Langbein Social Investing Laws and Trusts

SOCIAL INVESTING AND THE
LAW OF TRUSTS
John H. Langbein * andRichard-l.
Posner**
In October 1979 the United Auto Workers negotiated a three-

year labor contract with the Chrysler Corporation containing a pro-
vision that up to ten percent of new pension contributions would be
invested in "socially desirable projects." The agreement defines
these investments to include residential mortgages in areas where
UAW members live, as well as investments in nursing homes, nurs-
ery schools, health maintenance organizations, and "other socially
desirable projects."' The union also obtained the right "to recom-
mend that pension trustees not invest in up to five companies that
conduct business in South Africa."'2 In Wisconsin and elsewhere
there has been growing pressure to restrict large portions of the pen-
sion funds- of state employees to investments inenterprises and mort-
3
gages in the state.
These developments illustrate the increasing pressure on pension
plan sponsors and fiduciaries to engage in what is called "social in-
vesting."'4 For the last year or two there has been hardly a month in
which the industry journal, Pensions and Investments, has failed to
carry some story about the demand on the part of a labor union or
other group for social investing. As the Chrysler agreement indi-
cates, these efforts have begun to get results. Similar pressures have
been directed for an even longer time at the trustees of university
endowment funds; some universities have yielded to those pressures
* Max Pam Professor of American and Foreign Law, University of Chicago. A.B. 1964,
Columbia University; LL.B. 1968, Harvard University; LL.B. 1969, Ph.D. 1971, Cambridge
University. - Ed.
** Lee and Brena Freeman Professor of Law, University of Chicago. B.A. 1959, Yale
University; LL.B. 1962, Harvard University. - Ed.
The helpful comments of Fischer Black, Walter Blum, Kenneth Dam, Frank Easterbrook,
James Lorie, Bernard Meltzer, Myron Scholes, and Rex Sinquefield on an earlier draft are
gratefully acknowledged, as is the valuable research assistance of Judith Rose and Joseph
Rugg.
1. 263 PENSION REP. (BNA) A-28 (Oct. 29, 1979).
2. Id
3. See D. SMART el. al, INVESTMENT TARGETING: A WISCONSIN CASE STUDY 121-257
(Wisc. Center for Pub. Policy 1979).
4. For a good introduction to the debate over social investing, see EMPLOYEE BENEFIT
RESEARCH INSTITUTE, SHOULD PENSION ASSETS BE MANAGED FOR SOCIAL/POLITICAL PUR-
POSES? (D. Salisbury ed. 1980).
HeinOnline -- 79 Mich. L. Rev. 72 1980-1981

November 1980] Social Investing
and have begun to utilize noneconomic criteria in the design of their

portfolios, particularly with regard to the securities of companies do-
ing business in South Africa.
In view of the growing practical importance of social investing, a
careful examination of its economic effects and of its legality seems
overdue, and we try to provide that examination in this Article. But
we have first to define the term "social investing." We define it to
mean excluding the securities of certain otherwise attractive compa-
nies from an investor's portfolio because the companies are judged
to be socially irresponsible, and including the securities of certain
otherwise unattractive companies because they are judged to be be-
having in a socially laudable way. By "attractive" and "unattrac-
tive" we refer to the conventional objective of investment, which is
to make money (in a slightly complex sense, explained in the next
part of the Article) for the investment beneficiary. Not every practi-
tioner of social investing would agree that there is a trade-off be-
tween social and more narrowly financial interests. Some would say
that social investing is enlightened profit maximization. We evaluate
this contention later. We also consider later another economic, as
distinct from "social" (in a noneconomic sense), argument for social
investing: that it confers a nonfinancial sort of utility on the investor
by catering to his moral or political preferences. These qualifications
are important. But, provisionally, the reader will not go far wrong if
he understands social investing to be pursuit of an investment strat-
egy that tempers the conventional objective of maximizing the inves-
tor's financial interests by seeking to promote nonfinancial social
goals as well.
Our definition of social investing is narrow in one sense: we ex-
clude the voting of shares, as distinct from the selection of which
stocks to hold (or not hold) in the investor's portfolio, in accordance
with social objectives. Social share voting has been proposed, 5 and
it, or its threat, has apparently achieved some modest sub rosa suc-
6
cesses in deflecting management from profit-maximizing policies.
We exclude it from our definition of social investing not because it is
unimportant or uninteresting, but simply because it raises somewhat
different lega 7 and economic8 issues.
5. The most recent proposal is in Curzan & Pelesh, Revitalizing Corporate Democracy:
Controlof Investment Managers' Voting on Social Responsibility Proxy Issues, 93 HARv. L.
REv. 670 (1980).
6. See D. VOGEL, LOBBYING THE CORProATON 203-08 (1978).
7. The legal issues involve primarily the SEC's regulation of proxy voting.
8. Social share voting, to the extent successful in deflecting corporations from profit-max-
imization, is more costly to the investment beneficiary than social portfolio design because it

Michigan Law Review [Vol. 79:72
We also pass over the broader question - of which social invest-

ing in both its portfolio-selection and its share-voting form might be
thought but an aspect - of the social responsibility of corporations. 9
The objective of those who advocate social investing is to make cor-
porations behave in a socially responsible way by denying them cap-
ital if they do not. Therefore, if the debate over the social
responsibility of the corporation is resolved in the negative, the so-
cial-investing issue is resolved as well. But as we shall see, social
investing could be a bad idea, and a violation of trust law (and of the
statutory counterparts to the common law of trusts, such as ERISA
and the statutes governing investment by insurance companies), even
if one thought it proper for corporations sometimes to subordinate
profit maximization to other goals. The distinction justifies separate
consideration of the social-investing issue. But we emphasize that
the reader who has already decided that corporations should not be
"socially responsible" need read no further.
Social investing could in principle be attempted by any investor,
not just a trustee or other fiduciary. But the decision of an individ-
ual to include social goals among his investment objectives is not
interesting from a policy standpoint and is not our focus in this pa-
per. There are several small mutual funds which proclaim adher-
ence to various social principles in selecting their investments.10 If
an individual decides to invest in such a fund, presumably he has
balanced the possible financial costs of such a policy against the util-
implies a capital loss, rather than a mere reshuffling of the investor's portfolio. There is also an
inconsistency between social portfolio design and social share voting: the former implies that
the investor should not buy into certain companies; the latter that he should buy into the same
companies. The social share voter could accuse the social portfolio designer of selling his
shares to just those who will not vote their shares in a socially responsible manner.
9. For a variety of perspectives on corporate social responsibility, see ECONOMICS OF COR-
PORATION LAW AND SECUaIS REGULATION ch. 13 (R. Posner & K. Scott eds. 1980);
Baumol, Business Responsibility and Economic Behavior, in ALTRUISM, MORALITY, AND ECO-
NOMIC THEORY 45 (E. Phelps ed. 1975); Chirelstein, CorporateLaw Reform, in SOCIAL RE-
SPONSIBILITY AND THE BUSINESS PREDICAMENT 41 (J. McKie ed. 1974); Conard, Reflections on
Public Interest Directors,75 MICH. L. REv. 941 (1977); Demsetz, Social Responsibility in the
EnterpriseEconomy, 10 Sw. L. REv. 1 (1978); Engel,An Approach to CorporateSocialespon.
sibility, 32 STAN. L. REv. 1 (1979). Cf. Arrow, SocialResponsibilityandEconomic Efficiency, 21
PUB. POLICY 303 (1973).
10. These are Foursquare, Dreyfus Third Century, and Pax World. Foursquare just
avoids liquor, tobacco, and drug company stocks. According to its prospectus, Third Century
limits itself (rather vaguely) to companies "contributing to the enhancement of the quality of
life." Pax World excludes any company more than five percent of whose sales are to the
Defense Department. See Pacey, Investment Do-Gooders. 4 Look at a Dogged Trio of Socially
Conscious Mutual Funds, Barron's, July 21, 1980, at 9. Curiously, none of the three seems
particularly interested in screening out companies that do business in South Africa, although
that is the main objective of the social-investment advocates who complain about university
endowment portfolios. See generally Stern, S. Africa Issue Stalls in PensionArea, Pension &
Investments, Sept. 24, 1979, at 19, coL 1.

ity - a form of personal consumption - that he derives from ex-

pressing support for the social aims implied by the fund's investment
policy. Few individuals have found the trade-off an attractive one,
but we can think of no reason for prohibiting, or even discouraging,
people from offering or purchasing such financial products.
A legal issue arises only when the investor or investment benefi-
ciary has not consented to a decision by the investment manager to
subordinate the investor's financial welfare to other objectives. In
principle this could be a problem of individual trusts, as well as
group trusts such as pension funds and charitable (e.g., university)
endowment funds. But there has been little pressure on trustees of
individual trusts to adopt social investing, so again this is not a focus
of our analysis. The main purpose of the typical individual trust is
to generate income for the immediate support of the current benefici-
ary (as opposed to the remaindermen, if any), who would be strongly
inclined to protest if the trustee adopted an inconsistent goal. Also,
many trust instruments authorize the beneficiary or the settlor to
change trustees; such a provision tends to concentrate a trustee's
mind wonderfully on profit maximization. In a pension fund, in
contrast, most of the beneficiaries are not currently receiving income,
so any adverse impact of social investing on the value of the trust
assets will be felt in the future." Also, pension plan sponsors, such
as labor unions, or corporations that bargain with labor unions
about pension matters, are more exposed to the interest-group pres-
sures that underlie, or at least influence the direction of, social in-
vesting.
For simplicity, we discuss the social-investing issue as if it arose
in only four group-trust settings: a defined-contribution pension
fund, such as that operated by the college teachers' pension fund; a
corporate defined-benefit plan; a union-sponsored plan; and (in Part
III of this article) a university endowment fund. 12 This classification
is not exhaustive, but it allows us to discuss the principal legal and
11. Employees who have retired and are receiving pension benefits may or may not be
affected by social investing. They will not be affected if on retirement they received a lump-
sum payment from the fund or were otherwise able to "cash out" or "roll out" of the fund.
Even if they are affected, they are unlikely to receive as much attention from the pension fund
as current employees; retired employees are no longer making contributions and hence cannot
take their money elsewhere or persuade their employer to switch to another pension fund.
12. In a defined-benefit plan, the benefits to be received by the employee on retirement are
specified in advance. The employer is responsible for paying these benefits, and the purpose of
the pension trust fund is to assure that the employer has the assets to pay them in full even if
the income from his business is insufficient. In a defined-contribution plan, the employee on
retirement receives an amount determined by his and his employer's contributions plus accu-
mulated income and appreciation on these contributions; he is not entitled to an amount speci-
fied in advance.

policy issues presented by social investing. The defined-contribution

fund presents the trade-offs between profit maximization and social
investing in the simplest setting. The defined-benefit plan adds the
wrinkle that most of the financial burden of social investing falls on
the corporation rather than the employees. This apparent realloca-
tion of financial burdens turns out to be more formal than real, but it
does make a difference so far as the underdiversification caused by
social investing is concerned. The union fund adds a different wrin-
kle: social investing (e.g., to preserve jobs) here may provide a pecu-
niary offset to the financial cost of departing from conventional
investment strategy. The university endowment fund illustrates the
social-investing issue in a context where the protection of retirement
income is not at stake.
In Part I, after presenting a brief primer on the economics of se-
curities markets, we analyze the economic and policy issues
presented by social investing. We conclude that the usual forms of
social investing involve a combination of reduced diversification and
higher administrative costs not offset by net consumption gains to
the investment beneficiaries. Social investing may therefore be eco-
nomically unsound even though there is no reason to expect a port-
folio constructed in accordance with the usual principles of social
investment to yield' 3 a below-average rate of return - provided that
administrative costs are ignored.
Part II relates our policy analysis to the law of trust investing.
We conclude that the duty of loyalty, the prudent-man rule, and cog-
nate doctrines, which govern both pension funds and trust invest-
ment generally, forbid social investing in its current form. But if the
pension-fund beneficiary is allowed to opt out of any fund that prac-
tices social investment and into one that pursues investor financial
welfare single-mindedly, social investing may be a reasonable and,
under the ratification doctrine, legally permissible investment strat-
egy for pension funds and related types of trusts. Part III extends
our analysis to the university endowment fund, where the rights of
individual beneficiaries do not hamper fiduciary investment deci-
sions, but where a variety of other legal and practical hazards con-
front trustees who permit non-economic considerations to affect
portfolio construction.
13. We define "yield" throughout this Article to include appreciation as well as dividends
and interest.

