3.5.2 Fiduciary duty and ESG factors: the Freshfields report

Traditionally, many ESG factors have not been incorporated in financial analysis. This is beginning to change as institutional investors see the connection between long-term interests of their beneficiaries and the medium to longterm risks of issues such as climate change, dependence on biodiversity and ecosystem services corporate governance and employee relations. In respect of the role of institutional investors in promoting CSR and socially responsible investment (SRI), it has often been contended by pension funds that their fiduciary duties only allowed them to strive for profit maximalisation and that they are not allowed to consider ESG factors in their investment decisions.1 The United Nations Environment Programme - Finance Initiative, Asset Management Working Group (UNEP FI)2 commissioned a study on this question by the law firm Freshfields Bruckhaus Deringer (Freshfields). UNEP FI had submitted the following question to Freshfields:

UNEP FI released a report in 2005, entitled A legal framework for the integration of environmental, social and governance issues into institutional investment' (Freshfields Report).3 The report shows that there are in fact no limitations on the integration of ESG factors in the investment decision-making process; to the contrary, the law not only allows but requires it in certain circumstances. The Freshfields Report defines the concept of fiduciary duties as duties that common law jurisdictions impose upon a person who undertakes to exercise some discretionary power in the interests of another person in circumstances that give rise to a relationship of trust and confidence.' The UNEP FI question was analysed in seven major capital markets' jurisdictions:

(i) the common law jurisdictions of the US, the UK, Australia and Canada, and

(ii) the civil law systems of Germany, France, Italy, Spain and Japan. The Freshfields Report noted that none of these jurisdictions had rules prescribing how ESG factors should be integrated and that investment decision-makers retain some degree of discretion as to how they invest the funds under their control. According to Paul Watchman, leading author of the report, in most jurisdictions, the law gives a wide discretion, encircled by general duties rather than exacting standards' and that a number of the perceived limitations on investment decision-making are illusory'.4 As the Report states:

One common legal element of the investment decision-making for all the examined jurisdictions is the requirement that decision-makers follow the correct process' in reaching their decisions. For common law jurisdictions, this requirement stems from the fiduciary duties of prudence and, in the civil law jurisdictions, the duty to seek profitability and otherwise manage investments conscientiously in the interests of beneficiaries. According to the Freshfields Report, decision-makers are required to have regard (at some level) to ESG-considerations in every decision they make. This is because there is a body of credible evidence demonstrating that such considerations often have a role to play in the proper analysis of investment value.As such they cannot be ignored, because doing so may result in investments being given an inappropriate value.6

After the Freshfields Report was launched, many comments and critics emerged. Professor Cynthia Williams from the College of Law at the University of Illinois opined that the Freshfields analysis confirms the fact that not only is it permissible to consider ESG factors, but fiduciary duties require that they be considered where there is the potential for a material, financial impact from those factors. She stated: 'Thus, the impacts of climate change and how to mitigate them would be something that trustees and other fiduciaries really must consider, since the physical risks from climate change, and the regulatory and legal risks, portend serious financial impacts in addition to social impacts, health, welfare, and other impacts.'7 To consider ESG factors in investment decisions is therefore part of the fiduciary duty (to be a prudent fiduciary').

One interesting and controversial question relates to the interests of beneficiaries: when the report states that the fiduciary duty must be in the interests of beneficiaries, does this mean in the immediate future or in the longterm? E.g., Professor Jim Hawley, the co-director of the Center for the Study of Fiduciary Capitalism at St. Mary's College of California, poses the following question: If what you do now is very likely to create a world 30 years from now that's far more polluted, is that in the beneficiaries' best interest or not?'8 The Freshfields Report does not provide an answer to this question as it merely states that the term interests' can have different meanings in different jurisdictions. The Report considers the duty to act prudently and the duty to act in accordance with the purpose for which investment powers are granted, i.e. the duty of loyalty, to be the most important fiduciary duties, which may include the duty to do due diligence on ESG issues.