Fiduciary Duty in Support of Responsible Investment

CONVENING REPORT Fiduciary Duty in Support of Responsible Investment January 14, 2015 Introduction On January 14, 2015, the Initiative for Responsible Investment held a Convening to discuss Fiduciary Duty in Support of Responsible Investment. Fiduciary duty is a key issue in the development of Responsible Investment in the twentieth-first century. The convening was focused on the following suppositions. Conventional interpretations of fiduciary duty have all too often served as a barrier for the responsible investment community, restraining innovations meant to align investments with long-term time horizons and the best interests of a broad set of beneficiaries. Whether trustees and advisors are dedicated to responsible investment, incorporating a broader understanding of risk into their portfolios, or wish to play a more prominent role in reshaping financial markets towards long-termism, the meaning and application of fiduciary duty is of paramount importance. Recent work on fiduciary duty has emphasized the congruence of responsible investment with the legal obligations of fiduciary duty encompassed in its duties of loyalty, care, and prudence focused on the well-being of beneficiaries. To what degree can a revitalized vision of fiduciary duty reflect a more comprehensive investment practice? To consider these issues, this convening looked at the following three themes: What are the most fruitful ideas being produced in the emerging scholarship around fiduciary duty? What are the most promising global developments in fiduciary duty? How can fruitful ideas and positive global developments be extended and deepened by those dedicated to responsible investment and the establishment of a sustainable financial system? The convening was intended to help share common understandings of fiduciary duty and approaches to remedying some of the roadblocks in the current practice of responsible investment. The agenda started with a discussion of global developments in fiduciary duty, transitioning into highlighting important ideas that are emerging in the field. The meeting ended with a discussion on the ability of a modern conceptualization of fiduciary duty to contribute to systemic understanding of how to address challenges in finance, business and society. The specific agenda was as follows: 1

SESSION ONE Current Global Developments in Fiduciary Duty FD in the UK FD in US: Practices, Regulatory and Third-Party Efforts, and Horizons of Litigation FD in Canada FD in Australia SESSION TWO What are the ideas in Fiduciary Duty that most need to be examined, extended, and/or developed? Some Important Emerging Ideas Trustee Behavior: How to Change Trustee Behavior without Litigation FD and Materiality in Practice FD and Tax Policy, Transparency and Fees The Political Process and Fiduciary Duty SESSION THREE Fiduciary Duty and Society FD and the Myth of Shareholder Value Fiduciary Society Unleashed Agency Capitalism v. Fiduciary Capitalism The meeting was conducted under Chatham House rules, and the following summary of the conversation adheres to that spirit. Session 1: Current global developments in fiduciary duty The meeting began with an in-depth analysis of a recent report of the UK Law Commission on the Fiduciary Duties of Investment Intermediaries, a significant addition to the modern literature on fiduciary duty. The Commission s inquiry, it was explained, was driven largely by the financial crisis; the UK government was concerned about the implications of short-termism in investment, which current interpretations of fiduciary duty seemed, anecdotally, to promote. The Commission looked at whether fiduciary duty, either in law or interpretation, was reinforcing problematic behavior by investors. The inquiry took place in the context of serious challenges in UK pension funds. Many funds are seriously underfunded, and while defined benefit plans are decreasing in popularity, there is recognition that defined contribution plans put pensioners at increased risk. While there was evidence that existing fiduciary duty law encourages short-termism, the bigger conclusion seemed to be the cultural use of the fiduciary duty concept to avoid awkward or probing questions from trustees or beneficiaries. There are a limited number of court cases concerning fiduciary duty, and nothing in the law mandates a responsibility on trustees to make short-term decisions in the UK, but it is true that trustees have to have prime concern for financial issues. They, however, may take into account all issues they believe are relevant. The challenge is an excessively narrow interpretation of existing law people surveyed as part of the inquiry weren t acting out of malice, but genuinely confused about what the right thing is and how to go about it. Understanding fiduciary duty as a flexible concept that allows for broader interpretations of fiduciary duty and holds trustees accountable when they are mad or bad was seen as the best path to follow. Rather than proscribe appropriate topics for trustees to consider, the Report focuses on processes and guidance for trustees who are approaching environmental, social, 2

