In February of this year we reported on the Law Commission's consultation on the fiduciary duties of investment intermediaries. The Law Commission has now completed its project, which followed on from the 2012 Key Review of UK equity markets and decision making, and published its report. Here we take a look at that final position and what it might mean for the industry going forward.
By way of reminder, this whole project really came to life after Professor Kay undertook a year long review of the UK's equity markets and ultimately published his findings in 2012. He had grave concerns about the way markets operated, warning against the prevalent approach of "trading" for short term profits rather than long-term "investment". He also believed that there was a necessity for a greater level of fiduciary duty to be present in the whole investment chain and this is what prompted his recommendation for review of the legal concept of fiduciary duties by the Law Commission.
Following the Government's acceptance of the analysis and conclusions of the Kay Review, the Law Commission was jointly tasked by the DWP and the Department for Business, Innovation and Skills to do five things, which included investigating how far fiduciary duties currently applied and to evaluate whether such duties are conducive to beneficial investment strategies. Crucially, it was also asked to consider whether change was necessary.
The Law Commission closed its consultation with stakeholders in January and published its final report in July. The report broadly covers three areas:
- the challenges of governance for DC workplace pensions;
- duties in the investment chain; and
- financial and non-financial factors for trustee consideration in investment decision making.
Governance that is fit for purpose
The Commission summarised that despite an industry awareness that good governance is crucial to achieving good member outcomes, the problem is that the weak buyer-side of the DC market leads to a "governance gap".
It welcomed the suggestions made, following the Office of Fair Trading's report, for independent governance committees to be installed within contract based DC pension providers. Now, in publishing its own legal recommendations, it has gone further and said that those governance committees should owe a statutory duty to members to act, with reasonable care and skill, in their interests and that the duty should not be excludable by contract. It has further recommended that providers should be required to indemnify members of the governance committees against any liabilities, the idea being that people should not be dissuaded from sitting on these committees for fear of personal liability.
Ensuring duties towards members in statute has been a necessary first step to making these committees actually fit for purpose and stopping them from just being an optical box-ticking exercise but whether they can carry any real weight when pitted against a determined provider remains to be seen.
The other angle in the governance piece was about the fact that the charge cap will not apply to transaction costs. The Commission reported that many consultees feared that a charging system that saw management charges capped but transaction charges uncapped could lead to providers increasing transaction costs to make up for lower management charges. As a result the Commission has recommended that the Government specifically consider whether the design of the default fund charge cap has incentivised trading over long-term investment when it reviews the cap in 2017.
A long linked chain
The consultation paper had previously set out the complex "chains of intermediation" that essentially separate the pension saver from their actual investment and how it had been tasked with identifying where fiduciary duties existed in this chain.
The Commission in undertaking a detailed review, has concluded that there is a reluctance to apply fiduciary duties to sophisticated parties in a contractual relationship, especially where an intermediary has followed regulatory rules. The principles it has broadly identified are that:
- courts don't want to assign fiduciary duties in commercial relationships as the parties have had the chance to set out their responsibilities already;
- fiduciary duties can be modified by contract; and
- courts can incorporate regulatory rules into the contract.
The Commission noted that there is no case law which addresses the question of whether an intermediary owes a duty to the end investor and so it had to review case law covering where there is a duty of care not to cause financial loss in the absence of a contract. The outcome of that review is that in the absence of a contractual relationship, it is only in very limited circumstances that duties will be owed.
This is far away from the position that Professor Kay strongly advocated back in 2012, but is the conclusion the Law Commission has come to on the current state of the law. It therefore turns next to considering whether law reform is necessary.
In general terms the Law Commission backed the view it had previously set out in the consultation paper that fiduciary duties are difficult to define and inherently flexible and best judged by the courts on a case by case basis so there should be no general reform of the law through statute.
