Canada: The Lorax Speaks To Pension Fund Administrators - And They Better Listen!

A proposed1 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.

The Bottomline

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.

Randy Bauslaugh leads McCarthy Tétrault's national pensions, benefits, and executive compensation practice. This article was originally published on bpmmagazine.com and can be accessed by clicking here.

Footnote

1 Here is a link to the Proposed Amendment: http://www.ontariocanada.com/registry/view.do?postingId=16584

To view the original article please click here.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Similar Articles
Relevancy Powered by MondaqAI
 
In association with
Related Topics
 
Similar Articles
Relevancy Powered by MondaqAI
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions