by Greg Liddell*
In the period immediately prior to the UN Secretary General’s Climate Summit in November 2014, a number of large pension and endowment funds announced plans to divest their portfolios of fossil fuel companies. One of these was the Australian National University. What is a fund’s duty as a fiduciary in this case?
At that time, one of Australia’s most experienced finance columnists, Robert Gottliebsen, wrote: “Trustees of big superannuation funds like the Australian National University are taking considerable personal risk if they divest fossil fuel resource stocks as a result of their personal environmental beliefs.”
Gottliebsen went on to write: “But for the vast majority of superannuation funds, it is the individual members of the fund who will be the losers if the trustees’ decision to quit certain stocks on personal belief grounds reduced investment returns. Members could take class actions against the trustees’ personal assets.”
This article examines the question of fiduciary duty as it relates to climate change. What is fiduciary duty and how is it impacted by climate change? Is de-carbonising the investment portfolio a breach of fiduciary duty or prudent risk management? It concludes that Gottliebsen is largely correct – divestment of fossil fuel assets purely on the basis of the personal environmental beliefs of individual trustees would be a breach of fiduciary duty with the possible consequence of personal liability to trustee directors. However, this is far from the full picture as to the relationship between climate change and fiduciary duty. In fact the same decision, implemented for different reasons, could be entirely consistent with fiduciary best practice.
Since the Australian National University announced its decision to divest from fossil fuels, the ASX 200 Energy sector has underperformed the broader Australian market by more than 25%. Rather than costing money, the decision to divest has allowed ANU and other funds to avoid substantial losses. The trustees of ANU would appear to be safe from the threat of legal liability. The question arises as to whether the trustees of funds that have not acted to reduce climate risk in their portfolios are also at risk from class action litigation? This article explores that issue as well.
Defining Fiduciary Duty
In June 2014 the UK Law Commission published a report on the Fiduciary Duties of Investment Intermediaries; an intermediary being defined as “…an intermediary in the investment chain. Typically investment managers, brokers and custodians.” For the purposes of this article it is a useful report in that it attempts to bring together the multiple sources of law that define fiduciary duty. The Law Commission concluded that: “…the law does not require substantive change….the main problem is that it is complex, inaccessible and poorly understood.”
This problem of complexity and lack of understanding by trustees was highlighted by a quote in the report from Shareaction, a UK charity that promotes responsible investment.
“In response to member emails on climate change, 25% of funds referenced fiduciary duty – half as a reason to act on climate change, the other half as a reason to ignore it. In our view, there could scarcely be a better demonstration of the continuing confusion that surrounds this question.”
Legislators, regulators and courts do not hand out booklets that specify exact behaviours consistent with best practice fiduciary duty. In Australia, s52 of the SIS Act requires an RSE to exercise the same degree of care, skill and diligence as a prudent superannuation trustee (i.e. professional trustee). But what does that actually mean? No one says to a trustee, “If you do A, B and C then you will have complied with your fiduciary duty”. To a large extent fiduciary duty has been defined in the negative by identifying actions that breach fiduciary duty. Those breaches can generally be classified as breaches of the Duty of Loyalty and breaches of the Duty of Care. The Duty of Loyalty requires the trustee to act in a manner entirely consistent with the purposes of the trust; to act at all times in the best interest of his/her principal (e.g. the members of the fund); and to avoid acting where there is a conflict between their own interest and that of the principal.
The Duty of Care was described by Lord Blackburn in 1883 as “… all those precautions which an ordinary prudent man of business would take in managing similar affairs of his own.” This prudent person test has largely remained the benchmark for trustee directors, although recent case law, discussed below, has arguably raised the bar on what it means to be a “prudent” trustee.
I have heard it said that a fund trustee’s only fiduciary duty is to maximise the returns to members. Is this correct? The single minded pursuit of the highest possible returns, i.e. return maximisation, implies a low allocation of the “governance budget” to the oversight of risk, tax, liquidity and other factors. In truth return maximisation is an overly narrow interpretation of fiduciary duty. The onus is on trustees to generate the best possible return for members, after tax and fees, while maintaining sufficient liquidity and operating within a sound risk management framework appropriate to the circumstances of members; to make prudent investment decisions with the best interest of members paramount.
The Duty of Loyalty – Acting in the Best Interest of Members?
According to the UK Law Commission report the phrase “in the best interest of members” is not well defined in law and not particularly well understood by trustees. It has no statutory definition and there is little case law. The most significant case, “Cowan v Scargill” has generated considerable controversy with even the presiding judge, Sir Roberty Megarry, stating that conclusions drawn from his judgement were more general than warranted given the facts specific to the case. The Law Commission found helpful the comment by Lord Nicholls that “the duty to act in the beneficiaries’ best interests was a formulation in different words of a trustee’s duty to promote the purpose for which the trust was created.” In Australia, s62 of the SIS Act states that each trustee must ensure the fund is maintained solely for its prescribed core purpose(s).
