How policy makers can implement reforms for a sustainable financial system: stewardship

Effective stewardship, with an explicit focus on delivering sustainability outcomes and impacts, delivers real benefits for investors and for society as a whole.

By pursuing sustainability outcomes and impacts through stewardship, investors can mitigate system-level risks (such as climate change, biodiversity loss and inequitable social structures) to improve the long-term performance of economies and of their investment portfolios, as well as improve social and environmental outcomes in line with their beneficiaries’ objectives and with public policy goals.

“Investors cannot diversify away from systemic risks such as those presented by climate change. Stewardship is a tool that investors can use to help manage these risks.”

Kate Griffiths, Executive Manager, Research and Policy, Australian Council of Superannuation Investors

The term stewardship encompasses a multitude of activities. Investors – depending on the asset class, geography and investment strategy – can exercise their stewardship obligations by:

engaging with issuers (whether current or potential investees);
voting at shareholder meetings or equivalent meetings of other asset classes;
filing or co-filing shareholder resolutions or proposals;
holding positions on investee boards and board committees;
litigating or seeking legal recourse, where necessary.

Stewardship can also be implemented by investors using their influence over policy makers and other non-issuer stakeholders by, for example:

engaging with policy makers;
engaging with standard setters
contributing to public goods (such as research) and public discourse (such as media) that support stewardship goals.

Stewardship by investors can be undertaken individually or collaboratively. Collective action tends to both reduce the costs of taking action and increase the likelihood of success. By using a combination of tools, such as stewardship, capital allocation and engagement with policy makers, investors can bring about assessable changes in the behaviour and performance of investee companies and other assets, as well as in the systems in which companies and investors operate, to deliver better sustainability outcomes and impacts.

What is the value of stewardship?

In practice, stewardship creates value by:

enhancing risk-adjusted portfolio returns;
improving the governance of investee companies and strengthening their accountability to their investors;
supporting the long-term growth of investee companies by monitoring and driving improved sustainability performance;
helping to manage ESG- and greenwashing-related risks;
providing crucial levers for investors to generate desired sustainability outcomes and impacts, including supporting the transition towards more sustainable economies;
addressing system-level risks through collaboration with policy makers and key stakeholders along the investment and supply chains.

Why establish a regulatory framework for effective stewardship?

The reasons for regulators to establish regulatory frameworks for effective stewardship largely fall into two categories:

the need to align investor stewardship with investors’ duties to their clients or beneficiaries;
the desire to facilitate stewardship as a tool to support public policy objectives.

Aligning stewardship with investor duties

Given the influence of institutional investors in the capital market, it is, therefore, important to ensure that investors’ stewardship activities align with investors’ legal duties.

Investor duties, such as duties of prudence, care and loyalty, establish how investors are required to make decisions and use the powers granted to them to pursue their proper legal purpose – often described as investing in the best interests of clients or beneficiaries. In this way, legal duties apply to all relevant aspects of investment decision making and action, including on voting and the exercising of other investor rights that may impact the performance of investee companies. The way in which duties apply and the precise nature and scope of appropriate actions may change depending on the type of investor involved (e.g., asset owners, investment managers, insurers) and their particular circumstances (e.g. jurisdiction, mandate, asset class, product, and so on).

Increasingly, sustainability issues, including system-level issues like climate change, are being widely recognised as financially material. For example, the PRI, UNEP FI, and the Generation Foundation’s 2019 report Fiduciary Duty in the 21st Century argued that it would also be a failure of investor duty if institutional investors did not exercise stewardship to encourage high standards of ESG performance in the companies or other entities in which they were invested. The significant growth in stewardship activity on ESG provides further confirmation of this argument.

Financial policy makers and regulators should ensure that stewardship is not treated, as it often is, as an investment activity suitable only for some purposes or for specific asset classes. Rather, policies should consistently promote the appropriate use of stewardship by investors as part and parcel of discharging their duties.

It is important to emphasise that institutional investors should retain the flexibility and the discretion to decide on a case-by-case basis whether and when to exercise stewardship in light of the best interest of their clients or beneficiaries. In cases where they decide it is in their clients’ or beneficiaries’ best interests not to exercise stewardship, they should clearly communicate and explain the reasons to clients and beneficiaries.

US SEC and Department of Labor on the scope of fiduciary duties in relation to stewardship

Under the Investment Advisers Act of 1940, for investment advisers registered with the US Securities and Exchange Commission (SEC), an adviser is a fiduciary that owes each of its clients the duties of care and loyalty with respect to all services undertaken on the client’s behalf, including proxy voting. The duty of care requires an adviser with proxy voting authority to monitor corporate events and to vote the proxies. To satisfy its duty of loyalty, the adviser must cast the proxy votes in a manner consistent with the best interest of its client and must not subrogate client interests to its own.

