Langbein Social Investing Laws and Trusts
Langbein Social Investing Laws and Trusts
Langbein Social Investing Laws and Trusts
LAW OF TRUSTS
John H. Langbein * andRichard-l.
Posner**
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.
13. We define "yield" throughout this Article to include appreciation as well as dividends
and interest.
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
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.
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).
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.).
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).
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-
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.
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.
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).
...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).
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.
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.