Principles for Responsible Investment: Fiduciary Duty – Coming of Age

fdUnfortunately, fiduciary duty can be a contested term when it comes to investments, with different legal interpretations in countries around the world. 

Fiduciary obligations exist to ensure that those who manage other people’s money act responsibly and in the interests of their beneficiaries (or clients), rather than serving their own interests. The nature of the fiduciary relationship means that a fiduciary is expected to be loyal to the person to whom they owe a duty. In particular, fiduciaries should not put their personal interests before the duty to their beneficiaries: they should avoid conflicts to the extent possible (and, if they cannot be avoided, conflicts should be minimised, disclosed, and carefully managed to prevent any breaches of loyalty obligations); they should ensure that their fiduciary duty does not conflict with other legal duties or their own interests; and they should not profit unreasonably from their fiduciary position.

An important part of managing someone else’s money, is to act with the same care and diligence as you would when managing your own affairs. That means managing risk. Risk covers a wide variety of issues and includes environment, social, and governance risks, which can, and do, affect investment returns.

“An important part of managing someone else’s money, is to act with the same care and diligence as you would when managing your own affairs.”

For some, fiduciary duty and environmental, social, and governance (ESG) considerations do not always sit well together. Part of this has to do with how legal cases over the years have been interpreted with regard to fiduciary duty. Another part of it is how people assess risks. Some investment professionals believe that looking at any considerations other than financial performance is a breach of their fiduciary duty. The answer to this latter point is that we need to expand our risk universe and our interpretation of financial risk as a company may look solvent according to the bottom line but a host of ESG time bombs might be waiting to go off which could place in jeopardy the reputation, financial performance, and even survival of the organisation. In recent years, we have seen this all too frequently, with ESG scandals from oil spills to Libor rigging erupting across well-known organisations.

Fiduciary duty and ESG risks really came into the spotlight a decade ago when the landmark UNEP FI (United Nations Environment Programme Finance Initiative) report, The Integration of Environmental, Social, and Governance Issues into Institutional Investment was published. The report concluded that “integrating ESG considerations so as to more reliably predict financial performance is clearly permissible and is – arguably required – in all jurisdictions.”

In 2005, a report by international law firm Freshfields Bruckhaus Deringer concluded that pension funds are legally required to consider an ESG criterion, if there is a clear consensus amongst beneficiaries in favour of this criterion or if the criterion is believed to be financially beneficial.

The report went on to say that when exercising their powers, trustees must take into account all relevant considerations and ignore any irrelevant considerations. This is the duty of adequate deliberation, and concerns the nature of trustees’ decision-making process rather than the scope of the power itself. There are no “hard and fast rules” as to what might be relevant. For example, it is fairly well settled that the tax consequences of a decision will usually be relevant.

Following on from the Freshfields report, in 2014 the Law Commission in the UK released a report looking at how the law of fiduciary duties applies to investment intermediaries and to evaluate whether the law works in the interests of the ultimate beneficiaries. The project arose from the Kay Review, published in July 2012. Professor Kay conducted a year-long review of the UK equity market and was highly critical of the way it worked.

One of his main findings was that investment chains were too long, with growing numbers of intermediaries between an investor and the company in which they invest. He argued that this led to increased costs, misaligned incentives, and reduced trust.

According to Prof Kay, the central problem was “short-termism” in which many investment managers “traded” on the basis of short-term movements in share price rather than “investing” on the basis of the fundamental value of the company. Furthermore, shareholders did little to control bad company decisions.

Who Has Fiduciary Duties?

In investment, the most common fiduciaries are the trustees of trusts or pension funds. Beyond trustees, different jurisdictions have different interpretations of who exactly holds fiduciary obligations and who simply has duties of care. A comparison between the United Kingdom and the United States provides a good illustration of these differences. In the UK, investment consultants do not generally define themselves as fiduciaries, whereas they are accepted as such in the United States.

Moreover, in the US the Employee Retirement Income Security Act (ERISA) explicitly states that fiduciary liability attaches not only to trustees but also to anyone exercising discretion over investment plan assets. That is, under ERISA, asset managers have direct fiduciary obligations, and the appointment of asset managers is itself a fiduciary function. In the UK by contrast, where fiduciary obligations are not defined in this way, some asset managers consider that their relationship with clients has a fiduciary character whereas others consider it defined by, and limited to, the contract between them.

“This autumn, PRI will be publishing a report, in conjunction with the UNEP FI, covering fiduciary duty across eight national jurisdictions: US, UK, Canada, Germany, South Africa, Brazil, Japan, and Australia. We hope that this report will serve as a global roadmap – or action plan – for ESG integration across the financial services sector and help remove the last remaining barriers to the question of ESG and fiduciary duty.”

This question of who holds fiduciary duties is likely to change. The shift in many countries to contract-based defined contribution (DC) pensions raises the question of who is responsible for protecting the interests of these savers. The specific question that policy makers will need to address is what duties are owed by insurance companies, asset managers, and sponsoring organisations (i.e. employers) in contract-based schemes (i.e. where the pension provider does not have fiduciary or equivalent obligations to the beneficiary in the way that a trustee would in a trust-based scheme).

In the Netherlands, the board members of a pension fund have a statutory duty to – in the performance of their duties – follow the interests of the scheme members, deferred members, the pension beneficiaries, and employers. The board must also ensure that these parties can feel that the consideration of their interests is balanced.

Also in the Netherlands, a draft legislative proposal introduces a catch-all clause with a fiduciary duty for providers, advisors, and intermediaries regarding – in short – investment properties, electronic payments, current accounts, loans, savings accounts, and insurances. This draft proposal does not apply to investment firms. The proposal states that these financial services providers must observe the interests of the client carefully; that advisors must act in the best interest of the client, and that these financial services providers must refrain from acts or omissions that have or may have negative consequences for their clients.

Can Fiduciaries Only Consider Financial Factors in their Decisions?

In many jurisdictions, fiduciary duty is widely considered as imposing obligations on trustees or other fiduciaries to maximise investment returns. This narrow interpretation originated from the concern that trustees might put their personal ethical values over their fiduciary obligations to their clients or beneficiaries; this position appeared to be confirmed in the widely cited 1984 case of Cowan vs Scargill, although this narrow interpretation has been challenged (see, for example, UNEP FI (2005), Fairpensions (2011), and Kay (2012).

Apart from the legal implications of this case, the practical consequence has been that environmental, social, and governance (ESG) risks have tended to be neglected in investment practice; that the maximisation of investment returns has focused on short-term returns rather than seeking an appropriate balance between short and long-term returns; long-term and systemic risks to savers have been overlooked, and there has been relatively low demand for active ownership (e.g. engagement) directed at the creation of long-term sustainable investment value.

This is changing in a process driven by three factors. The first is that as the materiality of ESG issues has become clear, meaning the argument that investors should not take account of these factors in investment practice has become less tenable. The ground-breaking 2005 Freshfields Report on fiduciary duty stated: “…in our opinion, it may be a breach of fiduciary duties to fail to take account of ESG considerations that are relevant and to give them appropriate weight, bearing in mind that some important economic analysts and leading financial institutions are satisfied that a strong link between good ESG performance and good financial performance exists” (UNEP FI, 2005, p. 100).

The second is that expectations of investors are changing. As more and more investment organisations make commitments to responsible investment it is likely that the duties that investors owe their clients will also evolve to reflect these changes. That is, the interpretation of fiduciary duty, both in practice and at law, is likely to be much wider than at present.

The third is that the assumptions (e.g. in relation to the efficiency of markets) underlying the prevailing finance theories used during the last half of the 20th century have been questioned over the past decade, in particular as a result of the global financial crisis. The consequence is that investors are increasingly expected to take account of factors such as systemic risks and low probability/high consequence events (“black swan” events), as well as the insights from areas such as behavioural finance, in their investment decisions.

We are also starting to see action by beneficiaries who believe that trustees who do not take issues such as climate change into account are in breach of their fiduciary duty, by not properly assessing the risk that climate change may cause to investments over the long term.

Recently, it was revealed that the law firm Climate Earth is preparing for such an action against the trustees of a yet to be named UK pension fund. There is also discussion of a claim against a US endowment fund, for the mismanagement of the funds finances due to the fact that the fund has a large holding in fossil fuels.

This autumn, PRI will be publishing a report, in conjunction with the UNEP FI, covering fiduciary duty across eight national jurisdictions: US, UK, Canada, Germany, South Africa, Brazil, Japan, and Australia. We hope that this report will serve as a global roadmap – or action plan – for ESG integration across the financial services sector and help remove the last remaining barriers to the question of ESG and fiduciary duty.


About the Author

Fiona Reynolds is the managing director of Principles for Responsible Investment (PRI).

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