For most funds, including superannuation funds, the core or defined purpose of the fund is generally to provide financial benefits for members. Therefore, the best interest test is framed in financial terms and Gottliebsen is correct that investment decisions based on non-financial considerations leave trustees vulnerable. Nevertheless, trustees do from time to time apply a broader than financial only interpretation of “best interest”. A material number of funds around the world, including Australia, now exclude tobacco from their investment portfolios. They argue that as it is a product that, consumed as intended by the manufacturer, results in serious illness and death, than it is not in the “best interest” of members to finance the industry. However, even though serious lung diseases are clearly not in a member’s best interest, across the industry there would still be a considerable range of opinions as to whether a superannuation fund trustee was in breach of fiduciary duty by divesting tobacco.
A question arises as to whether it is within the remit of trustees to make decisions that improve the quality of life of beneficiaries. Superannuation fund members want high (risk-adjusted) returns. But they also want to live out their retirement in a society that is clean, safe and secure . In the UK Law Commission report the Association for Member Nominated Trustees was quoted:
“What is the point of targeting pension fund benefits that are nominally higher but buying lower quality of life? To the extent that trustees’ choice of investment…may consciously have the effect of trading well-being against money, that would seem to sit ill with their proper purpose.”
It was the conclusion of the UK Law Commission that, “whilst generating financial returns should be trustees’ predominant concern, we do not think that the law requires it to be trustee’s sole concern.” Trustees may take into account quality of life factors but these should be subject to two tests: 1) do trustees have a good reason to think scheme members share the concern? And 2) the decision should not risk significant financial detriment.
The Duty of Care – What does it mean to be Prudent?
The obligation of a trustee to exercise a Duty of Care is especially relevant to the investment responsibilities of trustees. In Australia, Superannuation Prudential Standard SPS 530 sets out the requirement for an RSE licensee to establish a sound governance framework. Section 23 states:
- An RSE licensee’s investment selection process must result in the RSE licensee being satisfied that:
- it has sufficient understanding and knowledge of the investment selected, including an assessment of any factors that could have a material impact on achieving the investment objectives of the investment option;
- it has sufficient understanding of how the investment is expected to perform under the range of stress scenarios determined under paragraph 19(a); and
- the investment is appropriate for the investment option.
The requirement to assess “any factors that could have a material impact on achieving the investment objectives of the investment option” clearly places risk management as central to the trustee’s responsibilities. The Duty of Care however does not imply that all risk should be avoided. The UK Law Commission explores this area in some detail, noting that some degree of risk must be undertaken in order to achieve investment objectives. However, as noted in Bartlett v Barclays Trust Co:
“..the distinction is between a prudent degree of risk on the one hand, and hazard on the other.”
The UK Law Commission also notes that the courts have recognised that the concept of risk must adapt to current economic circumstances and a contemporary understanding of markets and investment.
Recent cases have arguably raised the bar in terms of what is required by a trustee/director. The judgement in the Centro case stated it was a duty of directors to “…take diligent and intelligent interest in the information available to him or her, to understand that information and apply an enquiring mind to the responsibilities placed upon him or her”. The Centro case underlines that there are limits to the degree to which directors can rely on assurances from management and appointed professional service providers and that they are expected to be pro-active in the execution of their duties. In particular they should have quality information gathering processes in place and should apply the skills they have (or are expected to have given their responsibilities) to make considered decisions within sound governance frameworks. Going forward it is likely the ability to demonstrate “intelligent enquiry” will be fundamental to a defence against breach of fiduciary duty.
Fiduciary Duty and Climate Change
So where does the law now sit with regard to climate change and trustees’ fiduciary duty? Gottliebsen writes, “If the trustees (of funds that divest fossil fuels) assembled a large amount of research which showed that fossil fuel stocks were likely to perform worse than other shares, then the trustees would be on stronger ground.” The implication he makes is that if a climate change “true believer” can manufacture an investment case, then divestment could be implemented without breach of fiduciary duty. Is this correct? It would seem making a decision on the basis of an environmental belief and then “mining” for studies to reverse engineer a decision already made represents a poor governance model. It does not sit well with our understanding of a Duty of Care requiring intelligent enquiry.
Similarly, the climate change denialist that ignores the considerable weight of scientific evidence and refuses to incorporate climate change in investment risk management processes is equally in breach of his/her fiduciary duty. If divesting fossil fuels because of an environmental belief in climate change is a breach of fiduciary duty then so too is not divesting because of climate change denial. It is not the decision that creates the liability, but the inadequate rational for the decision; the absence of intelligent enquiry.
