Potential avenues for reform of the financial system towards a low-carbon, resource-efficient and sustainable economy have been mapped out in an interim report, published by the EU High-Level Expert Group on Sustainable Finance.
Established last year by the European Commission, the Group is composed of 20 senior experts from civil society, the finance sector and academia. It is expected to deliver concrete policy recommendations to the European Commission by the end of this year in a final report.
The interim report presents recommendations on directing investments that support sustainable projects. More importantly, the Group explores how to transform the system into a more sustainable one by reforming the corporate governance of both financial institutions and public corporations.
Several of their recommendations have direct implications for the interpretation of fiduciary duties:
- The reflection of end beneficiaries’ interests and, as part of it, the integration of environmental, social and governance (ESG) factors and sustainability in investors’ fiduciary duties;
- The promotion of integrated reporting and the reinforcement of transparency on ESG issues;
- The definition of European directors’ duties incorporating long-term sustainable value-creation.
The term “fiduciary duty” refers to an obligation based on trust to act in the best interest of another person. There are two separate forms of fiduciary duties that are relevant to improving corporate governance: those of institutional investors and those of corporate directors. What differentiates them is to whom the duty is owed.
Responsibilities of institutional investors
In the case of institutional investors and other financial intermediaries, the Expert Group recognises that the responsibilities owed by the financial institutions to their beneficiaries and clients (including an obligation to consider the principle of sustainability) is encompassed within their fiduciary duty.
Furthermore, the interim report reflects the common misinterpretation of the fiduciary duty as a principle that focuses solely on the maximisation of short-term financial returns.
In order to address this misconception and, in addition, establish sustainability factors across the investment and lending chain, the Expert Group recommends the formation of a single set of principles relating to fiduciary duty and associated concepts of loyalty to beneficiary interests and prudence in handling money.
Although it is generally accepted that legislation requires ESG factors to be taken into account, the Group also calls for clarification on those legal requirements, as there is a lack of clarity with regards to how far this duty extends and how it relates to other considerations.
Furthermore, the interim report states that the legal definition of investors’ and directors’ duties should be amended to include the management of long-term sustainability risks. The Expert Group even calls on the European Commission to push for such clarification and common interpretation of fiduciary duty at the international level via an OECD convention.
This clarification may also have major implications on listed companies. The above-mentioned changes would assist beneficiaries and clients of financial institutions in claiming damages arising from financial institutions, by ignoring material ESG risks and not acting in their client’s best interests.
This will arguably change the expectations of investors regarding their investee companies and their directors, in terms of identifying and managing such risks and developing long-term economic plans to contain them.
Eventually, a change in the interpretation of investors’ fiduciary duties will affect the understanding of the directors’ duties of listed companies and will have similar implications in terms of increased litigation risk.
Responsibilities of EU company directors
The High-Level Expert Group also addressed the question of governance of listed companies and the duties of their directors. The Group argues that developing a set of principles of corporate governance and stewardship that incorporate long-term and sustainable value-creation should be a central objective at the European level.
The report addresses this point at a fairly general level, but it identifies the definition of European directors’ duties as one of the principal means to improve corporate governance. This and other corporate governance-related recommendations will be further expanded upon in the final report.
The law recognises that directors’ duties are owed to the company, rather than to the shareholders. This point was recently confirmed by a study funded by the European Commission. Therefore, corporate directors are already under an obligation to proactively and critically evaluate the material financial risks to, and opportunities for, their business.
Furthermore, European directors are legally permitted and required to take into account ESG factors when they meet the materiality threshold.
ESG risks are increasingly seen as financially material, both in positive terms (high ESG performance is correlated with improved long-term financial performance) and in negative or defensive terms (ignoring them can result in lower returns or losses, directly through stranded assets; and indirectly through the vulnerability of companies to regulatory investigations, litigation, regulatory changes and reputation/brand damage).
From the perspective of integrated reporting and governance, ESG issues represent a different kind of capital that is essential, alongside the financial capital, to foster the long-term success of the company.
Adoption of a common definition of directors’ duty as considered by the Expert Group would assist in clarifying the misinterpretation of the term currently espoused by the dominant corporate model, which serves the perceived interests of shareholders in a short-term manner, rather than promoting long-term sustainable value-creation.
This narrow model has directed the focus of executives and boards towards managing short-term increases of market value. Evidently, such an understanding of directors’ duties, and to whom they are owed, prevents directors from properly considering the challenges of sustainability.
Such clarification would have two major implications for companies and their directors. Firstly, it would act as a defence for their refocus on long-term strategy, instead of focusing on the short-term due to pressure from shareholders.
Secondly, and if coupled with a similar clarification of investors’ fiduciary duties, it would increase the the risk of litigation if they fail to properly consider material ESG risks and plan for a sustainable future. Concerned shareholders could then hold them accountable for harming the company’s prospects.
Short-termism—the biggest obstacle to a sustainable economy
The interim report notes that the pressure to maximise short-term returns prevents investors and publicly listed companies from properly considering strategy, risks and opportunities: “the time horizon in finance is typically much shorter than the time horizon needed to address society’s pressing challenges; and the conception of risk in finance is typically much narrower than one that effectively captures economic, social and environmental sustainability”.
Any solution to short-termism must, in addition to expanding and broadening an investor’s horizon, recognise that companies need to be protected from this pressure to maximise short-term shareholder value. Corporate governance policies must encourage companies to focus on sustainable long-term strategies directly, rather than bend to the will of investors.
This is only possible if the policy is built on the recognition that shareholders do not run or own companies, because an over-reliance on their role increases the pressure on company managers to put the interests of shareholders first, and therefore sustainability, ESG and indeed any other factors second—irrespective of their importance for the company’s longevity and success.
 Ibid., section Vl, p.60
 Ibid., section lll, p.19
Filip Gregor is head of responsible companies section at Frank Bold, a purpose-driven law firm that leads the Purpose of the Corporation Project. The project invites businesses, academics, policymakers and civil society to debate the future of publicly traded companies. Recent publications include “Corporate Governance for a Changing World: Report of a Global Roundtable Series” and “Revisioning the Corporation: A Short Guide to Sustainable Corporate Governance”.