Responsible Investment from a Fiduciary Perspective November 18, 2008
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1 Responsible Investment from a Fiduciary Perspective November 18, 2008 Murray Gold, Partner Queen Street West Toronto, Ontario, M5H 3R3 Tel: Fax: mgold@kmlaw.ca
2 Introduction Legal context of investments influenced by environmental, social and governance ( ESG ) considerations in a fiduciary context. Focus is on pension funds. Greater latitude in non-pension, especially non-trust situations. 2
3 General Nature of Fiduciary Obligations Pension fund administrators hold the assets of the funds which they invest as trustees. A trust is a unique legal entity; its nature is quite different from that of an individual or a corporation. 3
4 General Nature of Fiduciary Obligations The essence of a trust is that it splits the ownership of assets into two aspects: legal ownership, and beneficial ownership. Legal ownership is in the trustee, but beneficial ownership, is in the beneficiaries. 4
5 General Nature of Fiduciary Obligations When exercising the powers of the legal owner, the trustee is obliged to do so not in the trustee s own interest, but in the interests of the beneficiaries. 5
6 General Nature of Fiduciary Obligations When the law sees power over an asset in one party, but the intended benefit of the asset in another, relatively powerless party, the law imposes extremely strict obligations from the legal owner towards the beneficial owners. These obligations are known as fiduciary obligations. 6
7 General Nature of Fiduciary Obligations Among other things, fiduciary obligations entail a duty of loyalty, i.e. a duty to act solely in the best interests of the plan s beneficiaries 7
8 General Nature of Fiduciary Obligations A corollary to the duty of loyalty is the duty to avoid conflicts of interest. A conflict of interest arises where an interest affects a trustee so as to distract the trustee from their duty of loyalty towards the beneficiaries. 8
9 Fiduciary Law and Restrictions on ESG Courts in Canada have not yet considered the ESG issues, though they have often written about fiduciary obligations. However, there are conflicting leading decisions in both the U.K. and the U.S. in regard to ESG. 9
10 Fiduciary Law and Restrictions on ESG In the U.K., the leading case in this area continues to be Cowan v. Scargill, a 1984 decision of Sir Robert Megarry. In that case, Arthur Scargill, President of the National Union of Mineworkers, advocated that the investment strategy for the Coal Miners Pension Funds prohibit or limit investments in industries that competed with 10
11 Fiduciary Law and Restrictions on ESG coal (including oil), and prohibit or limit investments outside the U.K. Scargill s opponents took the position that these limits were motivated by a desire to protect employment in the coal mines, and not by the best interests of the pension plan s beneficiaries (which included retirees). 11
12 Fiduciary Law and Restrictions on ESG In its decision, the court set out a number of principles which continue to be cited in this area. Perhaps most important, the court in Cowan v. Scargill set out the principle that the best interest of the beneficiaries generally meant their best financial interests. 12
13 Fiduciary Law and Restrictions on ESG The emphasis on best financial interests was especially applicable to pension funds, because they provide financial benefits. 13
14 Fiduciary Law and Restrictions on ESG A second important principle articulated by the court put the ESG issue in the context of a conflict of interest, and prohibited the trustees from making pension investment decisions on the basis of their personal and political beliefs. 14
15 Fiduciary Law and Restrictions on ESG The Court decided against the National Union of Mineworkers, and held that the investment limitations and restrictions that were proposed, were not appropriate for pension plans. Cowan v. Scargill may well be the high water mark of a strict application of fiduciary principles restricting trustees from making investment decisions for moral or ethical reasons. 15
16 Fiduciary Law and Restrictions on ESG However, the Cowan decision has also received much criticism; critics argue that the decision has been overinterpreted. Judge Megarry subsequently indicated that the case may have been differently decided if the policy had been expressed as a preference, other things being equal. 16
17 Fiduciary Law and Restrictions on ESG In the U.S., the courts have adopted a similar approach to ESG, but have come to different conclusions in different factual circumstances. 17
18 Fiduciary Law and Restrictions on ESG In the U.S., the two leading cases are Withers v. Teachers Retirement System, and The Board of Trustees of the Employees Retirement System of the City of Baltimore v. The Mayor and City Council of Baltimore City 18
19 Fiduciary Law and Restrictions on ESG The City of Baltimore case took a somewhat different direction from the Cowan v. Scargill. 19
20 Fiduciary Law and Restrictions on ESG It concerned an ordinance adopted by the City of Baltimore, directing the trustees of its pension funds to divest themselves of companies doing business in South Africa. The magnitude of the divestment was significant: 20
