21st Century Fiduciary Duties: 21st Century Fiduciary Duties: A New Day and a New Dawn for A New Day and a New Dawn for Investors?Investors?13 November 200813 November 2008

Paul Q Watchman

QWCQWCQuayle Watchman ConsultingQuayle Watchman Consulting

AgendaAgenda

The UNEP FI Report on ESG and The UNEP FI Report on ESG and investment decisionsinvestment decisions

Overview of fiduciary dutiesOverview of fiduciary duties Conclusions of the UNEP FI ReportConclusions of the UNEP FI Report How these conclusions relate to fiduciary How these conclusions relate to fiduciary

duties and climate changeduties and climate change Recent developmentsRecent developments Final thoughtsFinal thoughts

The focus of today’s discussions The focus of today’s discussions

““The business of business is business”The business of business is business”

(Milton Friedman)(Milton Friedman)

““If we are to build a more successful, vibrant, modern If we are to build a more successful, vibrant, modern economy we can no longer afford to view economic success economy we can no longer afford to view economic success as being in conflict with social and environmental goals. On as being in conflict with social and environmental goals. On the contrary these goals must be seen as integral to economic the contrary these goals must be seen as integral to economic success and the very essence of sustainable development”success and the very essence of sustainable development”

(Rt Hon Mike O'Brien MP, Minister of State for (Rt Hon Mike O'Brien MP, Minister of State for Pensions Pensions Reform, 21 May 2008)Reform, 21 May 2008)

UNEP FI Report UNEP FI Report Primary ConclusionPrimary Conclusion

““Institutional investors who hide behind profit Institutional investors who hide behind profit maximisation and the limits supposedly placed by their maximisation and the limits supposedly placed by their legal duties as fiduciaries do so at their own peril. There legal duties as fiduciaries do so at their own peril. There is no legal bar to the integration of ESG considerations is no legal bar to the integration of ESG considerations into investment decision-making (provided the focus is into investment decision-making (provided the focus is always on the beneficiaries best interests) and indeed always on the beneficiaries best interests) and indeed failure to have regard for such considerations where failure to have regard for such considerations where there is a proven link between an ESG consideration and there is a proven link between an ESG consideration and investment value may itself amount to a breach of investment value may itself amount to a breach of fiduciary duties by the pension fund trustee or on his fiduciary duties by the pension fund trustee or on his behalf by an asset manager.” behalf by an asset manager.”

(UNEP FI Report, October 2005 )(UNEP FI Report, October 2005 )

More recent conclusionsMore recent conclusions

Some are very positive:Some are very positive: ““There is no reason in law why trustees cannot consider social There is no reason in law why trustees cannot consider social

and moral criteria in addition to their usual criteria of financial and moral criteria in addition to their usual criteria of financial returns, security and diversifications. This applies to trustees of returns, security and diversifications. This applies to trustees of allall pension funds.” pension funds.”  (Lord McKensie, House of Lords, Pensions Bill, Hansard, 7 (Lord McKensie, House of Lords, Pensions Bill, Hansard, 7 October 2008)October 2008)

This may go further than judicial interpretation This may go further than judicial interpretation • Gives greater latitude to church and charity pension fundsGives greater latitude to church and charity pension funds

Indicative of the government's position to encourage RIIndicative of the government's position to encourage RI

More recent conclusions More recent conclusions

““It is an obligation on pension fund trustees not simply a right or It is an obligation on pension fund trustees not simply a right or option to state in their Statement of Investment Principles what option to state in their Statement of Investment Principles what the fund's guidelines are on responsible investment and to what the fund's guidelines are on responsible investment and to what extent social, environmental or ethical considerations are taken extent social, environmental or ethical considerations are taken into account.into account.””  (Lord McKensie, House of Lords, Pensions Bill, Hansard, 7 (Lord McKensie, House of Lords, Pensions Bill, Hansard, 7 October 2008)October 2008)

More recent conclusionsMore recent conclusions

Some are more negativeSome are more negative US Department of Labor interpretive bulletin on "economically US Department of Labor interpretive bulletin on "economically

targeted investments”, 23 October 2008targeted investments”, 23 October 2008• If ERISA plan fiduciaries choose investments for reasons other than If ERISA plan fiduciaries choose investments for reasons other than

the economic interests of the plan, then they only can choose the economic interests of the plan, then they only can choose investments that are economically equal to available alternative investments that are economically equal to available alternative investments. investments.

