This month a leading UK panel of judges, lawyers and legal scholars issued a high-profile advisory opinion firmly endorsing the consideration of climate change by pension fund trustees as consistent with their fiduciary duties under English law.

The Financial Markets Law Committee (FMLC), which is chaired by the UK's former Lord Chief Justice, is "an independent body that seeks to reduce legal uncertainty in the financial markets." The FMLC issued the opinion to address what it felt were legal uncertainties faced by pension fund trustees regarding sustainable investing practices, with particular emphasis on consideration of risks and opportunities relating to climate change.

Takeaways from FMLC statement

The FMLC's stated goal was not to produce a "comprehensive report" on fiduciary law, but rather "a short paper that trustees can have with them in the meeting room." Key principles from the paper that may inform the parallel debate over U.S. fiduciary law as applied to ESG investing include the following:

  • While there may be some debate over whether pension fiduciaries' decision-making may incorporate "non-financial" factors (i.e., those "motivated by concerns such as improving members' quality of life or showing disapproval of certain industries") in addition to "financial" factors (i.e., those focused on balancing investment returns against risks), there is no doubt that climate change is a "financial" factor. "Sustainability may reduce risk or improve return. Taking sustainability into consideration may reveal new understandings of unrewarded or unmanaged risks or illuminate true return."
  • "It may be necessary to consider whether a strategy should reject shorter term gains because they create identifiable risks to the longer term sustainability of investment returns in the fund."
  • Fiduciary decision-making should take into account both "numbers and narrative," especially as there may be relevant climate-related risks that cannot currently be quantified numerically, but which are nevertheless financially material to potential returns. "At least some of the effects of the subject of climate change fall into the category of outcomes to which it may be difficult to attribute probabilities, but which are nonetheless material and could be judged sufficiently important to warrant being taken into account."
  • Following the decision to invest fund assets in a company's stock, fiduciary obligations may include ongoing "stewardship" activities thereafter – such as exercising proxy rights and engaging directly with company management. "Stewardship involves using rights and benefits acquired by the investment. It is, in effect, a logical progression of the ongoing exercise of the investment power by the pension fund trustees. Given the significance of sustainability and the subject of climate change, the concept of stewardship may be said to include them when they affect the likely risks and returns on the pension fund's investment portfolio over time."

Impact on the U.S. debate over fiduciary duties

The law of fiduciary duties in the U.S. and UK are branches of the same tree, with deep shared roots in the English common law. They have core principles in common, including the fundamental duty of loyalty to put beneficiaries' interests ahead of the fiduciary's own interests.

More recent legislation and judicial precedent have, at least arguably, resulted in some divergence between the jurisdictions. For example, the federal Employee Retirement Income Security Act of 1974 (ERISA), which governs most U.S. private retirement and health plans, imposes fiduciary duties that are frequently interpreted as expanding upon the common law fiduciary duties. Similarly, many states have adopted statutes covering their public plans that impose ERISA-like fiduciary duties.

Therefore, critics of ESG and sustainable investing can be expected to dismiss the FMLC opinion as irrelevant and inapplicable to U.S.-based fiduciaries. They typically argue that ERISA and corresponding state statutory duties require retirement plan fiduciaries to focus solely on maximizing financial returns, and deem any consideration of climate change impact or other ESG factors as necessarily unrelated to financial returns – and as motivated instead by the fiduciary's separate social or political agenda.

But the FMLC's reasoning cannot be written off so easily. The panel's core conclusions are grounded firmly in the fiduciary principles that are foundational in both countries – that a pension fiduciary's most basic duty is to balance investment returns against risks for the sole benefit of plan participants. The key conclusions highlighted above all flow directly from that duty and the corollary premise that climate-related risks and opportunities are financial in nature.

The divergence between the FMLC's conclusions and the arguments of the ESG skeptics is not due to differences in UK and U.S. legal precepts. Instead, the difference is due to the basic false premise of the U.S. anti-ESG movement, that incorporation of ESG factors is motivated by social or political goals rather than investment returns. The FMLC opinion stands as another powerful and well-reasoned rejection of that premise, in keeping with recent litigation developments.

An anti-ESG statutory workaround?

Perhaps realizing that the existing law of fiduciary duties does not support their critique of ESG investing, Republican lawmakers in more than a dozen U.S. states have adopted statutes requiring that asset managers serving as fiduciaries to state pension plans commit to making investment decisions based solely on material financial factors — or "pecuniary factors" – and certify that they are doing so.

For example, Kentucky prohibits state retirement system assets from being invested or proxies voted with a "purpose to further a nonpecuniary interest," defined to include "an environmental, social, political, or ideological interest which does not have a direct and material connection to the financial risk or financial return of an investment."

As a practical matter, providing a certification of compliance with this "pecuniary factors" requirement may not prove difficult for many fiduciaries. They can simply respond that — contrary to the statutes' inaccurate inference otherwise — they use ESG considerations to identify material financial risks and opportunities to maximize portfolio returns. In other words, ESG factors are pecuniary, just like the more traditional financial metrics, and there is in fact no disconnect.

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