Ethical investments: a case of disjointed thinking (Thornton: 2008)

Introduction:

- The socially responsible investment (SRI) market is huge both in the UK and internationally- Trustees however are not free to follow their conscience when investing trust assets. The notion

of SRI of trust funds, at least in legal theory, is an extremely restrictive concept.

Guiding principles of trustee investment

- The trustee Act 2000 largely codified the default powers and duties of trustees (including their investment functions)

- The standard of care to be applied when exercising investment powers is in s1- s3 liberalised the range of investments which a trustee is permitted to make under the general

law (any he could make if absolutely entitled to the trust)- s4 provides that trustees must essentially monitor the trust and have regard to modern portfolio

theory

- Note that the 2000 legislation does not affect the longstanding CL principle that when investing the trust funds, he should take such “care as an ordinary prudent man would take if he were minded to make an investment for the benefit of other people for whom he felt morally bound to provide”. This means a trustee must avoid investments “which are attended with hazard” So despite s3, trustees must remain more cautious when selecting the investment portfolio

- Also unaffected is the basic principle guiding trustees when making any decision regarding the investment of the trust fund (per Cowan)

- “The starting point is the duty of the trustees to exercise their powers in the best interest of the present and future beneficiaries of the trust… 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… the power must be exercised so as to yield the best return of the beneficiaries, judged in relation to the risks of the investments in question…”

- “trustees must put on one side their own personal interests and views. They may hold strong personal opinions as to the immorality of a particular company, industry, or sector, but if investments which they regard as unpalatable would be “more beneficial to the beneficiaries than other investments”, they must not refrain from making them on these grounds. … whatever [the trustee’s] own views, he must “none the less do his best to exercise fair and impartial judgment” in what is the best interests of the beneficiaries”

- Further, it is clear that the notion of the standard of care pertaining to trustee investment must be “capable of adaptation to current economic conditions and contemporary understanding of markets and investments”; in relation to the question of diversification in particular, trustees are “to be judged by the standard of current portfolio theory, which emphasises the risk level of the entire portfolio rather than the risk attaching to each investment taking in isolation” (Nestle)

- Thus, any assets which are individually more hazardous may be offset by other, safer investments. The trustee act w/ s3 allows them to take full advantage of modern portfolio theory (and indeed with s4 almost requires it)

Excursus: Portfolio Theory

- Explains the use of covariance (tends towards zero the lower the relation between assets)- In most markets, assets tend to be interrelated. Thus by increasing the number of assets in the

portfolio and by ensuring they are as independent as possible, the variance of risk can be minimised (but never reduced entirely)

- Fund managers typically look either for the highest possible variance on the portfolio for a given expected return, or else the highest possible expected return for a given acceptable level of variance or risk

Forms of ethical investment strategy

- The Untied Nations Environment Programme Finance Initiative (UNEPFI) identifies two mechanisms for incorporating ethical factors into the investment decision making process

o Positive screening – criteria must be met before an asset can be includedo Negative screening – criteria to exclude assets

- In either case, the policy in question may beo Socially dictated – uses predetermined ethical conditions to limit or determine the

selection of investment assetso Socially sensitive allows SRI factors to come into play only when choosing between

investments which appear equivalently attractive according to normal financial criteria- Note the idea of “shareholder engagement”: involves investors attempting to influence the

performance in ethical terms of companies in which they hold shares, through the use of shareholder voting rights and other forms of lobbying or influence.

o If trustee investors engage even in this type of pressurising activity, they may well be acting in breach of duty

Ethical decision-making: The exceptions to the rule

1. For small family trusts where all the beneficiaries are sui juris adults, it may be to their ‘benefit’ to consider SRI (mentioned in Cowan)

o Not really an exception as they can just exercise their Saunders v Vautier rights2. In Evans v London Co-operative Society, Brightman J ruled a law from the Co-operation society’s

pension fund to the society at an interest rate below prevailing market rates. o Barely an exception either. The beneficiaries of the pension fund were all employees of

the society and “dependent for their employment upon the financial health of the society”, which moreover, because of its cooperative structure, lacked the usual means of raising working capital available to commercial undertakings. So it seems that the loan is entirely consistent with the interest of the beneficiaries’ economic well-being.

