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July 23, 2009

ESG Issues Should be Embedded in Legal Agreements Between Investors and Advisors, Report Finds
    by Robert Kropp

A new report by the Asset Management Working Group of the United Nations Environment Program Finance Initiative argues that advisors who fail to raise ESG issues with clients face the risk of lawsuits. Second in a two-part series. -- In 2005, the Asset Management Working Group (AMWG) of the United Nations Environment Program Finance Initiative (UNEP FI) commissioned the law firm of Freshfields Bruckhaus Deringer to author a landmark report entitled A Legal Framework for the Integration of Environmental, Social and Governance Issues into Institutional Investment. The report broke important new ground in its finding that the consideration of environmental, social, and governance (ESG) criteria falls within the bounds of the fiduciary duty of asset owners.

According to Paul Watchman, the senior author of the Freshfields report, "Far from preventing the integration of ESG considerations, the law clearly permits and, in certain circumstances, requires that this be done."

In July, the AMWG published a follow-up to the Freshfields report, entitled Fiduciary Responsibility: Legal and Practical Aspects of Integrating Environmental, Social and Governance Issue into Institutional Investment (Fiduciary II). The new report builds upon its predecessor by arguing that "Advisors to institutional investors have a duty to proactively raise ESG issues within the advice that they provide, and that a responsible investment option should be the default position."

Furthermore, according to the report, investment advisors that fail to incorporate ESG issues into their investment services face "a very real risk that they will be sued for negligence." In order to avoid such a scenario, "ESG issues should be embedded in the legal contract between asset owners and asset managers, with the implementation of this framework being governed by trustees via client reporting."

Fiduciary II consists of three major sections. The first of these examines the legal perspective on the incorporation of ESG criteria into the investment process, and concludes with several recommendations. In addition to recommending that the incorporation of ESG issues become a routine part of the investment process, the report recommends that asset managers that are signatories to the Principles for Responsible Investment (PRI) should commit to proactively raising ESG issues within their advisory processes.

Referring to the findings in the legal section of Fiduciary II, Paul Hilton, who is the Director of Advanced Equities Research at Calvert Investments and served as Co-Project Lead for Fiduciary II, said, "Pension fund trustees and other institutional investors should consider having their asset managers adopt the PRI, and ask that their asset managers demonstrate active participation in the development of the PRI."

"This report specifies how institutional asset owners should begin to operationalize their responsibility to integrate ESG considerations into their investment analysis," Hilton continued. "It also highlights the related responsibilities of investment advisors to be more proactive in raising such issues."

The second section of the report analyzes the responses by investment management consulting firms to a survey from the AMWG. While the report notes an increase in demand for ESG services since the advent of the PRI in 2006, it also finds that the industry has not yet developed ways to measure the competence of asset managers relating to ESG integration and engagement.

Furthermore, the report finds that in some cases, the responses of investment advisors conflict with the legal advice contained in the report. While the report states that it is "the professional duty of institutional investment consultants and asset managers to proactively raise ESG considerations with their clients", respondents to the survey indicated that they generally wait for their clients to raise ESG issues. Respondents also differed with the report's finding that ESG considerations should be embedded in investment services contracts.

Mary Jane McQuillen, the Director and Portfolio Manager of Socially Aware Investments at ClearBridge Advisors and a Fiduciary II Co-Project Lead, said, "To wait for trustees or managers to raise this issue may be a breach of consultants' professional duty to their clients."

As an example of good practice by investment consultants, McQuillen referred to the answer provided by Mercer to the question, "Do you consider that integration of ESG matters is a requisite aspect of investment management as part of fiduciary duty?"

Mercer's response was, "Yes. An increasing body of evidence exists to show that ESG factors can impact investment performance. Therefore, fiduciaries concerned with long-term preservation and growth of capital should have some understanding of how ESG factors may affect their portfolios."

The third section of the report finds that while laws regarding fiduciary duty have changed little since the Freshfields report, "many institutional investors are beginning to see their fiduciary duty as allowing for, or even requiring, a more sustainable investment approach." The section examines several initiatives among pension plans and institutional investors that explicitly incorporate ESG issues into their processes, and cites numerous studies that provide guidance for institutional investors wishing to do so.

The third section of Fiduciary II also describes the integration of ESG criteria into new asset classes, such as private equity and property investment, and financial sectors such as insurance.

Butch Bucani, Program Officer for Insurance and Investment at UNEP, and the Fiduciary II Project Manager and Chief Editor, said, "Many leading institutional investors are adopting longer-term and more responsible and sustainable investment strategies, and in fact are moving toward greater integration of ESG issues into overall investment philosophy and practice."

Bucani continued, "In order to achieve the original vision of the Freshfields report, ESG issues should be embedded into the legal contracts between asset owners and asset managers. The report makes the case that asset managers have a duty to proactively raise ESG issues with their clients."

He concluded, "Taking ESG issues into account will align institutional investors with the interests of society."

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