Fiduciary relationships involve the delegation of authority to an agent who is charged with investing assets for the benefit of third-party beneficiaries. However, the beneficiaries rarely possess both the information and expertise to evaluate the integrity and effectiveness of the agent's management services in a timely way, even though the beneficiaries are forced to rely on them. Fiduciary duties are the legal principles that protect beneficiaries and society from being taken advantage of by these fiduciary agents. While local culture and legal structures influence how fiduciary principles are expressed, due care in managing the assets and dedication to serving beneficiaries' interests are key to this relationship of trust (Richardson, 2011).
The practices used to implement these fiduciary principles typically evolve over time in response to changing circumstances and knowledge. Given the changes that have occurred in the global economy over the past 40 years, including responsibility for greater amounts of assets being delegated to fiduciary agents, increased resource constraints from rising populations and growing prosperity and soaring costs from the effects of pollution and climate change, fiduciary standards are once again in flux. Because environmental issues and climate risk are global matters which cross national borders, have financial implications and involve fiduciary issues of intergenerational fairness, they have become a major focus of the current international evolution in fiduciary thinking.
This paper explores the importance of guiding legal principles in protecting beneficiaries and society from abuse of delegated investment powers by fiduciary agents. It argues that countries that can most effectively navigate the transition to modern and sustainable fiduciary investment practices will be able to allocate capital more efficiently, reduce the negative side effects of investment practices and have a long-term competitive advantage in the 21st century. Given the growing economic significance of China's pension funds, the National Social Security Fund and other assets managed by delegated agents on behalf of third-party beneficiaries, this could be an opportune time to establish culturally appropriate fiduciary principles for China. Pension funds in South Africa, the Netherlands, Norway and the United States offer models for the People's Republic of China (PRC) to consider in planning its transition to fiduciary standards and investment practices that support sustainable development.
1.0 The International and Historical Origins of Fiduciary Duties
While the proliferation and complexity of investment fiduciary relationships is a relatively recent phenomenon from the 20th century, the basic concepts of fiduciary duty are ancient. In fact, the English word "fiduciary" has its roots in the Latin word "fiducia," which means both "trust" and "confidence."1
Today's fiduciary duties have historical roots in China that can be traced back to Confucius (whose questions of self-examination included whether, when acting on behalf of others, one has always been loyal to their interests) and to the Great Qing Legal Code (where criminal punishment was provided for one who receives deposit of property of another and consumes it without authority) (Aikin & Fausti, 2010–2011). Outside of China, historians attribute the origins of fiduciary concepts to the Code of Hammurabi (~1790 BC) in Babylon on the role of agents entrusted with property, medieval English trust law, 5th century Islamic laws on family and charity and 4th century Roman efforts to avoid legal restrictions on inheritance (Aikin & Fausti, 2010–2011; Avini, 1996). Those early fiduciary arrangements typically involved transferring the ownership of assets to a third-party agent who would manage the assets to achieve specific wishes of the grantor, for example, to take care of family members, pursue charitable purposes or hold it for the benefit of someone else where necessary to avoid legal restrictions on the transfer of property (Avini, 1996).
Today, investment fiduciary relationships also involve delegation to an agent of discretionary management responsibility for particular assets in order to provide future benefits to one or more third-party beneficiaries or specified purposes. Such relationships are based on a high level of trust and confidence in the agent. Fiduciary duties supply rules which guide the agent's implementation of those delegated responsibilities, with the goal of ensuring that the fiduciary faithfully fulfills its obligations (Sarro & Waitzer, 2012). However, there is no universal definition of fiduciary duty. Concepts of fiduciary duty cross the boundaries of different fact situations, legal systems and cultures, making a single global definition impossible (Krikorian, 1989).
2.0 Fiduciary Duties Protect Vulnerable Beneficiaries
Despite the local distinctions that create nuances of fiduciary duty in each jurisdiction, there are common dynamics at play in investment fiduciary relationships, regardless of the culture or jurisdiction. These issues must be resolved in some manner, whether intentionally or by default. The primary challenge is that investment fiduciary relationships typically leave beneficiaries and society vulnerable to abuse at the hands of the fiduciary Sarro and Waitzer, 2012). For example:
- The fiduciary is given control over management of assets that must be deployed for the benefit of others, creating an inherent conflict of interest.
- Fiduciaries usually possess specialized expertise that the beneficiaries do not have, making the quality of services hard to evaluate.
- Breaches of faithfulness or investment prudence might not be immediately evident, which impedes effective monitoring of the fiduciary.
- Unlike investors in tradable company securities, beneficiaries often do not have the practical ability to avoid harm by removing a fiduciary or timely withdrawing assets from the fund.
- Workers are likely to be heavily reliant upon pension funds and other fiduciary savings vehicles for their future security, creating both personal and broader economic risks.
- In many countries, growth in the amount of assets controlled by institutional investor fiduciaries has turned them into a formidable economic force with societal ramifications.
- Fiduciaries may have more to gain than lose personally by generating near-term performance through externalization of costs and risks to society, especially when damage is not immediately apparent.
Given these vulnerabilities, it is evident why fiduciary relationships are based on trust and confidence. Fiduciary duties are intended to supply the standards needed to protect beneficiaries and society from being taken advantage of in fiduciary relationships. However, fiduciary duties arise within the context of local culture, legal systems, authorizing statutes, regulations, practice codes and court decisions.
