Fiduciary duty may well be two of the most important words in finance - words that are often misunderstood and widely interpreted.
This is the genesis of a new report, co-authored by the Principles for Responsible Investment (PRI), Fiduciary Duty in the 21st Century. Its purpose is to end the debate about whether fiduciary duty is a legitimate barrier to investors integrating ESG issues into investment processes.
Its precursor, a 2005 report commissioned by UNEP FI from law firm Freshfields Bruckhaus Deringer concluded that integrating ESG considerations into investment analysis is "clearly permissible and is arguably required."
Fiduciary Duty in the 21st Century goes further. Far from being a barrier, the report finds that there are positive duties on investors to integrate ESG issues, to mitigate risk and identify investment opportunities. Therefore, failing to consider all long-term investment value drivers, including ESG issues, is a failure of fiduciary duty.
"The concept of fiduciary duty is organic, not static" explains Paul Watchman, Honorary Professor at Glasgow University's School of Law. "It will continue to evolve as society changes, not least in response to the urgent need for us to move towards an environmentally, economically and socially sustainable financial system."
The manner in which fiduciary duty is defined has profound implications. Decisions made by fiduciaries cascade through the investment chain and in turn through the investment decision-making process, ownership practices, and ultimately, the way in which companies are managed.
Fiduciary duties exist to ensure that those who manage other people's money act in the interest of beneficiaries, rather than serving their own interests. In practice, fiduciary duty tends to be defined in three ways.
The first relates to the duties owed to beneficiaries, for example, a pension fund to its scheme members; this definition tends to include the duty of loyalty and the duty of prudence. The second relates to investment practice and specifically to the idea that investment managers have a duty to the end investor. The third is duties owed by company directors to their shareholders.
Despite significant progress, outdated perceptions about fiduciary duty persist. Many large investors have yet to fully integrate ESG issues into their investment decision-making processes. Lawyers and consultants, particularly in the US, too often characterise ESG issues as non-financial. There is inconsistency in corporate reporting and weaknesses in implementation of legislation and codes on responsible investment.
These challenges were identified at a meeting of PRI signatories in Montreal in September 2014. An overwhelming majority reported that fiduciary duty remains a major barrier to responsible investment. Implementation, they said, is progressing at different rates, in different asset classes, in different geographies.
To modernise interpretations of fiduciary duty in a way that ensures these duties are relevant to 21st century investors, the report proposes a series of recommendations for institutional investors, financial intermediaries and policymakers.
Institutional investors should make explicit their commitments to ESG integration, implement across investment processes and require companies to provide robust integrated reporting. Intermediaries should advise their clients to take account of ESG issues in their investment processes. Policymakers should harmonize definitions of fiduciary duty and clarify that fiduciary duty requires that investors pay attention to long-term value drivers.
Integrated reporting is key. It allows investors to consider the material impact of issues such as climate change, resource use and employee relations, and therefore, in complying with their fiduciary duty, make better investment decisions about the companies in which they invest.
These relatively modest changes in interpretation and practice of fiduciary duty could catalyse rapid change in the importance assigned by investors to ESG issues. Contributing to the report, Al Gore and David Blood conclude, "there is no 'do nothing' task' ... considering sustainability is not only important to upholding fiduciary duty, it is obligatory. Sustainability is an important factor in the long-term success of a business."
We agree. Integrating ESG issues into investment research processes will enable investors to make better investment decisions and improve investment performance. Failing to do so, is not just a failure of fiduciary duty, but a failure of much more. At stake is a greener economy and a more sustainable financial sector. This is the investment community's 21st Century challenge.
This blog was written for IIRC, the International Integrated Reporting Council.