In a previous post it was argued that a best interest standard is necessary to protect financial consumers from the pervasive conflicts of interest in the wealth advisory industry. The arguments against adopting the standard fail on two accounts: uncertainty is a burden that is better carried by financial advisors than by financial consumers and, more importantly, financial advisors should not be regarded as salespersons but rather, as stewards of their clients’ financial well-being.
However, a fiduciary standard is not a panacea for ensuring the financial well-being of individual investors (retail investors). At worst, the standard could actually undermine clients’ interests by unintentionally cutting off access to investment opportunities that align with their social and environmental values. Millennials, in particular, show a strong interest in investment opportunities that allow them to contribute to positive social and environmental benefits for communities, while also generating a financial return on their investments.
As Canadian securities regulators deliberate over adopting the fiduciary standard for financial advisors this fall, it is essential that their analysis includes consideration for how the standard could impact individual investors’ access to socially responsible investment (SRI) products and investment products that generate positive social and environmental benefits (impact investments). In other words, the concept of investor protection must be extended beyond traditional concerns for conflicts of interests and transparency to include consideration for social and environmental risks and opportunities.
At issue is whether a fiduciary standard would have similar unintended consequences on the average individual (a.k.a ‘retail’) investor, as it has on institutional investors.
For many pension funds, fiduciary standard is widely regarded as a constraint for innovative investment strategies, including socially responsible investment (SRI) strategies and impact investment. For example, a 2004 study of Canadian investors finds that pension fund trustees’ interpretation of fiduciary duty constrains their ability to address full range of relevant corporate responsibility considerations’.
But interpretations of the legal concept have evolved in recent years to reflect a more progressive understanding. For example, one frequently cited legal interpretation argues that trustees’ fiduciary duty actually requires trustees to take into consideration ESG issues when (i) they are financially material; (ii) the financial risk/return of two investments are equivalent (iii) they have a mandate from the trust to do so, and (iv) when beneficiaries request non-financial criteria. More recently, regulators in the US and the UK have clarified that fiduciary duty does not preclude the inclusion of material environmental, social and governance (ESG) issues.
However, fiduciary duty continues to be seen as an obstacle to sustainable and responsible investment. The 2015 UN-backed PRI Report ‘Fiduciary duty in the 21st century’ finds that “many asset owners cite their fiduciary duties as the reason why they are yet to integrate ESG issues into their investment processes.”
In applying fiduciary duty to retail investors and their financial advisors, some scholars suggest that the retail sector provides a more generous space than the institutional investor context. “The debate about the role of social responsibility criteria in the fiduciary obligations of trustees of pension funds is important but it is seldom relevant in the usual settings of financial advisors.”
In particular, Statman (2007) notes that clients of financial advisors are most often also the sole beneficiaries of their portfolios. If the client/beneficiary requests the inclusion of social or environmental criteria in investment portfolio, the advisor’s fiduciary duty of loyalty (impartiality) is not a constraint to doing so. In contrast, pension fund fiduciaries and other institutional investors – by definition – have often thousands of beneficiaries, and incorporating ESG criteria that are not unanimously agreed upon by all beneficiaries would violate fiduciaries’ duty of loyalty (impartiality). To summarize, fiduciaries with individual clients have much lower hurdles in recommending SRI and impact investment products to clients than do fiduciaries that are responsible to multiple beneficiaries at the same time (e.g., pension fund trustees).
But there are other constraints on retail financial advisors to SRI and impact investing that a fiduciary standard would likely impose. In particular, the duty of prudence, which requires that fiduciaries use care, skill and prudence exercised by similar fiduciaries, continues to be seen as a major barrier to SRI by many scholars. This is because measuring prudence with reference to the performance of other investors leads to herding effects, since fiduciaries are afraid to stand out among the herd, even if standing out means better managing portfolio risks and enhanced returns. Financial advisors fearing litigation under a new fiduciary standard may be even more sticking to conventional practices and avoiding customized advice and strategies for their clients.
Initiatives to overcome the challenges to SRI that the duty of prudence presents are underway in the institutional investor context. Many scholars, and even some regulators, are beginning to argue that the duty of prudence actually requires that fiduciaries take into consideration ESG factors when making investment decisions on behalf of beneficiaries, since these sustainability issues present material financial risks to their portfolios.
As Canada’s securities regulators contemplate adopting a fiduciary standard for financial advisors, it is essential that this decision includes consideration for the risks of unintended consequences of cutting off clients’ access to the emerging SRI and impact investment opportunities that are now available to retail investors in Canada, and strategies for mitigating these risks.
Some reccomendations for regulators that are contemplating the adoption of the best interest standard for financial advisors include:
- Know your client (KYC) form should include questions that consider the client’s values and social impact investment goals. This information should be given equal weight as the client’s financial risk preferences and return objectives.
- Advisors should be knowledgable about material environmental, social and governance risks of the products that they are offering to their clients.
- Financial stewardship must replace financial salesmanship as the ultimate guiding principle for actions of financial advisors. Stewardship invokes a more holistic approach to advising clients on their wealth management.
Finally, it is important that regulators recognize that fiduciary duty is not the only obstacle to SRI and impact investment opportunities. As one scholar points out, “this obsessive focus on the supposed fiduciary law barrier to SRI can overlook other institutional [and organizational] obstacles to its practice.” Advisor education, misaligned incentives and lack of standard approaches to measurement of impact and social returns remain significant constraints to extending SRI and impact investment opportunities available to institutional investors to retail investors. These barriers, among others, are highlighted in the Retail Impact Investing Guidebook for Canadian Credit Unions, authored by Purpose Capital and the Canadian Credit Union Association.