A proposed change to pension fund investment regulations in Ontario will require pension fund administrators to include in their statements of investment policies and procedures (SIPPs), information about whether and, if so, how, environmental, social, and governance (ESG) factors will be incorporated into their investment decision-making process. This doesn’t seem very onerous. It’s not like it’s a requirement to take ESG factors into account – or is it?
Well, it might be. Certainly pension fund administrators will now have to explicitly consider whether and to what extent to take ESG considerations into account. Pension fund administrators would be well advised to take legal advice before making any admissions about ESG at all. This includes any statement that they do not take such factors into account.
As explained below, the enactment of this requirement will serve to validate legal arguments that ESG factors can and, in some circumstances, should be taken into account. There are three main areas to consider:
- Should ESG factors be taken into account when they are financially relevant, either to improvements in financial return or financial risk mitigation?
- Can ESG factors be used as a tie-breaker between investments with equivalent financial characteristics?
- Must ESG factors be taken into account where they can be clearly shown to be consistent with the purposes of the plan or the implicit or explicit interests or directions of all plan beneficiaries?
The Legal Debate
Whether the fiduciary duty of pension fund administrators is compatible with taking ESG concerns into account has been the subject of intense legal debate since the introduction of the prudent portfolio approach to pension fund investing – which coincidentally arose at about the same time as Dr. Seuss first published ‘The Lorax’ in 1971. Originally, the debate was between those who insisted that fiduciaries could take ESG concerns into account and those who felt that fiduciaries could not take into account any factors other than financial factors. Legal debate has now evolved to the point where there are issues about:
- whether ESG factors must be taken into account in order to appropriately balance return and risk
- whether they can be taken into account without breaching fiduciary duty
- whether such factors must be taken into account in order to properly reflect the specific interests of the specific beneficiaries to whom fiduciary duty is owed.
In 1984, the famous case of Cowan v. Scargill in the UK suggested that because a pension plan is a device for securing and paying financial benefits, powers of investment under a pension plan have to be exercised in the best financial interests of plan members, without regard to other social or political interests.
In Cowan v. Scargill, the pension fund was jointly trusteed. The board of trustees consisted of five trustees appointed by the National Coal Board and five appointed by the National Union of Mineworkers. In 1982, the union trustees wanted a new investment policy to be adopted that would end investment overseas and in industries competing with coal. The intent of this strategy was to improve the coal business and provide greater job security for plan members. The court essentially ruled that the trustees could not be criticized for not taking social and non-financial benefits into consideration, and that “When the purpose of the trust is to provide financial benefits for the beneficiaries, as is usually the case, the best interests of the beneficiaries are normally their best financial interests. In the case of a power of investment, as in the present case, the power must be exercised so as to yield the best return for the beneficiaries, judged in relation to the risks of the investments in question; and the prospects of the yield of income and capital appreciation both have to be considered in judging the return from the investment.”
The decision left open some questions about whether ESG considerations could or should be taken into account if those considerations were relevant to investment return or to precautionary risk management. Subsequent cases indicated that such considerations in some circumstances are acceptable – maybe even required. Other cases also confirmed that fund administrators could consider the social and moral interests of beneficiaries where they relate to the express or implied objects of the trust or they affect decisions as between two investments with the same financial characteristics.
A real turning point came in 2005 when one of the world’s largest law firms – Freshfields, Bruckhaus, Deringer – co-ordinated a legal review of several large capital market jurisdictions, including Canada, and found that, in all cases, the law permits the integration of ESG issues. More significantly, the study found that, in certain cases, failure to consider ESG issues may constitute a breach of fiduciary duty.
Manitoba partially settled the issue for Manitoba fiduciaries by indicating ESG factors could be considered when it revised its legislation in 2005, provided the administrator otherwise complies with statutory fiduciary standards. The proposed change to Ontario Law does not so nicely say administrators will not be breaking the law by taking into account non-financial factors, but it might serve to implicitly suggest that ESG factors are relevant to pension fund investment – and arguably must be considered.
It should be noted that there may already be a partial ESG issue for all jurisdictions that have adopted the federal investment rules. Those rules require SIPPs to deal with the retention or delegation of voting rights acquired through plan investments. How proxies are voted is seen by many to be an integral part of the fiduciary duty to make investment decisions in the best interests of plan members. How a fiduciary votes proxies is part of the ‘G’ in ESG, so how proxy voting is addressed in the SIPP may also have legal implications and ought to be consistent with ESG disclosure.
