A Fiduciary Duty to Consider ESG Issues? New Study Indicates "Yes"
by Peter D. Kinder

Do fiduciaries - especially pension fund trustees - have a duty to consider environmental, social and governance (ESG) issues in their investment decision-making process?¹

I argued, in a paper initially published last year, that the Securities & Exchange Commission's 2003 proxy voting rules would lead fiduciaries under its jurisdiction to consider ESG issues when monitoring their investments.² I also argued that US law allowed fiduciaries more latitude in integrating non-financial criteria than is commonly acknowledged.

New UNEP FI Study

A comprehensive study prepared by the major international law firm, Freshfields Bruckhaus Deringer, and published by the United Nations Environmental Program's Finance Initiative (UNEP FI)³ on October 25 goes considerably farther."Conventional investment analysis focuses on value, in the sense of financial performance. ...[T]he links between ESG factors and financial performance are increasingly being recognised. On that basis, integrating ESG considerations into an investment analysis is clearly permissible and is arguably required in all jurisdictions."⁴

A Global Study & Conclusion

UNEP FI asked Freshfields to determine whether the integration of ESG "issues into investment policy (including asset allocation, portfolio construction and stock-picking or bond-picking) [is] voluntarily permitted, legally required or hampered by law and regulation; primarily as regards public and private pension funds..."⁵ in seven major capital markets jurisdictions.

The seven countries were: the US, the UK, Germany, France, Italy, Spain and Japan. Freshfields also looked at Australia and Canada.⁶ The surveyed countries represent two distinct legal traditions: the Anglo-American common law system and the Roman-French civil law system. Nonetheless, Freshfields found all permitted consideration of ESG issues.

The unanimity of these nine jurisdictions makes it difficult to argue that including ESG consideration in the investment decision-making process is a fringe concept.

Emphasis on Process

Trustees must consider these factors "because there is a body of credible evidence demonstrating [they] often have a role to play in the proper analysis of investment value."⁷ So, they cannot be ignored - in the proper context.

"One element of the law governing investment decision-making", concludes the report, "that is common to all the jurisdictions is the requirement that decision-makers follow the correct process...."⁸ Nothing about the consideration of ESG criteria modifies that rule.

Nor does it alter the trustees' discretion in assigning a weight to these factors. Fiduciaries remain free to decide that, for instance, they will have no material effect on the investment's performance. But, Freshfields argues, they must assess them. And that assessment must take place within the disciplined investment process courts expect of fiduciaries.

Significance of the Study

The legal conclusions Freshfields reaches are foreshadowded in other papers and law journal articles. What is different is the comprehensiveness of their survey. Investors and stakeholders interested in SRI or ESG should see that this 150 plus page report reaches trustees and their lawyers.

The source of the study is also significant. Although it has a limited presence in the US, Freshfields Bruckhaus Deringer is a top international law firm based in Germany and the UK. The team it assigned, headed by partner Paul Q. Watchman, produced the quality of report one would expect from such a firm.

That said, one familiar with the US situation will find emphases to disagree with.

I would argue, for example, that the Uniform Prudent Investor Act's negative commentary on the duty of loyalty and SRI fall well outside the mainstream, especially in its failure to admit the existence of contrary authority. Freshfields should have explored its implications.

I would also argue that Modern Portfolio Theory, which has become embedded in the law of trusts, provides less comfort to those advocating incorporating ESG criteria than Freshfields thinks. It has led many to assume - not wrongly - that safety comes from conformity, from making sure one's discipline varies little from the norm.

But, these are quibbles with a study that alters the course of the debate in precisely the direction SRI has urged for 35 years.

A Prediction

Klaus Topfer, UNEP's Executive Director, predicts, "As the world's largest pension schemes ... and foundations adjust, this will set in train a new dynamic along the investment chain. When these large institutional investors move on ESG issues, the broader market will listen and react."9

I agree. We owe our deepest thanks to UNEP for commissioning the study and Freshfields for carrying it out.

