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March 23, 2011
Contracts Between Asset Owners and Fund Managers Should Include Language on ESG Risks
    by Robert Kropp

The Model Mandate Initiative of the International Corporate Governance Network proposes contract terms that include long-term risk assessment, codes for stewardship of active ownership, and mandates for transparency.

Failures of corporate governance and in the assessment of long-term environmental, social, and governance (ESG) risks have forced even mainstream institutional investors to reconsider the terms of their contracts with fund managers.

Finding support in the assertions of the landmark 2009 Fiduciary II report from the United Nations Environment Program Finance Initiative (UNEP FI)—which stated, "Advisors to institutional investors have a duty to proactively raise ESG issues within the advice that they provide, and that a responsible investment option should be the default position."—as well as by the drafting of Stewardship Codes in the UK and South Africa, asset owners are increasingly acknowledging the need for the incorporation of long-term ESG risks and benefits into both their portfolios and their contracts with fund managers.

Anticipating the need for guidance on the inclusion of such terms in contracts, the Shareholder Responsibilities Committee of the
International Corporate Governance Network (ICGN) last year organized a Model Mandate Initiative, which seeks to "consider and promote best practice in the agreements between asset owners and their fund managers," according to ICGN.

Stephen Davis, Executive Director at the
Millstein Center for Corporate Governance & Performance and a member of ICGN's Shareholder Responsibilities Committee, told, "An accumulation of pressures, including those reports, have collectively persuaded mainstream institutions that they need to be much more attentive about aligning the behavior of agents with the interests of beneficiaries."

Davis also cited last year's Gulf of Mexico oil spill, and ongoing concerns about the safety of nuclear power following the recent earthquake in Japan, as additional reasons for increased attention by asset owners to ESG risks.

The model contract terms recently issued by ICGN contain a number of key focal points. Primary is the need to incorporate into contracts information about assessing long-term ESG related risks. Also included in the model are expectations for standards of stewardship and proposed requirements for transparency in reporting by fund managers.

As the initiative states, "Events over recent years have demonstrated that no manager that fails to manage the risks inherent in its investment approach will perform effectively for its clients." Furthermore, "Following the financial crisis, there is also an increasing focus on the risk to asset owners of investment approaches which generate systemic risk or systemic benefits," the document continues.

Davis told, "It's a really important initiative, because it's heading into the direction of building ESG into contracts."

In Davis's view, perhaps the most important aspect of the initiative is its inclusion of increased reporting requirements by fund managers. The initiative states, "Clear and regular reporting provides the foundation for manager accountability."

"Hopefully, the model will incorporate for the first time a detailed reporting relationship, from the agent to the fund, on governance and environmental risks in long-term investment planning," Davis said. "My guess is the final document will include a strong emphasis on information disclosure by the fund managers, and equally proposals for contracts that provide more scrutiny by funds of their fund managers."

"I wouldn't be surprised if it contains not only ideas and language for model contracts, but also supplementary advice for investors on what to look for in such contracts, and what they might want to incorporate as part of their normal oversight," Davis continued. "On ESG, for instance, the language might not be very specific, but ICGN might provide guidance for ascertaining whether the fund manager is doing a substantive job of fulfilling those terms."

Regarding the responsibilities of fund managers for proper stewardship, the document states, "Stewardship is working with the underlying assets to ensure that they focus on delivery of risk-adjusted value over the time horizons that matter to long-term owners." The initiative proposes that model contracts define the stewardship responsibilities of managers, and require that asset owners be provided with proxy voting oversight.

"There are Stewardship Codes in the UK and South Africa, and investors in those markets have something very specific that they can incorporate into a model agreement," Davis said. "The Codes allow them to be very targeted in asking questions and inspecting behavior."

In countries such as the US where Stewardship Codes are not in place, Davis continued, either contracts will have specify terms of stewardship, or the markets will press for the development of Codes such as those in the UK and South Africa.

Asked about comments received by ICGN relating to its Model Mandate Initiative, Davis said, "The comments I've seen have been very supportive, particularly model contract agreements that include long-term thinking with particular attention to ESG risks. It's striking how it seems to have drawn a wide spectrum of support beyond the likeliest advocates."


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