect on a governmental plan’s ability to invest in a socially screened fund. For example, a legal list statute that prohibited investment in stocks would clearly prevent a governmental plan from investing in a socially screened stock-based fund.
Some commentators have suggested that because UMPERSA calls for the repeal of all state laws that deal with social investing, it impliedly prohibits such investing. However, Steven L. Willborn, the Reporter for the Uniform Law Commission on UMPERSA, explicitly rejected such an interpretation. Rather, he states that the Commission intended the repeal of state laws governing social investing only to result in the replacement of a patchwork of state standards with one uniform standard, with that standard being identical to the ERISA standard.
Moreover, the ERISA and common law financial penalties for imprudence apply only to the extent that trust beneficiaries suffer harm as a result of imprudent investments. Thus, for example, if a socially screened fund performed equally with or better than other investments available to the trust, the fiduciaries could not be held financially liable for investing in it, even if their actions at the time they invested might be seen as imprudent. They could, however, be subject to nonfinancial penalties, such as being required to divest themselves of the socially screened funds, being removed as trustees, or being prohibited from serving as trustees of other funds, or other equitable remedies.
Under either ERISA or common law, a trustee who improperly invests trust assets can be held liable for the amount of trust funds expended in the purchase plus or minus the amount of a reasonably appropriate positive or negative total return thereon. ERISA section 409; Restatement of Trusts 3d § 210. Thus, for example, if a court held that trustees had improperly invested trust assets in socially screened funds, and those funds did poorly, the trustees could be held liable for the price they originally paid for the socially screened funds, plus the amount the trust could reasonably have been expected to earn on the amount of such purchase price, minus the actual value of the socially screened funds on the date of the decree.
In actual practice, trustees have not to date been held liable for damages incurred due to consideration of social factors in making investments.
Socially screened investments by pension funds and endowments, like other investments they make, are subject to fiduciary standards. All judgments about the prudence of fiduciary actions are to be made from the perspective of the time the fiduciaries made the decisions, not in hindsight. The relevant courts and agencies have long recognized that estimating risks and returns is imperfect. Provided that the fiduciaries exercise both the substantive and the procedural component of their fiduciary duties (see paragraph 3, below), a court is likely to give deference to their investment decisions, even if those decisions later prove to have been less than optimal.
Fiduciary duties have both a substantive and a procedural component. On the substantive side, a fiduciary needs to maintain a written investment policy statement on investments, and have investment decisions made by a “prudent expert.” The plan should have a due diligence procedure for selecting the “prudent expert.” The due diligence process for searching for an appropriate money manager to execute the socially responsible investment initiative should be the same as the process for selecting any other money manager. A fiduciary who invests in a socially screened investment without making adequate investigation into its risk and return characteristics thereby violates his or her procedural fiduciary duties.
In determining the risk and return ratio of an investment option that excludes tobacco stocks versus one that includes such stocks, it is appropriate to consider risk factors specific to the tobacco industry (such as the prospect of legislation or litigation that might affect the value of stock in tobacco companies), regardless of whether the plan is subject to ERISA.
If a tobacco-free investment option is at least as prudent, taking into account risk, likely investment return, and transaction and market impact costs, as other investments a pension plan or nonprofit entity could make, merely choosing it from among other prudent investments based on nonfinancial factors is not likely to be a fiduciary violation. This is true regardless of whether the investor is a pension plan subject to ERISA, a pension plan not subject to ERISA, or another type of nonprofit entity.
If, even after considering risks specific to the tobacco industry, an investment option that excludes tobacco company stock appears likely to produce lower returns (after considering transaction and market impact costs), in relationship to its risks, than other investments available to a pension fund, but the difference is de minimis, at least one authority would suggest that the investment does not violate common law fiduciary standards applicable to non-ERISA pension plans. However, it is unclear how much of a difference in return would be considered de minimis under this standard. Moreover, the issue is much less clear, even under state law, than if the risks and returns were at least as great for the socially screened fund as for other investments. And the Department of Labor takes the position that the consideration of social factors cannot result in any diminution of return, even a de minimis one, in the case of an ERISA-covered plan.
Despite the comments in paragraph 7, above, a church pension fund can typically avoid fiduciary issues if the trust instrument provides for socially screened investments, and no applicable state statute voids such trust provision. Moreover, First Amendment issues could arise if a state statute attempted to void a church’s preference for socially screened investments. This contrasts with an ERISA plan, in which similar plan language cannot eliminate fiduciary issues.
Even if a pension fund’s fiduciaries cannot be certain to be free from liability in making a decision to invest in a tobacco-free fund, they can permit plan participants to choose to invest in such a fund, if the plan also offers participants the right to choose from a variety of funds, including a selection of funds that would be prudent without regard to social factors. If the standards of ERISA section 404(c) or comparable provisions of state law are followed, the fiduciaries will not be liable under such circumstances for losses that arise from the participant’s own choice of investments.
For nonprofit entities or for rabbi trusts maintained by nonprofit entities, the permissibility of not investing in tobacco company stock, even if such decision means that the fund appears likely to produce lower returns, in relationship to its risks, than other available investments depends on specific state law. In some cases, nonprofit corporations are subject to a “prudent investor” standard similar to ERISA; in others, they are subject to a lesser “business care” standard that would allow the consideration of social objectives equally with financial ones.
For any pension fund or nonprofit organization which screens for social factors other than tobacco, the impact of all such exclusions must be considered in applying the above standards.
3. ERISA sections 406 through 408 impose certain prohibited transaction rules on plans. However, these sections would not be an issue unless investing in the socially screened funds occurred through dealings with a “party-in-interest” (e.g., the employer which sponsored the plan, or a union which represented employees covered by the plan).
ERISA sections 406 through 408 impose certain prohibited transaction rules on plans. However, these sections would not be an issue unless investing in the socially screened funds occurred through dealings with a “party-in-interest” (e.g., the employer which sponsored the plan, or a union which represented employees covered by the plan).

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