An adviser does not need to exercise every opportunity to vote a proxy if either of two situations applies. First, the investment adviser need not cast a vote on behalf of the client where contemplated by their agreement. Second, an investment adviser that has voting authority may refrain from voting a proxy on behalf of a client if it has determined that refraining is in the best interest of that client.

For private pension plans subject to the Employee Retirement Income Security Act of 1974 (ERISA), the longstanding position of the Department of Labor (DoL) is that the fiduciary act of managing plan assets includes the management of voting rights (as well as other shareholder rights) attached to shares of stock. Although the rule relating to fiduciary duties regarding proxy voting and shareholder rights have been subject to frequent changes recently,15 this core principle has remained the same.16 To guide plan fiduciaries to exercise the right to vote to fulfil their duties, DoL provides guidance on what must be taken into consideration when they decide whether and when to exercise shareholder rights.

The interaction between the Kenyan Stewardship Code and investor duty

Introduced in 2017, Kenya’s Stewardship Code for Institutional Investors sets out seven key stewardship principles to be complied with on an apply or explain basis. Through an Application section, the Code provides additional clarity on how investors should implement the principles, including in relation to investor duties:

“(3) in the investment context, stewardship calls for diligence on the part of institutional investors, both asset owners and asset managers, to exercise ownership rights actively and responsibly as part of their fiduciary responsibilities to their clients. The role of a stewardship code is to codify the key institutional investor responsibilities that come with ownership rights and to provide guidance on how institutional investors act as responsible stewards in their oversight of issuers. The Code also articulates the commitment that institutional investors make to their clients to address these responsibilities.”

China’s voting guidelines for fund management companies

The Asset Management Association of China’s voting guidelines state that the guidelines are intended to promote the faithful performance of fiduciary obligations by fund management companies by providing guidance for fund management companies who vote proxies for the funds they manage to properly manage conflicts of interest, prevent tunnelling and protect the legitimate interests of fund shareholders.

Facilitating stewardship for public policy reasons

Policy makers may also choose to support investor stewardship if they see that such stewardship might support or enable the delivery of wider public policy objectives. For example, policy makers might see that stewardship policies can play a role in:

restraining short-termism and encouraging long-term investment to support the sustainable growth of the real economy and enhance overall financial market stability. One of the lessons of the 2008 financial crisis was that institutional investors should act as responsible shareholders of public companies to restrain excessive risk-taking and short-termism. Monitoring and improving the performance of investee companies from the perspective of a long-term patient investor is an essential element of good stewardship.
creating an enabling environment for delivering real-world sustainability outcomes. A clear regulatory framework to guide stewardship practices enhances accountability and strengthens synergies with other sustainable investment policies, supporting the potential for investors to direct capital to address sustainability issues and drive positive change, including transitioning the economy towards climate targets set by the Paris Agreement.
clarifying basic elements of good stewardship. As stewardship practices become increasingly prevalent, there is a need to distinguish between positive and negative investor influence on investee companies. This is even more important when investors have significant influence within an economy.
addressing the challenge of collective action. A notable disincentive to investors pursuing stewardship practices is free-riding. A stewardship code or similar regulations that sets stewardship expectations for all institutional investors can encourage a distribution of stewardship costs across investors, by increasing accountability.

Examples of public policy reasons for regulating or guiding investor stewardship

South Africa’s Second Code for Responsible Investing in South Africa (CRISA) identifies seven objectives including, among others, the following objectives that clearly relate to public policy objectives:

“To create a context within which the investment environment can evolve towards positive outcomes to address South Africa’s unique environmental and social challenges, including poverty, inequality, unemployment and transformation, balanced with the delivery of suitable, transparent, cost-effective and relevant services to the users and beneficiaries of investment products.”
“To encourage collaborative action towards the mainstreaming of sustainable finance that contributes to a more equitable and inclusive economy.”
”To promote the development and implementation of green and sustainability-oriented investments and investment vehicles that address ESG issues (such as those encapsulated in the SDGs and [the 2030 National Development Plan]).”