Even though fiduciary standards may vary in how they are applied between jurisdictions, there are consistent themes. Table 1 provides a representative list of common law fiduciary duties and civil law principles that guide the governance and investment practices of institutional investment fiduciaries across the globe (Freshfields Bruckhaus Deringer 2005; 2009). Fiduciary duties focus on process and behavior, rather than investment outcomes. Despite variations in wording, fiduciary principles in most jurisdictions address:
- Loyalty, including faithfulness to the interests of beneficiaries and purpose of the fund and impartiality when taking different interests of beneficiaries into account.
- Prudence and care in managing investments, diversification and risks.
- Control of costs and management of conflicts of interest.
- Transparency and accountability.
- Compliance with terms of the operative documents and applicable laws.
BOX 1 SAMPLE FIDUCIARY DUTY PRINCIPLES
COMMON LAW FIDUCIARY STANDARDS
Restatement of Trusts (Duty of Prudence)
Restatement of Trusts (Duty of Loyalty)
Restatement of Trusts (Duty of Impartiality)
Employees Retirement Income Security Act (Standard of Care; Sole Purpose)
CIVIL LAW STANDARDS
The [..] capital of pension funds has to be invested in a way which guarantees the highest possible security and profitability, a sufficient liquidity and an adequate spread of risks.
The pension fund has to inform the beneficiaries in writing if and how it takes ethical, social and ecological aspects into account in its investment policies.
[Investments] are to be managed professionally in particular by putting in place adequate systems to control risk, efficient in-house investment principles and control mechanisms, a sound investment policy and other organizations safeguards.
Administrative officers of the fund are obliged to obey the law and regulations, decisions of the Minister of Health, Labor and Welfare pursuant to the law and the investment principles established by the fund and must perform their duties with regard to the management and administration of the fund faithfully on behalf of the fund.
Operation of the fund must be carried out in a prudent and effective manner in accordance with applicable governmental orders.
3.0 Governance of Fiduciaries
Within the context of these guiding fiduciary principles, there are differences between jurisdictions in institutional investor structures and how fiduciaries function. For example, common law jurisdictions tend to operationalize fiduciary relationships through trusts and provide greater interpretive discretion to judges, while civil law countries are likely to use a contractual arrangement with a financial institution or management company and focus more on specific regulatory guidance than principles (Stewart & Yermo, 2008).
However, there are a growing number of exceptions to this traditional divergence. In the United States, insurance companies sell annuities and other pension products under a contractual structure, without accepting trust law fiduciary responsibilities. Even in the UK, investment managers hired by pension boards to manage assets are treated as contractors and not considered fiduciaries, unless bound as such by contract (Freshfields Bruckhaus Deringer, 2005; Berry, 2011). Conversely, by one count, over 40 civil law jurisdictions (including the PRC) have explicitly adopted common law trust statutes and related fiduciary duties for some purposes (Honoré, 2008).
Table 2 illustrates how fiduciary duty flows through common law and civil law systems. While the structures and operational systems can be very similar, they can also be quite complex. As noted above, different entities even in the same jurisdiction can fall under different regulatory and legal systems. For instance, insurance companies and mutual funds might be seen as contractors while pension funds and sovereign wealth funds are trust fiduciaries. Regardless of the category (civil law, common law, contract or trust), governance and investment practices are available for implementation to protect beneficiaries and society from fiduciary misconduct or irresponsibility (Honoré, 2008; de Graaf & Johnson, 2009).
Indeed, governance and implementation practices of institutions that function as investment fiduciaries are essential aspects of fulfilling fiduciary duties. Fiduciary responsibility and fiduciary governance are opposite sides of the same coin. Fiduciary duties are of no avail if they are not understood and implemented appropriately (Weng, 2011). Transparency and enforcement are particularly essential for an effective fiduciary structure.
FIGURE 1. FIDUCIARY DUTY AND GOVERNANCE FLOW CHART
4.0 Ongoing Evolution of Fiduciary Duty
Fiduciary relationships have ancient roots, but understanding and implementation of fiduciary duties are dynamic. Fiduciary norms regularly evolve in response to changes in society, the economy and knowledge.
Following the collapse of the South Sea Bubble in the early 18th century, English courts required trustees to limit investments to government debt and securitized mortgages. As circumstances changed, American courts loosened investment restrictions and expanded allowable investments to those that would be purchased by a prudent man in managing his own affairs. The tables turned again in 1869, when American courts and legislatures excluded corporate stock and reverted to a more conservative legal list of allowable investments. In the 1970s and 1980s, common law jurisdictions transitioned to Modern Portfolio Theory (MPT) as the controlling concept for investment fiduciaries, looking at investment risk on a portfolio (rather than individual investment) basis. At the end of the 20th century, reference to practices of similar prudent expert investment fiduciaries and use of MPT were firmly established as the operative fiduciary standards (Hawley, Johnson, and Waitzer, 2011).
However, changes in the markets and risk environment have again brought many jurisdictions to a point where understanding of fiduciary duty has begun to change. A number of factors are driving this current fiduciary duty evolutionary cycle (Hawley, Johnson, and Waitzer, 2011). Among them are:
- Worldwide growth of the assets managed by institutional fiduciaries and corresponding influence on the economy.
- A series of economic crises of increasing severity.
- Demonstrated unreliability of assumptions underlying MPT.
- Emergence of climate change as a threat to long-term economic stability.
- Recognition that environmental pollution has become a drag on economic productivity.
- Global population increases, rising consumer demands from improved living standards in emerging markets and impending natural resource shortages.
Originally published in International Institute for Sustainable Development Report.
1 "Fiducia." Def. Latin Word List. http://www.latinwordlist.com/latin-words/fiducia-10914362.htm
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