Fiduciary duty: great power, great responsibility

As the landscape for investment changes rapidly, so too does the notion of fiduciary duty. Fiona Reynolds, managing director of PRI, argues that using the status quo as a reason not to adapt to changing perceptions and new demands from investors is no longer possible or acceptable. The PRI will publish a fiduciary duty roadmap for long-term investment, in conjunction with the UNEP FI, UN Global Compact and UNEP Inquiry, this autumn.

Fiduciary duty was one of the recurring themes at the Fiduciary Investors Symposium held at Oxford University from April 19-21.

Fiduciary duty exists to protect the interests of beneficiaries. In the pensions fund world, one of its roles is to protect beneficiaries’ retirement funds from conflicts of interest with the trustees and asset managers who take care of the trust funds.

In today’s increasingly complex financial and economic world, the decision-making process by trustees has become ever more challenging. One of these challenges has been the increasing importance of evaluating so called “non-financial” considerations such as environmental, social and governance (ESG) factors, which has added another layer to the decision-making process.

Fiduciary duty is often given as the reason for why pension funds decline to look at ESG issues, with trustees declaring that their only responsibility is to look at financial data.

However, recent studies have broadened the interpretation of fiduciary duty away from the narrow confines of past definitions, and have emphasised that there is no conflict between fiduciary duty and ESG considerations, with a growing recognition, that ESG issues are in fact financially material to a portfolio.

If the economic downturn has taught us anything, it’s that merely looking at financial performance is insufficient to give a full picture of a company’s health. Financial performance does not tell us, for example, if a company is dumping toxic waste, mis-managing their tax exposure or dealing with supply chain risks—issues that can have enormous impact on both the company’s reputation and share price.

Ten years ago, 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.’

The freshfields report added 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.

The findings of the freshfields report were crystallised in a study released in 2014 by the UK Law Commission, which looked 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.

Prior to the Law Commission report, the Kay Review of UK Equity Markets, published in July 2012, found that investment chains were too long, with growing numbers of intermediaries between an investor and the company in which they invest. Professor Kay argued that this led to increased costs, misaligned incentives and reduced trust.

According to Professor Kay, who also spoke at the Fiduciary Investors Symposium, 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. To overcome the spectre of short-termism, Professor Kay recommended calling an end to quarterly company reporting, and the focus on short-term corporate performance.

Last year, The Financial Conduct Authority in the UK scrapped the rule requiring public firms to release interim management statements, as part of the Government’s push to encourage more long-term thinking in the stock markets.

Fiduciary duty and climate change

We know that climate change is one of the biggest issues facing investors in the coming years. Given that trustees are legally required to look at risks in their investment strategy and prudently manage those risks, climate considerations must be a part of this framework.

For example, if a trustee was to consider investing in an energy company, it is part of their fiduciary duty to consider the long-term risks associated with such an investment and focus attention on investments on companies, for example, that invest in renewable energy and are trying to achieve emissions efficiency.

When we think of pension funds, with their long investment horizons, there is also an obligation to manage risks and look at investments over the longer horizon. This means looking at all risks, including climate change.

Despite the outcry from those in the anti-climate change camp, climate change has now been recognised by myriad experts as a real and present danger.

According to the American Association for the Advancement of Science, “The scientific evidence is clear: global climate change caused by human activities is now and is a global threat to societies.” And in 2013, a new survey in the journal Environmental Research Letters of more than 12,000 peer-reviewed climate science papers, the most comprehensive survey of its kind, found that 97 per cent of scientists agree that global warming is manmade.

In Australia, a majority of surveys show that most Australian trustees now believe that addressing climate risk is part of their fiduciary duty.  (The Climate Institute and Australian Institute of Superannuation Trustees, Asset Owners Disclosure Project (Australia) Funds Survey Results, 2011). So like it or not, climate change and its concurrent risks are a reality as is the economic materiality of climate risk.

Not recognising the financial consequences of climate change is a clear breach of fiduciary duty.

Finally, trustees must recognise that the rapid growth of the pensions industry worldwide is leading to changing expectations regarding long-term sustainability and the way in which investments should be made. Using the status quo as a reason not to adapt to changing perceptions and new demands from investors is no longer possible or acceptable.

This autumn, PRI will be publishing a report, in conjunction with the UNEP FI, UN Global Compact and the UNEP inquiry, covering fiduciary duty across eight geographies—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 long term investment including ESG integration across the financial services sector and help to finally eliminate the remaining barriers around ESG and fiduciary duty.