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UN-backed report says advisors and fund managers risk being sued if they don’t put ESG in contracts

Follow-up to Freshfields report on fiduciary duty extends legal argument on environmental, social and governance responsibility.

Institutional investment consultants and fund managers face a “very real risk” of being sued for negligence if they are not proactive in incorporating environmental, social and governance (ESG) factors into legal contracts with pension funds, according to a United Nations-backed report. The opinion, published by the Asset Management Working Group of the United Nations Environment Programme Finance Initiative (UNEP FI), a partnership between the UN and over 180 financial institutions worldwide, is titled Fiduciary 2, and is a follow-up to 2005’s Freshfields report that looked at whether pension trustees, notably in the UK but also in different countries, would be breaking fiduciary law if they considered ESG aspects in investment. It goes further than its predecessor by suggesting that the contract law under which consultants and asset managers operate in some jurisdictions could see them taken to court if they are found not to be providing a “duty of care” on issues such as environmental protection.
The report is based on the legal opinion of Paul Watchman of Quayle Watchman Consulting in the UK, principal author of the Freshfields Report, and Michael Gerrard, Robert Holton and Aron Estaver of Arnold & Porter LLP in the US. The report says consultants and asset managers’ mandate contracts and operation under tort law as professional advisers mean they couldbe obliged to raise ESG considerations that could be “material” to the contract, or face action if they don’t: “As professional investment advisers, investment consultants and asset managers are under a contract for services rather than a contract of service. They are professional advisers to the client, not employees of the client; hence in exercising significant professional discretion (unless the professional investment adviser contracts out of that duty and even then it may be doubted if this can be done successfully), investment consultants and asset managers must be proactive rather than reactive.” The report said: “If the investment consultant or asset manager fails to do so, there is a very real risk that they will be sued for negligence on the ground that they failed to discharge their professional duty of care to the client by failing to raise and take into account ESG considerations. The duty of care as a professional is much more onerous than that of a non-professional as the person to whom the duty is owed is placing trust in the skills of the professional, and the professional is exercising discretionary powers far beyond those to be expected of a non-professional or layman.” The report looks specifically at fiduciary and corporate law in the UK and US. Quayle Watchman Consulting said three main factors in the UK supported the case for a legal backing for ESG consideration. The

first, it said, was commentary from Lord McKenzie during the passage of the UK Pensions Bill in 2008 that there was no reason in law why trustees could not consider social and moral criteria in addition to their usual criteria of financial returns, security and diversification. The second it said was the ‘obligation’ on pension fund trustees to say in their Statement of Investment Principles what the fund’s guidelines are on responsible investment and to what extent social, environmental or ethical considerations are taken into account. The third it said was the potential related precedent of the 2006 Act on corporate directors’ duties that it said could also cover pension trustees. The Act includes a duty for directors to run their business with regard to the impact on the community and the environment. The report said: “It is arguable that the duties of pension fund trustees are similar to company directors’ common law statutory fiduciary duties but, if anything, because of the special relationship between trustees and beneficiaries, are more extensive and more long-term than the duties of company directors.”
US law firm, Arnold & Porter in its commentary, said: “It does not appear that current US law forbids integrating ESG considerations into an asset manager’s decisionmaking process, so long as the focus is always on the value inuring to the beneficiaries and not on achieving unrelated objectives—even if positive collateral benefits result.” It added: “So long as ESG considerations are assessed within the context of a prudent investment plan, ESG factors can (and, where they implicate value, risk and return, arguably should) constitute part of the asset management process.” The report said that pension funds could look to base ESG policies on specific international law treaties, conventions or voluntary guidelines or principles, such as the Universal Declaration of Human Rights, ILO conventions, World Bank or IMF guidance and policies, the Equator Principles, the Carbon Principles, the Private Equity Council Guidelines for Responsible Investment, the UN Global Compact Principles, and industry or agricultural standards, for example, in relation to coffee, cocoa, palm oil or sustainable forestry. The UNEP FI report is due to be discussed at the Principles for Responsible Investment (PRI) Annual Event in Sydney, Australia, which starts today and convenes many of the world’s largest institutional investors representing more than $18 trillion in assets.
Link to download report