governance, or similar topics. If a trustee is considering a topic from a financial perspective, the Report suggests a particular set of guidance that covers short-term and long-term risks and returns. Responsible investment can also be practiced by trustees from a nonfinancial perspective, so long as there is a reasonable degree of confidence that beneficiaries share these values, and secondly, that the decision to invest or not invest will not cause significant financial detriment. International regulations or similarly broadly accepted topics (conventions on human rights or cluster munitions, for example) are acceptable proxies for beneficiary norms. Fiduciary duty is understood here a balancing act there is no single right answer, but right processes to follow. Financial considerations must be respected, but such considerations include much more than short term financial returns. The UK government has accepted the Report s set of recommendations as guidance, and it is hoped that they make it into the regulatory landscape at some point. In response to this initial presentation, another respondent from the UK context reviewed a set of questions heard frequently from trustees, some of which were answered in the report, and some of which were not. This respondent suggested that the key overarching question was: how we can move from a situation where there is agreement that the law says one thing, but behavior says something different? Key Trustee Questions on Responsible Investment 1. Am I legally required to ensure that every investment I make generates the highest possible level of return within its asset class? The Law Commission Report says no, I m not legally required; but, if I m not, what s my basis for decision-making? 2. Can I legally focus on more than just short term returns? The Law Commission Report says yes, you are not legally required to focus on short term returns, and you are legally required to take a longer-term view. But, it s important to think beyond legal obligations, as the funding status of a particular pension may require different approaches. 3. How, if at all, can I or should I take action to protect the long term health of the economy on which the long term performance of my fund requires? You can take action to protect the long term interest of the economy if you judge it in the long term financial interest of your plan. 4. Can I have an eye on ESG issues? Yes, if those issues are financially material. 5. What, if anything, should I divest from? There is some past experience with divestment, and use of international agreements has served as valid reference points for social norms judgment by other investors. Next, the conversation turned to the US. An observer described the current climate of attacks on defined benefit plans, and explained how fiduciary duty is used as an excuse to tell trustees that they cannot engage in responsible investment, as well as to chill debate on the topic among trustee boards. However, it was suggested that there is some favorable legal precedent in US case law for an understanding of fiduciary duty that allows for responsible investment to the 3

extent that investments provide economic benefits to beneficiaries. Another observer from the US described varying legal standards for fiduciary duty across levels of government, suggesting potential for greater flexibility at the state, county, and municipal levels around fiduciary duty. However, as in the UK, ongoing issues with interpretations of fiduciary duty both in how it is described by asset managers, lawyers, and consultants, and how it s taught to trustees at seminars and conferences pose cultural challenges. Specific efforts to address fiduciary duty challenges in the US were addressed in two parts: advocacy around fiduciary duty interpretation at the federal level, and provision of material sustainability information that meets legal standards of materiality. The Canadian perspective was examined next, in particular the challenges of Canada s focus on natural resources, which makes the issue of the E in ESG a complex one in the country. Canadian fiduciary duty is closely aligned to that of the UK. There is no specific case law challenging trustees who have taken ESG considerations into account. It was observed that the Canadian judiciary seems more likely to take up fiduciary duty questions of the type discussed in the convening, more that courts in the UK or US. Similar to Canada, Australia s fiduciary duty law is also a product of common law and significant shifts towards defined contribution plans have effected substantial changes in regulation of trustee practice. In Australia, the biggest challenges to responsible investment when talking to trustees have been fiduciary duty, the judgment rule, and a belief that it s not their job to take those issues into account. However, increasingly stringent standards for trustees to act as prudent professionals, enacted in the last few years, make it clear that trustees must be proactive and actively oversee what is happening in the fund. In practice, while fiduciary duty and trustee law do not explicitly reference anything related to responsible investment, the increased standards for trustees means that ignoring climate change and similar topics with financial repercussions for the fund is a breach of duty. Climate change is seen as a material financial issue. In general the law doesn t mandate what you do, but does require a trustee to think about the topic in a diligent way. Session 2: What are the ideas in fiduciary duty that most need to be examined, extended, and/or developed? In reviewing important ideas in the field, especially in light of the publication of the Cambridge Handbook of Institutional Investment and Fiduciary Duty, it was observed that the 2008 financial crisis and the continuation of the development of the theory and practice of responsible investment has created various practical and intellectual tensions in the field, presenting an opportunity for thinking about what the impact of the crisis means in terms of business as usual. An observer noted that recent conversations around responsible investment have been predicated on the materiality of ESG information, which is a very contained argument that has been successfully advanced with organizations like the UNPRI. From an academic perspective, most researchers are being asked to provide an evidentiary basis for the materiality of ESG factors, but it s difficult to point to that payoff in the short term versus the long term, especially in regard to the "S" in ESG. The way that ESG has been sold promises investors change without a cost, but real change will absolutely have some cost; what does fiduciary duty look like when we ve said you can take ESG considerations into account, but you can t sacrifice return? This concept and question sparked a conversation about the difference between a principlesbased and a rules-based approach to fiduciary duty. The courts are clear that standards for what is material for the investor is fairly high and they wish to avoid situations where companies are so worried about everything being material that they dump a boatload of useless information on 4