But what exactly could this new disclosure requirement mean for administrators of registered pension plans in Ontario? Is it a signal that Ontario feels that ESG factors must be considered by pension plan fiduciaries? Is it simply implying that it is appropriate to take such factors into account? Is Ontario concerned that plan administrators are giving the wrong emphasis to ESG factors? Or is it simply to address transparency? It is difficult to say. Accordingly, one ought to be careful when inserting any statement about this in the SIPP.
The starting point for administrators to consider is simply what is ESG all about in the context of investment of registered pension funds? And what are the fiduciary implications?
It’s my experience that the whole issue of ESG and the legal implications are not well understood. It doesn’t help that the issue of recognizing ESG factors is tied up with principles of responsible investment (PRI), socially responsible investment (SRI), and ethical investment. So let me take a moment to spell out what I think this issue entails from a legal perspective.
ESG Is Not Ethical Investing Per Se
Taking into account ESG factors does not mean avoiding investment in so-called ‘sin’ industries, like gambling, tobacco, pornography, or landmine production. That is simply an ethical screen. It also doesn’t mean sacrificing financial return for environmental, social, or governance reasons. What it does mean is using non-financial information to improve assessment of financial returns and investment risk. What it might also mean, is giving effect to non-financial interests of plan beneficiaries where those interests are consistent with the purposes of the plan, even in our legal environment where tax rules require the ‘primary purpose’ of a pension plan be to provide financial benefits in the form of lifetime pensions.
By way of example, take Dr. Seuss’s book, ‘The Lorax.’ It tells the story of a business tycoon, the Once-ler, who ignores the evidence and warnings of the Lorax (an environmental expert) about the effects the Once-ler’s business is having on the environment. The Once-ler “biggers” his “Thneed” business to the point of destroying the environment necessary to grow Truffula trees which he needs to support the business. Predictably, the Once-ler’s business collapses along with the environment and the quality of life for everyone in the vicinity.
ESG to Assess Value and Risk
From a purely financial perspective, the Once-ler’s Thneed business clearly looked like a great investment. He was literally making truckloads of money right up until the sudden collapse. There appeared to be no market risk, credit risk, liquidity risk, or operational risk – the usual financial metrics associated with risk management. However, from a long term investment perspective (the perspective pension fiduciaries adhere to), the collapse could easily have been predicted by looking at ESG factors.
First, from a corporate governance perspective, the Once-ler held opaque control over his business. He only employed his relatives and friends, he failed to take into account the expert advice of the Lorax, and he failed to establish a capital expenditure program to deal with waste and planting of new Truffula trees to protect the business. From environmental and social perspectives, he failed to take into account early warnings of environmental degradation caused by his Thneed operations, namely the departure of the Bar-ba-loots for lack of Truffula fruits, their sole source of food, then the Swomee-Swans for want of clean air; and lastly the Humming-Fish to escape the polluted water.
The Freshfields opinion would suggest that any pension fund administrator holding this investment at the date of its collapse would be personally liable for failure to take into account the relevant ESG factors, even if any idiosyncratic risk associated with Thneed production had been addressed by diversification strategies. Clearly, taking ESG factors into account when the factors are financially relevant is not only allowable, but arguably obligatory for long term investors seeking value creation and sustainability without undue risk of loss.
But how do pension fund administrators get access to that information? Lack of information and reliable ESG analytics may have been an excuse 10 years ago, but growing investor interest in ESG performance data has resulted in greater disclosure of such factors in regulatory filings made by public corporations. Demand for ESG analytics has also resulted in a number of reliable providers.
Benefits and Pensions Monitor recently reported that a Hermes Investment Management survey, ‘Responsible Capitalism,’ found 71 per cent of institutional investors across the UK and Europe believe company retirement programs will reject more investment opportunities over the next five years because of ESG risks. More than three-quarters (79 per cent) said significant ESG risks with financial implications are good enough justifications for rejecting an otherwise attractive opportunity. It also found 55 per cent of respondents think companies that focus on ESG issues, especially corporate governance, produce better long-term returns for investors. This accords with compelling research showing that good governance correlates with increased returns.
ESG as a Tie-Breaker
Another aspect of ESG is whether it is permissible to take such factors into account when deciding between investments with the same financial metrics. It seems to me that this is clearly permissible and falls within comments found in Cowan v. Scargill. “Trustees cannot be criticised for failing to make a particular investment for social or political reasons, such as in South African stock for example, but may be held liable for investing in assets which yield a poor return or for disinvesting in stock at inappropriate times for non-financial criteria.”
