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Is the law to blame for unethical investing?

May 27

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27/05/2014 07:02  RssIcon

New report seeks to clarify position

Guest Blog: Rebecca O’Connor, editor for Trillion Fund (the renewable energy crowdfunding platform) on next month's Law Commission report into Ethical Investing.


The City might not be full of morally bankrupt Gordon Geckos after all – the divorce between ethics and money-making (ie. to do the latter, you can’t care about the former) may simply be a result of a misinterpretation of the law and an understandable desire not to be sued.

We will find out next month whether some unfortunate legal wording is behind the systemic aversion to ethical and “ESG” (Environmental and Social Governance) concerns among pension fund trustees and fund managers when the UK Law Commission publishes it's report on fiduciary duties (i.e. on the obligations of those who manage our money).


Current interpretations 

As it stands, the law could be seen to favour morally neutral or even downright unethical investing, because of its insistence that ONLY the financial interests of beneficiaries (such as shareholders) are considered when making investment decisions. 

This is unhelpful, especially as evidence grows that the long-term financial best interests of beneficiaries does, in fact, also correspond with activities that are of long-term ,social and environmental benefit: renewable energy, for example. 

How did we arrive at such a confusingly amoral/ immoral understanding of the law? The potential for the legal definition of fiduciary duties to be interpreted in a way that might exclude ESG considerations was brought to light by the 2012 Kay review of UK equity markets and long-term decision making, which stated that: 

“Some pension fund trustees equated their fiduciary responsibilities with a narrow interpretation of the interests of their beneficiaries which focused on maximising financial returns over a short timescale and prevented the consideration of longer term factors which might impact on company performance, including questions of sustainability or environmental and social impact.”

This observation prompted the consultation by the UK Law Commission, which began in October last year and will conclude next month.



The key reference is to short-termism.  Over the short-term, bumper profits can (and are arguably more likely) to be made from activities that are in some way damaging – oil exploration, for example. But over the long-term, taking into account externalities (a cost borne by all of us) and risk factors, which in the case of oil might be a rig explosion or climate change, returns from such activities are likely to be less favourable than their nicer alternatives. Slow and steady, as they say, wins the race.

The problem is that LEGALLY, investment professionals have had to prioritise financial considerations above all others unless specifically instructed otherwise. And up until recently, a view has prevailed that being ethical or mindful of ESG has hampered financial performance full stop. Asking a fund manager to be ethical is like “tying one hand behind his back”, says one Independent Financial Adviser.

There are legal cases used to support the archaic understanding of returns versus morals but they are ancient. 

In Cowan v Scargill (1985), it was found that acting in the interests of beneficiaries referred only to their best financial interests. The burden of proving any other kind of benefits, such as social and political benefits to the beneficiaries, would rest heavily on the trustees. 

This case and other similar ones has led to an almost pathological aversion among trustees to a consideration of ethical factors, even if they are found to support returns in the long term, because taking into account anything other than pure financial benefits, on the basis of the precedents, might leave them open to claims of negligence. 

A further conclusion of the case was that fiduciaries should not be influenced by their personal views and may even have to act dishonourably (although not illegally) to obtain the best result for their beneficiaries, helping to cement a view that the law understands being morally good is at odds with making a profit. 


The view of the Law Commission

The Law Commission itself agrees that: “The statement that “the best interests of the beneficiaries are normally their best financial interests” could be seen as precluding pension schemes from taking into account environmental, social and governance (ESG) issues when making investment decisions.”

Catherine Howarth, chief executive of ShareAction, the pension campaign group, thinks that the legal case history has made trustees “excessively cautious” about taking into account ESG concerns. “There is lots of evidence that trustees are confused, cautious and anxious about doing anything that could be interpreted as not in the best financial interests of the beneficiaries. They are actually worried they could get on the wrong side of the law if they take into account the environmental impact of an investment. We need trustees to feel confident that they can legally consider Environmental and Social Governance factors”, she says. 

She goes further than saying trustees should not feel discouraged by the law to consider these factors and says that in fact, the world has turned so much that NOT taking into account ESG concerns amounts to financially gambling with other peoples’ money, putting them at greater risk of losses than if the money had been invested in a slow, steady and nice set of assets. 

This is because since these cases were brought to court in the mid-eighties, Environmental and Social Governance issues have gone from being profit dampeners to profit enhancers. This will often be true if the trustees are taking a long-term view, and even sometimes when they are not, as this Moneyfacts data shows. Guinness Alternative Energy was the top performer in trustnet's tables last year: There are also some academic studies which show comparable, if not better returns.

The Law Commission says it recognises the financial merits of an ESG approach. "At its most basic, taking account of ESG factors is designed to reduce risks. The Kay Review highlights how poor safety procedures, together with a lack of environmental concern, may lead to disastrous and expensive mistakes. For example, the Deepwater Horizon saga significantly reduced the value of BP shares. However, an ESG driven approach is not simply about avoiding the next company crisis. It works on the basis that companies do better in the long term if they are well-run and sustainable, and have loyal suppliers, customers and employees.”

So there you have it. Given the evidence that ESG factors can lead to better returns in the long run, the answer is clearly that pension trustees not only can consider wider factors – in many cases, they should.  So while the law might well not change next month as a result of the Commission's findings, the best we can hope for is that it is worded better so that it encourages ESG considerations. If then it becomes clearer to all that ESG-led investments are better performers over the long term, then this could cause the decline in unethical investments that many of us want to see.






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