Written by Partner Penny Nikoloudis and Lawyer Patrick Easton
The Commonwealth Treasury is seeking feedback on how to kickstart social impact investment in Australia. Superannuation has long been seen as a latent capital source for investment in projects delivering benefits to both fund members and the general public. The growing interest of superannuation fund trustees to engage in social impact investing has led Treasury to ask how superannuation capital can be unlocked in an effort to develop the market in Australia.
Treasury's discussion paper on Social Impact Investing, released in January, follows recommendations of the Financial System Inquiry (FSI) to 'facilitate development of the impact investment market' in Australia and for Australian Prudential Regulatory Authority (APRA) to provide 'guidance on the appropriateness of impact investment for superannuation trustees'.
The scale of the superannuation industry at over $2 trillion of assets, larger than Australia's GDP at around $1.7 trillion, illuminates the need for a regulatory overlay to deal with the vast distinction between today's superannuation funds and their humble trust origins. And this phenomenon is emerging globally, with the UK Law Commission expected to hand down a report on pension funds and social investment in May 2017.
The discussion paper identifies several regulatory barriers that have limited the growth of the social impact investment market in Australia. These include:
- the concern that private ancillary funds (being a potentially important investor class for social impact investment products) often do not qualify as 'wholesale clients' under the Corporations Act 2001 (Cth);
- some specific concerns regarding program-related investments (being investments generally made for the primary purpose of accomplishing a charitable purpose rather than for financial gain); and
- the absence of a purpose-built legal structure to accommodate social enterprises in Australia.
Another regulatory barrier that has been identified, and which is the focus of this article, is the concern that superannuation trustees may be constrained from making social impact investments because of their fiduciary duty to make decisions in the best interests of members.
The discussion paper defines social impact investments as investments made with the intention of generating measurable social and/or environmental outcomes in addition to a financial return.
Social impact investing is distinguishable from forms of socially responsible investing which merely apply a set of negative or positive screens to potential investments – for example, excluding investments in tobacco, alcohol and firearms, or including investments with superior sustainability performance relative to peers. Social impact investing is active in targeting investments aimed at solving social or environmental problems, while also delivering financial returns. This may include projects that seek to alleviate poverty, provide access to education, clean water, affordable housing and other resources, and to protect human rights and the environment.
The discussion paper describes social impact investments as falling into three buckets:
- social enterprises, such as The Big Issue and Homeground Real Estate;
- social impact bonds (SIBs), such as the recently announced South Australian Aspire SIBs targeting homelessness and the New South Wales Newpin SIBs (see our Focus: Social Benefit Bonds – Their Role in the Funding Challenge for Social Infrastructure And Services); and
- social impact investment funds, such as the Murray-Darling Basin Balanced Water Fund (Australia's first water investment fund to address environmental, agricultural, social and financial outcomes) and the LeapFrog Fund (targeting fintech for development in emerging economies).
Trustees of superannuation funds have a fiduciary duty to make decisions in the best interests of members under both the general trust law and section 52 of the Superannuation Industry (Supervision) Act 1993 (the SIS Act). Traditionally, this duty has been viewed as synonymous with the duty to maximise financial return to the members.
The SIS Act also requires a trustee to formulate, review regularly and give effect to an investment strategy, having regard to a range of factors including risk, likely return, diversification, liquidity, valuation, tax consequences, costs, as well as 'any other relevant matters'.
Also relevant is the overriding 'sole purpose test' in s62 of the SIS Act which, in essence, requires trustees of superannuation funds to ensure that the fund is maintained solely for the provision of benefits for each member of the fund on or after the member's retirement or attainment of retirement age.
In this context, it is not surprising that trustees have not rushed into social impact investment. This is so even though the SIS Act does not prohibit social impact investing, and the judiciary has generally avoided second guessing a trustee's investment decision unless it is one that 'no reasonable trustee could make on the material which was before it'.1 One reason for the limited engagement is a measure of uncertainty.
This uncertainty arises from the legal risk of trustee decisions being challenged on the basis that, in making a social impact investment, the trustee would be taking into account a factor (that is, the social benefit) that is not specifically mentioned in the SIS Act and that, arguably, is not a 'relevant matter' for the purposes of the SIS Act. Unlike socially responsible investment through positive or negative screening, the factors that lead to social impact investment cannot as readily be characterised as impacting on for example, 'risk' or diversification.
Members providing superannuation trustees with additional factors to take into account by choosing funds and investment options with additional factors built-in does not resolve the problem of uncertainty in restraining social impact investment. Conversely, any additional factors provided by members create a further cause of uncertainty for superannuation trustees in how to satisfy the best interests obligation.
So, where does a trustee go for guidance in pursuing the best interests of their members?
Enter the FSI's recommendation and the Treasury paper's consultation question:
What guidance in particular would provide a desired level of clarity on the fiduciary duty of superannuation trustees on impact investing?
In its Prudential Practice Guide SPG 530 Investment Governance, APRA leaves open the door to social impact investing by stating that a superannuation trustee may take additional factors into account where there is no conflict with the requirements of the SIS Act, including the requirement to act in the best interests of the members. APRA expressly recognises that 'this may result in [a superannuation trustee] offering an "ethical" investment option to beneficiaries…which is typically characterised by an added focus on environmental, sustainability, social and governance (ESG) considerations, or integrates such considerations into the formulation of the investment strategy and supporting analysis.'
APRA goes on to say that it expects a superannuation trustee to have 'a reasoned basis for determining that the investment strategy formulated for such an investment option is in the best interests of beneficiaries, and that it satisfies the requirements of section 52 of the SIS Act for liquidity and diversification'.
APRA's guidance goes some way to providing comfort to superannuation trustees who wish to pursue social impact investment opportunities. However, given the qualifications and caution underpinning the APRA guidance, superannuation trustees can be justified in adopting a conservative approach. Also, there is no express reference in SPG 530 to social impact investment, as opposed to investment options reflecting ESG factors. APRA's guidance could be improved by providing a more positive, clear statement that additional factors, such as ESG and social impact factors, can be considered by a trustee, so long as an investment case showing an expected rate of return commensurate with risk can be established2 and the other requirements of the SIS Act are otherwise satisfied.
This would simply involve clarifying the existing legal position in order to remove any uncertainty that may be preventing superannuation trustees from pursuing social impact investment opportunities.
However, it would not necessarily open the floodgates to social impact investment by superannuation trustees, or address all of the challenges facing this market. In order to mobilise superannuation capital into this sector, what is needed is the availability of investment opportunities with scale market rates of return that are suitable investments for superannuation funds. Treasury's discussion paper acknowledges that there is currently a lack of such investment opportunities and seeks feedback as to how this can be addressed, including through the involvement of different levels of government. Nevertheless, clearer APRA guidance to superannuation trustees would be an important first step.