How trustees can respond to Russia's invasion of Ukraine

Caution over exclusions is needed if motivated by non-financial factors

clock • 7 min read
Kyiv, Ukraine

Kyiv, Ukraine

Sackers partner Stuart O’Brien assesses how trustees can respond to Russia’s invasion of Ukraine and looks at the potential impact on schemes.

The global response to Russia's invasion of Ukraine continues to escalate, with new sanctions against Russian state interests and those connected with its leadership.

Many pension trustees will be considering how and if they should respond, as well as what the impact might be on the pension schemes they are responsible for.

In most cases, UK pension schemes will have extremely low exposure to investments in Russia. However, we know that some trustees are considering whether any action is nonetheless appropriate, perhaps even including an outright scheme-wide prohibition on their managers investing in certain Russian entities.

Trustees should always seek both legal and investment advice before formulating and implementing any exclusions policy. This is because the law is generally restrictive on trustees' ability to lawfully act on non-financial factors. However, a legal route to divestment is possible where financially motivated and, in practice, many of the current issues will have both financial and non-financial implications.

Key issues

Broadly speaking, the legal duties imposed on trustees require them to exercise their investment powers for their "proper purposes", namely the provision of members' pensions (and not for ulterior or political purposes).

In addition, they must take account of factors which are relevant to that purpose, which will usually mean those which are financially material to the pension scheme (this will involve consideration of risks as well as returns).

And they must invest in accordance with the so-called prudent person test - broadly this is the principle that trustee investment powers must be exercised with the "care, skill and diligence" a prudent person would exercise, when dealing with investments for someone else for whom they feel "morally bound to provide".

Taken together, these duties will usually constitute a good reason for trustees to act on most ESG factors, where doing so is financially material to the scheme's investment strategy.

Non-financial factors

It should, however, be noted that the law is generally restrictive on the circumstances in which it is permissible for trustees to take account of purely non-financial factors in making any investment decisions and where these are not in the best financial interests of the scheme's beneficiaries.

Non-financial factors may include expressions of moral disapproval, political or ethical motivations, or furthering of external purposes not directly attached to the pension fund and the financial best interests of its beneficiaries.

In order to act on a pure non-financial factor when making an investment decision, a trustee board must be confident that it would be supported by the pension scheme membership as a whole and risks no financial detriment to the scheme.

This is sometimes referred to as the Law Commission two-stage test, which was set out in the Law Commission's 2014 report on the fiduciary duties of investment intermediaries. However, this is an extremely difficult test to meet in both legal and practical terms, so few pension schemes currently take non-financial factors into account in their investment approach.

In practice, the distinction between financial and non-financial factors is often a fine line. Against a backdrop of non-financial considerations, the escalating sanctions regime will likely have financial implications for Russian companies. The key is that trustees must base their investment decisions on what is financially relevant to the pension scheme at the time the investment decision is made.

Trustees must also be mindful that, unless they are Financial Conduct Authority regulated, they are not authorised to make day-to-day decisions on specific investments, so investment decisions will usually need to be kept at a strategic/policy level with implementation delegated to authorised investment managers.

Divestment and exclusion

In general, when considering ESG matters, most pension fund trustees have tended to take the view that engagement with the companies they invest in (via the scheme's investment managers) is the most effective tool for changing corporate behaviour.

However, many trustees have gone further and set an exclusion framework under which the scheme will divest from certain companies entirely where engagement has reached its limits and/or the risk of holding the asset outweighs the benefits.

Where introduced by trustees of UK pension schemes, such policies have typically sought to exclude, for example, companies involved in thermal coal production or tar sands oil extraction as part of a scheme's overall approach to climate risk. Alternatively, or in addition, they might seek divestment from industries on the basis of different forms of material regulatory or political risk, for example companies directly involved in the production or sale of controversial weapons.

In nearly all cases, however, such exclusion policies will be financially-based for the reasons set out above. Trustees considering an exclusion of Russian entities from their investment portfolio in response to the invasion of Ukraine will probably wish to take the same approach on the basis that financial-motivated exclusions are the legally more straightforward route, as long as a financial rationale for the exclusion can reasonably be held.

As noted above, exclusion purely on non-financial grounds is not impossible but the legal bars are set high and this would always need careful legal consideration. Trustees may, however, observe that many issues that start out as non-financial (eg public censure in relation to a particular company) may quickly become financial (eg where this translates into reputational damage or reduced customer demand). So a financial investment case for divestment may often be found to mirror a non-financial issue.

Next steps

Trustees may wish to consider a number of things in response to current events.

First, check that managers/custodians have effective measures in place to comply with sanctions, although we would usually expect this to be the case.

They should also speak with their scheme's investment consultants and managers to understand any direct exposure to broader Russian investments. In many cases, UK pension schemes will have extremely low exposure to Russian entities - most developed market benchmarks will have no direct exposure to Russia and exposure in emerging market indices will often be relatively small. Some active managers may have some (off-benchmark) exposure to Russia, although they may already be making changes or otherwise implementing their own divestment policies in response to recent events. Trustees should start by understanding their scheme's exposure in practice. Trustees may also wish to get a handle on any indirect exposures, although this will likely be more complex to navigate.

Where trustees do have direct Russian exposure within their investment portfolio and their managers are not already proposing action, trustees may be considering introducing their own scheme-based and targeted divestment policy.

From a legal perspective, and as highlighted above, a financially-motivated divestment policy will usually be easier to implement than a non-financially motivated one but, in either case, investment and legal advice will need to be taken.

There may also be practical implications to consider. For instance, any exposures within passive mandates would likely require discussion with the manager to apply an overlay to the index being tracked.

Russia's central bank has also ordered brokers to suspend the execution of all orders by foreign legal entities and persons who want to sell off their Russian investments. This may bring practical challenges to the immediate implementation of any divestment policy.

More broadly, trustees may wish to engage with their investment consultants and managers to see what is being done from an engagement/stewardship perspective.

Even where a scheme does not have direct exposure to Russian entities within its investment portfolio, it may have indirect exposure by virtue of the business activities or subsidiaries of the non-Russian companies it is invested in. Trustees should seek to understand how investment managers are engaging in relation to such issues and consider whether this is aligned with the trustees' policies.

Having considered the above, trustees may wish to make a statement to their scheme members about any actions being taken. Care will be needed to articulate any rationale for investment decisions in a way that does not suggest the trustees have relied on factors which the law does not allow them to take into account.

Stuart O'Brien is a partner at Sackers

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