I. THE ECONOMICS OF SOCIAL INVESTING
We begin this part of the Article with a brief introduction to the

economics of investing, meant for readers who are not familiar with
modem portfolio theory. After deriving the optimal strategy for the
investment manager to follow if his only concern is the financial
well-being of the investment beneficiary or beneficiaries, we then
consider how his strategy will be different - and with what conse-
quences for the beneficiaries - if he decides to include in his invest-
ment strategy social goals distinct from the financial well-being of
the beneficiaries.
A. An Introduction to the Economics of Investing

14
An investment decision involves two analytically distinct steps.
The first is evaluating specific assets, such as the stocks of particular
companies, that might be included in the investment portfolio. The
other is combining specific assets to form the portfolio, which is the
package of assets that is being managed for a particular beneficiary
or beneficiaries.
Portfolio selection or design is critical because, from the stand-
point of the beneficiary, who is the true owner of the investment,
what counts is the performance of the portfolio rather than the per-
formance of the individual components of the portfolio. If the port-
folio as a whole rises or declines in value, the fact that the rise or
decline is the summation of changes (possibly in opposite directions)
in the value of the specific assets comprising the portfolio is of no
moment. The portfolio is the relevant security.
The term "security" should be understood widely here, as includ-
ing any asset that one might care to own. While the commonest se-
curities are financial instruments such as stocks and bonds,
nonfinancial assets such as real estate, a stamp collection, or a race
horse could be part of an investor's portfolio. Because securities in
the financial sense are the commonest investment assets, we shall use
that term rather than the broader term "assets;" but our analysis ap-
plies regardless of the nature of the asset contained in the portfolio.
A security, including the composite security that we call a portfo-
lio, has two dimensions: its expected return and its risk. The ex-
pected return of a security (or other asset) is straightforward: it is the
14. This section of the Article draws heavily on Langbein & Posner, Market Funds and
Trust-Investment Law, 1976 AM. BAR FOUNDATION RESEARCH J. I [hereinafter cited as
Langbein & Posner]. For a fuller introduction to the modem theory of finance, see selections
in ECONOMICS OF CORPORATION LAW AND SECURTIES REGULATION, supra note 9.

Michigan Law Review [Vol, 79:72
sum of the possible benefits (including dividends, interest, apprecia-

tion, and, in the case of a nonfinancial asset, consumption benefits)
to the security holder, multiplied by the probability that the benefits
will actually materialize. So, setting to one side everything except
appreciation in order to simplify the analysis, assume that a stock
worth $10 today is expected to be worth either $12 or $14 a year
from now - that is, either $2 or $4 more - and there is a 50 precent
probability of each outcome. Then the expected return of the secur-
ity is $3 (.5 X $2 + .5 x $4).
Notice that the expected return would be the same if, instead of a
50 percent probability that the stock would be worth $12 and a 50
percent probability that it would be worth $14, there was a 100 per-
cent probability that it would be worth $13, or a 99 percent
probability that it would be worth nothing and a 1 percent
probability that it would be worth $1300. In each case, the expected
return is $3. Therefore, if investors cared only about expected re-
turn, they would be indifferent to the different distributions of possi-
ble returns in the above examples. But suppose investors are risk
averse - they do not like to gamble. Then the stock in the second
example, which yields a certain return of $3, is preferable to the first
stock, which yields a range of returns from $12 to $14, and still more
preferable to the third stock, which yields a range of returns from $0
to $1300. Economic theory implies and empirical study has con-
firmed that investors are generally risk averse, especially where sub-
stantial investments are involved. If we are dealing with a trust from
which the beneficiaries derive a significant part of their present or
future income, we can safely assume that they are risk averse.
Risk aversion implies, as we have said, a preference as between
two or more securities having the same expected return for the one
that yields this return with the least variance of possible returns
about the mean or expected return. It follows that the risk averse
investor will be willing to pay more for a less risky than for a more
risky stock, even though the expected returns are the same. Stated
otherwise, he will not pay as much for a riskier stock as he would for
a less risky one having the same expected return. Suppose the ex-
pected per-share earnings of a company over some period, including
appreciation, are $1; there is no risk that the company will earn more
or less than this figure; and the stock market capitalizes these earn-
ings at a price-earnings ratio of ten, so that the price of the stock is
$10. It follows that if there is another stock which is expected to
yield $1 a share over the same period, but the stock may yield more
or less than this amount, the -market will capitalize the stock at a

price-earnings ratio of less than ten. Once this happens, the investor
will earn a higher expected return from the riskier stock. Suppose
the price-earnings multiple of the less risky stock is eight. Then the
stock will be priced at $8, and its expected earnings will be 12.5 per-
cent of its value. The riskless stock will be priced, we said, at $10; it
yields only 10 percent. The higher the risk, in short, the higher the
expected return.
But this conclusion must be qualified in one important aspect,
which requires us to distinguish between two types of risk - that
which is diversifiable and that which is nondiversifiable (or system-
atic, as it is sometimes called). Diversifiable risk is that risk which
can be eliminated by adding more securities to or changing the mix
of securities in the portfolio; and it is the opportunity for diversifica-
tion that makes portfolio design so critical a factor in investment
strategy. The clearest example of diversification is where two stocks'
earnings are perfectly negatively correlated. Suppose two firms have
the pattern of returns assumed in our first example, i.e., a fifty per-
cent chance of their share values rising from $10 to $12 and a 50
percent chance of their share values rising from $10 to $14, but sup-
pose further that if one firm's better outcome occurs the other's
worse outcome will occur; that is, if the first firm's share value rises
to $14, the second firm's will rise only to $12, and vice versa. (Per-
haps the first firm sells dental drills, and the second sells fluoride.)
Then a portfolio consisting of an equal amount of each stock will
yield a return of $3 with certainty; there will be no risk. Assuming
that it is no more costly to hold a portfolio consisting of both stocks
than a portfolio consisting of only one of the two, neither stock will
command any higher expected return in the market place than a
stock which yields a certain return. In other words, diversifiable risk,
the kind of risk involved in the stylized example just discussed, is not
compensated risk; it does not command any higher return than a less
risky stock yielding (before adjustment for risk differences) the same
expected return. The reason is that no one will offer to sell a risky
stock at a lower price than a riskless security if he can eliminate the
risk, at no cost, simply by a change in portfolio design.
The returns to few if any stocks are negatively correlated, let
alone perfectly negatively correlated. But neither are they perfectly
positively correlated, and as a result portfolio risk can be reduced by
diversification. By holding a portfolio that is diversified by region
and industry, for example, the investor is buffered against certain
sources of risk. To the extent that something which hurts one region
or industry benefits another, the investor whose portfolio includes

companies in both regions or industries will incur a smaller loss than

if he were not diversified in this way. Conversely, the unexpected
good fortune of one industry or one region will have a smaller posi-
tive effect on the value of the portfolio if the portfolio is diversified
than if it is not, because in the former case the good fortune affecting
one industry or region will tend to be offset elsewhere in the portfo-
lio.
But not all risk can be diversified away, no matter how broad the
portfolio. This is because the fortunes of firms tend to be positively
correlated - they react in the same direction (though not to the
same extent) to economy-wide events, such as decreases in aggregate
demand or increases in interest rates. Risk that cannot be eliminated
by diversification is called systematic risk and is illustrated by the
day-to-day behavior of the broad stock indexes such as the Standard
& Poor's 500. The S&P 500 is a diversified "portfolio" of common
stocks, but of course it changes in value from day to day, implying
the operation of forces that affect the stock market as a whole, as
distinct from forces that merely alter the relative values of firms and
whose effect on portfolio risk can therefore be eliminated by diversi-
fication.
Systematic risk can be reduced, though not through diversifica-
tion. It can be reduced by increasing the proportion of assets in the
portfolio that have below-average systematic risk, or even no system-
atic risk, such as short-term federal notes. But the investor pays a
price; the expected return of such assets is lower than that of riskier
assets, since risk averse investors will accept lower expected returns
in order to reduce or avoid risk. The beauty of diversification is that
it allows risks to be reduced or eliminated at a small cost - the cost
of creating and maintaining a diversified portfolio. This cost is apt
to be modest even for portfolios containing several hundred different
stocks - at least, modest compared to the reduction in expected re-
turn that occurs when the investor changes the mix of the portfolio in
favor of systematically less risky assets such as bonds and notes.
How far to go in diversifying one's portfolio thus depends on two
things: the incremental reduction in risk from further diversification
and the incremental administrative cost. There is debate among
financial experts as to the optimal degree of diversification. Some
believe that careful selection (stratified sampling) enables the major
gains from diversification to be exhausted with a relatively small
number of different securities, perhaps not more than 100. Others
favor poitfolios consisting of thousands of different stocks, including
those sold in foreign securities markets. We shall have more to say

November 19801 SocialInvesting
about optimal diversification later, when we consider some of the

portfolio-design decisions of social-investing trustees.
The discussion thus far has assumed that the identity of the par-
ticular securities held in the portfolio is a matter of indifference to
the investor pursuing an optimal strategy. When we said that the
trade-off involved in deciding how far to go in diversifying the in-
vestment portfolio was between the gains from further diversification
and the administrative costs of increasing the number of securities in
the portfolio, we implicitly excluded, as a possible cost of diversifica-
tion, the forgone opportunities in exceptional performance which ex-
tensive diversification necessarily involves. The more diversified a
portfolio, the less impact a shrewd decision to sell an overvalued
stock or to buy an undervalued one will have on the value of the
portfolio; the effect of the shrewd choice will be diluted by the fact
that the stock in question will have only a small weight in the portfo-
lio as a whole if the portfolio is indeed highly diversified.
We must therefore consider whether an alternative to diversifica-
tion as a means of increasing investor utility may not be to exercise
greater care in the selection of a smaller number of securities, so that
the expected return of the portfolio will exceed that which could be
expected from holding a larger number of securities. We must con-
sider, in short, whether "stock picking" is a profitable investment
strategy. Restated, the question is whether the costs of stock picking
- which include not only the research and trading costs involved in
an active strategy, but also the sacrifice of diversification that is en-
tailed in concentrating one's investment assets in those stocks ex-
pected to outperform the market average - are likely to be more
than offset by the higher expected return that can be obtained by
careful selection among the array of alternative securities within any
given class (common stock, for example) of investment asset.
It may seem self-evident that a skilled investor, who conducts
careful research into the conditions and prospects of particular com-
panies and of the economy as a whole, will earn a higher return (cor-
recting for any difference in systematic risk) than the investor who
simply "buys the market," blindly investing in the entire stock-mar-
ket list and never selling a stock when its prospects begin to sour.
But, on reflection, this proposition really is not self-evident. There
is, to begin with, the inherent difficulty of forecasting the future.
Since the value of a stock is mainly a function of its anticipated earn-
ings, and therefore depends primarily on events occurring in the fu-
ture, it will often be impossible to determine whether a stock is
undervalued at its current price without knowing what the future

holds. As for the stock that is undervalued because of some charac-

teristic of the company (or of its competitors, suppliers, customers,
political environment, etc.) that is not widely known or correctly in-
terpreted, the problem is that the underlying information is in the
public domain. (If it is not in the public domain - if it is "inside"
information - it cannot lawfully be used for purposes of buying or
selling stock, and presumably the law has some deterrent effect.) In-
formation in the public domain is equally available to all security
analysts. The only way of making money from such information is
to interpret it better than the other analysts. This is not a very prom-
ising method of outperforming the market; it requires both that the
analyst's interpretations of publicly available information differ from
the average opinion of the analyst community and that his deviant
interpretations be correct substantially more often than they are in-
correct.
Thus it is not surprising that studies of the mutual fund industry
have found that the funds, despite their extensive employment of se-
curity analysts and portfolio managers for the purpose of out-
performing the market, do not outperform it. They do no better than
the blind "market portfolio." To this it may be replied that the
proper comparison is not between all mutual funds and the market
but between the most successful mutual funds and the market. But
the studies show that there are almost no consistently successful mu-
tual funds. Naturally, some enjoy shorter or longer runs of success,
but the degree of success observed is no greater than one would ex-
pect if luck, not skill, was the only factor determining the fund's per-
formance.
The study of money managers has focused on the mutual funds
because they are required by federal law to report in detail on their
performance, thus affording a large data base; but there is every rea-
son to believe that common trust funds, pension funds, and other
institutional investors likewise fail to outperform the market portfo-
lio. Paul Samuelson has concluded that there is ample reason for
doubting whether even "the best of money managers" are "capable
of doing better than the averages on a repeatable, sustainable ba-
sis.'15
The studies support an even stronger conclusion: when broker-

age costs and management fees are taken into account, the average
mutual or common trust fund yields a significantly lower net return
than a fund keyed to a broadly based market index such as the S&P
15. Samuelson, Challenge to Judgment, J. PORTFOLIO MANAGEMENT 17 (Fall 1974).