1. "ESG" is a phrase devised to allow institutional investors to talk about investing using non-financial criteria similar if not identical to those used by social investors but without using the descriptor "socially responsible investing" which is anathema to them.
2. See Peter D. Kinder, "Pensions & the Companies they Own", paper delivered at the University of Colorado Leeds Business School Symposium on Business & the Broader Culture, "Corporate Retirement Security: Social & Ethical Issues", March 11, 2005. http://www.kld.com/resources/papers/UniversityOfColorado_050311.pdf. For a discussion of what "ESG" refers to and where the phrase came from, see Peter D. Kinder, "Socially Responsible Investing: An Evolving Concept in a Changing World", pp. 32-42. http://www.kld.com/resources/papers/SRIevolving050901.pdf.
3. Freshfields Bruckhaus Deringer, A legal framework for the integration of environmental, social and governance issues into institutional investment (New York/Nairobi: UNEP FI, Oct. 2005). Available at www.UNEPFI.org
4. Id., p. 13.
5. Id., p. 6.
6. Id., pp. 6-7.
7. Id., p. 11.
8. Id., p. 10.
9. UNEP, 'Press Release: Institutional Investors' Legal Responsibilities on Environmental, Social and Governance Issues under Spotlight', New York/Nairobi, Oct. 25, 2005, p. 1.

Mercer Investment Consulting Releases SRI Survey

In October 2005 Mercer Investment Consulting sent out a survey on socially responsible investing aimed at the US investment community. Mercer hopes to complete the survey by the end of the month.

Building on a trend in investing, the purpose of Mercer's survey is to develop some concrete data on the extent socially responsible investing has penetrated the industry. The survey is aimed at a wide range of investment entities from not-for-profits to public funds to pension plans. The idea is to get as broad of a response as possible. The survey focuses on four substantive sections: socially responsible investing, assessment of the use of environmental, social and governance (ESG) criteria, shareholder engagement, and minority and emerging managers.

We look forward to the results of Mercer's survey.

Senior Analyst Updates

From Liz Ulmas:

Nike recently made a big decision to disclose its factory base. Five months later, Levis followed suit, with a soon-to-be-named company making a similar announcement any day (that company's CSR report is imminent but the information is not public yet, so I won't name names). That's a big shift in transparency in a short time.

An equally interesting example of transparency emerged this month when Freeport-McMoRan, an embattled mining company with very controversial operations in developing countries, released a social audit it had commissioned the International Center for Corporate Accountability (ICCA) to conduct of its mines on Indonesia's Papua island. The report contained some pretty negative assessments.

Business Week called the release of the social audit a "major development", "gutsy", and pointed out that no other major oil or mining company had "come close" to this kind of transparency. Human Rights Watch, while welcoming the independent assessment, was more critical of the company for not having earlier addressed the problems found in the audit.

Companies like Freeport will continue to be very controversial, and for every revelation - including self-revelation - of major human rights violations in a particular corner of the earth, sad to say, there are lots of serious rights abuses connected to these corporations that the outside world will never find out about. But what if Business Week is right, that Freeport's social audit could end up "setting the standard" for multinationals on human rights assessments? It's worth close scrutiny over the next couple of years, and there's even evidence that at least parts of the mining industry - not known for being progressive - are starting to listen to human rights groups and social investors.

In the meantime, the Non-Transparency Award of the Month goes to British American Tobacco; the UK's Guardian broke a story last week that BAT had been secretly operating a factory since 2001 in North Korea, one of the most repressive regimes in the world.¹ In a country where people are starving, BAT feels OK about manufacturing cigarettes there, apparently for local consumption. BAT is a member of the Dow Jones Sustainability Indexes.

As for Wal-Mart's planned changes on energy efficiency, employee health insurance coverage, labor standards and women/minority contracting, we'll have to watch these carefully in 2006 to know how much is real substance.

¹Ian Cobain and David Leigh, "Tobacco firm has secret North Korean plant," The Guardian, October 17, 2005.