It has, however, conceded that providing investors with greater rights and to sue for loss caused by intermediaries' unfair behaviour might bring the position closer to what Professor Kay envisaged. They have focussed on a possible extension of s.138D of the Financial Services and Markets Act 2000, which allows "private persons" to sue for loss caused by a breach of the FCA Rules, so that a wider scope of acts and omissions would be actionable. Because such an extension could be controversial it has passed the mantle back to the Government to consider further, with the Law Commission's blessing as to the merit of doing so.
Finally in respect of the investment chain review, being both the regulation of investment consultants and the practice of "stocklending", the Commission has decided not to recommend any review at this stage. Its fear with regard to further regulation of the providers of "generic" financial advice was that it could hinder investors being able to obtain this advice easily and cheaply. And for now, it thinks that the emphasis should be on making stocklending fees retained by intermediaries more transparent, with a wider review being done more generally by the Government in 2017.
Should ethics come into it?
One of the largest parts of the report is the consideration of how far trustees may, or even must, consider factors beyond the maximisation of financial returns and ethical views, even if not in the immediate financial interest of beneficiaries.
As a starting point the Commission believes factors should be identified as either "financial" or "non-financial". The responses to consultation apparently asked for much more guidance to be available for trustees and as a result the Law Commission has produced a guidance paper which it has appended to the report. Its strong recommendation is that this guidance should be adopted and promoted by the Pensions Regulator, first by putting it into its Trustee Toolkit and eventually a Code of Practice.
As well as setting the background to the various investment duties and considerations and where in law they stem from, the guidance helpfully steers trustees through which factors they may choose to consider and which they must consider when looking at financial considerations and what tests must be met to take non-financial factors into account.
The conclusion is that trustees may take account of any financial factor which is relevant to the performance of an investment. Therefore if environmental, social or governance (ESG) factors may be financially material as they may, for example, have a bearing on the long-term sustainability of a business, they can be regarded.
But do they have to take account of ESG factors? Well, according to the Law Commission, that depends. It states that it is for trustees to consider, in discussion with advisers and investment managers how to assess risks and long-term sustainability and to consider whether and to what extent a particular factor, of whatever nature, is financially material to the particular investment.
A good example is given by the Law Commission of what a non-financial factor would look like compared to a financial factor. As they put it, withdrawing from investment in tobacco because the risk of litigation makes it a bad long-term investment would be acting on a financial factor whereas doing so because tobacco kills people would be based on non-financial factor.
As to whether trustees can take non-financial factors into account, the Commission has stated that they can, provided two tests are met.
- The trustees have good reason to think scheme members would share the concern They cannot impose their own ethical views on beneficiaries and so have to think that the majority of members would agree. They may need to consider consulting members except perhaps where they could make reasonable assumptions (such as activities contravening international conventions).
- The decision should not involve a risk of significant financial detriment to the fund Advice will be required from financial advisers on the effect of the decision on returns to the fund. If there is significant risk, then the trustees should not proceed.
There can be exceptions to the "no significant financial detriment" however if either the decision is expressly permitted by the trust deed or where a DC member has chosen to invest in a specific fund.
Furthermore, whilst not quite an exception, the Law Commission's guidance is that a slightly more relaxed approach can be taken with the answers to the two questions referred to above in respect of what it calls "affinity groups" – those sharing particular morals or political viewpoints.
The final point the Commission makes, when commenting on the fact that an occupational scheme's Statement of Investment Principles must include a note as to how far social, environmental and ethical considerations are taken into account, is that the phrase may be confusing and it is better for trustees to think in terms of "financial" and "non-financial" factors instead.
Are we any clearer?
There has obviously been a tremendous amount of work that has gone into this project over the last few years, but are we really any further forward?
In some areas it seems like the Law Commission has added real value, such as the guidance for trustees on wider investment considerations. But in other aspects it seems a bit more disappointing with plenty of holding off charge or waiting for other future reviews. In particular, it seems likely that Professor Kay would be less than impressed with the outcome on fiduciary duties for intermediaries. The Law Commission's stance that the vast gap between the current legal position and the model Professor Kay advocated means it is better left without legislative change may leave some slightly underwhelmed.