Redefining Fiduciary Responsibility

March 13, 2012

Lisa Genasci mulls over why and how fiduciary duty should look beyond profit-making

-Investment culture simply to maximize rates of return has slowed investment that promotes social good

-Fiduciary duty = to act prudently — a prudent person is farseeing

-Most investors ignore basic environmental risk like water scarcity which is also an important business risk

I’ve been thinking recently about Fiduciary responsibility and what that has come to mean over the past two decades of rapid growth in Asia.

I’ve been thinking about how and why the interpretation that has crept into investment culture over that period – simply to maximize rates of return has slowed an appreciation of investment that doesn’t cause social or environmental harm.

It goes without saying that this has also slowed investment that promotes social good as well as generating returns.

I’ve also been thinking that by itself this narrow interpretation ignores both business risk and opportunity both of which should instead be centre stage,  considering the dictionary definition of fiduciary duty: To act prudently.

Picking up on this inconsistency as it applies to his own circumstances,  Stephen Viederman, former president of the US-based Jessie Smith Noyes Foundation, writes in a Capital Institute blog that foundations should align program work with investment strategy – something that is all too rare.

“Foundation fiduciaries have an obligation to seek ‘good’ and ‘competitive’ returns, not necessarily to maximize them,” he says.

Part of the problem has been the accompanying “myth of financial underperformance from ‘social investing,’ a myth that still lies at the heart of the problem for finance committees who conveniently forget that two-thirds of traditional active managers underperform their benchmarks every year,” Viederman says.

“Yet the profit-maximizing argument–that you will underperform if you do sustainable investing–comes up time and time again in conversations and is never examined by the people who are making it.”

Indeed, most investors are not considering the business risk associated with investing, for example, in a power company, a textile operation or mining business in a region that is water scarce.  Most ignore the reputational risks associated with investing in factories or plants that are polluting, overly consumptive of resources, or engaged in bad labor practices.

“All investments are about the future, but most investment decisions are made on retrospective data, which as fund offerings make clear, are not predictors of future earnings,” says Viederman.

“We need to ask about … ‘predictable surprises,’ which include climate change, the BP Gulf disaster and the financial bubble among others. …Any institutional investor who ignores them is in breach of their fiduciary duty. To be prudent, as in the prudent person, is in its original meaning, to be farseeing.”

Investors certainly have operated with a short-term view, which in part has been the nature of the investment horizon: Just a few years. But few would disagree that for example in China the regulatory environment is changing rapidly to reflect resource consumption and that water pricing in the near future will reflect scarcity.

Few could disagree that NGOs are increasingly sophisticated in exposing pollution incidents and that local protests in China are growing around pollution incidents.

Workers are no longer content to suffer exposure to hazardous chemicals silently, or work extraordinarily long hours without proper compensation.

Last years reports from the Institute of Public and Environmental Affairs and a coalition of Chinese environmental NGOs on Apple, which had been slow to respond to questions about worker exposure to toxic chemicals, as well as subsequent articles in the New York Times on the topic should alert any company to reputational  risks.

All are, potentially, a drag on profits. Would it not then make sense for fiduciary duty to include analysis of such risk?

Fully Risk-Adjusted Returns (FRR), as they might be called, should certainly not be lower as a result, indeed given the current and future challenges the world faces, they could be enhanced by additional material information.

For those who missed this, one company that is looking to consider the impact of production is PUMA, which earlier this year announced the results of an unprecedented environmental profit and loss screening.

This was a big step toward assigning economic value to resources consumed and to emissions. The value assigned was also a step toward determining the true cost of production of PUMA apparel and shoes.

Results from PUMAs Environmental Profit and Loss Analysis

The analysis showed that raw material production accounted for the highest relative impact of Greenhouse Gas Emissions and water consumption within PUMA’s operations and supply chain.

“By identifying the most significant environmental impacts, PUMA will develop solutions to address these issues, consequently minimizing both business risks and environmental effects.”

According to PUMA’s report, the direct ecological impact of company operations translated to the equivalent of 7.2 million euros of the overall impact valuation. An additional 87.2 million euros was distributed along the four-tier supply chain.

Thus, the overall environmental impact of GHG and water consumption amounted to 94.4 million euros. That compares to a third-quarter net profit of 82 million euros.

“By putting a monetary value on the environmental impacts, PUMA is preparing for potential future legislation such as disclosure requirements,” the company said.

Finally, a new and important report from IESE Business school, “In Search of Gama, an Unconventional Perspective on Impact Investing,” steps into the discussion with questions such as:

By focusing exclusively on the creation of financial wealth for individuals are financial markets destroying value for society?

Is social responsibility a component of investment that is necessarily detrimental to financial return?

Should changes be made in the taxation and supervision of financial transactions to account for financial markets’ responsibility to society?

Clearly, business as usual is no longer smart business and change is imminent. Considering the impact of investments and reconsidering how we make investment decisions will be the way forward.

Let’s start by redefining fiduciary responsibility, considering Fully Risked Returns. Clearly, returns may actually be enhanced either when viewed through the lens of an appropriate risk framework/weighting or in reality as a result of a superior business environment.