Contrast to:Contrast to:

““Calvert Letter”, US Dept. Of Labor PWBA Advisory Opinion 98-Calvert Letter”, US Dept. Of Labor PWBA Advisory Opinion 98-04A, 28 May 1998)04A, 28 May 1998)

• If properly made, the selection of a Calvert socially responsible mutual If properly made, the selection of a Calvert socially responsible mutual fund for plan investment would not be inconsistent with the ERISA fund for plan investment would not be inconsistent with the ERISA fiduciary standardsfiduciary standards

Background to the UNEP FI Report Background to the UNEP FI Report

The legacy of Milton Friedman and the Chicago The legacy of Milton Friedman and the Chicago School of Law and EconomicsSchool of Law and Economics

Goldman Sachs, UBS, ABN Amro and others Goldman Sachs, UBS, ABN Amro and others A legacy of the miners strikeA legacy of the miners strike

UNEP FI Report StudyUNEP FI Report Study

Common law countries, Common law countries, states, provinces and states, provinces and other legal jurisdictionsother legal jurisdictions

United StatesUnited States United KingdomUnited Kingdom CanadaCanada AustraliaAustralia

Civil law jurisdictionsCivil law jurisdictions

FranceFrance SpainSpain JapanJapan GermanyGermany

UNEP FI Report StudyUNEP FI Report Study

Countries or regional governments which Countries or regional governments which recognise ESG explicitly in primary or recognise ESG explicitly in primary or secondary legislation as relevant and secondary legislation as relevant and material investment considerationsmaterial investment considerations United KingdomUnited Kingdom FranceFrance GermanyGermany Canada (Manitoba)Canada (Manitoba) AustraliaAustralia ““Italy”Italy”

Where do fiduciary duties come Where do fiduciary duties come from?from?

Open to debate – conflicting theoriesOpen to debate – conflicting theories From From fiduciariusfiduciarius "(holding) in trust," from "(holding) in trust," from fiderefidere

"to trust" "to trust" Have been traced back to Roman lawHave been traced back to Roman law One scholar on trusts and fiduciary duties found One scholar on trusts and fiduciary duties found

a breach of “fiduciary duty” by a steward in the a breach of “fiduciary duty” by a steward in the BibleBible

Fiduciary duties change over timeFiduciary duties change over time

Fiduciary duties are organic and respond to Fiduciary duties are organic and respond to changes in societychanges in society

ExamplesExamples Equal pay for women for equal work held to be an Equal pay for women for equal work held to be an

unlawful breach of fiduciary dutiesunlawful breach of fiduciary duties Encouraging provision for disabled people on public Encouraging provision for disabled people on public

transport held to be unlawful breach of fiduciary dutiestransport held to be unlawful breach of fiduciary duties Pricing public transport fares to discourage the use of Pricing public transport fares to discourage the use of

cars in city centres held to be an unlawful breach of cars in city centres held to be an unlawful breach of fiduciary dutiesfiduciary duties

What are the modern fiduciary What are the modern fiduciary duties of a pension fund trustee?duties of a pension fund trustee?

Duty of loyaltyDuty of loyalty Duty of prudenceDuty of prudence Duty to act fairlyDuty to act fairly Duty to act in the interests of all beneficiary classes and Duty to act in the interests of all beneficiary classes and

balance interest between beneficiary classes, including balance interest between beneficiary classes, including present and future contributors and beneficiariespresent and future contributors and beneficiaries

Duty to spread risk according to modern portfolio theory Duty to spread risk according to modern portfolio theory Duty not to crusade unless a bona fide crusaderDuty not to crusade unless a bona fide crusader Duty to take a long term not short term or medium viewDuty to take a long term not short term or medium view

Conclusions of the UNEP FI ReportConclusions of the UNEP FI Report

The view associated with Friedman and the Chicago The view associated with Friedman and the Chicago school that investment profits must be maximised and school that investment profits must be maximised and ESG considerations rejected as an unlawful breach of ESG considerations rejected as an unlawful breach of fiduciary duties is wrong and is not based on an analysis fiduciary duties is wrong and is not based on an analysis of case law or legislation of case law or legislation

ESG considerations are ESG considerations are mainstream investment mainstream investment considerationsconsiderations not SRI niche not SRI niche

Conclusions of the UNEP FI ReportConclusions of the UNEP FI Report

Where there is evidence that there is a Where there is evidence that there is a relationship relationship between value and an ESG considerationbetween value and an ESG consideration it should be it should be taken into account. For exampletaken into account. For example Climate change in the insurance & reinsurance, oil & Climate change in the insurance & reinsurance, oil &

gas, automobile manufacturers and real estate gas, automobile manufacturers and real estate industriesindustries

Child labour in the clothing and food & drink industriesChild labour in the clothing and food & drink industries Human rights in the clothing, food, retail and electrical Human rights in the clothing, food, retail and electrical

and electronic industriesand electronic industries Biofuels (food v. fuel)Biofuels (food v. fuel) Good governance in all industriesGood governance in all industries

Conclusions of the UNEP FI ReportConclusions of the UNEP FI Report

Where a decision is made on Where a decision is made on political or ethical values political or ethical values rather than valuerather than value there is a there is a dangerdanger that fiduciary duties that fiduciary duties may be breachedmay be breached There is an exception for moral and other crusaders, There is an exception for moral and other crusaders,

such as churches, charities and political fundssuch as churches, charities and political funds Otherwise no crusading: decisions should be based Otherwise no crusading: decisions should be based

on investment value not moral valueson investment value not moral values

UNEP FI Report Part IIUNEP FI Report Part II

Commenced last monthCommenced last month Review of changes in policy, practice and Review of changes in policy, practice and

law since 2005law since 2005

How does this relate to climate How does this relate to climate change?change?