500. This comparison was long derided on the ground that the S&P
500 is a hypothetical fund and hence has no administrative costs.
Now that there are some real market funds in operation, it is possible
to evaluate - and reject - this criticism. The administrative costs
of a market fund turn out to be so low (on a $500 million portfolio,
they would be no more than eleven percent of the costs of conven-
tional management) that the net returns of a properly constructed
market fund are only trivially different from those of the hypotheti-
cal market portfolio. The administrative costs are low because the
management of a market fund does no securities analysis and very
little trading (just enough to handle redemptions and maintain the
desired level of diversification of the fund). In short, a passive, mar-
ket-matching fund is likely to outperform a conventional, actively-
managed fund in terms of expected return; in addition, it is much
more diversified than a conventional fund. On both counts, it yields
6
greater utility to the investor.'
Having outlined in this section of the Article the optimal invest-
ment strategy for an investment manager concerned solely with the
financial well-being of his (risk-averse)'investment beneficiary, we
consider in the next the modifications of the strategy that are neces-
sary if the manager decides to embrace a social-investing strategy as
a substitute for or supplement to a strategy of maximizing investor
financial well-being (as we have defined that concept interms of ex-
pected return and of risk). We shall also consider to what extent our
analysis must be modified if some of the more controversial aspects
of the theory of finance presented in this section are rejected.
B. Portfolio Adjustments by the Social Investor

It is not easy to specify the portfolio adjustments that an investor
committed to social investing would have to make, because the social
principles are poorly specified. There is no consensus about which
social principles to pursue and about which investments are consis-
tent or inconsistent with those principles. At a time when most of
the social activism in investing was liberal or radical rather than con-
servative, there was some agreement among the activists as to the
types of companies that should be avoided and the types that should
be embraced. The ranks of the disapproved included companies
lending to or having branches or subsidiaries in the Republic of
South Africa, big defense contractors, nonunion companies, and
16. For the evidence supporting the assertions in the above discussion, see references in
Langbein & Posner,supra note 14, at 6-18; and for reply to criticisms, Langbein & Posner,
Market Funds and Trust-Investment Law: I, 1977 AM. BAR FOUNDATION RESEARCH J. 1.

prominent or recurrent violators of federal discrimination, pollution,

safety, and antitrust laws. More recently, the nuclear power and
herbicide industries have also fallen into disfavor. The ranks of the
approved included companies that manufactured anti-pollution
equipment, or used especially clean technologies, or invested in the
inner cities. Most of the literature on social investing discusses the
portfolio adjustments that must be made by an investment manager
who follows the list of exclusions and inclusions recommended by
liberal and radical spokesmen. We shall do the same for want of any
practical alternative, while emphasizing the arbitrariness of these
conventions even as a litmus of activist thinking. With the rapid rise
of right-wing social activism, we can expect social-investment advo-
cates to appear who will urge investment managers not to invest in
corporations that manufacture contraceptive devices, or publish text-
books that teach the theory of evolution, or do business with the So-
viet Union. And with the growing concern about the military
strength of the Soviet Union relative to the U.S. - a concern not
limited to right-wing extremists - a desire to penalize companies for
having large defense contracts no longer has the appeal it once did.
There is also increasing awareness that the criteria used to identify
socially irresponsible companies are dubious even if the ultimate ob-
jective - say, getting the Republic of South Africa to abandon
apartheid - is accepted. A U.S. corporation that has a plant in
South Africa where it engages in collective bargaining with a black
union is not obviously contributing more to the perpetuation of
apartheid than an American corporation that, without having an of-
fice in South Africa, manufactures goods that find their way to South
17
Africa.
These complications to what once seemed, at least to social-in-
vesting advocates, clear-cut criteria of portfolio exclusion and inclu-
sion make it difficult to describe the typical portfolio constructed in
accordance with social principles, and hence to determine the portfo-
lio adjustments required to bring an investment portfolio into con-
formity with those principles. However, even without attempting to
describe the typical social-investment portfolio, we can offer a few
observations on the probable characteristics of such a portfolio and
on the consequences of those characteristics for the investment bene-
ficiaries' financial well-being.
17. For a powerful criticism of social investment along these lines see Schotland, The Op.
ponent's4rguments.: .4 Review and Comment, in SHOULD PENSION ASSETS BE MANAGED FOR
SOCIAL / POLITICAL PURPOSES?, supra note 4, at 105. Schotland's essay has been reprinted in
Trusts & Estates in several parts. See especially Schotland, Should Pension FundsBe Used To
Achieve "Social" Goals? (Pt. 2), TRUSTS & ESTATES 27 (Oct. 1980).

1. A portfolio constructed in accordance with social principles

will be less diversified than a portfolio constructed in accordance
with the optimal strategy of portfolio design described in the previ-
ous section. This is because stocks are added to and subtracted from
the portfolio by the social investor without regard to the effect on
diversification. To be sure, if social responsibility were a random
characteristic of firms, so that the set of socially responsible firms
differed from the set of socially irresponsible firms only in respect to
social responsibility, and not in size, profits, location, or other rele-
vant financial characteristics, the effect on diversification of exclud-
ing the socially irresponsible firms from the investment portfolio
would be limited to what is called sampling error. That is, one could
not draw so large a sample from the underlying universe of firms if
some of the firms were ineligible for inclusion in the sample. For
example, if one wanted to have a portfolio consisting of ninety per-
cent (by value) of the firms on the New York Stock Exchange, and
twenty percent of such firms were deemed socially irresponsible and
hence ineligible for inclusion in the portfolio, exclusion would create
more sampling error than desired, and therefore diversification
would be less than desired.
If socially irresponsible firms are not a random draw from the
underlying universe of firms, then the use of social-investing criteria
to design the portfolio will result not only in sampling error, but also
in sampling bias. One can approximate the performance of the stock
market as a whole by an approximately randomized (including strat-
ified) sample that is much smaller than the market as a whole, but it
is much harder to approximate the performance of the market if the
sampling procedure is nonrandom. And a sampling procedure that
involves first excluding firms deemed socially irresponsible is not a
random sampling procedure, because the set of such firms is not a
random draw from the universe of firms. Firms deemed socially ir-
responsible tend to be disproportionately large firms, and they tend
to be concentrated in particular regions and industries. For example,
the South would be underrepresented in a sample limited to socially
responsible firms because firms located in the South are more likely
to be deemed anti-labor and excluded from the socially responsible
portfolio on that ground than firms located elsewhere in the U.S.
The bias imparted by social investing interacts with the problem
of sampling error in the following way: a large firm is, by virtue of
its size, less likely to survive social-investing screening than a small
one, but the exclusion of a large firm from the investment portfolio
has a bigger effect in creating sampling error than the exclusion of a

small firm. This is because the large firm has a greater weight in the
overall performance of the market, and it is that overall performance
that one is seeking, through diversification, to track as closely as pos-
sible.
If one asks why large firms are more likely to be "fingered" as
socially irresponsible than small ones, the answer is not that large
firms contain a higher proportion of wicked people than small, or
engage in a higher proportion of wicked acts. It is rather that, simply
by virtue of being large, they do more wicked acts or contain more
wicked people (as well as more people pursuing virtue). But if ten
small firms cause as much human suffering as one large one, ethical
principles hardly justify punishing the large firms and not the small
firms. Indeed, it is probably the case that wickedness is proportion-
ally more prevalent among small firms than among large, simply be-
cause law enforcement efforts, journalistic muckraking, and other
activities that result in the exposure of illegal or immoral acts are
concentrated on large firms.
Our discussion of sampling error and sampling bias has been
qualitative rather than quantitative. To measure the amount of un-
derdiversification to which social-investing would give rise would re-
quire an initial specification of the social-investing portfolio. At one
extreme, in a portfolio composed of the S&P 500 weighted by the
relative market value of the total outstanding shares of each stock,
the discarding of half a dozen small firms, amounting in the aggre-
gate to one-tenth of one percent of the total market value of the S&P
500, would have only a small effect on the diversification of the port-
folio. The effect would be even smaller if the original portfolio was
broader than the S&P 500. At the other extreme, consider an invest-
ment manager who decided that social principles required him to
discard the stocks of all defense contractors, all adjudicated violators
of health, safety, antitrust, or discrimination laws, major oil compa-
nies, all firms doing business with any nation in which there were
serious violations of human rights, all liquor and tobacco companies,
and even all firms that invest abroad ("export jobs").' 8 The removal
of all such firms from a portfolio of common stocks would result in a
seriously underdiversified portfolio.
There have been several studies of the effects on diversification of
the intermediate level of exclusions that typifies the mutual funds
and university endowment funds that have embraced the concept of
18. This last suggestion appears in RUTTENBERG, FRIEDMEN, KILGALLON, GUTCHESS &
ASSOCIATES, INC., AFL-CIO PENSION FUND INVESTMENT STUDY 57 (Wash., D.C., Aug. 20,
1980).

November 19801 Social Investing
social investing. The principal exclusions considered in these studies

are firms having branches or subsidiaries in the Republic of South
Africa. There are many such firms, including many of the largest
firms in the market,' 9 and the effects on diversification of casting
them out of the investment portfolio are, therefore, not trivial. But
because most of the gains from diversification can be achieved with a
portfolio significantly smaller than the market portfolio or some ap-
proximation thereto such as the S&P 500, it is possible that a portfo-
lio could be constructed in which a significant fraction of the largest
U.S. firms were ineligible for inclusion yet which was not grossly
20
underdiversified.
But would a consistent and principled devotion to the concept of
social investing allow the manager to stop with such comparatively
modest exclusions as those described above?21 If one wants to place
economic pressure on the government of the Republic of South Af-
rica, the good pressure points are not limited to firms having
branches or subsidiaries there. Getting AT&T to sever telephone
service with South Africa, or U.S. banks to refuse to honor checks
drawn on South African banks, would be more efficacious than get-
ting U.S. firms to close their offices in South Africa. This implies the
desirability of refusing to hold the stocks of these companies as a
means of bringing pressure on them to stop dealing with South Af-
rica. But if this point is accepted, the social-investing advocate will
have to argue for much greater portfolio exclusions than those dis-
cussed above.
Furthermore, while the Republic of South Africa may be an iniq-
uitous society, it is not unique in this respect. We find it difficult to
condemn more severely a society in which 80 percent of the inhabit-
ants lack political and civil rights than the many societies in which
99 percent of the inhabitants are in this position. It will not do to
say, with Yale's Ad Hoc Committee on South African Investments:
"We acknowledge .the possibility that the policies of other govern-
ments throughout the world are equally antagonistic to the basic
principles of American society and this University; if so, then our
19. See Rudd, Divestment of South African Equities How Risky?, J.PORTFOLIO MANAGE-
MENT 5, 6 (Spring 1979).
20. See Rudd, supra note 19; Emery & Hawkins, Sound FundManagementAllows Some
Social Considerations, ARIZ. REv. 1 (Oct. 1973); S. BALDWIN, J. TOWER, L. LrrVAK & J.
KARPEN, PENSION. FUNDS AND ETHICAL INVESTMENT: A STUDY OF INVESTMENT PRACTICES
AND OPPORTUNITIES, STATE OF CALIFORNIA RETIREMENT SYSTEMS 103, Al-A2 (Council on
Economic Priorities, New York City, 1980) (effect on diversification of excluding 132 U.S.
corporations doing business in or lending to the Republic of South Africa).
21. For a good discussion of this question, see Malkiel & Quandt, Moral Issues in Invest-
ment Policy, HARv.Bus. REv. 37 (March-April 1971).

