Introduction

This Handbook responds to the evolution in the ownership of companies and financial assets over the past thirty to fifty years. It also is concerned with the more recent widespread failure of pensions and other long-term savings vehicles to deliver on sustainable financial security goals for the individuals whose monies they are investing.

The volume highlights important changes in the landscape of finance, especially with regard to institutional investors: those large financial institutions entrusted to manage most of our savings, pensions, retirement funds, insurance assets and national wealth reserves. It primarily focuses on the changing legal understanding of the role and purpose of these institutions in many countries. This includes recognition of the influence that collective investment practices of institutional investors have on society and the greater economy, as well as the corresponding influence that economic health and social stability have on the sustainability of institutional investors’ performance and their ability to succeed in meeting long-term goals for the beneficiaries who depend on them and who collectively constitute the societies in which they exist. The Handbook is also a testament to the rapidly evolving nature of academic research and public policy discourse concerning institutional investment and financial markets.

Introduction

The fiduciary duty principle has taken center-stage in the debate concerning the integration of environmental, social and corporate governance (ESG) performance. For decades, it has been widely agreed that “trustees or fiduciaries [are to manage] assets in the best interests of the individual beneficiaries or investors: the ultimate recipients or owners of the funds” (Chapter 1 of this volume). The “best interests” of the beneficiaries or investors have typically been reduced to their financial interests (Langbein and Posner 1980; Sandberg 2011). Addressing this fiduciary duty problem is seen as pivotal for future development of the socially responsible investment (SRI) market in general (e.g., Richardson 2009). As a result, an ever-increasing body of literature has focused on the analysis of the financial implications of incorporating nonfinancial interests into investment decision-making. Over the past three decades, several thousand “does it pay to be green?” or “does it pay to be responsible?” studies have been published with the aim to shed light on this relationship (for excellent – albeit slightly contradictory – overviews see, for example, Margolis and Walsh 2003; Orlitzky et al. 2003; Salzmann et al. 2005). It is generally agreed that the inconclusiveness within this body of literature is a result of the diversity of the underlying measures of financial performance, the methodologies applied, the sample sizes analyzed, the time horizons under investigation, the respective industries analyzed and, most importantly, the operationalization of the environmental or social performance of the companies under investigation (cf. Horváthová 2010; Ullman 1985).

The world currently faces increasingly complex governance challenges. While there is a growing recognition that we urgently need to take a longer-term view in order to deal with them successfully, many of the incentives that shape the thoughts and actions of leaders encourage myopia in the private and public sectors alike. Strategies with a high probability of success are available but not pursued because powerful short-term incentives are increasingly misaligned with the timeframes required for the solution of growing problems with profoundly destructive inter-generational impacts.

Thus far, legislators have not adequately addressed these inter-generational issues. In previous eras, when obvious and invidious injustices grew to intolerable scale due to the protracted paralysis of leaders, the necessity for action has often found its venue, by default, in the judiciary. Now, once again, courts – responding to specific fact situations – may well play a critical role in breaking this logjam. One likely legal strategy is based on the concept of fiduciary duty – the legal obligation to act in the best interests of others.

Introduction

Based on a conservative interpretation of fiduciary duty, pension funds are considered to arrive at investment decisions purely based on the financial performance of the underlying assets. Hence, whatever the real world implications of the asset, trustees following this view are legally obliged to invest as long as the expected returns in financial markets are abnormally high (Entine 2005; Munnel and Sundén 2005; Rounds 2005). Practically, this means that they have to speculate with soft commodities and thereby potentially drive basic food prices so high that the poorest on this planet can barely afford two meals a day. More paradoxically, a pension fund representing health care workers is legally obliged to invest substantially in alcohol, tobacco or gambling companies, so called “sin stocks,” should they be associated with an abnormally high return. Even the Freshfields Report, a rather liberal interpretation of the constraints that fiduciary duty imposes on pension funds aiming to consider social criteria in their decision-making, can hardly be interpreted as recommendation to ignore financially well-performing stocks on moral grounds. Its most liberal conclusion is that social criteria may be considered by pension funds if they do no financial harm, which effectively prohibits underweighting or excluding well-performing sin stocks (Freshfields Bruckhaus Deringer 2005).

Hence, the question is, can undesirable assets such as soft commodities or sin stocks reasonably be expected to experience an abnormally good financial performance? While we are not aware of such evidence for soft commodities, there is a very prominent academic study finding portfolios of sin stocks to have a superior financial performance: Hong and Kacperczyk (2009). This study has been discussed in various mainstream media sources such as Financial Times, Forbes, Reuters or the Wall Street Journal. As a result, pension funds are in a dilemma: many stakeholders – although not necessarily all members – put pension funds under considerable pressure to act with a social consciousness, while the mainstream media celebrates sin stocks for their financial performance and hence fiduciary duty obliges them to invest in these over-proportionally.