Fiduciary Duties of Investment Intermediaries Law Com No 350 The Law Commission (LAW COM No 350) FIDUCIARY DUTIES OF INVESTMENT INTERMEDIARIES Presented to Parliament pursuant to section 3(2) of the Law Commissions Act 1965 Ordered by the House of Commons to be printed on 30 June 2014 HC 368 © Crown copyright 2014 You may re-use this information (excluding logos) free of charge in any format or medium, under the terms of the Open Government Licence v.2. To view this licence visit www.nationalarchives.gov.uk/doc/open-government-licence/version/2/ or email [email protected] Where third party material has been identified, permission from the respective copyright holder must be sought. This publication is available at www.gov.uk/government/publications Print ISBN 9781474107631 Web ISBN 9781474107648 Printed in the UK by the Williams Lea Group on behalf of the Controller of Her Majesty’s Stationery Office ID 19061402 06/14 41342 19585 Printed on paper containing 75% recycled fibre content minimum ii THE LAW COMMISSION The Law Commission was set up by the Law Commissions Act 1965 for the purpose of promoting the reform of the law. The Law Commissioners are: The Right Honourable Lord Justice Lloyd Jones, Chairman Professor Elizabeth Cooke David Hertzell Professor David Ormerod QC Nicholas Paines QC The Chief Executive of the Law Commission is Elaine Lorimer. The Law Commission is located at 1st Floor, Tower, 52 Queen Anne’s Gate, London SW1H 9AG. The terms of this report were agreed on 4 June 2014. The text of this report is available on the Law Commission’s website at http://lawcommission.justice.gov.uk/areas/fiduciary_duties.htm. iii THE LAW COMMISSION FIDUCIARY DUTIES OF INVESTMENT INTERMEDIARIES CONTENTS Paragraph Page GLOSSARY ix CHAPTER 1: INTRODUCTION 1 The Kay Review 1.3 1 Terms of reference 1.14 4 The meanings of fiduciary duty 1.16 5 Who invests in UK equities? 1.21 6 A pensions focus 1.24 7 Other trusts 1.28 7 Our review of social investment by charities 1.29 8 The consultation responses 1.34 8 This report 1.36 9 Thanks and acknowledgments 1.44 11 CHAPTER 2: THE PENSIONS LANDSCAPE 12 Types of pension scheme 2.4 12 Automatic enrolment 2.26 17 Pensions regulation: a dual system 2.32 18 Types of pension scheme: a summary 2.45 21 The changing nature of occupational pensions 2.46 23 Pension challenges 2.61 27 iv Paragraph Page A comparison with Australia 2.73 30 Conclusion 2.75 30 CHAPTER 3: FIDUCIARY DUTIES WITHIN THE LEGAL FRAMEWORK 31 Multiple sources of law 3.5 31 The meanings of fiduciary duty 3.11 33 Who is subject to fiduciary duties? 3.14 34 The content of fiduciary duties 3.25 38 Duties connected to the exercise of a power 3.44 46 Duties of care 3.68 53 Conclusion 3.89 60 CHAPTER 4: INVESTMENT DUTIES OF PENSION TRUSTEES 61 The pensions legislation 4.6 62 The principles of trust law 4.31 68 Statutory schemes 4.59 78 Conclusion 4.82 83 CHAPTER 5: FACTORS IN PENSION TRUST INVESTMENT: CONSULTATION PAPER AND RESPONSES 84 What we said in the Consultation Paper 5.5 85 Consultees’ views 5.20 88 What is the purpose of the trust? 5.24 89 Maximising returns at the expense of long-term risks? 5.47 93 The need for clarity over terms 5.57 96 Should trustees always take ESG factors into account? 5.63 97 Stewardship: beyond the reach of small funds? 5.77 101 v Paragraph Page Conclusion 5.99 107 CHAPTER 6: FACTORS IN PENSION TRUST INVESTMENT: THE LAW COMMISSION’S VIEW 108 The duties of pension trustees: an overview 6.4 108 The statement of investment principles (SIP) 6.16 111 Delegation 6.19 111 Financial and non-financial factors 6.21 111 Financial factors 6.24 112 Non-financial factors 6.33 113 The tests for applying non-financial factors 6.57 118 Exceptions: when can significant financial detriment be justified? 6.84 124 Conclusion 6.99 127 CHAPTER 7: FACTORS IN PENSION TRUST INVESTMENT: A NEED FOR REFORM? 128 An appropriate understanding of beneficiaries’ interests? 7.5 128 Is the law sufficiently certain? 7.20 131 Codification 7.37 135 The need for guidance 7.44 136 Reviewing the Occupational Pension Schemes (Investment) Regulations 2005 7.60 140 CHAPTER 8: CONTRACT-BASED PENSIONS: DUTIES TO ACT IN THE BEST INTERESTS OF MEMBERS 147 A contract with each individual member 8.4 147 Regulation 8.9 148 The role of the employer 8.37 156 vi Paragraph Page Independent governance committees 8.42 158 Do fiduciary duties apply to contract-based pensions? 8.46 159 Consultees’ views 8.55 161 Conclusion 8.64 162 CHAPTER 9: DEFINED CONTRIBUTION WORKPLACE PENSIONS: CHALLENGES OF GOVERNANCE 164 The governance gap 9.7 165 The Government’s response 9.22 168 Comment on these changes 9.47 174 Challenges ahead 9.54 175 Chosen funds 9.73 179 Conclusion 9.82 181 CHAPTER 10: DUTIES IN THE INVESTMENT CHAIN: THE CURRENT LAW 183 The Kay Review’s recommendation 10.9 185 Who might be considered a fiduciary? 