recommendations concerning South African investments should be

applied to them."' 22 It is not a possibility that there are other such
societies; it is a certainty. (At the time that the Ad Hoc Committee
wrote its report, the Amin regime was still in power in Uganda and
the Pol Pot regime in Cambodia.) What the Committee seems to be
saying, if one reads between the lines, is that it will not consider
further applications of the social-investment principle until some
group raises as great a stink as the opponents of the South African
regime have raised. This approach makes social investing a branch
of interest-group politics.
In sum, we are skeptical that a portfolio constructed in accord-
ance with consistent, and consistently applied, social principles could
avoid serious underdiversification. In 1979, Corporate Data Ex-
change, Inc. identified ninety-nine companies that a socially respon-
sible investor should avoid. The aggregate market value of the
stocks of these companies was $342 billion. Yet the only criteria for
exclusion were whether the company was predominantly nonunion-
ized, had a poor record in occupational health and safety, failed to
meet equal employment opportunity guidelines, or was a major in-
vestor in or lender to South Africa. 23 Although this is an arbitrarily
limited set of criteria, it results in excluding such a large fraction
(weighting numbers by market value) of listed equities as to create a
degree of sampling error and sampling bias inconsistent with ade-
quate diversification of the portfolio. Stephen Manus and David
Steirman of American National Bank of Chicago, under the direc-
tion of Rex Sinquefield, Executive Vice-President of the bank, at our
request attempted to construct a portfolio of common stocks that
would be optimally diversified, subject to the constraint that the
ninety-nine firms designated by Corporate Data Exchange be ineligi-
ble for inclusion in the portfolio. They constructed a portfolio of 163
stocks, carefully selected to offset so far as possible the biases intro-
duced by excluding the ninety-nine stocks. The portfolio they con-
structed contained 2.1 percent more residual risk than the S&P 500.
What that means is that whatever the return of the S&P 500 might be
in a particular year, the portfolio they constructed - a socially re-
sponsible portfolio by the standards of Corporate Data Exchange -
would have a five percent probability of being 4.2 percent or more
higher or lower, and a one percent probability of being 6.3 percent or
22. YALE UNIVERSITY, AD Hoc COMMITTEE ON SOUTH AFRICAN INVESTMENTS, REPORT

TO THE CORPORATION 4 (April 14, 1978) (on file with the Michigan Law Review).
23. See CORPORATE DATA EXCHANGE, INC., CDE HANDBOOK: PENSION INVESTMENTS, A
SOCIAL AUDIT 8-11 (1979).

more higher or lower, than the return of the S&P 500. Stated other-
wise, in any given year one in twenty socially responsible investors
would be expected to deviate from the performance of the S&P 500
(itself but an approximation of the fully diversified market portfolio)
by more than 4.2 percent. We think this is a substantial increment in
risk.
We leave to the moral philosophers to advise us whether a port-
folio constructed in accordance with the suggestions of Corporate
Data Exchange or any other proponent of socially responsible in-
vesting would indeed be socially responsible. It seems to us that the
list of ninety-nine is arbitrary. To this it may be replied that it is
appropriate to trade off moral gains from excluding more and more
socially irresponsible firms against the financial costs, in increased
portfolio risk, of doing so. Assuming such trade-offs are morally
permissible or attractive, we nevertheless point out that both the
costs and the benefits of social investment are positively related to
the extent to which the principles of social investment are pursued in
a serious and consistent fashion. If only token exclusions from the
portfolio are made, the costs in underdiversification are slight but so
are the social or moral benefits of social investment. As more and
more companies are excluded, the benefits in conforming to consis-
tent and serious principles of social investment are increased but so
are the costs in increased portfolio risk. The Corporate Data Ex-
change list of ninety-nine illuminates the nature of the trade-off by
showing that, even when exclusion is arbitrarily limited to a subset
of the plausible candidates for exclusion (arbitary given the underly-
ing values and principles of the proponents of social investing), sub-
stantial costs in increased portfolio risk are incurred.
The type of social investing espoused by some union, and some
state and local government employee, funds requires separate con-
sideration under the head of diversification.2 4 A union pension fund
that decided to avoid investing in any stock issued by a nonunion-
ized company would be imparting a pronounced regional bias to its
portfolio, because unionized companies are concentrated in the na-
tion's declining industrial base in the northeastern and midwestern
24. For a defense of this form of social investing, see D. SMART, supra note 3; for recent
developments in this area, see Epstein, Illinois Group Recommends FundsAdoptSocial Criteria,
Pensions & Investments, June 23, 1980, at 3; Minick, Social Investing Sparks N.Y Fund De-
bate,id, Sept. 24, 1979, at 1; Scott, Sacramento UnionsBlast 'Social'Concept, id, Nov. 5, 1979,
at 1; Sojacy, Bill Limiting Public Fund Stock Holdings Introduced, id, Jund 23, 1980, at 3;
Stem, Unions Band Together To Discuss Other UsesforPension Assets, id, April 28, 1980, at 4;
Stem, Drexel To Use Social CriteriaTo Invest, id, Sept. 10, 1979, at 1. Prudential Insurance
Company has recently announced a pension investment fund limited to "mortgages of projects
built by union labor." Wall St. J., Dec. 9, 1980, at 19, coL 1 (Midwest ed.).

states. Even worse effects on diversification would be caused by a

decision to concentrate the fund's assets in one state or region: in
Michigan, for example, which has been so hard hit by the recent
near collapse of the domestic automobile industry. Or suppose that
a school board in the vicinity of Mount St. Helens had insisted on
investing locally.
We consider that the larger danger to adequate diversification
lies not in what might be called the ideological version of social in-
vesting, which has been characterized by tokenism, but rather in the
seemingly "practical" version that seeks to use employee retirement
assets to enhance the employment security of employees who have
not yet retired. To be sure, the costs in reduced diversification might
be offset by gains in enhanced employment security for nonretired
employees; but we think this unlikely. Suppose an employer is
threatening to move his plant to another region of the country be-
cause his labor costs, which include both pension costs and wages (as
well as other fringe benefits), will be lower there. To induce him to
stay, the union might be tempted to furnish him with capital at at-
tractive rates by lending from the union pension fund beyond the
level that a prudent regard for portfolio risk would indicate; but
equally it could agree to a reduction in some other fringe benefit, or
to a reduction in wages. Many workers, if asked whether they would
prefer, in response to adverse conditions in the industry in which
they were employed, a lower wage while working or a less secure
retirement, would choose the lower wage. The alternative, a less se-
cure retirement, is often attractive to labor unions because they are
dominated by current rather than retired workers, and so would
rather transfer wealth from retired workers than from current work-
ers.25 By increasing the risk or reducing the solvency of the fund
assets, the union can place the heaviest costs of social investing on
those workers - the retired ones - whose current income is gener-
ated by the fund assets. Active workers' expected retirement benefits
are also reduced, perhaps substantially, but against this future loss is
set a present gain, in which retired workers do not share, in greater
employment security.
When the pension fund is not a defined-contribution plan
(where, as mentioned earlier, retirement benefits fluctuate with the
25. The Taft-Hartley Act imposes some limit on this tendency by requiring that employee
benefit plans established jointly by a union and one or more employers be administered by
equal numbers of union and of employer-designated trustees (together with any "neutral" per-
sons that they choose to co-opt). Labor Management Relations Act § 302(c)(5), 29 U.S.C.
§ 186(c)(5) (1976).

November 19801 Social Investing
performance of the fund) but instead a defined-benefit plan (where

an employer, or employer group, contracts to provide a specified
level of benefits), the analysis is altered slightly. If a corporation
having a defined-benefit plan decides to invest in the local commu-
nity without regard to the soundness of the investment, most of the
resulting risk is borne by the corporate shareholders rather than the
pension fund beneficiaries. The latter are hurt only to the extent that
the solvency of the corporation, and hence its ability to meet its con-
tractually defined obligations to retired workers, is impaired. 26 To
be sure, a corporation that anticipates that its employees, their un-
ions, or the local community will pressure it into making suboptimal
investments will treat the resulting risk as a cost of employment and
shift it to the workers. But the defined-benefit feature will tend to
buffer the effect on retired workers. Moreover, the amount of risk
imposed on the corporation, and hence the amount of cost it will try
to pass on to its employees, will tend to be slight.2 7 When the entire
corporation is viewed in the financial sense as a portfolio of assets,
the pension fund is only one corporate asset, and if it is underdiversi-
fled, this can be offset by adjustments in the other assets of the corpo-
ration. And from the standpoint of the corporation's shareholders,
even if this one stock in their portfolios has been made riskier as a
result of the corporation's pension-investment policy, this will have
little effect on their overall portfolio risk so long as the shareholders
hold well-diversified portfolios.
Thus far we have been discussing common stock funds, rather
than bond funds or mixed stock and bond funds. The problem of
diversification is less acute in the case of bonds than in the case of
stocks, because the variance in the performance of bonds across
companies (we are not speaking here of variance due to changes in
interest rates, which affect all bonds of the same maturity) is much
smaller than in the case of stocks. Stated otherwise, by holding
bonds instead of or along with stocks in one's portfolio, one accom-
plishes by another means the objective of diversification, which is to
reduce variance in yield. Therefore, to the extent that the concept of
social investing is applied to bonds as well as stocks, the result will
be some cost in reduced diversification of the bond component of the
26. ERISA's pension insurance and guarantee arrangements contemplate that much of this
risk will be shifted to the other employers in the insurance system, and in the last resort to the
federal treasury. See 29 U.S.C. §§ 1301-23 (1979).
27. See Black, The Investment Policy Spectrumr: Individuals,Endowment Fundsand Pension
Trusts, FINANCIAL ANALYSTS' J. 3, 9 (Jan.-Feb. 1976).

portfolio, but the cost will be less than in the case of the stock com-
ponent.
2. We may seem to have dwelled at excessive length on a rather
esoteric effect of social investing - the reduction in diversification
- and to have ignored what might appear to be the larger effect on
the investment portfolio - the effect on the rate of return - of ex-
cluding many successful companies and including many less success-
ful companies. In fact, the modern theory of finance undermines the
notion that portfolio selection based on social, or on any other, prin-
ciples will affect the expected or average return of the investor, net of
administrative costs. If stock picking is futile, then every stock (of
the same risk class) is an equally good investment ex ante. There-
fore, even if adherence to social principles biased the investor's port-
folio in favor of unprofitable or financially precarious companies,
the expected return of the portfolio would be the same as that of
portfolios managed in accordance with a sole objective of investor
wealth maximization. If a firm's expected earnings are low, the price
of its stock will be bid down by the market to the point where it
yields the same expected return to the shareholder as any other stock
having the same systematic risk. If it yielded a lower return, no one
would buy it, and the issuer (or current holder) would have to reduce
price until the expected return to the purchaser was equal to what
the purchaser could get elsewhere. Even if a firm is bankrupt, its
stock will command a positive return so long as it has any prospect
of yielding a positive return to shareholders through reorganization
or liquidation, and it will be priced at a level that will yield the same
expected return to the purchaser as that of a blue chip, correcting for
any difference in systematic risk.28
Hence we are not concerned that adherence to social principles
will result in portfolios that yield lower average returns than portfo-
lios designed to maximize the financial well-being of the investment
beneficiaries. The average return will be the same - a prediction of
theory that is consistent with the (very limited) empirical studies that
have been made of social-investment portfolios. 29 By the same to-
ken, we reject the argument that the social investor can consistently
pick winners by being more sensitive to political and social factors
that can impinge on corporate profitability. This is just another the-
28. See Langbein & Posner,supra note 14, at 17-18.