21 Fiduciary Law and Restrictions on ESG It was estimated that the ordinance would bar investments in 120 of the 500 companies in the S&P 500 Index that represented approximately forty percent of the market capitalization of that index. 21
22 Fiduciary Law and Restrictions on ESG On the other hand, the ordinance permitted the trustees to suspend the divestments if they concluded that the funds had been performing below their five-year average, or that continued divestment would be inconsistent with generally accepted investment standards for pension funds or would cause financial losses to the funds. 22
23 Fiduciary Law and Restrictions on ESG Suspensions of the divestments were permitted for up to ninety days, and the trustees did in fact make use of the suspension power repeatedly. 23
24 Fiduciary Law and Restrictions on ESG The trustees argued that the ordinance restricted their ability to diversify, and imposed divestment costs and ongoing compliance costs. They argued that such restrictions were imprudent, and contravened their duty of loyalty by requiring to them to consider the situation in South Africa rather than the financial interests of their beneficiaries. 24
25 Fiduciary Law and Restrictions on ESG The court found that the initial cost of divestment would be $750,000, or 1/16 of 1% of the funds total value. It also found that there would be ongoing costs of $1.2 million per year, or 1/10 of 1% of the funds total value. Both the trial court and the Court of Appeal in Maryland concluded that these amounts were minimal, and declined to pay any attention to them. 25
26 Fiduciary Law and Restrictions on ESG In terms of legal doctrine, the Maryland Court of Appeal also adopted a different view from that taken by the U.K. courts. Citing a leading U.S. academic authority on trust law, the court rejected the proposition that trustees are rigidly bound to attempt to secure the maximum return, whether it is to income or principal, consistent with safety. 26
27 Fiduciary Law and Restrictions on ESG The court cited a leading text on trust law, as follows: Trustees in deciding whether to invest in, or to retain, the securities of a corporation may properly consider the social performance of the corporation. They may decline to invest in, or to retain, the securities of corporations whose activities or some of them are contrary to 27
28 Fiduciary Law and Restrictions on ESG fundamental and generally accepted ethical principles. They may consider such matters as pollution, race discrimination, fair employment, and consumer responsibility. 28
29 Fiduciary Law and Restrictions on ESG In reaching this conclusion, the court relied, in part, the distinction between short-term and long-term earnings, and held that a socially responsible approach may be beneficial in the longer term. Finally, the court concluded as follows: 29
30 Fiduciary Law and Restrictions on ESG The Mayor and City Council of Baltimore were motivated to enact the Ordinances, in part, because the Trustees prior investment practices offended a growing number of the systems beneficiaries and residents of the City. Moreover, given the vast power that pension trust funds exert in American society, it would be unwise to bar trustees from considering the social 30
31 Fiduciary Law and Restrictions on ESG consequences of investment decisions in any case in which it would cost even a penny more to do so. Consequently we conclude that if, as in this case, the cost of investing in accordance with social considerations is de minimis, the duty of prudence is not violated. Accordingly, we hold that the Ordinances do not alter that duty. 31
32 Fiduciary Law and ESG Obligations In our view, the law as set out in the four cases referred to above is not internally consistent. It is not possible to reconcile the Maryland Court of Appeal s decision in The City of Baltimore case, with Sir Robert Megarry s decision in Cowan v. Scargill. So, the boundaries of the restrictions remain somewhat uncertain. 32
33 Fiduciary Law and ESG Obligations But, no case rules out and, indeed, the general fiduciary obligation requires - that trust investments be made with regard to all risk and return variables, including balance sheet risks, business risks, technology risks, legal risks, governance risks and social, environmental and labour risks. 33
34 Fiduciary Law and ESG Obligations Indeed, it would be negligent and a breach of fiduciary obligation to ignore material risks or opportunities, whatever their character. Going forward, we would expect that the issue of ESG will be considered less in the context of investing for non-investment reasons (very limited potential) and more in the context of investing having regard to all material opportunities and risks, whatever their character. 34
35 Other Investment Vehicles (not pension plans) Where trusts have a financial purpose, their mission is generally considered to be financial. However, where the purpose of the trust is different, there is more flexibility in the pursuit of non-financial goals. So, cancer charities need not invest in tobacco companies. 35
36 UN Sponsored Initiative April 2006 On April 27, 2006, the UN Secretary General launched the global Principles for Responsible Investment ( PRI ) at the New York Stock Exchange. PRI have been generated by an investor group sponsored by the UN, though the PRI is not a UN document. 36
