The UK Law Commission’s consultation paper on fiduciary duties, which was issued in response to the Kay Review of the UK Equity Markets and Long-Term Decision Making, presents a challenge for pension savers, institutional fiduciaries and their advisors. With the consultation period ending the 22nd of January, an all hands on deck effort is needed to ensure that the Commission receives broad input on both its consultation questions and on the assumptions that underlie them. The Commission still has much work to do in order to produce a balanced final report that reflects an up-to-date understanding of the investment industry and which consistently applies all of fiduciary duty principles it cites to the issues it examines. The Commission’s consultation paper makes great strides towards achieving an understanding of fiduciary duties that fits today’s circumstances. For example, the Commission concludes that consideration of factors relevant to long-term investment performance, including questions of sustainability or environmental and social impact (ESG factors), is “clearly permissible.” It also concludes that trustees may consider “the effect of investments on the economy as a whole” and “should consider, in general terms, whether they will take account of macroeconomic [systemic] factors in their decision-making.”
However, the consultation paper misses the mark in a number of other respects by using outdated assumptions and by recognizing fiduciary principles that it then fails to uniformly apply. Getting the analysis correct is of great importance – not only for UK fiduciaries and their beneficiaries – but also for pension schemes in Europe and in common law countries that are influenced by British precedent. Impact of the Commission’s findings will extend beyond the British Isles. In today’s global economy, practices of foreign institutional fiduciaries will also affect the British economy, as nearly all of them invest in UK companies.Let’s take a look at some of the assumptions and inconsistencies that should be addressed in the Commission’s final report.
• Application of first principles. Fiduciary duty principles are not that complicated, but the legal profession (as well as the investment industry) can often become so distracted by details that it loses sight of the forest for the trees. The Commission recognizes that fiduciary duties are “designed to protect the vulnerable when others have discretionary power to act on their behalf.” Indeed, fiduciary duties are intended to serve as a check on the influence of countervailing pressures on, incompetence by and conflicts of interest of the fiduciary agents upon whom beneficiaries rely. It is surprising that the Commission presents an extensive discussion of how complex the regulatory rules and industry structures have become and how increasingly ill-served many pension savers have become, but then fails to evaluate whether current practices serve first principles of fiduciary duty. Each of the Commission’s conclusions should be tested against the fundamental public policy purposes of fiduciary duty.
• Confusion of investor herding solutions with their causes. One of the primary questions posed to the Commission arose out of a series of reports and studies (cited in the consultation paper culminating in the Kay Review) that documented the myriad problems caused by excessive investment short-termism. The Commission concludes that investor herding around short-termism “is mainly caused by the nature of human behavior” and is “exacerbated by an industry structure . . . where investment managers are judged in relation to other investment managers.” The Commission then surmises, “We do not think that herding is caused by trustees’ legal duties, or that a change in the law would make a practical difference.” Unfortunately, the Commission fails to recognize that social pressure
and conflicts of interest are things that fiduciary duty was meant to counteract. While resolving short-term pressure may not require a change in the law, enforcement of existing fiduciary principles so that they serve their intended purpose would certainly help.
• Application of Cowan v Scargill to current circumstances. The consultation paper quotes from the famous Cowan v Scargill case, which found that it is the “duty of trustees to exercise their powers in the best interests of the present and future beneficiaries of the trust, holding the scales impartially . . .” However, it then fails to consistently apply this duty. For instance, despite finding that consideration of the long-term effects of ESG and macroeconomic factors on a fiduciary’s portfolio is appropriate, the Commission ignores financial benefits to future portfolio companies from maintenance of quality infrastructure. Instead, the consultation paper applies a tie-break comparison to infrastructure investments that appears to focus only on comparative short-term returns. The Cowan v Scargill duty of impartiality should be consistently applied throughout the consultation.
• Giving adequate deliberation to the right questions. The Commission recognizes that the duty of adequate deliberation precludes fiduciaries from exercising a power “without having given proper consideration to relevant matters.” It also cites the principle under Scots common law that fiduciaries may not turn a blind eye to relevant facts and circumstances or fail to consider the right question. However, once again, the Commission does not consistently apply these duties. The duties to engage in adequate deliberation and not turn a blind eye are not even mentioned when discussing if trustees have an obligation to deliberate over whether ESG factors (or macroeconomic issues) are relevant for impartial delivery of sustainable risk-adjusted earnings over the long term.Instead, the Commission creates unnecessary ambiguity by asking what appears to be the wrong question. After stating that “trustees should consider, in general terms, whether their policy will be to take account of ESG factors,” the consultation paper restates the question as: “must pension trustees use wider factors?” and answers in the negative. The duty of adequate deliberation is not mentioned. Similar concerns about whether the wrong question has been asked are raised when future inflation and cost of living matters that involve improving future financial outcomes for younger beneficiaries are framed only as “quality of life” issues.
• Outdated understanding of investor practices. The Commission assumes that only large institutional fiduciaries have the ability to conduct ESG stewardship in a cost-effective manner. However, the consultation paper misses an opportunity to recognize that, as with macroeconomic factors, ESG stewardship can be undertaken by smaller investors through the exercise of proxy voting rights, proactive investment manager selection and contracting procedures and collaboration with other investors or outsourcing stewardship to a third party service provider.
There is an important role for the legal profession to play in counseling institutional investors who serve as fiduciaries. The Commission notes that much of the legal precedent in this area is several decades old. During that time, the circumstances and relevant knowledge base for application of those legal precedents have dramatically changed. Legal counsellors have a unique opportunity to help improve pension security over both the short and long term, if the Commission gives them the tools to do it.
Keith L. Johnson heads the Institutional Investor Legal Services team at Reinhart Boerner Van Deuren