29. Pacey, supra note 10, finds that the three mutual funds that follow a social-investment
strategy have done better than the average of mutual funds during the period in which these
fund's have been operating. But she presents no evidence that this performance is due to any-
thing other than luck, or possibly a higher systematic risk of the funds' portfolios.

November 1980] SocialInvesting
ory of how to beat the market, and it has no firmer basis than any
other such theory. If, however, the theory were correct, the issue of
social investing would not be worth discussing, at least by the likes of
us; it would be a tactic for maximizing investor financial well-being,
and we would leave it to the finance theorists and investment profes-
sionals to determine whether it was a good tactic. Finally, if we are
wrong that stock picking is a futile strategy for pension fund trustees
to follow, and if social investing is not just another theory of how to
beat the market, or is not a good such theory, then, to the costs of
underdiversification which social investing, consistently pursued,
gives rise, would be added another cost: the forgone gains from fol-
lowing a better theory of how to outperform the market.
3. Our conclusion that a social-investing portfolio will probably
have the same -expected return as a standard investment portfolio (of
the same systematic risk) requires qualification in one respect: the
administrative costs of a social-investment portfolio will be higher,
and the net expected return therefore lower, than the administrative
costs of a portfolio constructed in accordance with the principles of
modern finance theory. The strategy of the latter portfolio is, as al-
ready explained, a passive one, and it reduces management and trad-
ing costs to negligible levels. The portfolio manager buys and sells
securities only to maintain the desired amount of diversification 30
(and these trading costs generate more than offsetting gains in reduc-
tion of portfolio risk). And he engages in no securities analysis at all.
In contrast, the social investor, in proportion to how seriously he
takes his self-imposed duty to screen out socially irresponsible com-
panies and screen in socially responsible ones, incurs costs both of
securities analysis (albeit of an unconventional kind, since the focus
is not on the company's income prospects but on monitoring its com-
pliance with the investor's social aims), and of trading; stocks will be
added to and subtracted from the portfolio with changes in the issu-
ing corporation's policies and in the conception of what social invest-
ing requires.
An interesting point emerges from this discussion: while the so-
cial-investing strategy generates higher administrative costs than the
passive strategy prescribed by the theory of finance, it need not gen-
erate higher administrative costs than an investment strategy that in-
volves research and active trading. The administrative costs are
30. Out of an abundance of caution, most "index" funds screen out of their portfolios firms
in danger ofgoing bankrupt. There is no sound economic reason for the practice, other than to
minimize legal risk (see Langbein & Posner,supra note 14, at 26-38), but it is common, and it
does increase the costs of management and trading above those of the pure index fund.

incurred in slightly different activities, because the investor who is

trying to "beat the market" and the social investor are looking for
different attributes in the companies in which they invest; but it does
not follow that administrative costs are higher in one type of active
strategy than the other. At a guess, research costs would be higher
under a social-investing approach if the investment manager took
seriously his obligation of social investing, and trading costs higher
under a beat-the-market strategy. Although the net effect is difficult
to predict, one thing seems clear: an investor who tried to combine
social investing with conventional wealth maximizing would incur
the highest administrative costs of all. A related implication of our
analysis is that the investor who is passive and does not attach much
importance to diversification will not obtain, on average, any better
results than the social investor, in terms of risk, return, or adminis-
trative expense, unless the social investor carries exclusion to the
point where his portfolio is even less diversified than the investor
who does not attach great importance to diversification. But there
3
are few fiduciaries who do not value diversification highly. '
4. Thus far we have considered only the conventional investment
attributes of the socially responsible investment portfolio - risk and
diversification, return, and management and brokerage fees. The so-
cial-investment strategy is inferior in these attributes to the optimal
strategy prescribed by the modern theory of finance. But perhaps
social investing confers a compensating utility on the investor. An
analogy can be drawn to the ownership of works of art. There is
both a consumption and an investment aspect to such ownership.
Historically (except in very recent times), the rate of return on in-
vestments in art has been lower than that on "pure" investments
such as common stocks. 32 The fact that people were nevertheless
willing to invest in art reflected the fact that they obtained consump-
tion value from their investment which, when added to the invest-
ment return, equaled or exceeded their alternative investment and
consumption opportunities. It is not only possible, it is strongly im-
plied by economic theory, that people who choose to invest in mu-
tual funds dedicated to social investing derive a consumption value
from their investment, since the pure investment value is, at least on
an expected basis, inferior to that of alternative investment vehicles.
But this presumption fails when the investor lacks a free and in-
formed choice among investment vehicles, which is the practical sit-
31. See Langbein & Posner, Market Funds and Trust-Investment Law: II, 1977 AM. BAR.
FoUNDATION RESEARCH . 1, 24-28.
32. See Stein, The Monetary 4ppreclationof Paintings,85 . POL. EcON. 1021 (1977).

November 1980] SocialInvesting
uation in which many pension-fund beneficiaries find themselves.

Even if pension-fund trustees adhered steadfastly, and for long peri-
ods, to clearly articulated standards of social investing, the choice of
an individual as to what occupation to enter, or what employer to
work for, would probably not be materially influenced by his agree-
ment or disagreement with the announced standards of the relevant
pension fund managers. It would be especially unlikely when the
pension fund covered an entire industry, as is virtually the case with
some of the so-called Taft-Hartley plans, or with the college teach-
ers' pension fund. 33 Thus, social investing imposes disutility on
many pension fund beneficiaries at the same time that it confers util-
ity on others. Because there is no practical mechanism by which
pension fund trustees can make the felicific calculations necessary to
decide which social principles they should adopt in order to maxi-
mize the overall utility of the fund beneficiaries, 3 4 there is no basis
for a judgment that the positive consumption aspects of social invest-
ing will on average exceed the negative. If the consumption aspects
are assumed to be a wash, then one can conclude that social invest-
ing involves a probable reduction in the overall wealth or utility of
investors, compared to an investing strategy that focuses exclusively
on maximizing the financial well-being of investors.
But this analysis is probably sound only if the disutility resulting
from the pension fund trustees' decision to pursue social investing
(or what social objectives to set) is small on an individual basis. If it
is large, then employees will sort themselves among employers in
accordance with the pension fund policies on social investing fol-
lowed by the employers. In truth, our whole analysis implies that
the disutility of social investing to the individual investment benefi-
ciary will tend to be modest. The fund dedicated to social investing
will be less diversified and more costly administratively than the
fund which follows the optimal strategy, and these are sources of
disutility, but the difference in overall performance should not be
great - and anyway most pension funds probably do not follow the
33. To be sure, in principle a worker who disliked the social principle followed by his
pension fund would demand a higher wage in compensation; but union rules against wage
differentials among workers of the same seniority doing the same job would prevent such a
compensating adjustment, at least in the unionized sector. Nor would a university, for exam-
ple, agree to pay a higher wage to teachers offended by the social principles adopted by the
teachers' pension fund - the university would find it impossible to determine the sincerity of
the teachers' protestations.
34. The difficulty pension fund trustees face in trying to determine the social-investing
preferences of the beneficiaries is acknowledged in Ferguson, The .4dvocate's Arguments: A
Review and Comment, in SHOULD PENSION ASSETS BE MANAGED FOR SOCIAL/POLITICAL
PURPOSES?, supra note 4, at 94, 100-03.

optimal strategy, at least as taught by the modem finance theorists,

but instead adhere to the inferior strategy associated with trying to
beat the market, at the price of heavy administrative expenses and
underdiversification. Of course, some individual employees will be
offended by the choice of social-investing objectives of their pension-
fund trustees - provided they know what those objectives are - but
the disutility resulting from such offensiveness is probably small for
most people, and if it is great for a particular employee, then, as
mentioned, he will go elsewhere. We conclude that the disutility to
the individual investment beneficiary from social investing will nor-
mally be small, but the sum of these disutilities across all the affected
individuals may not be small, which supports our conclusion that
when all relevant factors are considered, it is probable that social
investing results in a net diminution of the overall utility of the in-
vestment beneficiaries.
It is consistent with this analysis, however, that a mode of social
investing which preserved the freedom of choice of investment bene-
ficiaries might confer greater net benefits than a refusal to offer any-
thing but the strategy that maximizes purely financial well-being.
We explore in the next part of this Article the feasibility of such a
"check-ofi ' 35 system under the ratification doctrine of trust law.
II. Is SOCIAL INVESTING LAWFUL FOR A TRUSTEE?

A. GeneralAnalsis
We have argued that social investing is undesirable because it
appears to reduce the overall utility, however broadly defined, of the
investment beneficiaries. It remains to consider whether social in-
vesting is contrary to trust law and its statutory counterparts. We
conclude that it is (except in the optional format discussed later); a
trustee who sacrifices the beneficiary's financial well-being for any
other object breaches both his duty of loyalty to the beneficiary and
his duty of prudence in investment. In reviewing the law on these
matters, we shall take the conventional law of private trusts as our
starting point but pay special attention to the issues that arise under
pension trusts.
The essence of the trustee's fiduciary relationship is his responsi-
bility to deal with the trust property "for the benefit of'36 the trust
beneficiary. Indeed, in the language of the Restatement (Second) of
Trusts, "[tihe trustee is under a duty to the beneficiary to administer
35. See text at Part IIB infra.
36. RESTATEMENT (SECOND) OF TRUSTS § 2 (1957) [hereinafter cited as RESTATEMENT],

the trust solely in the interest of the beneficiary. ' 37 Although most of
the case law applying this duty of loyalty to the beneficiary's inter-
ests has arisen in situations of self-dealing or other confficts of inter-
est in which the courts have acted to prevent the trustee from
enriching himself at the expense of the trust beneficiary, 38 the same
result has been reached with regard to fiduciary investments for the
benefit of a third party (that is, a party other than the trust benefici-
ary or the trustee). The Restatement says, in the Official Comment
treating the duty of loyalty: "The trustee is under a duty to the bene-
ficiary in administering the trust not to be guided by the interest of
any third person."' 39 Because the entire object is to protect the trust
beneficiary, nothing of principle turns on the identity of the party
who profits at his expense.
Blankenshio v. Boyle, 40 decided in 1971, applied the duty of loy-
alty to social investing. A multi-employer pension fund for coal
miners that was dominated by the United Mineworkers Union
bought large blocks of shares in certain electric utilities in order to
induce their managements to buy union-mined coal. On the com-
plaint of some of the pension-fund beneficiaries, the court enjoined
"the trustees from operating the Fund in a manner designed in
whole or in part to afford collateral advantages to the Union or the
41
[employers].'
The 1974 pension reform law, ERISA, 42 codified the duty of loy-
43
alty in the so-called "sole interest" and "exclusive purpose" rules.
Section 404(a)(1) provides that the "fiduciary shall discharge his du-
ties with respect to a plan solely in the interest of the participants
and beneficiaries and . . . for the exclusive purpose of providing
benefits to participants and their beneficiaries . ."44
37. Id at § 170(1) (emphasis added).
38. See generally 2 A. ScoTT, THE LAW OF TRUSTS §§ 170-170.25 (3d ed. 1967 & Supp.
1980).
39. RESTATEMENT, supra note 36, at § 170, Comment q (emphasis added). See id at § 187,
Comment g (emphasis added):
Impropermotive. The court will control the trustee in the exercise of a power where he
acts from an improper even though not a dishonest motive, that is, where he acts from a
motive other than to further thepurposes of the trust. Thus, if the trustee in exercising or
failing to exercise a power does so because of spite or prejudice or to further some interest
of his own or ofa person other than the benoeciary, the court will interpose.
For decisional authority see, e.g., Conway v. Emeny, 139 Conn. 612, 96 A.2d 221 (1953).
40. 329 F. Supp. 1089 (D.D.C. 1971).
41. 329 F. Supp. at 1113.
42. Employee Retirement Income Security Act of 1974, 29 U.S.C. §§ 1001-1381 (1976).
43. See H.R. REP.No. 533, 93d Cong., 1st Sess. 13, 21, reprinted in [1974] U.S. CODE
CONG. & AD. NEWS 4639, 4651, 4659.
44. ERISA § 404(a)(1), 29 U.S.C. § 1104(a)(1) (1976).