Accordingly, using ESG metrics as a tie-breaker is allowable. Using ESG metrics to assess value and mitigate risk is also allowable and arguably required. In other words, using ESG as an additional investment lens, rather than a screen, is fine.
ESG to Reflect Plan Purpose or Non-Financial Beneficiary Interests
What about claims that choosing investments on ESG grounds is obligatory when it is reasonable to believe that the selection would be supported by plan beneficiaries? There is a line of legal thinking, mostly in the U.S. and the UK, that suggests that the duty of loyalty owed by pension fiduciaries is to the actual human beneficiaries, not to the plan itself, and that courts have on some occasions allowed exceptions to the rule that financial interest trumps other interests where trustees have considered their interests in a slightly broader sense.
I am not so sure this is the case in Canada. First, unlike the U.S. or the UK where pension legislation makes it clear that the fiduciaries have a duty to the human beneficiaries, Canadian law recognizes either explicitly or implicitly that employers are also beneficiaries of pension plans. So aside from any difficulty in aligning all human beneficial interests relating to employees, retirees, deferred vested, and others, the employer’s interests would also have to be aligned.
Second, ‘exceptions’ to the general legal rule which requires a focus on financial interests (value and risk mitigation) arise in cases where it is clear that the purpose of the fund is not simply to provide financial benefits, where the will of all plan beneficiaries is known, or where the investment is so morally or socially repugnant it should not have been made, regardless of financial return. Those exceptions may be difficult to find in most registered pension plans. Also, in Canada, there is a legal imperative imposed by income tax legislation that the “primary purpose” of a registered pension plan must be to provide lifetime pensions in order to obtain and retain tax qualification.
It seems to me that much of the discussion about purpose and beneficiary interests borders on arguments relating to ‘ethical’ investments which can be better addressed by including express terms in the governing plan documents – the plan text or trust agreement. It seems reasonable that a pension plan for the Cancer Society or the Heart and Stroke Foundation might purposely avoid investment in tobacco products, but that is more of an ethical screen. To be legally sound, it should be set out in the plans’ foundation documents, not just the SIPP. In my view, the SIPP, as a policy document, is not by itself going to enable what is essentially an investment screen based on non-financial criteria to override the underlying legal requirement to assess yield, value appreciation, and mitigate risk without compelling and allowable language in the core plan documents.
As stated in the Ontario Report of the Expert Commission on Pensions, it “remains somewhat uncertain precisely how, in practical and legal terms, the decisions of trustees and administrators to pursue socially responsible investment (SRI) can be reconciled with their duty to maximize the plan’s investment returns for the benefit of its active and retired members. However, there is a growing global consensus that trustees must at least have a considered and informed discussion on the issue.”
The requirement to disclose information about whether and, if so, how, ESG factors are to be incorporated into the investment decision-making process does not provide legal clarity. Yes, it does mean there will be transparency, but it also signals that trustees must have a considered and informed discussion since they will not be able to reference ESG in a SIPP one way or the other without discussion about whether or how to take such considerations into account. So it seems to me that this is a change to the legal landscape. It is a change that may give legitimacy to ESG considerations in a broader context.
It is also going to create angst for administrators of funds that are passively invested in mutual and segregated funds and for defined contribution investment offerings. How are ESG considerations to be discussed or identified in those contexts?
Mandatory ESG disclosure goes beyond transparency. At the very least, it implicitly acknowledges the potential materiality of ESG for fiduciary investment processes. But it also shines a light on fiduciary liability for these issues. As a result, pension fund administrators will need to understand and consider the relevance of ESG issues for their particular pension funds in a way that does not expose them to future legal liability. For one thing, they will need to reflect discussion around this issue in their governance committee minutes. They should also take care in how they express this in their SIPPs.
In giving consideration to ESG considerations it may be a useful starting point to separate legal implications arising from use of ESG information into three broad categories, namely:
- Being financially relevant – ESG analytics as an additional lens to assess value and to provide precautionary risk management
- Fulfilling a tie-breaker function where all financial considerations are equal
- Reflecting the purpose of the plan or unanimous beneficiary consent or directio
The move to disclose ESG considerations will certainly be applauded by those in the SRI movement as a step forward in legitimizing the ability or even the requirement for fiduciaries to incorporate ESG considerations into investment analysis and risk management processes. But does it really go that far? I wonder what the Lorax might say.
The lawyers will say that pension plan administrators need to tread carefully. Clearly administrators will be required to consider these issues. And they need to think twice about the legal implications before they write anything about ESG into their governance committee minutes or into their SIPPs.