Last month, the European Commission launched a public consultation on the relationship between fiduciary duties and sustainable investing, which could lead to some important clarifications affecting many of private equity’s most important investors – and, indeed, private equity firms themselves. The Commission is trying to align its financial systems with its sustainability objectives following the 2015 Paris Agreement, and there is already strong institutional support for environmental, social and governance (“ESG”) issues to be taken into account in investment decision-making. However, that approach is apparently challenging some traditional conceptions of an investor’s fiduciary duty and, in July, a high-level expert group appointed by the Commission urged policy-makers to develop a “single set of principles” to run through various regulatory regimes (including the Alternative Investment Fund Managers Directive).
Generally speaking, trustees (and most other asset managers) have a duty to invest in the manner, and for the purposes, mandated by the beneficiaries. The law also normally requires an investor to act in what he genuinely believes to be in the beneficiaries’ best interests. Usually – and unless otherwise specified in the investment mandate – that is achieved by investing to maximise financial returns, subject to adopting an appropriate attitude to risk.
One problem is that this area of law is not harmonised, and the investor’s duty is applied differently in different European legal systems. That problem is compounded by the fact that the duty itself is often misunderstood and misstated, even by lawyers who should know better.
For example, the UK’s leading case on this question – involving Arthur Scargill and the National Union of Mineworkers, and decided in 1985 – has often been said to affirm the rule that pension fund trustees have to pursue short-term financial returns for their beneficiaries. In fact, the case – which involved the trustees seeking to protect the UK coal industry with pension fund assets – merely confirmed that investment powers should be exercised in the best interests of the fund’s beneficiaries (taken as a whole), and not for ulterior political motives that could have a detrimental impact on their financial returns.
So when should investment managers in the UK take account of ESG issues? The law is actually reasonably clear – although because ESG issues actually come in various forms, and with varying levels of financial impact, there is no single answer that covers everything that could be included in that category.
First, ESG issues should be taken into account when it is reasonably believed that the ESG factors in question will have an impact on (long- or short-term) financial return or risk. In such a case, failure to take account of the ESG issues could actually be a breach of fiduciary duty. Many investors take the view that long-term risk-adjusted returns are going to be better when ESG factors are properly considered, and there is mounting evidence to support that view. Indeed, in 2016, the UK Pensions Regulator produced updated guidance on investment governance, in which it recommended that sustainability factors become part of any investment risk analysis.
Secondly, whatever the expected impact of the ESG factors concerned on risk or returns, is there a good, reliable indication that the beneficiaries want them to be taken into account? For instance, did the investment manager, when it raised its fund, say it would take ESG issues into account? If so, ESG factors should be taken into account – even if failure to do so would not have an adverse impact. It may even be a breach of duty to fail to take such considerations into account if they have been explicitly included in the mandate.
Thirdly, if otherwise equally attractive investments are differentiated by ESG considerations, the ESG issues may be taken into account (to the extent that they will not harm financial returns) along with all other relevant considerations - even if the first two conditions above are not met.
Fiduciary duties are a product of the social and cultural norms of the day. We are affected today by concerns that were not on the radar 30 years ago and it is clear that many ESG issues have the capacity to affect the viability and long-term growth of investments in a wide variety of ways (as demonstrated by the recent ClientEarth report on the challenges and opportunities created by climate change). It is now clear that sustainable investing and fiduciary duties are not polar opposites, as some once believed. It seems likely that the European Commission (like the UK’s Law Commission in 2014) will help to change some long-standing misconceptions.
Anyone wishing to make their views known has until 11 December to respond to the European Commission’s impact assessment, and until 22 January 2018 to respond to the public consultation. The private equity industry will respond to both.