3. Two related exceptions which specifically concern charitable trusts. They derive from Harries v Church Commissioners for England.

o “when the objects of the charity are such that investments of a particular type would conflict with the aims of the charity” (E.g. cancer charity investing in tobacco)

o Where the trust holdings of a particular asset might hamper the work of the trust either by alienating potential donors or by deterring potential recipients of the charity’s aid from being willing to take advantage of it

i. Alienating – should be fed into the equation for assessing the financial benefit of the investment regardless

ii. Deterrent – liable to be difficult to gauge, and unlikely to be sufficiently disruptive to outweigh hard economic arguments the other way in any but very occasional circumstances

4. (Seems to arise by default. Comes from Cowan v Scargill) Megarry seems to suggest that when trustees are faced with a choice between 2 assets which are equally advantageous in financial terms, they’d not be in breach by making a selection on ethical grounds. (I.e. a ‘socially sensitive’ SRI policy would not be unlawful)

o Based in unreality. The occurrence of such a choice is a practical unreality.i. Intuition – real world assets won’t have exact twins

ii. Artificial statistical world – no as wello Even if trustees genuinely find themselves in such a position, there will always be ways,

albeit unknown, in which the real future risks of the two assets differ. According to economic analysis, the optimal decision is not to pick either way but to split between the two. If all else appears equal, diversify.

5. (Implied from the judgment in Harries) The vice-chancellor implies that even a predetermined socially dictated SRI strategy based upon negative screening was not unlawful provided that it left available to the trustees a sufficient range of choice. (Here, Commissioners’ existing policy – which was upheld as lawful – excluded approximately 13% by value, of listed UK companies)

o The notion that it is possible to rule out a significant section of the economy in this way without damage to the expected financial return upon and level of risk to the trust portfolio is clearly flawed.

o Statistically, any reduction will have an effect, however small, upon efficiency. A 13% exclusion is likely to have a comparatively large effect.

o Moreover, in Harries, the exclusion was of whole industry blocks, often likely to perform similarly at similar times and under similar market conditions. The effect is likely to be a remaining universe which is not only numerically narrower but also appreciable less varied and with a tendency to higher covariance, reducing the trustees’ ability to spread and reduce risk to the portfolio.

Talking down Cowan v Scargill

The most sustained attack came in a report in October 2005, commissioned for UNEPFI and produced by Freshfields, which argued for a legal framework for integrating ethical issues into institutional investment worldwide. It contends that Cowan is of dubious reliability

- Emphasis on the fact that Megarry writing extrajudicially did not consider himself to be making new law

o It is understandable as he was doing no more than enunciating the principles which necessarily flow from the nature of the trust

- Also suggests that much of what Megarry said is obitero It is difficult to see how the main points of his judgment are obiter

- It was decided “21 years ago, before legal acknowledgement of the modern portfolio theory”o If anything, modern portfolio theory points against a wider role for SRI policies. Indeed,

this point casts doubt on the validity of the 5 exceptions

Disjointed thinking: SRI rhetoric and legal theory

- It is well established there is no duty to obtain a particular level of financial return. - (Per Hoffman in Nestle) “a trustee exercising investment powers is not under a duty to achieve

results” - The flipside of this proposition must be that the fact t a particular level of return happens to be

achieved does not mean that the duty has been properly discharged.o Trustees must pursue the optimal policy, judged in the light of the information available

to them; they must seek to do the best they possible can for their beneficiaries.

- Normally, breach of duty will occur whenever a decision is based in improper or immaterial considerations; one allowance in Cowan though

- “If trustees make a decision upon wholly wrong grounds, and yet it subsequently appears from matters which they did not express or did not refer to, that there are in fact good and sufficient reasons for supporting their decision, then I do not think that they would incur any liability for having decided the matter on erroneous grounds; for the decision itself was right”

- So even if decisions are made on illegitimate grounds, if they are justifiable separately on objective, economic grounds, it seems they will be alright. However, it is still the decision itself, and not the result that determines the breach and it is still a breach of trust whether loss ensues or not.

- With regards to the Trustee Act 2000, it is fairly silent on ethical investment. The explanatory notes make a mention to it however, they appear to refer only to those situations in which case law already recognises that SRI factors may apply. The word “relevant” is key, as is the phrase “appropriate for the trust”

Nestle and de facto immunity

The current situation is thus something of an anomaly. There is clearly a growing trend of SRI by both trustees and other investors. Yet, the practice is of doubtful legality, and is certainty suboptimal in terms of portfolio theory, narrowing as it does the universe of shares available for investment and therefore affecting the efficient frontier, to the detriment of the financial interests of the beneficiaries.

This practice has been allowed to continue for quite a while without further challenge in the courts. Cowan and Harries are first instance decisions; the legality of ethical investment has never been considered by the higher courts, nor been litigated at all for 15 years.

- The answer may lie in Nestle; since that decision, it is very clear that, due to the risk and uncertainty inherent in making investment choices, it will be very difficult in practice for aggrieved beneficiaries to prove loss arising from breach of their trustees’ duties in this respect.