investors. Materiality is a mushy concept it was argued, and both US Supreme Court and the Securities Exchange Commission often seem to assume a singular reasonable investor, but there are multiple kinds of investors. What if an average investor doesn t exist at all? Is there a single investment theory to determine what is material and what isn t? It was agreed that climate change is a material factor, no matter the details of one s perspective on fiduciary duty, or what definition of materiality is used. Further questions were raised about the role of empirical evidence and at what point, consistent with fiduciary duty, investors might be prepared to sacrifice short term financial return for greater long-term returns and stability. Throughout the day, the cultural, non-legal elements of fiduciary surfaced, and were discussed at length in this section. This discussion focused at length on the agency chain between people who have the money, and where the money is ultimately invested. The power dynamics of staff, trustees, and service providers was discussed in detail. It was suggested that a key piece of work in this responsible investment and fiduciary duty question is to tackle power and cultural relationships that distance investments from society and confuse control over investment decisions. Whether this is something that national governments, unions, or other stakeholder groups can or should take the lead on was discussed briefly. Section 3: Fiduciary duty and society The last section started with a conversation about the idea that the primacy of shareholder maximization is a myth. It was suggested that when we talk about fiduciary duty, outside of some narrow contexts, basically a business judgment rule prevails and trustees have legal discretion to do a wide variety of things. Any other perspective is simply a result of cultural norms and a default to maximizing profits as a benchmark because it is the safest thing to do, and the incentives and capacity aren t there to do otherwise. This is something that is changeable, and perhaps generational change is a leverage point. Next, it was suggested that we are at the beginning of a new era of capitalism where asset owners play a more substantial role in how financial markets operate, specifically encouraging more long-term capital formation. Agency capitalism may be changing to fiduciary capitalism. This approach to investment gives asset owners the ability to change the rules of the game, though they now own the tragedy of the commons and have responsibility for investing to minimize their liabilities. Further, the depth of the importance and substance of fiduciary principles was seen as cascading through society, including through its regulation, law and practice. Such use of the fundamental ethical relationship between those in a fiduciary relationship provides a potential anchor for a number of important societal relations in civil society. In this context, a conversation about the fiduciary duties of endowments was advanced, and the differences that a more diffuse set of beneficiaries may or may not make for such an understanding of fiduciary duty. Finally, it was observed that progress in the understanding and use of fiduciary duty in investment and society is present. Current failures in interpretation and practice are based on profit maximization and current cultural practices, not iron clad legal or historical regimes. Thus, adjustments to behavior, regulation, law and culture of fiduciary duty may hold the key to the advance of fiduciary duty at a time in condition of the planet and its people that may hold tremendous promise. 5