Another obligation that trust law imposes on fiduciaries is the

duty of care defined by the prudent man rule. The case law is now
condensed in the Restatement, and effectively codified for pension
law in ERISA. 45 The Restatement says: "In making investments of
trust funds the trustee is under a duty to the beneficiary. . . to make
such investments and only such investments as a prudent man would
make of his own property having in view the preservation of the
estate and the amount and regularity of the income to be de-
rived .... ,,46
Trust law has placed greater emphasis on risk relative to return
than the modern theory of finance does, 47 but risk and return, how-
ever weighted, are factors exclusively related to the investor's
financial well-being. The highly risk averse investor of traditional
trust law accepts a lower return for a lower risk. He does not accept
a lower return for some other, nonfinancial purpose. The duty of
prudent investing therefore reinforces the duty of loyalty in forbid-
ding the trustee to invest for any object other than the highest return
consistent with the preferred level of portfolio risk.48
The chief ERIS:A administrator, Ian D. Lanoff of the Depart-
ment of Labor, has rejected the suggestion that social investing is not
subject to ERISA's rules of prudence and loyalty. He has said that
ERISA requires that the fiduciary's "overall investment strategy...
be designed to protect the retirement income of the plan's partici-
pants," and that both the duty of loyalty and the prudent man rule
would be violated if a fiduciary were to make an "investment deci-
sion based on other objectives, such as to promote the job security of
a class of current or future participants. '4 9 Social factors may be
brought in only if it is costless to do so. The Labor Department's
approval of the recent Chrysler/UAW agreement endorsing some so-
cial investing of pension fund assets was based on the understanding
that the investments in question would be "economically competitive
with other investment opportunities which may not contain similar
socially beneficial features. '50 As previously explained, the field for
such costless substitutions is limited because they usually involve
added administrative costs and, if attempted on a large scale, would
45. ERISA § 404(a)(l)(B), 29 U.S.C. § 1104(a)(1)(B) (1976).
46. RESTATEMENT, supra note 36, at § 227.
47. See Langbein & Posner,supra note 14, at 3-6.
48. A similar rationale underlies the trustee's familiar duty to invest promptly, in order to
make trust funds productive. See RESTATEMENT, supra note 36, at § 181, Comment c.
49. Lanoff, The Social Investment of PrivatePension PlanAssets: May ItBe Done Lawfuly
Under ERISA?, 31 LAB. L.J. 387, 389 (1980).
50. Id at 392.

impose on the trust the uncompensated risk that is created by inade-

quate diversification.
The attorney general of Oregon has issued a formal opinion ap-
plying the state's statutory prudent man rule to the question whether
investment managers for the state university endowment funds could
"take political and moral considerations into account in making in-
vestment decisions." He ruled that "[it is inappropriate and irrele-
vant for the investment managers to consider any factors other than
the probable safety of, and the probable income from, the invest-
ments as required by the statute." Political factors could only be
considered to the extent they affected "the safety of or return on in-
vestments.",51
There have been two notable efforts to avoid the implications for
social investing of the body of fidiciary law that we have just sum-
marized. The distinguished treatise writer, Professor Austin W.
Scott, announced his endorsement of social investing in a short state-
ment inserted in the pocket part to his treatise.5 2 And two practicing
lawyers, Ronald Ravikoff and Myron Curzan, later undertook a
53
more extensive effort in an article in the CaliforniaLaw Review.
As Ravikoff and Curzan admit, "Scott offers no rationale" and
no statutory or decisional authority.5 4 Scott states:
Trustees in deciding whether to invest in, or to retain, the securities
of a corporation may properly consider the social performance of the
corporation. They may decline to invest in, or to retain, the securities
of corporations whose activities or some of them are contrary to funda-
mental and generally accepted ethical principles. They may consider
such matters as pollution, race discrimination, fair employment and
consumer responsibility.
...Of course they may well believe that a corporation which has a
proper sense of social obligation is more likely to be successful in the
long run than those which are bent on obtaining the maximum amount
of profits. But even if this were not so, the investor, though a trustee of
funds for others, is entitled to consider the welfare of the community,
and refrain55from allowing the use of the funds in a manner detrimental
to society.
Scott makes no effort to reconcile his support for social investing
51. 38 Op. OR. ATry. GEN. No. 7616, at 2 (May 2, 1978), now being litigated in Associated
Students of the University of Oregon v. Hunt, No. 78-7502 (Lane County Cir. Ct., filed Nov.
22, 1978).
52. 3 A. Scorr, supra note 38, at § 227.17 (Supp. 1980).
53. Ravikoff & Curzan, Social Responsibility in Investment and the Prudent Man Rule, 68
CALIF. L. REv. 518 (1980).
54. Id at 527 n.31.
55. 3 A. Scorr, supra note 38, at § 227.17 (Supp. 1980).

with the trustee's duties of loyalty and prudence that he canvassed so

extensively in the body of his treatise.56 He ignores the ERISA rules,
discussed above, that contradict his position. Scott cites some of the
literature on corporate social responsibility but does not mention
that the legal analysis that has been applied in the corporation cases
is the opposite of the rule he is supporting for the law of trusts. The
rationale that has protected corporate directors in shareholder suits
complaining of acts of seeming corporate altruism is that the direc-
tors were in fact pursuing the longer-range self-interest of57the firm
and hence that their conduct has been wealth-maximizing.
Ravikoff and Curzan take a different approach. They assemble
scraps of supposed authority in order to give the appearance that the
law of trusts is in flux and is hence no obstacle to their policy prefer-
ences. Against the Blankensh#p case and its uncompromising insis-
tence that an investing strategy that does not seek to maximize the
investor's financial well-being breaches the trustee's duty of loyalty
to his beneficiaries, Ravikoff and Curzan juxtapose a misreading of
Withers v. Teachers'RetirementSystem .58 The Withers case, brought
by retirees who were beneficiaries of the New York City school-
teachers' pension fund, Teachers' Retirement System (TRS), chal-
lenged the decision of the TRS trustees to purchase $860 million of
New York City bonds as part of the plan that prevented the city
from going bankrupt in late 1975. Like most public employee pen-
sion funds, TRS had not been "fully funded." The main asset of
TRS was the city's contractual liability to pay benefits out of future
tax revenues calculated on past service. City payments to TRS in the
1974 fiscal year constituted sixty-two percent of TRS's total income
(as opposed to nine percent derived from employee contributions
and twenty-nine percent from investment income). The TRS trust-
ees testified that although the legal situation was far from certain,
their best guess was that in the event of bankruptcy essential city
services and past city bond debt would have priority over payments
to TRS and hence that payments to TRS would cease. In making
the loan to the city, the TRS trustees acted in concert with four other
municipal employee pension funds, which agreed to purchase $2.5
billion in city obligations over a two-and-one-half-year period.
The court upheld the trustees' action, even though the bonds bore
such a high risk of default that they would not have satisfied the
56. See 2 A. ScoTr, supra note 38, at §§ 170-170.25 (loyalty); 3 A. Scorr, supra note 38, at
§§ 227-227.16 (prudent investing).
57. See, e g., Shlensky v. Wrigley, 95 Ill. App. 2d 173, 180-81, 237 N.E.2d 776, 780 (1968).
58. 447 F. Supp. 1248 (S.D.N.Y. 1978), affd mem., 595 F.2d 1210 (2d Cir. 1979).

normal standards of prudent investing (the purchase was also exces-

sive in amount and would have been in breach of the duty to diver-
sify). Ravikoff and Curzan interpret the court's rationale as follows:
Withers may represent an interpretation of the prudent man rule
that is quite different from that set forth in Blankenshop. Blankenship
espouses the traditional conception of the rule: a trustee may not select
an investment that fosters nontraditional objectives at the expense of
adequate rate of return and corpus safety. In contrast, Withers appears
to permit a fiduciary to compromise these traditional objectives in
favor of the other goals-at least to some extent. The court upheld the
trustees' investment only because the investment gave much-needed
aid to the fund's principal contributor and helped to preserve the jobs
of fund participants. That is, the investment was prudent in this case
because it provided "other benefits." The prudent man standard that
emerges from Withers can thusly be cast: a trustee is permitted to sac-
rifice adequate return and corpus safety only where 59
the investment
provides "other benefits" to the interested parties.
But what the Withers court actually did was to point to the host
of special factors that made the TRS purchase justifiable under the
traditional wealth-maximizing standards of trust-investment law.
The trustees' "major concern" was "protecting what was, according
to the information available to them, the major and indispensable
source of TRS's funding - the City of New York," and they "went
to great lengths to satisfy themselves of the absence of any reason-
able possibility that the City would be able to obtain the needed
money from other sources."' 60 The trustees used the bond purchase
to precipitate federal government financing for New York City,
thereby creating for TRS's beneficiaries the prospect of reaching the
federal treasury to satisfy the City's liability to TRS. They "obtained
a provision conditioning the pension fund's investment in the City
bonds on the enactment of federal legislation" providing for interim
financing for the City.61 Indeed, since the trustees' $860 million in-
vestment was about what the City would have had to pay TRS over
the two-and-a-half-year period in question, TRS "could be no worse
off under the plan than it would be in bankruptcy without City
funds." 62 The court in Withers endorsed the Blankenship case, and
declared that "neitherthe protection of the jobs of the City's teachers
nor the generalpublicwelfare werefactorswhich motivatedthe trustees
in their investment decision. The extension of aid to the City was
59. Ravikoff & Curzan, supra note 53, at 523.
60. Withers v. Teachers' Retirement Sys., 447 F. Supp. 1248, 1252 (S.D.N.Y. 1978), affd
mem., 595 F.2d 1210 (2d Cir. 1979).
61. 447 F. Supp. at 1253.
62. 447 F. Supp. at 1253.

simply a means - the only means, in their assessment - to the legit-

imate end of preventing the exhaustion of the assets of the TRS in
the interest of all the beneficiaries. ' 63 The trustees found favor with
the court for their effort to protect their greatest asset, which was the
liability of the City to pay off its obligations to TRS over future de-
cades.
Ravikoff and Curzan next address ERISA's requirement that
pension-fund fiduciaries invest "solely in the interest of the partici-
pants and beneficiaries." '64 This provision constitutes, as Ravikoff
and Curzan correctly observe, "nothing more than a restatement of
the common law duty of loyalty. '65 Accordingly, they reason, since
"[tihe purpose of the duty of loyalty is to require a fiduciary to
avoid" self-dealing, social investing is unobjectionable "[a]s long as
the fiduciary avoids self-interested transactions ....-66 But the
view that the trustee's duty of loyalty governs only in situations of
self-dealing is incorrect. To be sure, most people who steal do it for
their own gain; that is why most of the case law concerns self-deal-
ing. But, as mentioned earlier, the trustee's duty of loyalty exists
solely for the protection of the trust beneficiary, and it is equally
violated whether the trustee breaches for the trustee's enrichment or
that of a stranger. 67 Furthermore, many forms of supposed social
investing contain overtones of conflict-of-interest or self-dealing:
"The legislative history [of ERISA] evinces deep congressional con-
cern not only with conflicts of interest on the part of employers -
such as investment in employer stock - but also with union self-
68
dealing."
Regarding ERISA's requirement that the fiduciary invest "for the
exclusive purpose of. . .providing benefits to participants and their
beneficiaries,"' 69 Ravikoff and Curzan assert that "[t]he concept of
'benefits'. . . need not be limited to payments that a participant or
beneficiary would receive upon retirement, ie., pure economic re-
turn to an investment. It is arguably broad enough to include nu-
merous types of positive returns, e.g., job security and improved
working conditions. '70 This interpretation of the term "benefits"
63. 447 F. Supp. at 1256 (emphasis added).
64. ERISA § 404(a)(1), 29 U.S.C. § 1104(a)(l) (1976).
66. Id
67. See text at note 39 supra.
68. Hutchinson & Cole, Legal StandardsGoverning Investment ofPension 4ssets/or Soclal
and PoliticalGoals, 128 U. PA. L. REV. 1340 (1980).
69. ERISA § 404(a)(1)(A), 29 U.S.C. § 1104(a)(1)(A) (1976).

