Europe Considers Adding ‘Sustainability’ to Fiduciary Requirements
The European Commission, the governing arm of the European Union, is seeking comments on the possibility of adding environmental, social and governmental factors to what asset managers there must consider when making investment recommendations to clients. The Investment Adviser Association, in a January 22 comment letter to the Commission, has raised concerns that such requirements not dilute the duty of asset managers to act in the best interests of their clients.
"Sustainable finance" is an EU concept that requires "development that meets the needs of the present without compromising the ability of future generations to meet their own needs," according to the EC consultation document that is the focus of the comments from the IAA and other interested parties.
The EC last year appointed a high-level expert group (the HLEG) to aid in the creation of an overarching and comprehensive EU sustainable finance strategy. It issued a set of eight "early recommendations" in a July 2017 interim report. Among them was "establishing a ‘fiduciary duty’ that encompasses sustainability," the consulting document said. "The HLEG suggested clarifying that the duties of institutional investors and asset managers explicitly integrate material environmental, social and governance (ESG) factors and long-term sustainability."
What will this mean for U.S. advisory firms with affiliates in Europe? That is too soon to definitively say, but it is something that needs to be watched, said Morgan Lewis partner William Yonge. "It’s still a long way off, but we’re definitely on a path for that."
"It’s very early days on this," said Shearman & Sterling partner John Adams. "The consultation is really just putting out feelers, to see whether and to what extent the EU might come up with formal proposals or guidance."
"Some investors and some managers already focus very openly on ESG and sustainability," he said. "Others less so. I don’t expect that to change dramatically. If legislation or guidance ultimately does result from this, I’d expect it to require that sustainability/ESG be a factor that’s taken into account by managers, but just one of many factors. In practice that would mean more paper trails for managers, and disclosure, to show that they’d properly considered all of this. More regulatory burden but perhaps not that much of a material change to decision making."
The IAA steps up
One of the main purposes behind the IAA’s comment letter, said the association’s associate general counsel Sarah Buescher, who wrote it, was to warn against making any ESG considerations "too prescriptive, which could affect the ability of asset managers to act in the best interest of their clients."
"The IAA appreciates the EU’s commitment to the important issue of sustainable finance," the association states in its just-over two-page comment letter. "Institutional investors and asset managers in the EU are required to act in the best interest of their clients, and are subject to duties of care, loyalty and prudence. These fiduciary principles are of paramount importance to investors."
"We are concerned, however, that requiring asset managers to consider a particular set of ESG factors when making investment decisions may run counter to or dilute these principles," the letter continued. "We are also concerned that specifying particular sustainability factors may be inconsistent with the European Commission’s goals of efficient allocation of capital and sustainable and inclusive growth."
The IAA then provided more detail to each of its concerns:
The EC should preserve and not dilute the duty of asset managers to act in the best interest of their clients. This duty, the letter said, "is critically important to investor protection. We are concerned that requiring asset managers to consider specific ESG factors when they provide investment advice would undermine this duty. The overarching duty of an asset manager to its client should not be diluted or reduced to a process that does not take into account the unique needs and requirements of each client. The investments that are in a client’s best interest differ by client, and specific ESG factors may not be relevant to each investment of each client. A client will have its own investment criteria, and may have assets allocated across multiple asset managers and accounts, with some accounts directed to ESG investing, and others with different objectives and strategies." The letter went on to say that "an asset manager’s focus should be on those factors that assist it in determining whether a particular investment is in the best interest of the client and not on a set of prescriptive criteria that may not meet that particular client’s investment goals."
Specifying particular sustainability goals may run counter to the EC’s goals of efficient allocation of capital, and sustainable and inclusive growth. The IAA noted that the demand for ESG investing is already "thriving, reaching over $22 trillion (in U.S. dollars) of assets globally in 2016." As that demand continues to grow, the association said, "asset managers should be provided the flexibility to respond with new and innovative approaches. A prescriptive approach on ESG investing would not allow for this flexibility because it would not take into account developments in markets and ESG-focused investment strategies."
Yonge applauded the IAA for sending the comment letter, saying that while an EC decision may not be near – in that sense, he said, the EC paper is "truly a green paper," meaning that it is both early in the process and also deals with sustainability concerns – "in terms of lobbying, now is the time to make some points."
The EC’s perspective
The EC, in its consultation document, recognized the existence of "duties of care, loyalty and prudence" already embedded in the EU’s financial structure. That said, the EC said that "it appears unclear that they require institutional investors and asset managers to assess the materiality of sustainability risks (i.e., risks relating to environmental, social and governance issues). Market practices indicate that institutional investors and asset managers generally understand these duties as requiring a focus on maximizing short-term financial returns and disregard(ing) long-term effects on performance due to sustainability factors and risks. This can lead to misallocation of capital and might give rise to concerns about financial stability since markets can be vulnerable to abrupt corrections, such as those associated with the delayed transition to low carbon economies."
The thing to remember is that "sustainability is very important to the ‘European project,’" the process of tying many of the diverse countries of the European continent together, said Yonge. "They are not going to let it go, but they will listen," and to that end, he said, comment letters and input are very helpful.
Those in the EC "see asset managers as the final link in the investment chain," he said, and want them to take sustainability into account when taking investment decisions for clients. What EC regulators must recognize is that "asset managers are already very effectively governed by regulations."
Going too far by being over-prescriptive runs the risk, Yonge said, that investors may simply withdraw their money from investment managers registered in Europe and give it to investment managers located in other parts of the world.