The Law Commission's paper, which is now open for consultation, addresses the criticisms of intermediaries' short-term investment strategies made as part of last year's Kay Review into UK equity markets. It considers the legal obligations of intermediaries including pension providers and trustees, and investment managers and custodians; and asks whether the law has struck the right balance between ethical considerations and the duty to maximise the return on savers' investments.
"We do not think that the pressures towards short-term trading come from the law," said David Hertzell, the Law Commissioner leading the project. "There are many other factors at play, including actuarial valuations. Many pension schemes are very small. They lack internal resources and depend instead on investment consultants and investment managers, who may recommend short-term trading because that is what everyone else is doing."
"Judge-made laws, such as fiduciary duties, cannot make up for gaps in regulation. We think that there may be gaps in the way that investment consultants and custodians are regulated, and ask whether there is a need to review these areas," he said.
The Law Commission was asked by the Government to consider the extent to which fiduciary duties, meaning the duty to act in the interest of another party, apply to those working in financial markets. It intends to publish a final report, which could include recommendations for law reform, by June 2014. The consultation is open until 22 January 2014, and although it uses duties owed in respect of trust-based and contract-based pension schemes as an example is relevant to all investment intermediaries and their advisors.
In its report, the Law Commission considers the difference between trust-based pensions, where trustees have a duty to act in the best interests of savers; and contract-based pensions. It suggests that trustees are not prevented from taking a long-term approach by the law, which allows them to take account of environmental, social and governance issues where these are "relevant to the risks and financial returns". However, trustees cannot make "ethically motivated decisions or improve the world in some general sense" unless savers have given informed consent. It is seeking views on whether this should be changed to encourage longer term investment strategies.
The Law Commission states that the position is much less certain in relation to contract-based pensions. Here, there are no clear legal duties on providers to act in the best interests of their members or reassess the suitability of investment strategies over time. It provisionally concludes, and is seeking views on whether, legal duties should be clarified and strengthened. It is also seeking comments on whether the regulation of investment consultants and custodians need to be reviewed.
"Many commentators have argued that contract-based pension schemes should have their governance 'beefed up' to the levels of fiduciary governance that members benefit from under trust-based pension schemes," said pensions expert Simon Tyler of Pinsent Masons, the law firm behind Out-Law.com. "The Law Commission's recommendation to clarify and strengthen the requirement for pension providers to review their schemes' investment strategies also builds on current FCA rules for contract-based schemes."
"The recent OFT marked study into workplace defined contribution schemes has led the ABI to introduce Independent Governance Committees embedded within pension providers. The Law Commission proposes that the members of those committees should be made liable for failing to act in members' interests. As individuals may be unwilling to come forward given that liability, it also suggests that pension providers give them a full indemnity. This is likely to prove controversial; and insurers may be reluctant to take on liability for decisions made by an independent committee," he said.
Amongst the recommendations in his July 2012 review of the equity markets, Professor John Kay recommended the wider application of fiduciary standards within the investment chain. Kay highlighted a "culture of short-termism" in the financial markets, and criticised intermediaries for excessive trading on the basis of short-term share movements rather than investing for the long term.
As part of the terms of reference of its work, the Law Commission is considering whether fiduciary standards should apply to all relationships in the investment chain which involve discretion over others' investments or advice on investment decisions. Insurance expert Alexis Roberts of Pinsent Masons said that although the Law Commission did not appear to be proposing statutory reform it did appear to favour "another layer of regulatory scrutiny in an already complex regulatory arena".
"This is again the point about 'short-termism', a hot topic within the FCA," he said. "However, whether an intermediary is complying with its duties to act in a client's long-term interests is not an easy one without the benefit of hindsight. It is also rather subjective: one person's long-term growth strategy is another's short-term strategy."
"It remains to be seen, for those intermediaries that are considered to have fiduciary duties, how they will balance these with the commercial realties of their role," insurance expert Sarah Bond of Pinsent Masons said. "For example, a fiduciary would breach its duty if it made a secret profit, regardless of the effect of this on its principal. Therefore, unless a client expressly consented, the intermediary would not be able to retain that profit. Similarly, a fiduciary duty is breached if the personal interests of the agent conflict with those of its principal."
"All intermediaries within the investment chain will need to keep a close eye on whether they, or their counterparties in the chain, may in fact have a fiduciary duty and be clear that they understand the implications of such duties and the consequences of breaching them," she said.