was rejected by the former administrator of the Labor Department's

ERISA office, James D. Hutchinson, and a co-author, Charles G.
Cole, in an article cited by Ravikoff and Curzan but ignored on the
precise question.7 ' Hutchinson and Cole point out that "the term
['benefits'] is used more narrowly throughout [ERISA] to refer to
those cash benefits that a participant or his family would receive in
72 and
accordance with the specifications of the [retirement] plan,
they conclude "that ERISA trusts are to be established and main-
tained for the limited purpose of providing retirement benefits and
not for other, socially desirable purposes which provide collateral or
speculative 'benefits' to plan participants or appeal to the philosophi-
cal leanings of the plan sponsor or other parties associated with the
plan."73
Ravikoff and Curzan avoid the common-law prudent man rule
by rewording it to suit their purpose. After quoting the Restatement
version of the rule,74 they purport to summarize it in a form which
changes it radically, and which they thereafter treat as a statement of
the law. The objects of the prudent man rule, they say, are "preser- 75
vation of the trust corpus and attainment of an adequate return.
The term "adequate" is their own invention, and in thus implying a
standard less than "optimal" or "maximum" it is wholly without au-
thority. The authors later endorse a movement from "adequate" to
"moderate or even no return," 76 still in the name of prudence.
The trustee's duty to diversify trust investments goes unmen-
tioned in the Ravikoff and Curzan article, although breach of that
duty is a main category of potential liability for trustees who engage
71. Ravikoff and Curzan cite the Hutchinson and Cole article as it appeared in EMPLOYEE
BENEFIT RESEARCH INsTrrTUTE, supra note 4, at 27. See Ravikoff & Curzan, supra note 53, at
531 n. 49. A revised version of the Hutchinson and Cole article has since appeared in the
University of PennsylvaniaLaw Review, cited supra note 68.
72. Hutchinson & Cole, supra note 68, at 1370 & 1371 n. 151.
The only reason that ERISA is less than explicit in defining "benefits" as a strictly eco-
nomic term is that no other usage even occurred to the draftsmen. In the Congressional find-
ings that constitute the preamble to the statute the term "benefits" is repeatedly used in the
conventional and strictly economic sense. "Congress finds . . . that despite the enormous
growth in [pension and other] plans many employees with long years of employment are losing
anticipated retirementbenets owing to the lack of vesting provisions in such plans; that owing
to the inadequacy of current minimum standards, the soundness and stability of plans with
respect to adequatefund topaypromisedbenefts may be endangered; that owing to the termi-
nation of plans before requisite fund have been accumulated, employees and their benefi-
ciaries have been deprived of anticipated benefits ....... ERISA § 2(a), 29 U.S.C. §
1001(a)(1976) (emphasis added).
73. Hutchinson & Cole, supra note 68, at 1371.
74. RESTATEmENT, supra note 36, at § 227, quoted in Ravikoff& Curzan, supra note 53, at
520.
76. Id at 528.

in social investing. We have elsewhere suggested that the concept of

optimal diversification - as refined in modem capital market the-
ory, the elimination of uncompensated or nonsystematic risk - will
77
come to supply the legal standard of the trustee's duty to diversify.
If, because of underdiversification, the portfolio incurs a loss com-
pared to an optimally diversified portfolio, this loss would be the
measure of the trustee's breach of his duty to diversify and would be
recoverable as damages to the beneficiaries at the suit of any of
them. For example, with the hypothetical American National Bank
socially responsible portfolio discussed earlier, there is a 5%
probability that the portfolio will underperform an optimally diver-
sified portfolio by as much as 4.2%. If the portfolio in fact exper-
ienced that loss, it would be the measure of the trustee's liability to
the beneficiaries. Of course, the loss could be much greater. There is
a 1%chance that the hypothetical portfolio would underperform an
optimally diversified portfolio by 6.3%. Other socially responsible
portfolios could involve much larger potential losses, either because
they excluded more stocks or because they were less adroit in mak-
ing compensating portfolio adjustments.
B. A Social-Investing Vehiclefor Pension Trusts

Although neither the common law of trusts nor ERISA, correctly
and conventionally understood, permits a trustee to adopt social in-
vestment criteria on his own initiative, trust law contains two doc-
trines, authorization and ratification, that permit the settlor and the
beneficiary respectively to waive the ordinarily applicable law and
thus to excuse the trustee from what would otherwise be a breach of
trust. These doctrines could be employed to authorize social invest-
ing for a private trust, and we suggest that ratification gives limited
scope to social investing in pension trusts as well.
Authorization. The general rule of trust-investment law is that
the settlor may impose on the trust whatever investment policy he
sees fit.78 There are some rudimentary limits on the settlor's discre-
tion, not well developed in the case law, but in the main he has the
same freedom with respect to investment that he has in designating
trust beneficiaries. The law seems to have reached this result for two
reasons. First, it respects the settlor's property rights, allowing him
77. Langbein & Posner, supra note 31, at 27-28, discussing the rule codified in Restalement,
supra note 36, at § 228: "the trustee is under a duty to the beneficiary to distribute the risk of
loss by a reasonable diversification of investments, unless under the circumstances it is prudent
not to do so."
78. RESTATEMENT, supra note 36, at § 164(a).

to extend to his trustee the same power that he himself had to man-
age his property in an eccentric fashion. Second, the settlor is pre-
sumed to know the needs of his beneficiaries better than anyone else.
When he insists on the retention of the family farm or the family
firm, he is presumed to be acting in the best interest of beneficiaries
whom he knows well. That rationale has been carried over to other
investment instruments.
Ratffcation. A trust beneficiary cannot "hold the trustee liable
for an act or omission of the trustee as a breach of trust if the benefi-
''79
ciary prior to or at the time of the act or omission consented to it.
Unless the beneficiary was deceived or acting under an incapacity,
he may ratify investment practices that would otherwise be in breach
of the trust instrument or of the common law. The idea is that if the
beneficiary is entitled to receive and waste the trust funds, he is
equally entitled to allow them to be wasted while still in the hands of
the trustee.
These waiver-based doctrines become problematic in the multi-
party setting of the pension trust. Even in private trust law, the
power of one beneficiary to ratify cannot be used to impair the rights
of other beneficiaries. The typical pension trust presents the problem
not only of multiple beneficiaries but also of multiple settlors - as in
multi-employer plans and in so-called contributory plans (where the
employee contributes to the fund as well as his employer). Further,
the authorization and ratification doctrines presuppose wholly vol-
untary trusts. In pension trusts, however, employee contributions
are often required as a condition of employment; and since in eco-
nomic terms the employer-paid component is a cost of employment,
it too is best understood as a form of involuntary savings whose true
cost is borne by the employee. Since the employee is in this impor-
tant sense the "settlor" of his own pension trust account, there is
good reason to prevent plan sponsors (such as employers and/or un-
ions) from using the authorization doctrine to impose social invest-
ing upon him.
One of ERISA's innovations was the prohibition against "any
provision. .. which purports to relieve a fiduciary from responsibil-
ity or liability,"' 0 and Hutchinson and Cole observe that as a result
"the plan documents cannot authorize a policy of social investment
that would otherwise be impermissible under the fiduciary standards
of the Act." 8' This rule against exculpation clauses eliminates the
79. RESTATEMENT, supra note 36, at § 216(1).
80. ERISA § 410(a), 29 U.S.C. § 1110(a) (1976).
81. Hutchinson & Cole, supra note 68, at 1372 & 1373-75.

common-law authorization doctrine from pension trusts, but does

not appear to have that effect on the ratification doctrine. Consider a
defined-contribution plan, the basic portfolio of which was invested
to maximize risk-adjusted return, but in which the individual benefi-
ciary was allowed an election to have his contributions (as well as
those made for his account by his employer) invested in an alterna-
tive portfolio constructed on social principles. A social-investing op-
tion of this sort would seem to fall outside the purpose of the ERISA
prohibition. Although the social portfolio would be part of the plan
and hence perhaps literally within the scope of ERISA's prohibition
on noncomplying portfolios, it would lack that element of involun-
tary imposition on the beneficiary that motivated the ERISA rule.
The beneficiary who knowingly elected the social-investing option
and found the market performance of the social fund to be disap-
pointing would be estopped to complain of the imprudence of that
social fund.
In a defined-benefit plan, however, a social-investing option
seems inapposite. Even when contributory, the distinguishing fea-
ture of a defined-benefit plan is that the employer (sometimes a
multi-employer group) obliges himself to pay a certain level of re-
tirement benefits to the employee regardless of the investment per-
formance of the fund. If the fund achieves disappointing results, the
employer is liable to make up the difference. There is no reason in
law to prevent an employer from assuming such a risk on behalf of
his willing employees, but he has good reason to resist union or other
efforts to induce him to increase his pension costs and liabilities in
this way.
It would probably not entail especially significant administrative
costs for-a pension plan to offer a social-investing option, or indeed
more than one, provided that the criteria were identified for the port-
folio manager with great precision. Investment professionals tell us
that no great expense would be involved in the construction of a
portfolio that had relatively mechanical, easy-to-apply criteria for
identifying forbidden stocks (for example, $X assets in South Africa,
$Y sales volume in the defense industry, or whatever). This is not to
say that such low-administrative-cost criteria would satisfy all or
even many advocates of social investing; the point, rather, is that
some form of social-investing option could be created that would be
consistent with the trust investment law and with ERISA. The plan
sponsor would be required to inform beneficiaries about the in-
creased risk and cost of the social portfolio, in order that the choice

be a truly informed one, and to arrange for confidentiality respecting

the portfolio election of each individual, in order to protect benefi-
ciaries from union or other pressures.
Such a social-investing option would be economically sound be-
cause the consumption benefits of social investing, which the option
would secure, are, in economic analysis, as real as investment bene-
fits. But those who believe that it is sound social policy to discourage
individuals from trading future retirement benefits for current con-
sumption will have a ground for continuing to oppose social invest-
ing even in the voluntaristic mode that we have endorsed.
III. UNIVERSITY ENDOWMENTS
We have thus far considered the social investing question only in

the context of the pension fund. The analysis changes when we
move from pension trusts to charitable trusts (or to charitable corpo-
rations, which for present purposes are indistinguishable from chari-
table trusts 82). This is an area of considerable consequence for
university trustees; they are currently being pressured to apply social
criteria to the investment of their endowment funds, and some
boards of trustees have succumbed.
The distinguishing juridical feature of the charitable trust is the
absence of conventional beneficiaries. A private trust must identify
by name or by class the persons who are to take as equitable owners
of the trust property, but a charitable trust is void if it is found to
serve individual rather than community benefit.83 The charitable
trust occupies a legally privileged position: it is not subject to the
rule against perpetuities; the attorney general or other public officer
may enforce it; the cy pres doctrine protects it against ordinary rules
of defeasance; and it enjoys a variety of tax and procedural advan-
tages pursuant to statutes that follow the common-law criteria for
defining charitable trusts.8 4 The law conditions the grant of these
privileges on the requirement of indefiniteness of beneficiaries. A
charitable trust will fail if "the persons who are to benefit are not of a
82. See generally 4 A. ScoTr, supra note 38, at § 348.1.
83. A recent Pennsylvania decision dealing with the claim of the Fraternal Order of Police
to be a charitable organization concluded that the group "is essentially a labor organization
existing solely for the benefit of its own membership," and hence that "its benefits are not
applied for the advantage of an indefinite number of persons as would be the case if the public
were to benefit." Commonwealth v. Frantz Advertising, Inc., 23 Pa. Commw. Ct. 526, 533-34,
353 A.2d 492, 496-97 (1976). For a good general background on such cases, see 4 A. ScoTr,
supra note 38, at § 375.2.
84. See RESTATEMENT, supra note 36, at §§ 365 (unlimited duration), 391 (public enforce-
ment), 395 (cy pres).

