Legal Context

Legal context: barriers to and enablers of sustainable investing

UK and US pension funds planning to engage in sustainable investing should not overlook their fiduciary requirements. These were discussed in detail in the previous Chapter, but it is worth adding a few further comments in the context of this Chapter’s framework. Debate surrounding fiduciary duty with respect to sustainable investing, and more generally SRI and RI, should move beyond references to the 1984 UK case of Cowan v Scargill458 and the early US work of Langbein and Posner, upon which many industry discussions on the subject appear to be built.

The preliminary work of Johnson and de Graaf with respect to the oft-forgotten duty of impartiality is useful in this regard. The fiduciary focus here is practical – this Chapter emphasises the importance for pension funds of documenting prudence and loyalty. The framework presented is designed to help pension fund trustees to do so, and therefore to protect themselves (and their beneficiaries) against potential breaches of fiduciary duty. This section concludes by considering the law’s constructive capacity, and suggests a number of potential regulatory enablers of sustainable investing for future discussion and research.

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Fiduciary Duty and Sustainable Investing: the need to document prudence and loyalty

Many authors have addressed the issue of whether various forms of SRI and RI are consistent with fiduciary duty. It is beyond the scope of this Chapter to examine all of their arguments in depth. It suffices to say that the issue of whether SRI and RI are compatible with fiduciary duty centre on two element of fiduciary duty as it applies in the context of US and UK pension funds: the duties of loyalty and of prudence. Putting to aside the minor variations in formulation between sources of law, the duty of loyalty requires trustees to act in the best interests of the beneficiaries.

The duty of prudence requires trustees to exercise prudence, or skill, care and diligence, in managing trust funds for beneficiaries. Under both US and UK law, prudent management of trust funds today means managing trust funds in accordance with modern portfolio theory.Following a spate of ethically-driven SRI in the late 1970s and 1980s (mainly consisting of divestment from companies in Apartheid Africa) critics argued that trustees were using SRI to further their own moral or political purposes, rather than to promote the financial interests of beneficiaries, and in doing so narrowed their funds’ investment universe in what amounted to a violation of both the duties of loyalty and prudence. These views were backed up by judicial decisions in both the US and the UK. However, the form that SRI took in the early cases such as these differs markedly from the form of RI or sustainable investing around which this Chapter’s framework is designed.Nonetheless, as the previous Chapter argued, the persistent lack of clarity in this area, combined with a tendency for courts and commentators to equate prudence with adherence to the status quo continues to dissuade trustees from adopting investment strategies (such as Strategy B) that break with convention (Strategy A) (see Table 2). In this climate of legal anxiety, it is all the more important for pension funds trustees to protect themselves (and the beneficiaries of their funds) with good governance.Where pension fund trustees can document the steps they have taken to arrive at the decision to implement an RI or sustainable investing strategy, and where those steps are based on sound investment beliefs, they should be able to demonstrate that their decisions were in the best interests of beneficiaries.

In this context, the framework provides trustees with a transparent structure, which, if executed properly, should establish that any such strategy is based on strong beliefs about the advantages it will provide to beneficiaries. It is difficult to see how a well articulated RI or sustainable investing approach demonstrably based on sound investment beliefs in and designed in the best interests of beneficiaries can be said to violate either the duty of loyalty or of prudence.The debate over whether RI or sustainable investing (in the form presented in this Chapter) violates the duties of loyalty and prudence has become somewhat stale. Until a new case on point is heard or relevant legislation is enacted, little can be gained from continuous rehashing of these old issues. That said, Johnson and de Graaf’s recent article questioning whether pension fund trustees are adequately addressing another aspect of their fiduciary duty, the duty of impartiality, does bring some fresh thought to the area. The duty of impartiality requires trustees to ‘make diligent and good-faith efforts to identify, respect, and balance the various beneficial interests when carrying out the trustees’ fiduciary responsibilities in managing, protecting, and distributing the trust estate’. While it is a long-standing duty in trust law, courts and scholars ‘have generally left the nature and implications of the duty vaguely defined and little explained.

’Johnson and de Graaf argue that pension fund trustees who are overly shortterm oriented may breach their fiduciary duty by, in essence, favouring older beneficiaries over younger ones:

Excessive focus on short-term investment horizons, use of short-term benchmarks and evaluation of portfolio managers based on short-term results, as well as a lack of attention to the risks associated with potential long-term value destruction … should ring fiduciary alarms for pension funds that are managing assets to meet liabilities over several generations.

It is difficult to know where to limit Johnson and de Graaf’s argument. In the context of pension funds, which often have thousands of beneficiaries at any one time, a narrow interpretation of the duty of impartiality could place unreasonable burdens on trustees.

However, it is an argument worth developing further, and may provide extra support for the value to be derived from long-term investing strategies.

Potential Regulatory Enablers of Sustainable Investing

Fiduciary duty is chiefly seen as a preventer of harm; regulation may also act as an enabler of constructive behaviour. Leaders in both the US and the UK could consider a number of potential regulatory enablers of sustainable investing. The suggestions here are not detailed, and do not presume to answer they questions they will raise, but instead to outline some discussion points for future research:

  • The introduction of ‘safe harbour’ principles: this approach could create incentives for sustainable investing by preventing litigation against fiduciaries with respect to practices covered by safe harbour clauses (where fiduciaries have followed due process and acted in good faith). The safe harbour clauses could be designed to protect from litigation fiduciaries that choose to adapt an RI or sustainable investing approach as described in this Chapter. Safe harbour principles have been used to provide trustees with a degree of certainty of compliance with their fiduciary obligations with respect to defined contribution default plans in the US under ERISA.
  • The introduction of a ‘comply or explain’ process with respect to sustainable investing: under this approach, legislators would encourage pension funds to think of sustainable investment as a norm, by requiring them to either comply and adopt aspects of sustainable investment (‘comply’) or provide a written explanation detailing why they have chosen not to comply and for what time period (‘explain’).

    This approach portrays sustainable investing as legislatively sanctioned, while allowing an alternative line of action to be pursued subject to explanation. Similar legislation has been effective in raising governance standards in the UK with respect to corporate governance (see Combined Code on Corporate Governance 2003 (UK)) and pension investment governance (‘Myners Principles’), and has already appeared to a limited extent for UK pension funds with respect to ESG issues. Under the Pensions Act 1995, pension funds must produce a written statement of investment principles (‘SIP’). The SIP must cover ‘the extent (if at all) to which social, environmental or ethical considerations are taken into account in the selection, retention and realisation of investments’. This regulation stops short of being a comply or explain approach because it merely requires pension funds to state whether they take social, environmental and ethical considerations into account, but not why they choose not to do so. This approach, while accommodating very limited response by many funds, is still productive in that it is sufficiently flexible to allow pension funds to adjust their strategies at their own pace, while gradually contributing to a change in expectations about sustainable investment.

  • Government funding for a permanent academy for training with respect to RI or sustainable investing: this has occurred in Australia, with the creation of the Responsible Investment Association of Australasia in 2007 (previously known as the Ethical Investment Association).
  • Government support for and engaged oversight of collaborative responsible investing activity: the UN PRI Clearinghouse arrangement is an early example of appropriate support for such activity.

Conclusion

This Chapter has presented a governance framework intended to provide UK and US pension funds with practical guidance for the successful implementation of sustainable investing. It has focused on the changes that pension funds adopting sustainable investing could make to their investment strategies and governance (in particular with respect to investment mission and investment beliefs). It has discussed how the framework is positioned with respect to fiduciary duty, arguing that it offers pension funds a structure that will help them to demonstrate their compliance with the fiduciary requirements of prudence, loyalty and impartiality. Finally, this Chapter notes that regulation, while often proscriptive, may also act as an enabler of constructive behaviour – to this end several potential regulatory enablers of sustainable investing have been put forward for future discussion.This Chapter has acknowledged the extensive terminological debate in this area.

It is to be hoped that widespread, successful implementation of sustainable investing or RI would put an end to the need for such debate. That is to say, if over time ESG-inclusive, intergenerationally equitable investing can be shown to be effective and desirable, at some point its goals will become internalised into pension fund investment beliefs systems. At this point, terminology would change: the terms sustainable investing and RI could drop from the lexicon, and the actions they describe would become merely ‘investment’. Behavioural norms have been shown to have a deep influence on the development of legal understandings. Thus, should norms change with respect to investment, a parallel development might be expected of law. If sustainable investing were to become increasingly conventional, it is arguable that trust law would treat it increasingly as a prudent manner of investing, obviating the need for inquiry into whether sustainable investing (as opposed to mainstream investment) met with fiduciary standards.Beyond the practical focus of this Chapter, there is a wider story to tell. In today’s changing economic conditions, a question arises about how pension fund investing should evolve to deal with emerging intergenerational problems associated with environmental and social risk and uncertainty.

The US Securities and Exchange Commission’s release of interpretive guidance about whether and when public companies should disclose climate change risk demonstrates, at the very least, an acknowledgment of the potential of climate change risk. Beyond climate change, other issues are changing the world economy. Ageing populations are expected to put increasing burdens on the pension fund industry. The developing economies of countries such as China, India, and Indonesia are now increasingly influential.

The scale of the US’s debt to China seems to suggest if not the start of, then at least the potential for, a new economic order.Under these circumstances, it is not inconceivable that pension fund governance may need to be rethought in the future. The pension fund, after all, is one of the few institutions that has a truly intergenerational role – arguably more so than governments, whose mandates often go no further into the future than the date of the next election. As the demands of the economy change, the role of pension funds in ensuring a level of intergenerational equity between members may become increasingly significant, perhaps through a renewed interpretation of the duty of impartiality. For the time being, however, the framework presented here provides a practical way for pension funds to implement a sustainable investing strategy that not only includes ESG and ownership considerations, but also provides for a focus on the long-term, allowing funds to prepare themselves for the economic and legal challenges of the futureNext Page – Sustainable Investing Framework