It is likely that most trustees are climate change agnostic. They accept the evidence that climate change is occurring and that the most likely cause is anthropogenic emissions of green-house gases. However, they do not immediately recognise a connection between climate change and their roles as fiduciaries. Remember that we wrote that fiduciary duty could largely be defined as comprising a Duty of Loyalty and a Duty of Care. It is the Duty of Care that impacts the climate change agnostic trustee. It is the responsibility of all trustees to pro-actively examine the evidence around climate change and make a determination as to whether that evidence warrants action.
It is interesting to speculate how a court might rule in the event of a class action against trustees for losses resulting from an extreme weather event. In 2014, Illinois Farmer’s Insurance filed class actions against nine municipal governments over damages from flooding. The insurance company argued that local governments should have known that rising global temperatures would result in heavier rains and did not do enough to secure sewers and storm drains. Papers filed in that suit showed that local governments were aware that climate change would place stress on public infrastructure, however they had not as yet implemented mitigation plans. Illinois Farmer’s ultimately dropped the claims as in the USA local governments are immune from damages. Nevertheless, the case clearly heralds that climate change cases will find their way to court and places fiduciaries on notice. It has become impossible for trustees to ignore possible climate change impacts on investment assets and say they have complied with their Duty of Care.
Besides the physical impacts of climate change, there is also risk which derives from public policy both domestically and overseas. To date the policy framework has been far from stable. In Australia and overseas government support for renewable energy has waxed and waned. Outside Australia, carbon pricing mechanism have been steadily introduced by a range of national, regional and municipal governments, whereas Australia has introduced and subsequently abandoned carbon pricing. Many investments in renewable energy reliant on government subsidies or policy settings have failed when those subsidies have been withdrawn. Around the world institutional investors are reluctant to commit funds to clean technologies in the absence of stable policy frameworks.
It is by no means certain that the unstable policy environment will continue indefinitely. Particularly as science develops the ability to explain the causal link between climate change and specific incidences of extreme weather. A failure to transition to a low carbon economy will mean that as time goes by the impacts of climate change will become more pronounced with more frequent severe weather incidents. It seems certain that in the wake of increasingly unstable weather, the pressure on policy makers “to do something” will eventually become sufficient to overcome inertia and vested interests. At that point in time it is likely the policy environment will change quite rapidly with the consequential re-pricing of high carbon intensive companies such as the fossil fuel companies from which ANU has divested. It is possible a large step toward effective climate change policy could come from the Paris climate change conference (COP 21) in December 2015. Unlike Copenhagen in 2009, the political environment is now far more conducive to achieving meaningful progress on a global climate agreement and significant reductions in carbon emissions. A prudent trustee should be aware of the possibility for material change in the global policy environment and give consideration to the risks that arise from that change.
Bringing all these threads together, it becomes apparent that the best way for a trustee to exercise their fiduciary duty is to pro-actively consider the risks to their investments and to take action to manage those risks. Divesting from fossil fuels because fossil fuels companies are ‘bad for the planet’ would appear to breach fiduciary duty unless the trustee is able to demonstrate that the majority of fund members share the concern (and they are also able to demonstrate that the divestment would not cause material financial detriment). It breaches the Duty of Loyalty a trustee has to the core (financial) purpose of the trust. However, divesting from fossil fuels because, after active investigation and consideration the trustee took the view that the assets were at risk from an (inevitable) change in the policy environment is totally consistent with fiduciary duty. By giving consideration to a material risk to assets in the investment portfolio the trustee has demonstrated prudence and by acting to avoid capital losses the trustee has demonstrated their loyalty to the core purpose of the trust.
It is almost certain that at some point superannuation fund losses from climate change will find their way to court, sections of the legal community are gearing up for it. When trustees find themselves in the courtroom, at that point the focus will be on the quality of the information gathering process they employed, the time they gave to the consideration of this material risks to assets, and the framework they implemented for the prudent governance of investments.
*Greg Liddell is project executive for the Investor Group on Climate Change and is a former fund manager and asset consultant, most recently managing director of Advisory Services at Russell Investments.
 UK Law Commission, Fiduciary Duties of Investment Intermediaries, 2014, Pp 131.
 Above, Pp 134
 Paraphrasing Richardson, “Do the Fiduciary Duties of Pension Funds Hinder Socially Responsible Investment?” (2007), 22(2) Banking and Finance Law Review
 UK Law Commission, Fiduciary Duties of Investment Intermediaries, Pp56
 Climate and the Weather. Is it global warming or just the weather?, The Economist, May 9th, 2015 Pp 53