Embracing the Cracks, Midwifing the Convergence, Creating the Coherence

Roles for lawyers in the Transformation

“There is a crack, a crack in everything

That's how the light gets in.”

Leonard Cohen

The last two posts have been about understanding the threat of compartmentalisation, and resisting it by embracing new ways of engaging with the world around us. This one illustrates how many significant voices are expressing similar opinions about the need for a new outlook and identifies roles for lawyers in bringing these individual interventions into a coherent and compelling new narrative.

The major cause of the climate and ecological crises we face is the unrelenting pursuit of profit maximisation and increased financial returns. In terms of cause and effect, vanishingly few contest this statement. A troublingly large number ignore it, however, and carry on regardless. Yet look around and more and more figures operating within the system and calling for urgent change. These can feel quite disparate, but common themes are discernible. Each might be regarded as a crack, letting some light in, and lawyers are as well placed as any to bring these together into a new way of conducting business and investment practice, which aligns greenhouse gas emissions reduction and nature restoration and financial sustainability.

Here is a non-exhaustive list of cracks.

The perspective of pension fund trustees

The UK Financial Markets Law Committee (FMLC) recently confirmed that systemic risks from sustainability are a proper consideration for pension fund trustees. The FMLC is an august body, comprised of leading lawyers from across the financial markets, chaired by a former Lord Chief Justice (head of the Judiciary). Their paper captures an essential point – and recurring theme – that there has been a convergence of the financial and what might previously have been regarded as the ethical, such that for trustees it is np longer (more often than not) about choosing between two distinct positions. “Sustainability is integral to decision-making by ... trustees where it may affect financial return or risk” the paper says, and as such identifies it as a financial factor.  

The FMLC recognises the threat of compartmentalisation, encouraging trustees to ensure that they and the advisers and investment managers do not work in silos.

The perspective of other large investors

The FMLC’s view aligns closely (unsurprisingly) with Universal Owner theory. This recognises that the largest investors, such as sovereign wealth funds, insurance companies and the largest pension funds, manage pots of money which are so large that they are vulnerable to, and need to actively take account of, systemic risk. It is unrealistic, and potentially actively harmful, to expect every individual investment to deliver a significant positive return. If this is achieved by some investees passing environmental and social costs arising from their activities onto others in the system and if the cumulative effect of this is that the value of the market as a whole declines, this is a problem for the universal owner. If the market actually collapses – by no means an improbable scenario given insurance companies are already ceasing to insure more and more risks, or only doing so at rates which are unaffordable to many – then the universal owners will have undermined their own positions if they have continued to encourage each individual investee to look only at their own financial returns and not consider their wider impacts.

Macro-stewardship

One way in which some universal owners are addressing this risk is to embrace the concept of macro-stewardship. This is the proposition that market participants have a responsibility to help preserve the integrity of the whole financial system, keeping it in healthy service of society and the planet. Whilst for some time investors have engaged in stewardship of their portfolios by communicating with their investee businesses, macro-stewardship involves similar action with regulators, policymakers and other systemic influencers. It demands an ability to see as much of the ‘whole’ as possible and the understanding that every system has leverage points where targeted interventions can have disproportionate impact – for good or ill.

Of course, there is no reason this should be confined to large investors and their efforts will be more impactful if their investees, their advisors, and the regulators, policymakers and the rest are also adopting a holistic perspective. Macro-stewardship is something for all of us to be alive to.

Consumer Duty

At the other end of the investor spectrum, the Financial Conduct Authority recently brought in a new consumer duty to protect individual investors seeking financial advice on their own investments. A significant aspect of this is the emphasis on cross cutting principles to avoid foreseeable harm to the customer; to ensure that they are able to make an informed choice about what they invest in and that the options presented to them are suitable. This means that independent financial advisors potentially need to be thinking about more than the financial outcomes of particular investments. They may need to consider what those investments may do in terms of climate heating and biodiversity loss and what they may mean for the client living through, for example, hotter summers as they become elderly; in water-stressed communities; or locations susceptible to extreme flash-flooding and whether the investment conversation should be about alternative applications of their discretionary capital. We, the customers and investors, of course, also need to be thinking about these wider considerations and the implications of foreseeable harms.

Charity trustee investment duties

Further focus on non-financial impacts of investments comes, perhaps more predictably, from the charity sector. The case of  Butler-Sloss & Ors v The Charity Commission for England and Wales & Anor [2022] EWHC 974 (Ch) (29 April 2022) made clear the reference point in terms of trustees’ fiduciary duties in respect of investments is the charitable purposes of the organisation. Where an investment may have a negative impact on the charity or its beneficiaries which outweighs any financial benefit, then the trustees may reasonably decide not to make such an investment even where there would be a financial gain.

In a separate but similar vein, there are initiatives under way where charitable foundations and social investors are exploring whether the traditional approach they have taken to grant giving and to social investments, by perpetuating established power dynamics, is inhibiting the grantees and investees in their attempts to achieve social or environmental outcomes. Dark Matter Labs in respect of grants  and Equality Impact Investing in terms of social investments have been considering whether they need to reconstruct how those parties come together and contract with one another, placing financial considerations alongside and not above other elements.