- In the case, it being impossible for the beneficiary to prove that alternative investments would necessarily have performed any better had the trustees exercised their powers properly in every respect, her action or equitable compensation failed.

- From the decision it seems clear that an investment taken on erroneous grounds may amount to breach of trust, but while trustees may be opening themselves to the possibility of a declaration that their strategy is unlawful, an action for injunctive relief, or an application to replace them as trustees, they stand very little practical risk of exposure to claims for compensation for resultant loss even should their ethical portfolio underperform. It is simply very unlikely that beneficiaries will be able to show that trustees would have chosen any differently, or chosen shares which performed any better had they followed the proper criteria for selection.

- The problem is a mismatch in thinking between law and economics: the law traditionally requires proof of factual causation on a case by case basis, whereas economists deal in probabilities.

- The insusceptibility of proof of loss is what lies behind David Hayton’s widely cited statement that, in spite of the paramount duty to pursue financial gain:

o “[T]here is still much scope for trustees quietly to take into account the moral, social and political views of beneficiaries and of themselves, since it will in practice be difficult to prove that at the time a particular investment was made it was not as equally financial meritorious as certain other possible investments.”

Reforms and the obstacles to it

One of the criticisms most frequently levelled at ethical investment policies is the subjectivity of their content. “The nature of the problem… is in part caught up with the difficulty of defining what is meant by ‘ethics’ in the first place” (Harbottle). It has been estimated that ethical grounds of some kind could be found for excluding as many as half of all companies in the FTSE 100 share index.

It is against this background, that we question how, if parliament were ever motivated to do so, they might create a legal framework within which trustees were entitled, or even obliged, to take account of SRI factors.

- Nobles has argued that in non-charitable trusts, any departure from the criterion of ‘best financial interests’ would leave “no standard by which to control the trustees’ investment policies other than the purely subjective one of whether they agree with the morals or politics of the trustees”

- However, with charitable trusts, he says that since they exist to further a charitable purpose, they provide their own non-financial criteria by which investment policy may be assessed.

o If he means exception 3(1), then this adds nothingo If he intends to suggest that the ‘public benefit’ aspect of charities somehow equips

their trustees to make investment decisions based on the broader ‘public benefit’, this is more questionable

It is against Harries It is hard to see where the content for such a generalised charitable approach to

investment would derive Though there is a body of jurisprudence on the meaning of ‘public benefit’, it is

tailored specifically to identifying purposes which fall within the definition of charity and not the different and much wider question of whether companies are sufficiently socially responsible to be candidates for the investment of charitable funds.

Nothing in the case law on charitable trusts would appear to disclose any workable or objectively defined criteria for determining what constitutes ‘ethical’ investment.

- One way around the lack of external consensus on what is “ethical” might be to base reform upon the wishes of the particular beneficiaries.

- Gary Watt suggests trustees be placed under a statutory duty to consult with beneficiaries and consider their views (similar to s11 TLATA 1996); Watt would require a mere obligation to “consider” their wishes though he further suggests a 75% majority might be appropriate before a SRI policy be adopted. (A more radical solution is to place trustees under an obligation to give effect, as far as consistent with the general interest of the trust, to a simple majority of the beneficiaries)

o Trust investment is a highly specialised activity. Even a duty to inform beneficiaries of the risks would do little as a safeguard. The exclusion of certain assets from the portfolio would not have a predictable income.

The same uncertainty makes it difficult for beneficiaries to bring a claim for mismanagement. And it would be hard to show failure to provide adequate information

These points suggest that any consultation process is unworkable aa that investment is a complex task better conducted by aspects

o Also, the rights of the minority will be overridden. Goes against ‘even-handedness’ You’d be allowing the majority to take a moral stand with others’ money.

o Charitable trusts have a different problem namely, a lack of beneficial owners. there’s no justification to take into account as an approximate equivalent, the

wishes of current services users, in the context of trusts which are perpetual, and which exist for the public benefit and not for the private benefit of those who happen, at a particular time to be the recipients of the charity’s benevolence

- The alternative is for settlors to make greater use of explicit SRI provisions.o Beneficiaries’ can’t complaino Downside is again that ethics is subjective and the settlor is giving trustees free reign to

factor in their own social and political opinions

- The question as to whether trusts are the appropriate vehicle for seeking social changes of the kind which SRI policies are designed to bring about remains.

o As valid as the concern may be, trusts exist for a specific purpose and have developed in a specific context. If a trust is to protect the interests of the beneficiaries, of all beneficiaries, then their property should not be sued to forward the views, however socially desirable, of either trustees or the majority of their fellow beneficiaries.