sufficiently large or indefinite class so that the community is inter-

'85
ested in the enforcement of the trust.
In place of the definite beneficiaries of private trust law, the law
of charitable trusts substitutes the standard of community benefit de-
fined by a circumscribed set of charitable purposes: the relief of pov-
erty; the advancement of religion; the advancement of education and
of health (including research); and the promotion of governmental,
municipal, and other purposes beneficial to the community. 86 At the
border of each of these categories there can be serious questions
about whether particular schemes qualify, but the typical university
charter declares purposes that fall unambiguously within the cate-
gory of education and research (and often within that of health as
well).
In analyzing social investing by private and pension trusts, we
derived the trustee's obligation to invest for the maximum financial
well-being of the trust beneficiaries from the trustee's duties of loy-
alty and prudent investing; but since, by definition, the charitable
trustee does not owe such duties to particular private beneficiaries,
the question arises whether there are any legal impediments to social
investing of university endowment funds. There are several:
1. Charter. University charters are often granted by special leg-
islative act, both for state schools and private universities. A univer-
sity may also be chartered under the general nonprofit corporation
statute of the jurisdiction. In principle, an authorizing instrument
under the common law of trusts would also suffice. Regardless of
the form, a university's charter is usually restrictive; it dedicates the
institution to educational and related purposes.
A variety of the causes espoused in the name of social investing
are not within the purposes of such charters - for example, expres-
sing disapproval of selected foreign governments, or supporting cer-
tain labor union organizing campaigns. For university trustees to
spend university funds on such causes directly would be ultra vires
and put the trustees in breach of their fiduciary duty to the institu-
tion.87 Were the trustees to pursue the same end by engaging in so-
cial investing of the university's endowment funds, they would
simply be attempting to do indirectly what they may not do directly.
Under conventional charitable trust law, the state attorney gen-
eral has standing to sue to prevent such misuses of university endow-
85. Id at § 375.
86. Id at § 368.
87. See id at § 379.

ment funds. Because he is a political officer, and there will often be

more votes to gain from supporting than from opposing the groups
that advocate social investing, his intervention might not always be a
serious prospect. We doubt that the attorney general of Connecticut
would sue Yale to force it to desist from the sale of shares in compa-
nies doing business in South Africa. But the attorney general proba-
bly does not have a monopoly of standing in such cases; other
persons who have a significant economic interest in the fate of the
endowment - for example, professors and students - probably
88
may sue.
2. Noncharitablepurposes. If a particular charter is too restric-
tive to permit a particular scheme of social investing, the proponents
of the scheme may reply that the institution ought to get its charter
amended. When the charter originates in special state legislation,
the legislature can authorize virtually any use of institutional funds
(at least as regards the state law of charitable purposes, although not
the federal tax consequences). When the charter is nonstatutory and
subject to the common law of charitable trusts, valid charter amend-
ments will be impossible for many social investing schemes. The law
of charitable trusts denies private autonomy over the definition of
what purposes qualify as charitable. The standard of community
benefit does not vary with the tastes of universities or their founders,
trustees, and donors.
Some of the schemes favored by proponents of social investing
are incompatible with these legal standards. In England, a trust for
the purpose of changing existing law is not charitable.8 9 Although
this rule generally has not been followed in American law, our law
does attempt to distinguish between "social" purposes, which are
permissible, and "political" purposes, which are not.90 Trusts to pro-
mote socialist political and educational activity have been held not
charitable; 91 a similar fate befell a bequest to create an education
and information center for the Republican women of Penn-
sylvania. 92 A Scottish case held that a trust to support resistance to
88. In Coffee v. William Marsh Rice Univ., 403 S.W.2d 340 (Tex. 1966), two opposing
groups of alumni were held to have standing to intervene in a lawsuit in which the trustees of
Rice University were seeking the application of the cy pres doctrine in order to eliminate
racially restrictive provisions from the trust instrument that had created the school.
89. National Anti-Vivisection Socy. v. Inland Revenue Commrs., [1948] A.C. 31.
90. 4 A. ScoTr, supra note 38, at § 374.6.
91. See cases in 4 A. ScoTT, supra note 38, at § 374.6.
92. Deichelmann Estate, 21 Pa. D. & C.2d 659 (1959).

strikebreaking and lockouts was political and hence void, 93 and a

New Zealand case ruled similarly against a trust for the League of
Nations. 94 University trustees faced with pressures to adapt their
portfolios to the requirements of union organizing campaigns, or
some group's foreign-policy views, must beware the force of such
precedents. The price of yielding to social investing demands may
be litigation costs and potential liability for breach of fiduciary duty.
3. Donors. Past donors - more likely their heirs or successors
- may claim that since social investing constitutes a diversion from
the educational purposes for which the funds were given, it breaches
an implied or express condition and ought to trigger defeasance of
the funds in favor of the donor. In Illinois, legislation in force since
1874 denies to universities the "power to divert any gift. . . from the
specific purpose designed by the donor." 95
Donors would have a
strong argument against applying the cy pres doctrine in order to
prevent defeasance, since cy pres applies only when it "becomes im-
possible or impracticable or illegal to carry out the" original charita-
ble purpose.96 Thus, trustees who yield to pressures to divert
endowment funds from education to other causes are exposing their
endowments to the restitutionary claims of donors and heirs.
Trustees must also be concerned with the reaction of future do-
nors. The existence of vigorous competition among universities lim-
its the ability of university administrations to make investment
decisions contrary to potential donors' desires in making gifts to uni-
versities - their main desire, we assume, being to further educa-
tional objectives rather than to foster the political views of those
groups that seek to impose social objectives on the university admin-
istration. From a practical standpoint, university trustees are also
obliged to give full weight to the savings in administrative costs that
result when they are spared the endless portfolio reviews and diffi-
cult investment decisions that are involved in social investing, espe-
cially in view of the absence of agreement on the social principles to
be pursued.
In sum, even though the legal analysis that protects individual
beneficiaries against involuntary social investing in the context of
private and pension trusts does not govern in the field of charitable
trusts with indefinite beneficiaries, much of the economic analysis
93. Trustees for the Roll of Voluntary Workers v. Commissioners of Inland Revenue,
[19421 Sess. Cas. 47.
94. In re Wilkinson, [1941] N.Z.L.R. 1065.
95. IM. Rev. Stat. 1971, ch. 144, § 1.
96. RESTATEMENT, supra note 36, at § 399.

does apply, and there are serious legal impediments of a different

sort to social investing of endowment funds. To be sure, the very
competitive pressures we have just described support an argument
for a legal rule that would give university trustees the discretion to
engage in social investing or not as they see fit. The analogy would
be to the business-judgment rule which, as noted earlier, allows cor-
porate directors substantial discretion in determining which business
policies to pursue, including those, such as giving to charity, which
may seem inconsistent with profit maximization, at least in a narrow,
short-run sense. The business-judgment rule is justified by the exist-
ence of competitive pressures, in both capital and product markets,
that serve as a check against abuse of discretion by business manag-
ers; and to the extent that similar pressures operate in the market for
education, an analogous grant of discretion to university trustees in
fashioning and implementing investment policies for the university's
endowment funds could be defended on similar grounds. However,
self-perpetuating boards of trustees of nonprofit educational institu-
tions are subject to considerably less intense competitive pressures in
both their capital (fund-raising) and their product (the sale of educa-
tional services to students in exchange for tuition) markets than are
their counterparts in the business sector; and this consideration
might argue for some intermediate rule.
Our analysis ends on an uncertain note. There are legal risks to
the charitable trustee who fails to try to maximize the value of the
charity's endowment fund, but we are not prepared to say that the
law does, or should, absolutely forbid social investing by charitable
trustees. We go no further than to enumerate the legal risks, affirm
that they are substantial ones, and counsel charitable trustees as a
matter of prudence to resist to the extent possible the pressures to
follow social investing as part of their investment strategy.
In emphasizing the legal risks that university and other charita-
ble trustees incur in pursuing social investing, we do not suggest that
the law requires social grievances to go without remedy. The law of
charitable trusts has been constructed on the quite intelligent (and
efficient) premise that the grand social issues of the day should be
resolved in the institutions whose procedures and powers are appro-
priate to them. The political and legislative process of the modem
democratic state is well-adapted to dealing with pressures for social
change. Charitable trusts have been designed to serve specialized
purposes - in education, healing, the arts, research, and so forth.
They are not well suited to be fora for the resolution of complex
social issues largely unrelated to their work. There is every reason to

112 Michigan Law Review [Vol, 79:72
think that charitable trustees will best serve the cause of social
change by remitting the advocates of various social causes to the po-
litical arena, where their proposals can be fairly tested and defined,
and if found meritorious, effectively implemented.

Langbein Social Investing Laws and Trusts

Uploaded by

Copyright:

Available Formats

Langbein Social Investing Laws and Trusts

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Langbein Social Investing Laws and Trusts

Uploaded by

Copyright:

Available Formats

SOCIAL INVESTING AND THE

In October 1979 the United Auto Workers negotiated a three-

HeinOnline -- 79 Mich. L. Rev. 72 1980-1981

and have begun to utilize noneconomic criteria in the design of their

HeinOnline -- 79 Mich. L. Rev. 73 1980-1981

We also pass over the broader question - of which social invest-

HeinOnline -- 79 Mich. L. Rev. 74 1980-1981

ity - a form of personal consumption - that he derives from ex-

HeinOnline -- 79 Mich. L. Rev. 75 1980-1981

policy issues presented by social investing. The defined-contribution

HeinOnline -- 79 Mich. L. Rev. 76 1980-1981

I. THE ECONOMICS OF SOCIAL INVESTING

We begin this part of the Article with a brief introduction to the

A. An Introduction to the Economics of Investing

HeinOnline -- 79 Mich. L. Rev. 77 1980-1981

sum of the possible benefits (including dividends, interest, apprecia-

HeinOnline -- 79 Mich. L. Rev. 78 1980-1981

HeinOnline -- 79 Mich. L. Rev. 79 1980-1981

companies in both regions or industries will incur a smaller loss than

HeinOnline -- 79 Mich. L. Rev. 80 1980-1981

about optimal diversification later, when we consider some of the

HeinOnline -- 79 Mich. L. Rev. 81 1980-1981

holds. As for the stock that is undervalued because of some charac-

The studies support an even stronger conclusion: when broker-

HeinOnline -- 79 Mich. L. Rev. 82 1980-1981

B. Portfolio Adjustments by the Social Investor

HeinOnline -- 79 Mich. L. Rev. 83 1980-1981

prominent or recurrent violators of federal discrimination, pollution,

HeinOnline -- 79 Mich. L. Rev. 84 1980-1981

1. A portfolio constructed in accordance with social principles

HeinOnline -- 79 Mich. L. Rev. 85 1980-1981

HeinOnline -- 79 Mich. L. Rev. 86 1980-1981

social investing. The principal exclusions considered in these studies

HeinOnline -- 79 Mich. L. Rev. 87 1980-1981

recommendations concerning South African investments should be

22. YALE UNIVERSITY, AD Hoc COMMITTEE ON SOUTH AFRICAN INVESTMENTS, REPORT

HeinOnline -- 79 Mich. L. Rev. 88 1980-1981

HeinOnline -- 79 Mich. L. Rev. 89 1980-1981

states. Even worse effects on diversification would be caused by a

HeinOnline -- 79 Mich. L. Rev. 90 1980-1981

performance of the fund) but instead a defined-benefit plan (where

HeinOnline -- 79 Mich. L. Rev. 91 1980-1981

28. See Langbein & Posner,supra note 14, at 17-18.

HeinOnline -- 79 Mich. L. Rev. 92 1980-1981

HeinOnline -- 79 Mich. L. Rev. 93 1980-1981

incurred in slightly different activities, because the investor who is

HeinOnline -- 79 Mich. L. Rev. 94 1980-1981

uation in which many pension-fund beneficiaries find themselves.

HeinOnline -- 79 Mich. L. Rev. 95 1980-1981

optimal strategy, at least as taught by the modem finance theorists,

II. Is SOCIAL INVESTING LAWFUL FOR A TRUSTEE?

HeinOnline -- 79 Mich. L. Rev. 96 1980-1981

HeinOnline -- 79 Mich. L. Rev. 97 1980-1981

Another obligation that trust law imposes on fiduciaries is the

HeinOnline -- 79 Mich. L. Rev. 98 1980-1981

impose on the trust the uncompensated risk that is created by inade-

HeinOnline -- 79 Mich. L. Rev. 99 1980-1981

with the trustee's duties of loyalty and prudence that he canvassed so

HeinOnline -- 79 Mich. L. Rev. 100 1980-1981