Fiduciary Duty’s Paradox Incrementally Flexible Essay Example

Fiduciary Duty’s Paradox: Incrementally Flexible Paper The above section has demonstrated that the uncertainty surrounding pension funds’ obligations with respect to non-financial factors in investment decision-making presents a practical barrier to consideration of environmental factors, including climate change, in both the US and UK context. It is clear that part of the problem is the lack of both current case law and consistent legislative commentary on the topic. However, the problem runs deeper than that – it is tied to the nature of fiduciary duty itself. This subsection examines what it is about fiduciary duty that makes it ill suited to adapt to changing social circumstances in anything other than an incremental manner. The urgent nature of climate change makes this situation all the more poignant. Fiduciary duty is a ramshackle concept. In early case law it arose, organically, out of certain relationships of trust. Whether a particular relationship was fiduciary, and what duty it entailed, was often difficult to predict. Indeed, it is difficult to escape the perception that in early times the finding of fiduciary duty, and its content, was rather arbitrary. The preceding sub-sections have demonstrated that although the nature of pension fund fiduciary duty has been clarified in both the US and the UK by successive pieces of legislation, uncertainties remain, particularly with respect to non-financial factors in investment decisions. And, as Langbein has argued, elements of the duty continue to evolve, both through legislation and through curial interpretation. In short, pension fund fiduciary duty remains, to an extent, ‘a concept in search of principle’. We will write a custom essay sample on Fiduciary Duty’s Paradox: Incrementally Flexible specifically for you for only $16.38 $13.9/page Order now We will write a custom essay sample on Fiduciary Duty’s Paradox: Incrementally Flexible specifically for you FOR ONLY $16.38 $13.9/page Hire Writer We will write a custom essay sample on Fiduciary Duty’s Paradox: Incrementally Flexible specifically for you FOR ONLY $16.38 $13.9/page Hire Writer In order to deal with the changing social and environmental realities associated with climate change, fiduciary duty must be able to accommodate certain investment innovations – in particular to allow the explicit consideration of the risks and opportunities associated with climate change. It must be able to recognise the increasingly financial implications of climate change, as legislation (e.g. on emissions trading) and markets are gradually doing. However, this subsection argues that while this type of innovation in fiduciary duty is possible, without legislative change it will be incremental – and too slow to meet the urgent changes required by climate change. This subsection explores the paradoxical nature of fiduciary duty with respect to investment innovation: the duty can evolve – history has seen it adapt to emerging social expectations – but the tendency for courts to judge fiduciaries’ prudence by reference to existing investment norms means that any innovation in investment is bound to be incremental – any change in fiduciary duty must fight against considerable inertia. As a result, while the past flexibility of fiduciary duty suggests that the investment innovation of the risks and opportunities presented by climate change is acceptable in theory, the past also suggests that innovation in the courts (that is, absent legislation) is incremental. Change, when introduced too quickly, has been equated by courts with imprudence in the past. The following subsections visit fiduciary duty’s incrementally adaptable nature, showing how it has adapted to evolving financial and social norms in the past, bu t also discussing its tendency toward inertia. The final subsection discusses what the nature of fiduciary duty means for pension funds’ attitudes toward climate change. Adapting to Changing Social Expectations (both Financial and Non-Financial) Fiduciary duty in an investment context has adapted slowly to changing social expectations about finance over the years. If we trace the development of trustees’ fiduciary duty since Victorian times, the change in expectations of investment is striking. In the 18th and 19th centuries, English law took a prescriptive, risk-averse approach to the investment of trust funds. In Learoyd v Whitely Watson LJ explained the principle as follows Business men of ordinary prudence may, and frequently do, select investments which are more or less of a speculative character; but it is the duty of the trustee to confine himself to the class of investments which are permitted by the trust and likewise to avoid all investments of that class which are attended with hazard. According to John Langbein, early English legal attitudes toward investment of trust funds were deeply affected by the South Sea Bubble: in 1719, Parliament allowed trustees to invest in the South Sea Company, whose shares promptly dropped by 90 percent. In the aftermath, the chastened Parliament instigated a conservative approach to investment of trust funds that began with the Bubble Act (1719) and would not disappear completely until the Trustee Act (2000). Under this risk-averse approach, trustees were only permitted to invest in assets specifically authorised in legislation. These generally included consolidated bank annuities, gilts and mortgages of real property. The prescriptive nature of these legislative lists was gradually relaxed over time: under the Trustee Investment Act 1961, trust funds were required to be divided into ‘narrower range’ and ‘wider range’ investments, with wider range investments including UK securities and some shares. It was not until the