Directors’ duties

The examples so far focus on investment perspectives but – acknowledging once again nothing exists in isolation - these shifts have material implications for any business or organisation seeking funding. Returning to the FMLC paper, they comment that ‘If [pension] trustees approach their fiduciary obligations today in the context of sustainability … their approach can be expected in turn to inform how investees measure success and identify [and] address risk and return”. In other words, companies and their boards better start aligning their ideas of success with those of their major shareholders.

Even without investor pressure, a new legal opinion on directors’ duties and nature risk demonstrates that a sole focus on the financial bottom line will be problematic – or, perhaps more accurately, that nature cannot be ignored in considering what will affect that bottom line. The opinion confirms that under existing UK company law,  a director who fails to identify and mitigate the nature-related risks faced by their company may be exposed to liability both under sections 172 and 174. The same may reasonably be inferred to apply in relation to climate risks.

True and Fair

A separate legal opinion has also been released recently on the legal duty of directors and auditors to satisfy themselves that the accounts they approve are "true and fair". This means considering whether and how relevant sustainability issues are properly reflected in their accounts. For example, if a firm has made a concrete commitment to go to net zero in a defined timeframe, what impact does this have on how it values its assets, and assesses its future cash flow and financial position? This opinion, issued by George Bompas KC, opens the door for the integration of some sustainability issues in the financial statements, as opposed to disclosures in a separate sustainability report. In other words, it is a further example of a requirement on company directors to think holistically about sustainability issues and the wider business.

Double materiality

Alongside the steep increase in reporting and disclosure requirements on companies generally, there is also increased focus on making assessments on the basis of what is called double materiality. This means not only looking at matters like climate heating and nature loss and considering what is the impact that these risks will have on your business, but considering the impact that the activities of the business will have on climate heating and nature. This is the approach adopted by the Taskforce on Nature-related Financial Disclosures (TNFD) and whilst it has been resisted in other quarters to date, if (as this post indicates) the direction of travel is inevitably towards acknowledging the reality of the interdependencies within which we all live, then it is nonsensical not to adopt a double materiality approach, not just to reporting but to business and investment decision making generally.

Reputational considerations

A different but similar example of how directors (and all of us, frankly) need to be thinking about matters from multiple materiality perspectives is the reputational fall out from a company’s activities. This can seem simultaneously quite nebulous (how to measure the extent to which a particular action may have lasting tangible consequences before it happens?) but potentially existential (remember Ratners, anyone?). In this context, one tangible outcome to note is that in developing Voluntary Principles for Science-based Investment in High Integrity Natural Capital Markets in the UK, the authors (including Federated Hermes and Finance Earth) have determined it appropriate to include Buyer Screening Criteria. The effect of this is that companies who may see the acquisition of nature credits as a means of greening their reputation are likely to be disappointed if their corporate practices are otherwise regarded as detrimental to nature – and the fact they may be excluded from doing so will itself be a further tarnishing of their reputation potentially. This is yet further evidence that a bit of ‘good’ activity over here, cannot be assumed to counter the ‘bad’ going on elsewhere and assessments will increasingly be based on overall impact.

None of the subheadings above may on their own set the pulse racing. However, the cumulative impact of them feels significant: directors and investors - and by extension their advisors - can no longer assume a focus solely on financial returns will safely discharge their profession duties. This is also becoming apparent to lawyers specifically, with the Law Society of England and Wales referencing the concept of advised emissions in its guidance to solicitors on climate change; the Legal Charter 1.5 developing a way for solicitors to engage meaningfully with this; and the UN Race to Zero consulting on the extension of this concept across professional services more generally.

It may feel overwhelming for the people affected, with layer upon layer of yet more things they need to take into account making their work seem unmanageable.

This is precisely where the real opportunity lies; not just for solicitors, but certainly for solicitors who both want to feel they are making a difference through their work in these difficult times and also that they can be of service to their clients. This won’t be through the traditional means of listing out all the steps they need to take to achieve legal compliance. It will be by identifying, firstly, new ways of approaching their work which overlay a systemic, holistic approach which roll many of these objectives into one coherent way of operating and, secondly, by advocating for regulatory and policy change to ensure that in the short term their clients are not punished by a regressive market for taking the progressive approach that these individual initiatives hint at.

I am under no illusion that this will be easy. Evidence of the desperate thrashing and flailing of a worldview undermining itself is all around (and most obviously apparent if the ESG backlash in the US). However, the examples cited above indicate that those who engage seriously with the challenges we face converge on the position that wider considerations must be taken into account to deliver not only medium term business and financial success, but even simply an economy in which to operate. These wider considerations include the impacts corporate and investment practice has on both nature and the environment, and weaving that thinking into legal instruments and legislation is where this inevitably leads. As the years of this critical decade roll by, aspirations for transition increasingly feel inadequate. It is transformation that now is necessary: another reason the lawyers need to step into this space and not wait for others to take the lead.

This (I realise as I type) will be the topic of the next posting – coming soon.