10.12 186 What is the content of the fiduciary duties? 10.41 194 To whom are the duties owed? 10.69 202 Conclusion 10.76 204 CHAPTER 11: DUTIES IN THE INVESTMENT CHAIN: A NEED FOR REFORM? 206 Should the law of fiduciary duties be reformed? 11.4 206 An alternative right to sue: extending section 138D 11.10 207 Strengthening FCA rules 11.36 213 Investment consultants 11.40 213 Stock lending 11.63 218 vii Paragraph Page The law of intermediated securities 11.105 227 Conclusion 11.145 237 CHAPTER 12: LIST OF RECOMMENDATIONS 239 APPENDIX A: TERMS OF REFERENCE 241 APPENDIX B: LEGISLATIVE PROVISIONS 243 APPENDIX C: LIST OF CONSULTEES 252 viii GLOSSARY Active investment An approach to investment which involves the continuous buying and selling of investments. An active investment manager will typically seek to outperform an investment benchmark. Active member Members who are currently accruing benefits under the scheme. Actuary A professional who specialises in statistics and risk who gives advice on a pension scheme’s assets and liabilities. They will predict movements in the scheme, such as deaths, retirements and withdrawals, and estimate the costs of providing the benefits due and accruing in the future. Annuity A fixed sum of money paid to individuals each year upon retirement. This may be for an agreed period or for the rest of the individual’s life. The amount of money paid will depend on the individual’s total accumulated pension savings. Asset manager See “investment manager”. Automatic enrolment Also known as “auto-enrolment”. A new legislative requirement introduced by the Pensions Act 2008 which requires all employers (beginning with the largest) to automatically enrol their qualifying employees into a qualifying pension scheme. Best of sector Also known as “best of class”. Companies that perform best in their industry sector against specified indicators. Broker An individual or organisation that acts as an intermediary between a buyer and seller, usually in return for the payment of a commission. Bundled scheme A pension scheme where the pension provider also administers the scheme. COBS Conduct of Business Sourcebook. The section of the Financial Conduct Authority’s Handbook that deals with business standards. ix Contract-based scheme These may be work-based or individual. In work-based contract-based schemes, the employer appoints a pension provider, usually an insurance company, to administer their pension scheme. The employees enter into a contract directly with the pension provider, although the employer may make arrangements to collect and pay contributions. In individual contract-based scheme, an individual enters into a contract directly with a pension provider. Contributions The money paid by members and employers into the pension scheme. CP 215 Fiduciary Duties of Investment Intermediaries (2013) Law Commission Consultation Paper No 215. Custodian An institution that is responsible for the safekeeping and administration of assets belonging to another. Custodians will often handle administrative arrangements such as collecting coupons and dividends. Default fund The investment fund into which employees’ contributions are paid if they fail to make an active choice of fund. It is usually designed for this purpose. Deferred member A member that no longer contributes to or accrues benefits under a scheme but has not yet begun to receive retirement benefits from that scheme. Defined benefit (DB) schemes Also known as “final salary” schemes. A type of pension where the amount an employee receives on retirement is pre-determined, and is often calculated on the basis of the employee’s final salary and length of service. The amount received on retirement does not depend on the performance of the pension scheme’s investments. Defined contribution (DC) schemes Also known as “money purchase” schemes. A type of pension where the amount received by a member on retirement will be calculated by reference to the contributions the employee makes to the scheme and the investment return on those contributions. Department for Work and Pensions (DWP) The government department responsible for pensions policy. x Direct payment arrangements Arrangements between the member and the employer under which contributions fall to be paid by the employer towards the scheme. Such arrangements will exist where the employer arranges to make employer contributions to a personal pension scheme and/or where the employer arranges to deduct the member’s contributions from pay and to pay them across to the pension scheme for the member. Environmental, social and governance (ESG) factors Sometimes referred to as “responsible investing”.