What Does Fiduciary Duty Require?
By Katherine Collins, Senior Sustainability Advisor, Ethical Markets Media
We place great trust in our fiduciaries, and require much from them in return: fiduciaries are charged with upholding highest principles of stewardship while also managing a wide range of complex operations and processes. This breadth of responsibility was reflected in the content of a recent panel discussion at the conference of the Pensions and Capital Stewardship Project of the Harvard Law School, March 28-30, 2012.
The panel, “Is It Time For A New Understanding Of What Fiduciary Duty Requires?”, referenced a number of complex issues, tracing philosophical matters through to their practical manifestations. As the discussion progressed, three major cautionary themes emerged for fund trustees: the potential for over-emphasis on process, the danger posed by taking a narrow view of portfolio risk, and the possibility for these first two issues to contribute to a defensive, liability-avoidance mindset as opposed to a proactive, true fiduciary mindset.
The panel was chaired by David Webber, Associate Professor of Law, Boston University Law School and included:
• James Hawley, Professor and Director, Elfenworks Center for the Study of Fiduciary Capitalism, Saint Mary’s College of California
• Keith Johnson, Program Director for the International Corporate Governance Initiative, University of Wisconsin Law School
• Edward Waitzer, Professor, Osgoode Hall Law School
• Larry Beeferman, Director, Pensions and Capital Stewardship Project, Labor and Worklife Program, Harvard Law School
In order to set context, it is helpful to review some of the inherent challenges fiduciaries face, starting with circularity within central ERISA tenets. For example, the panel noted, from a legal perspective, fiduciary duty is process-centric: courts view evidence of consistent process favorably. The focus on ‘process’ is a focus on prudent processes, which have effectively become defined as following the same processes as similar investors, resulting in herding behavior which increases short-term market volatility as institutional investors all manage to the same “prudent” processes standard.
However, outcomes and process do not always correlate: what about situations where the process seems solid, but outcomes are consistently subpar? What if currently accepted standards of “good process” are due for revision? Second, ERISA emphasizes that the sole focus of fiduciaries is to act in the interest of plan members. However, this ignores the shared fate that exists for many plan sponsors and members: clearly if a plan sponsor is in financial distress, the beneficiaries also risk distress. A third principle of ERISA management is investment diversification, but even this is not a hard and fast requirement: if diversification is deemed to be imprudent, fiduciaries are not obligated to diversify. We can see from these fundamental contradictions and caveats in basic ERISA tenets that the role of fiduciaries is a complex and context-specific one.
This complexity results in some common misconceptions about fiduciary law and the processes linked to it: for example, while many fiduciaries choose processes built upon Modern Portfolio Theory, there is NOT any obligation to do so. In fact, one could argue that fiduciaries are obligated to ignore such theory in circumstances where it is unhelpful or imprudent. The panel noted that legal standards are not tied to any particular finance theory, which leaves the burden for prudent process on the fiduciaries. This flexibility is valuable, but it does have a downside, especially in an often-litigious environment, where a clear, yet incomplete process might seem preferable to a more flexible and less straightforward one.
One result of this intense focus on process has been a generally narrow definition of risk. The panel reviewed several examples like the BP Gulf disaster, noting that “externalities” like safety and environmental records are often not so external at all in the longer term. Fiduciaries usually have explicitly long investment time horizons, unlike some other investors, so they are in a unique position to consider and emphasize broader concepts and measurements of risk. Yet most of our current standards for “good investment process” reinforce a system that is inherently short-term in nature, with little attention focused on important environmental, social, and governance factors, even when those factors proven to be material investment issues. Greater attention to the fiduciary duties of loyalty to participant interests and inter-generational impartiality are needed to counter balance value disruption from the ‘lemming behavior’ of prudent processes.
Given this attachment to established standards of practice, revisiting the trio of underlying duties of a fiduciary provides helpful perspective. Prudence, loyalty, and impartiality are the qualities that underlie ERISA principles and all fiduciary activity. The panel noted that “prudence” is often trustees’ top focus, while “loyalty” and “impartiality” are often under-emphasized. Part of the reason for this skewed emphasis may be an orientation towards the mitigation of legal liability, understandable in our litigious society. There is incentive to hire lots of “process experts” as evidence of good caretaking, and yet there are rarely similar experts at hand to prove (or ensure) loyalty and impartiality. Re-balancing these three duties could provide a more consistent and well-rounded backdrop for fiduciary action. And, importantly, balancing the three allows for a greater sense of dynamism. As noted above, fiduciary processes are supposed to be dynamic, given the changing circumstances in which they function. Yet such flexibility seems to be the opposite of what many systems currently embrace.
The panel concluded by making some recommendations to trustees, with a goal of moving from a liability-avoidance mindset to a proactive-fiduciary mindset. Specifically, there was a call to allocate resources towards understanding fiduciary challenges and best practices, as well as suggestions to expand focus and reporting on loyalty and impartiality principles. More operationally, fiduciaries were urged to adopt enterprise risk management, use beneficiary-aligned benchmarks, and ensure sustainable pension design. These lists might appear tactical in nature, but they are built on the foundation of the larger themes highlighted above: a balanced weighting of prudence, loyalty, and impartiality, a broader definition of risk, and a combination of strong process plus the flexibility to act proactively on behalf of plan members. By re-emphasizing these fundamental principles and planning their operations and decision-making accordingly, trustees ensure fulfillment of the complete, vital range of their fiduciary responsibilities.
Ethical Markets Media welcomes our new Senior Sustainability Advisor Katherine Collins, principal of Honeybee Capital, and is happy to post this excellent first of her reports. Watch Katherine and Hazel Henderson discussing ethics on Wall Street and in London on “Bypassing Wall Street” from the Ethical Markets TV series Transforming Finance.