We have heard recent reports that the EU wants to see a “critical mass” of shareholders taking engagement seriously. Already, there are rumblings in the UK about the threat of Europe undermining our ‘comply or explain’ corporate governance framework. But there’s a fundamental inconsistency in this framework that needs to be fixed if it is to be successfully defended in the post financial crisis era. At the heart of that inconsistency is fiduciary duty. Under the UK Companies Act, directors must ‘have regard’ to the long-term consequences of their decisions, and to the impacts of their business on communities and the environment. Underlying these duties is the concept of ‘enlightened shareholder value’: the UK government rejected stakeholder rights or prescriptive regulation and chose instead to encourage companies to take the high road, rather than the low road, to creating value for their shareholders. As we argue in our recently-published report, titled: ‘Protecting our best interests: rediscovering fiduciary obligation’, there’s a crucial mismatch between this ethos and the perception of many shareholders that their fiduciary duties actively prohibit them from taking an enlightened approach. Fiduciary duty is often spoken about as if it begins and ends with maximising return. This is simply not true. In fact, investors have a number of distinct fiduciary duties, developed over centuries of mostly judge-made law. The most fundamental of these is not the frequently-invoked ‘duty to maximise return’ (indeed, it is debatable whether such a duty even exists) but the duty of loyalty: agents must act in the best interests of their principals, and must not abuse their position for personal gain. In any discussion of fiduciary obligation, it’s crucial to keep this fundamental principle in mind. The key question must always be: is the status quo in beneficiaries’ interests?At the launch of our report, many industry players expressed concern that trustees were paralysed from exercising their judgement on this central question by legal advice which encouraged them to be ‘frightened of their own shadows’. Instead of ‘is this in beneficiaries’ interests?’ the question becomes ‘is this what everyone else is doing?’ – with the implication that if it isn’t, you could be sued. Thus, fiduciary duty is reduced not just to a duty to maximise returns but to a duty to maximise short-term returns judged against the benchmark, and to do so by following the herd. Ironically, this dynamic may actually work against beneficiaries’ best interests in the long run. Your typical fiduciary investor is no longer a private family trust but a multi-billion pound pension fund. Collectively, such investors still exert significant influence on the global economy. If prevailing interpretations of fiduciary duty thereby exacerbate ‘waves of optimism and pessimism’ in the markets, something is badly wrong. As the American academic Keith Johnson puts it, it’s akin to unleashing “a flock of 900-pound lemmings into the economy”. Moreover, if fiduciary investors fall into the trap of chasing short-term alpha, there is a danger that much more important determinants of long-term return for beneficiaries will be neglected. Evidence suggests that the vast majority of variation in pension funds’ returns is attributable to asset allocation decisions and the resulting beta exposure. Perhaps even more fundamental are the challenges of systemic risk: issues which cannot be factored into conventional analysis at company or even sector level, but which have the potential to bring down whole markets or even the global financial system. More and more investors are waking up to climate change, the defining systemic risk of our times. But the way we think about fiduciary duty still doesn’t provide the tools to act on this realisation. The idea that pension funds
are ‘universal owners’ is increasingly talked about in the abstract: such owners have an interest in discouraging profit-seeking in one investee company which relies on negative externalities for which the tab will be picked up elsewhere in their portfolio. But in practice there seems to be a lingering sense, even among fairly progressive investors, that any move that can’t be justified at the individual company level is dangerous territory for fiduciaries. For instance, when talking to investors about last year’s shareholder resolutions on oil sands, we were told categorically that stopping climate change could not be their concern: either the resolutions made sense for BP and Shell as individual companies, or they would not support them. Thus, somewhere between recognition of the systemic problem of climate change and decision-making about company engagement, universal owner theory gets lost in translation. And this is all without even touching on the vexed question of whether trustees are bound by law only to consider beneficiaries’ financial interests. Here again, we need to step back from received wisdom and return to first principles. If the purpose of a particular investment trust is, say, to provide a pension, then what is the purpose of the pension? Clearly, it’s to provide its members with a decent standard of living in retirement. It surely follows that trustees can legitimately avoid taking decisions which may directly undermine their beneficiaries’ future quality of life – for instance, by hastening irreversible climate change or exacerbating financial instability. In practice, this gets bogged down in the same collective action problems as universal owner theory – but we’re not even at that stage yet, because the principled argument has yet to be won.In order to really get to grips with today’s systemic challenges, trustees must be freed from restrictive interpretations of fiduciary duty and authorised to take a rounded, long-term view of their beneficiaries’ best interests. In other words, to take exactly the ‘enlightened’ approach embedded in the Companies Act. That’s why our report recommends, among other things, the introduction of provisions for institutional investors which parallel company directors’ duties.
The beauty of this approach is that it effectively defends the undeniable public interest in responsible behaviour by large investors – but without undermining the duty of loyalty that defines a fiduciary. Just as the Companies Act preserves the principle that directors’ duties are owed to the company, so this preserves the principle that fiduciary duties are owed solely to beneficiaries. Indeed, we don’t believe such a provision would constitute a significant change in the law: as government minister Ed Davey confirmed, speaking at the launch of our report, fiduciary duty can be about more than maximising the bottom line, and investors should take full account of environmental and social issues. But, whether it’s a smokescreen or a genuine straitjacket, that’s clearly not the way many fiduciaries see it. That has to change. Because enlightened shareholder value can only work if it’s supported by enlightened shareholders.
Christine Berry is Policy Officer at FairPensions
Link to FairPensions report: The Future of Fiduciary Responsibility
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