repeal of the 1961 Act with the Trustee Act 2000 that the prescriptive approach to investment disappeared from English legislation, allowing trustees to invest in any asset class. The law with respect to investment of trust funds in the US followed a similar trajectory. US law inherited the English system of prescribing suitable investments for trustees in Victorian times. It began to move away from the prescriptive approach with the seminal case, Harvard v Amory, which introduced the classic US statement of the more flexible prudent man test: All that can be required of a trustee to invest, is, that he shall conduct himself faithfully and exercise a sound discretion. He is to observe how men of prudence, discretion and intelligence manage their own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds, considering the probable income, as well as the probable safety of the capital to be invested. While there was some resurgence of the process of requiring trustees to invest only in assets included on a ‘legal list’ of investment options for trustees following the New York case, King v Talbot, legislative initiatives gradually broadened trustees’ investment opportunities throughout the 19th and 20th centuries. In particular, the advent of modern portfolio theory in the 1940s led to the legislative introduction of the modern prudent investor rule. The large amount of legislative change regarding the investment of trust funds in the US is testament to the flexibility of fiduciary duty. As Langbein notes the trust of today bears only a distant relationship to the trust of former centuries. The trust that we know is mainly a creature of the 20th Century; accordingly, common law processes of incrementalism were no more suitable for today’s trust law than for the regulation of nuclear power plants. Today, under the modern prudent investor rule, trustees in the US may invest in any asset that is appropriate to the fund portfolio, taking into account the risk and return objectives of the trust and its beneficiaries. The need for fiduciary duty to entertain new social and economic expectations surrounding investment was such that its adaption had to be facilitated by legislation. In this light, the past flexibility of fiduciary duty with respect to the investment of trust funds is demonstrated by its rapid adaptation to new financial standards. The potential for fiduciary duty to adapt to new investment approaches is therefore clear. Taking these points one step further, the next paragraphs argue that fiduciary duty also has the flexibility to adopt a broader view of investment by allowing the consideration of certain non-financial issues in investment decision-making. Changing societal expectations have affected fiduciary duty’s approach to investment in subtler ways than risk averseness. Fiduciary duty has had the flexibility to evolve with respect to non-financial factors in trustee decision-making in the context of changing attitudes toward women in the work place. Although dealing with trustees of a council rather than those of a pension fund, Roberts v Hopwood provides a vibrant illustration of how fiduciary duty can evolve in a social context. In this case, a local authority used its powers under statute to increase wages for its workers to above the national average and to pay men and women equally. The district auditor found that the council’s wage increase was unreasonable and ordered its reversal. The council appealed and the case progressed to the House of Lords. The House of Lords found that the council had breached its fiduciary duty by aiming to be a model employer instead of paying the minimum wage. Atkinson LJ stated that the council would, in my view, fail in their duty if, in administering funds which did not belong to their members alone, they put aside [minimum wage indicators] and allowed themselves to be guided in preference by some eccentric principles of socialistic philanthropy, or by a feminist ambition to secure the equality of the sexes in the matter of wages in the world of labour. Atkinson LJ regarded the council’s decision to increase wages for both men and women as a symptom of ‘the vanity of appearing as model employers of labour’ and of the council becoming ‘such ardent feminists as to bring about, at the expense of the ratepayers whose money they administered, sex equality in the labour market.’ In this case, the council’s consideration of non-financial factors in determining how to invest ratepayers’ money was found to violate its fiduciary duty to ratepayers. With the growth of the anti-discrimination movement throughout the 20th Century, the decision to grant wage parity between sexes no longer appears to be the fanciful indulgence of ‘some eccentric principles of socialistic philanthropy.’ Some sixty years later, in Pickwell v Camden London Borough Council,   the Court affirmed the fiduciary duty of a council to its ratepayers, but also noted the council’s entitlement to ensure the welfare of its workers, stating that the council ‘must therefore often be involved in balancing fairly these interests which may frequently conflict.’ The Court referred to the decision of the House of Lords in Roberts v Hopwood and said looking back, as we do, over 60 years of progress in the field of social reform and industrial relations some of their Lordships observations may, with the benefit of this hindsight, appear unsympathetic what has changed over those years is our attitudes to what should be regarded as pure philanthropy. In other words, whereas wage parity was once seen as philanthropy, it is now seen as a legitimate consideration potentially consistent with fiduciary duty. The Court’s comments with respect to Roberts v Hopwood indicate an acknowledgment of the flexibility of fiduciary duty to yield in accordance with evolving social forces as well as commercial forces. The development of fiduciary duty here was ancillary to the commercial context: just as the duty has adapted to evolving expectations in the investment context, it has also adapted to admit considerations once considered to be non-financial. It is therefore possible that fiduciary duty could adapt to changing social expectations about the environment, and in particular climate change. It is important to remember that fiduciary duty, no matter how immutable it appears to be at a single moment in time, is and always will be the object of interpretation; how it will be interpreted will vary with evolving investment and social stan dards. It is the rate of its evolution that is uncertain, an idea that is discussed below. Inherent Inertia: Prudence tends toward the status quo While the content of fiduciary duty clearly can evolve over time, change is often slow. It took more than 250 years for the investment conservatism engendered by the South Sea Bubble to give way to the concept of diversified investment portfolios. In particular, the law lagged significantly behind the finance industry (and, it must be said, financial reality) in adopting modern portfolio theory. It is argued here that legal inertia with respect to fiduciary duty and pension fund investment is linked to the prudent man standard. What is prudence? According to the UK Pensions Regulator, ‘[p]rudence is difficult to define in general terms and will apply differently to different circumstances.’ Prudence is so difficult to define precisely because it is circumstantial. When judges are faced with deciding whether a particular trustee’s decision was prudent, both US and UK law requires them to look at what other trustees in a similar position would do – they must look to the conventional behaviour in the pension fund industry. In 2000, Hawley and Williams argued that ‘the safest course of action for a professional owner is to take only those actions generally accepted as prudent – which historically has led institutions to adopt a conservative view of their responsibilities as owners.’ The prudent course of action in this light becomes the status quo, slowing innovation in investment decision-making. Therefore although fiduciary duty in the investment context is flexi ble, it is, paradoxically, susceptible to significant inertia. This is of great consequence for pension fund trustees, as it reinforces pre-existing behavioural biases within the industry (this problem is discussed in section IV below). This inertia comes from several quarters: legislation, incremental judicial interpretation, and through the behaviour of the pension fund industry itself. In the US, a formula urging fiduciaries to perpetuate the status quo in investment behaviour is built into the modern prudent investor rule. Under the rule as it is formulated in ERISA, trust funds must be managed ‘with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims.’ When determining how a prudent man in an investment context might act, it seems logical that investors should look to the investment behaviour of their peers – or at least to the behaviour of their peers that has not attracted criticism for imprudent investment. Fiduciaries are therefore encouraged to base their investment judgements essentially upon the prevailing investment conventions at any one time. In the UK, a trustee must manage the trust in the same manner as an ordinary prudent man of business would conduct his own affairs. Professional trustees and asset managers professing to have special fund management skills have a higher standard of care. The standard of care for both professional and other trustees is, like the US standard, self-referential. The prudence standard is once again associated with what other investors do. As such, UK pension fund trustees are expected to associate prudence with a conventional approach to investment. A preference for maintaining the status quo in investment behaviour can be seen in the historical reluctance of many courts to accept modern portfolio investment as prudent. Prior to the introduction of the modern prudent investor rule, courts across the UK and US legal world required fiduciaries to be able to demonstrate that each individual investment is ‘prudent’ – any single investment failure could amount to imprudence on the part of the fiduciary. This legal stance resulted in risk-averse decisions by pension fund trustees, but also in returns that were significantly lower than they could have been. The introduction of the US modern prudent investor rule, and its equivalent diversification rule in the UK, allowed fiduciaries to make investments that were more beneficial for the beneficiaries. The ability of pension funds to adapt to the realities of climate change are similarly restrained by the prudence standard’s hostility to anything other than inc remental change. Judicial interpretation of the standard of prudence presents a further pressure on trustees to invest according to the convention of their day. Fratcher points out that there is a tendency on the part of the courts even in the absence of a statute to lay down definite subsidiary rules on what is and what is not a prudent investment. When a certain investment is held in one case to be improper, the courts are likely to treat the case as a precedent holding that no investment of that type is proper. It is this tendency that has made palpable the fear of pension fiduciaries of considering factors traditionally seen as non-financial in investment decision-making; it is this tendency that allowed the judgment in Cowan v Scargill to grow to the (undeservedly) legendary proportions it has reached. In the US, the testimony of experts in financial affairs is usually admissible for