37 UN Sponsored Initiative April 2006 The investor group participants included a number of pension plans, primarily from Europe and North America as well as a small number of charitable and investment trusts. The Canada Pension Plan Investment Board participated in the investor group, as the TIAA CREF and CALPERS. 37
38 UN Sponsored Initiative April 2006 The PRI consists of six principles for responsible investment, together with possible actions that may be taken to implement them. See Appendix 38
39 UN Sponsored Initiative April 2006 The UNEP Finance initiative sponsored a report on the legal aspects of ESG investing from Freshfields, an international law firm based in London. Freshfields concluded that institutional investors were obliged to consider ESG factors in assessing risk and return criteria. 39
40 UN Sponsored Initiative April 2006 Freshfields also wrote that, while financial trusts such as pension plans were required to consider financial criteria first, other trusts (especially those with an explicit social purpose) had more leeway to give effect to the views of the beneficiaries in relation to matters beyond financial return. 40
41 Appendix PRI April We will incorporate ESG issues into investment analysis and decision-making process. Possible actions: Address ESG issues in investment policy statements. Support development of ESG-related tools, metrics, and analyses Assess the capabilities of internal investment managers to incorporate ESG issues. Assess the capabilities of external investment managers to incorporate ESG issues. Ask investment service providers (such as financial analysts, consultants, brokers, research firms, or rating companies) to integrate ESG factors into evolving research and analysis. Encourage academic and other research on this theme. Advocate ESG training for investment professionals. 41
42 Appendix PRI April We will be active owners and incorporate ESG issues into our ownership policies and practices. Possible actions: Develop and disclose an active ownership policy consistent with the Principles. Exercise voting rights or monitor compliance with voting policy (if outsourced). Develop an engagement capability (either directly or through outsourcing). Participate in the development of policy, regulation, and standard setting (such as promoting and protecting shareholder rights). File shareholder resolutions consistent with long-term ESG considerations. Engage with companies on ESG issues. Participate in collaborative engagement initiatives. Ask investment managers to undertake and report on ESGrelated engagement. 42
43 Appendix PRI April We will seek appropriate disclosure on ESG issues by the entities in which we invest. Possible actions: Ask for standardized reporting on ESG issues (using tools such as the Global Reporting Initiative). Ask for ESG issues to be integrated within annual financial reports. Ask for information from companies regarding adoption of/adherence to relevant norms, standards, codes of conduct or international initiatives (such as the UN Global Compact). Support shareholder initiatives and resolutions promoting ESG disclosure. 43
44 Appendix PRI April We will promote acceptance and implementation Principles within the investment industry. of the Possible actions: Include Principles-related requirements in requests for proposals (RFPs) Align investment mandates, monitoring procedures, performance indicators and incentive structures accordingly (for example, ensure investment management processes reflect long-term time horizons when appropriate) Communicate ESG expectations to investment service providers Revisit relationships with service providers that fail to meet EST expectations Support the integration. development of tools for benchmarking ESG Support regulatory or policy implementation of the Principles. developments that enable 44
45 Appendix PRI April We will work together to enhance our effectiveness in implementing the Principles. Possible actions: Support/participate in networks and information platforms to share tools, pool resources, and make use or investor reporting as a source of learning. Collectively address relevant emerging issues. Develop or support appropriate collaborative initiatives. 45
46 Appendix PRI April We will each report on our activities and progress towards implementing the Principles. Possible actions: Disclose how ESG issues are integrated within investment practices. Disclose active ownership activities (voting, engagement, and/or policy dialogue). Disclose what is required from service providers in relation to the Principles. 46
47 Appendix PRI April 2006 Communicate with beneficiaries about ESG issues and the Principles. Report on progress and/or achievements relating to the Principles using a Comply or Explain 1 approach. Seek to determine the impact of the Principles Make use of reporting to raise awareness among a broader group of stakeholders. [1] The Comply or Explain approach requires signatories to report on how they implement the Principles, or provide an explanation where they do not comply with them. 47
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