The Chinese Insurance Asset Management Industry’s ESG Stewardship Initiative has a strong focus on leveraging investor stewardship to deliver sustainability outcomes in line with public policy objectives. It states: “Insurance asset management companies (IAMCs) have been playing an important role in serving the development of the real economy. In the face of the opportunities and challenges under the national carbon neutrality strategy, IAMCs should actively and comprehensively participate in and promote the green transition of the economy as a part of the mission to promote the high-quality development of the insurance industry. In addition, as part of investors’ stewardship responsibilities, IAMCs should fully leverage their influence to guide stakeholders, including investee companies, to work together to build a green development ecosystem, support the sustainable development of China’s economy and help achieve the goal of carbon neutrality.”

What makes a regulatory framework for stewardship effective?

A regulatory framework for effective stewardship aims to formalise stewardship activities in regulation or guidance and to define expectations on investors’ stewardship practices and reporting. The way policy makers approach this depends on the available political resources and on market awareness. Around 25 markets have introduced stewardship codes or principles. Many countries have introduced mandatory stewardship expectations in investor regulations. These two approaches are not mutually exclusive.

Key to driving long-term improvements in investor stewardship will be gradually raising the floor for stewardship practices established by regulation, while ensuring codes or other voluntary standards recognise best-in-class practices.

For markets where stewardship codes have been adopted, there is generally guidance on how investors can fulfil their stewardship responsibilities while also complying with their wider duties and obligations as investors.

It is not the purpose of this report to discuss which approach policy makers should take. Instead, it seeks to identify key elements of a regulatory framework for effective stewardship which could be flexibly incorporated into the regulatory approach suitable for a particular market. Together, these key elements formalised in regulations or voluntary codes could form a layered system to support effective stewardship. These elements could be largely grouped into two categories: measures to enhance accountability and transparency for stewardship activities; and measures to encourage a market for effective stewardship, as set out in below.

A regulatory framework for effective stewardship should avoid applying a ‘one-size fits-all’ approach and should be flexible enough to recognise and allow for variation in specific investor approaches to stewardship. It should acknowledge, for instance, that: investor rights and influence vary across asset classes; the effect of other regulation (e.g. corporate governance requirements and investor duties); the scope of authority granted by clients or beneficiaries; and the investor’s structural context and position in the investor value chain.

The governance of proxy voting and related stewardship activities in the US

In the US, in addition to investor-driven stewardship principles, financial regulators have developed a mandatory regulatory framework to govern proxy voting and related stewardship activities, which covers key elements of a stewardship code.

Given the large influence of institutional investors in the capital markets and on the fortunes of their beneficiaries, both the US DoL and the SEC regulate proxy voting by institutional investors within the framework of fiduciary duty.

Regarding proxy voting, institutional investors are obliged to establish policies and procedures to ensure they monitor investees and vote client or beneficiaries’ proxies, resolve conflicts of interest so that votes are cast in the best interests of clients or beneficiaries, keep records of proxy voting and make disclosures and monitor proxy advisors. In 2022, the DoL published final rules amending the Employee Retirement Income Security Act of 1974 to address barriers to ESG considerations and provide clarity to fiduciaries on how to consider ESG factors in investment decision making and the process of proxy voting and exercising shareholder rights.

Measures to enhance accountability and transparency for stewardship activities

Clarify that investors should exercise stewardship as part of investor duties or other investor obligations owed to their clients or beneficiaries.
Set out key elements of stewardship responsibilities. Typically, these include expectations for investors to individually or collaboratively exercise their stewardship obligations by, for example:
- diligently monitoring portfolio companies;
- engaging with companies in which they invest or intend to invest, and with other stakeholders;
- exercising investors’ rights, including the right to vote and to file shareholder resolutions, etc.
Require incorporation of ESG factors in stewardship processes and decisions to support the long-term value of investments.
Require investors to align stewardship activities with clients/beneficiaries’ sustainability preferences and manage conflicts of interests.
Require investors to establish stewardship policies and report stewardship policies, activities and outcomes to clients and beneficiaries.
Set out the responsibilities of the board and senior management to oversee and provide sufficient resources for stewardship activities.
Establish monitoring mechanisms to assess the quality of implementation of stewardship requirements.

Measures to encourage a market for effective stewardship

Clarify investor rights, legal processes, and mechanisms and reduce barriers for investors to engage in stewardship activities (voting, engagement, filing shareholder resolutions, etc.) and monitor investee companies.
Encourage or require asset owners to embed stewardship requirements in investment mandates and the process of selecting, appointing and monitoring asset managers to ensure stewardship responsibilities are discharged.]
Improve the infrastructure for stewardship, such as platforms for collaborative engagement and a voting system that is neutral to different ways of voting.
Clarify any potential legal confusion in relation to existing laws or regulations when investors engage in stewardship activities, including collaboratively.
Encourage and guide the application of stewardship to cover asset classes beyond listed equity.