Once in a while trustees get frustrated with what the law appears to tell them is their fiduciary duty. If they can afford it, trustees can resolve such ambiguities or uncertainty by getting a ruling from the courts as to how to interpret their duties. This is what two sets of charitable trustees recently did in relation to an area of keen interest to pension trustees: how can one implement an investment strategy that is based on a commitment to align with the Paris Agreement on climate change (in keeping with a charitable purpose that expressly included environmental protection), which would inevitably mean excluding a significant part of the investment universe, without sacrificing financial returns to the trust?
The case was brought because of differing interpretations of an earlier but leading case in charity law, Harries v Church of England Commissioners , which had exposed the dilemma of how to balance moral or ethical views with the need to seek investment returns. Perhaps the most famous part of that judgment illustrates this dilemma:
“[Trustees] must not use property held by them for investment purposes as a means for making moral statements at the expense of the charity of which they are trustees. Those who wish may do so with their own property, but that is not a proper function of trustees with trust assets held as an investment.”
The parallels with pension fund investing are clear and Harries is often cited, along with the earlier case of Cowan v Scargill , for the authority that trustees must always invest in the best financial interests of their beneficiaries regardless of other considerations. Times have changed since those two decisions but the underlying challenges to trustees have not. However, we have now got, at least in pensions law, a formal recognition in statute that not only is there no inherent conflict between consideration of ESG factors, but also that those factors are regarded as financially material and must be taken into account by pension trustees in formulating their statements of investment principles. Charity law has not evolved at the same pace – hence the application to court.
The High Court found that there had been a widespread misunderstanding of the decision in Harries and summarised the central issue as follows:
“whether there is an absolute prohibition against making investments that directly conflict with the charity’s purposes or objects … or whether it [setting an investment policy] is always a discretionary exercise by trustees and a direct conflict is a major but not decisive factor in the balancing process.” [Emphasis added]
The judge concluded that the latter approach was the right way to read Harries, so that adopting an investment strategy that excludes investments on grounds that they conflict with a trust’s purpose is not an automatic breach of trust, so long as the trustees have exercised their discretionary powers of investment in the right way. Investment decision-making is no different in terms of an intellectual process from exercising other discretions; it means taking into account all relevant factors, ignoring irrelevant factors, acting in a way that a reasonable body of trustees would act and to exercise investment powers for the purpose for which they were given.
So what does all this mean for pension trustees, especially those who are thinking about or who have already set a TCFD compliance policy? Can they exclude investment opportunities on the grounds that they conflict with setting a net zero target? Or should they engage with investee companies to change climate laggards from within?
The first thing to recognise is that there are fundamental differences, as well as similarities, between the law’s expectations of pensions trusts and charities (which generally are established also under trust but may take another legal form). Similarities include the duty to diversify investments, to choose suitable investments and to take proper advice when investing.
Perhaps the most important differences are that:
- Charities do not have beneficiaries (i.e. members and dependants), but instead they have grantees, whose identity is unknown until the time of making a grant
- Pension funds have individual liabilities (to pay the pensions earned by their members) whereas charities’ raison d’être is to address a particular identifiable need in society as a whole (i.e. the charitable purpose)
- Charities are more likely to put express investment restrictions on trustees in their trust instruments, but these are very rare in pension trust deeds
- The position of donors to a charity is inherently voluntary, unlike that of employers and members who fund pension schemes as a consequence of an employment relationship and members are not volunteers.
The last point of distinction above is important because it leads to two subsidiary questions that we are often asked:
- To what extent can trustees take account of other parties’ views in making investment decisions?
- If they can and do take account of such views, what price should trustees put on those views (in terms of reduced returns)?
These questions have vexed pension trustees a lot in recent years and not just in relation to climate issues. The current crisis in Ukraine is the most recent example of anxiety about investing in ways that members might find unconscionable. Fortunately, the court addressed both issues.
It was the Harries case that first formulated the test (subsequently adopted by the Law Commission) that “trustees may, if they wish, accommodate the views [of third parties]… so long as the trustees are satisfied that course would not involve a risk of significant financial detriment.”
In a pensions context the law is clear that the extent to which a sponsoring employer’s views have to be considered is that pension trustees have to consult with it on their statement of investment principles. The thornier question, however, concerns members’ views.
The Occupational Pension Schemes (Investment) Regulations 2005 (as amended), now is clear that members’ views are a “non-financial factor” and that they may be taken into account (but by implication need not); all that trustees have to do is explain whether they have taken such views into account or not. In the Regulations, the risk of significant financial detriment is not something that Parliament made express, although that element of the test is widely understood to be a reasonable caveat.
In Butler Sloss, the trustees had in fact considered the risk of short term financial detriment which might be caused by restricting themselves to a more limited investable universe. But they had also assessed over a longer time frame the likelihood that their proposed investment policy (taking into account exclusions) would achieve their desired return objective of CPI+4%. The court found that they had behaved appropriately and tacitly acknowledged that the test of any future projection is based on a series of assumptions (including the integrity of the chosen benchmark). By definition, the risk of financial detriment and its materiality can only be calculated in a forward looking way, so it follows that if those assumptions are agreed in a reasonable way and the chosen benchmark is also reasonable, trustees should not be criticised at the time or indeed afterwards for reaching such a view.
Finally, one of the arguments used by the Charity Commissioners’ counsel was that the trustees should have considered the alternative of engaging with companies to achieve “change from within rather than divesting completely”. The judge disagreed with the implication that the trustees had not acted reasonably in deciding that engagement was not enough to achieve a “dramatic shift in investment policies in order to have any appreciable effect on greenhouse gas emissions and for there to be any chance of ensuring that there is no more than a 1.5C rise in pre-industrial temperature”. The judge did not criticise engagement per se as an alternative approach and it would be a mistake to read that into what he said. The point is was it reasonable to balance an objective of net zero with the extent of the financial detriment that might be suffered by implementing the proposed policy.
In conclusion, Butler Sloss is a helpful reminder of some basic principles about trustee decision-making. It will be helpful to some pension trustees who are grappling with how radical they want to be about climate risks and opportunities, but one should not lose sight of the fact that the case did not concern the investment rules that apply to pension trustees.
The opinions expressed are those of the author and do not necessarily reflect the views of the Firm, its clients, or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.