Investors are increasingly aware of the relevance of Investors are increasingly aware of the relevance of many other ESG issues such as human rights, health many other ESG issues such as human rights, health issues and supply chain management to companies’ issues and supply chain management to companies’ financial performancefinancial performance

Climate change is just one example of an ESG issueClimate change is just one example of an ESG issue Perhaps more accepted than other EGS issues?Perhaps more accepted than other EGS issues? Already recognised by mainstream investors as a Already recognised by mainstream investors as a

material financial issue?material financial issue? E.g. “cost of carbon” to power companiesE.g. “cost of carbon” to power companies

Principles for Responsible Principles for Responsible Investment (PRI)Investment (PRI)

Assets under management now in excess of Assets under management now in excess of US$14 trillionUS$14 trillion

Now approximately 360 signatoriesNow approximately 360 signatories First three principles of PRI First three principles of PRI

Insofar as is consistent with fiduciary dutiesInsofar as is consistent with fiduciary duties

• Incorporate ESG issues into investment analysis and Incorporate ESG issues into investment analysis and decision-makingdecision-making

• Be active owners and incorporate ESG issues into Be active owners and incorporate ESG issues into our ownership policies and procedures our ownership policies and procedures

• Seek appropriate disclosure of ESG issues by Seek appropriate disclosure of ESG issues by entities we invest inentities we invest in

Principles for Responsible Principles for Responsible Investment (PRI)Investment (PRI)

Who has signed up so far?Who has signed up so far? Asset ownersAsset owners Investment managersInvestment managers Professional services providersProfessional services providers

Very difficult to adhere to PRI values Very difficult to adhere to PRI values without taking climate change seriouslywithout taking climate change seriously

OECD DevelopmentsOECD Developments

The OECD have issued draft Guidelines The OECD have issued draft Guidelines on Pension Governance for consultationon Pension Governance for consultation

The Network for Sustainable Financial The Network for Sustainable Financial Markets has encouraged the "OECD to Markets has encouraged the "OECD to also examine the role that pension funds also examine the role that pension funds played in fostering a market environment played in fostering a market environment that produced the current economic crisis." that produced the current economic crisis." (1 October 2008) (1 October 2008)

Rethinking incentives?Rethinking incentives?

““The [pension fund] industry's 'incentive structure' is flawed - The [pension fund] industry's 'incentive structure' is flawed - the rewards and sanctions facing industry participants are the rewards and sanctions facing industry participants are not appropriate and so participants are incentivised to act in not appropriate and so participants are incentivised to act in ways that will ensure the system remains prone to periodic ways that will ensure the system remains prone to periodic crisis.”crisis.”

(Watson/Wyatt/Financial Times, Defining Moments: (Watson/Wyatt/Financial Times, Defining Moments: The The pension and investment industry of the future pension and investment industry of the future (2008))(2008))

Are short term incentives contrary to the duty of prudence Are short term incentives contrary to the duty of prudence and the duty of loyalty to all beneficiaries and hence breach and the duty of loyalty to all beneficiaries and hence breach fiduciary duties of pension fund trustees? fiduciary duties of pension fund trustees?

Government in the era of credit crunch sympathetic to Government in the era of credit crunch sympathetic to reforming incentives for financial industry in general? reforming incentives for financial industry in general?

Final ThoughtsFinal Thoughts

RI is not a substitute for existing valuation tools but an RI is not a substitute for existing valuation tools but an additional oneadditional one

Opportunities as much as risksOpportunities as much as risks Examples:Examples:

GE EcomaginationGE Ecomagination BP renewables investmentBP renewables investment Emerging climate change insurance products and Emerging climate change insurance products and

servicesservices Forget Friedman and his Chicago acolytes. Their response Forget Friedman and his Chicago acolytes. Their response

was based on corporate America getting on board the was based on corporate America getting on board the Marrakech Express with Crosby, Stills and NashMarrakech Express with Crosby, Stills and Nash

21st Century Fiduciary Duties: 21st Century Fiduciary Duties: A New Day and a New Dawn for A New Day and a New Dawn for Investors?Investors?

13 November 200813 November 2008

Paul Q Watchman

QWCQWCQuayle Watchman ConsultingQuayle Watchman Consulting