determining whether a fiduciary has acted prudently.346 This self-referential feature is likely to propagate conventional wisdom, rather than to encourage trustees to innovate. The practical consequence of requiring investors to base their actions on the actions of their peers is that the status quo tends to prevail. For this reason, Keith Johnson and Frank Jan de Graf have described the prudence standard as a ‘lemming standard’. In their view, ‘pension funds are often reluctant to pursue prudent strategies not being widely used by other pension funds for fear of exposure to liability’. In circumstances such as the present, where investors are typically driven by short-term performance, prudent investment becomes short-term investment. The situation in the UK is similar. A report published by the UK Department of Social Security in 1997 used in-depth interviews with trustees of 48 selfadministered private sector occupational pension schemes to examine trustee investment practice. The report found that the main objective for trustees in administering their funds was to provide a good return on assets, and that trustees sought to achieve this aim by ‘appointing expert advisers and fund managers with successful track records and monitoring their performance; adopting what they perceive as cautious investment policies; and providing guidelines and benchmarks for fund managers for investing schemes’ assets.’ In the UK, trustees who are unsure of their duty may take advice from experts, including those within the finance industry. There have been some moves made toward encouraging pension fund trustees to act independently of their peers if their fund is different to the norm. In 1990, the Committee of Enquiry Report into Investment Performance Measurement recommended that ‘trustees should consider whether their own fund has special characteristics which indicate that it should be invested differently from the generality of funds.’ However, this does nothing to encourage innovation in a fund which does not have ‘special characteristics’. The Outcome for Climate Change The evolution of fiduciary duty, from restricting investment to specific low-risk categories until the second half of the 20th Century to embracing the modern prudent investor rule, reflects a change in social attitudes toward investment. Statutes in both the UK and the US are helping to keep fiduciary duty up to date – this is particularly true of the statutory shift from prescriptive lists of investment options for fiduciaries toward the modern prudent investor rule. However, even the statutory developments of the last two decades are insufficient to enable pension funds to move toward a more sustainable investment paradigm. The incrementalism central to the maturation of fiduciary duty in the past cannot facilitate the urgent action required by climate change. Nor does it, more importantly, encourage a deep philosophical change of the kind necessary to look at the long-term sustainability of investments. An aggravating factor exists here in the question of whether, and to what extent, a court would consider an explicit reference to climate change in an investment strategy as a ‘non-financial’ issue. Until such a case is heard, or relevant legislation enacted, it will be difficult to displace fiduciaries’ anxiety with respect to the appropriateness of attention to the complex web of issues surrounding climate change in the context of investment decision-making. It is reasonable to predict that courts will decide by reference to convention: if most pension funds view climate change as a non-financial issue, then courts are likely to see this position as the prudent one. While almost all governments and major companies around the world now see climate change as a financial issue, as well as an environmental and social one, few pension funds have demonstrated this view. In a way, therefore, pension fund inaction on climate change is likely also to be self-perpetuating without legislative clarification. There is no intrinsic reason for fiduciary duty to prevent pension funds from adopting a forward-looking approach to investment that includes the consideration of factors (such as the risks and opportunities associated with climate change) which are coming to be recognised as financial but which have not traditionally informed investment decisions. In theory, fiduciary duty should adapt to new economic realities engendered by climate change, but change is likely to be incremental (just as it was with respect to modern portfolio theory and equal opportunity in the past). Left up to pension fund trustees and courts, it is likely that the concept of prudence will lag behind as legislative changes correct the market failures of climate change. In practice, the tendency for prudent behaviour to be equated with conventional behaviour means that most pension funds will not move beyond the status quo in terms of investment strategy. Pension fund trustee caution with respect to uncharted financial territory is not surprising, given the uncertainty surrounding fiduciary duty. However, the focus of pension fund trustees on fiduciary duty as the main reason for eschewing change in investment approach obscures significant behavioural impediments to sustainable investment: ingrained short-termism regarding both financial performance and environmental impact, and institutional inertia. These impediments, when combined with the prudence standard’s constant reference to the status quo, create a collective action problem: in order for climate change to become an accepted consideration for pension fund trustees, a group of trustees must act in unison. Next Page   Ingrained Inertia, Short-Termism and Collective Inaction Previous Page   Pension Fund Fiduciary Duty and Non-Financial Considerations