Sustainable finance regulation
Last week at London International Disputes Week 2022, the dispute resolution community came together to discuss the theme: Global, Sustainable, Ethical? This theme has become increasingly important in recent years and the term ESG (or Environmental, Social and Governance) has become something of a buzzword particularly in the financial services world. In the wake of high-profile events like COP26 and more recently concerns about the West’s reliance on Russian energy sources, “ESG funds” have become an attractive choice for investors who want their investments to have a positive impact. This trend is borne out in PWC’s 2021 Global Investor Survey which revealed that almost 80 per cent of investors considered ESG factors to be important to their investment decision making. Moreover, the professional services giant estimates that ESG funds will outnumber conventional funds by 2025.
As is often the case in the financial services world, growth in one area is usually rapidly followed by increased regulation and scrutiny from investors and shareholders. ESG funds are no exception and now there is another buzzword on everyone’s lips: greenwashing.
What exactly is greenwashing, and why could it be a problem for financial services firms in particular?
Greenwashing was first coined by the environmentalist Jay Westerveld in the 1980s. It referred to organisations that purported to be environmentally conscious for marketing purposes but were not actually making any significant sustainability efforts. In more recent years, financial services firms have been accused of greenwashing with allegations that they have exaggerated or misrepresented the ESG credentials of an investment product.
Part of the problem is that there is no clear market definition of what constitutes a “green” or “ESG-compliant” investment. Nonetheless, regulators such as the FCA and the Competition and Markets Authority are taking the issue of greenwashing seriously and firms must take great care when marketing funds in this way. With an increase in shareholder activism and group litigation, firms do not simply risk damage to their reputation; there are a number of potential litigation risks for firms that get it wrong.
Perhaps the most obvious risk is the possibility of enforcement action by the regulator. In the UK, the FCA has published a letter to the Chairs of authorised fund managers setting out its guiding principles and expectations in relation to the design, delivery and disclosure of ESG and sustainable investment funds. The FCA’s concerns are that ESG fund applications are often insufficiently clear as to their chosen strategy and how this relates to assets selected for the fund. This, the FCA believes, has the potential to erode consumer confidence in the ESG investment fund market. And though the FCA has not yet taken action against a firm for breach of these principles, it faces increasing public and political pressure to act. It was recently asked by the charity ClientEarth to penalise organisations such as JustEat for an alleged failure to comply with ESG disclosure obligations.
The increased regulatory focus on ESG issues may go hand in hand with an increase in claims by individual consumers and shareholders who believe that they have been misled as to the credentials of particular investment products. Complaints to the Financial Ombudsman Service are likely to increase and investors may even bring litigation claims against firms for misrepresentation or misselling products labelled as “ESG”.
Shareholders in a listed financial services firm may also seek to bring claims under the Financial Services and Markets Act 2000. This legislation provides that a person may be entitled to compensation if they can show that they have suffered loss as a result of any untrue or misleading statement in a firm’s listing particulars or prospectus. Financial services firms may also be liable for compensation in respect of misleading information published in other sources such as annual reports and accounts.
So financial services firms may be at an increased risk of shareholders bringing claims in respect of inaccurate or misleading statements published about their ESG credentials. Does this pose a real risk if proving such claims is not straight forward? The shareholder would need to be able to show that they bought, sold or held their shares in reliance on the published misleading information and that a manager within the firm knew or was reckless as to whether the statement was untrue or misleading. To date no claim under these causes of actions has gone all the way to trial. But the issue may not be the defence of the claims themselves but the context in which greenwashing allegations are highly publicised and lead to a subsequent fall in share price. For example, we could see more public scandals such as the allegations made last year against Legal & General Investment Management for greenwashing in relation to a fund investing purely in securities issued by wholly Chinese government-owned entities.
Based on this, firms that want to have a stake in the ESG investment fund market need to think proactively and pre-emptively about the litigation risks of doing so. When choosing to market a product as sustainable, seek early advice not just from regulatory lawyers and marketeers but from specialists with the necessary technical expertise to carry out a sustainability assessment. During the ongoing management of a fund, maintain clear documentary records of decisions that have been made and why such decisions meet the fund’s ESG requirements. Firms should also ensure that they have robust internal ESG policies in place and that both senior management and employees are trained to understand both the fundamentals of ESG and the risk of greenwashing.
If PWC’s market predictions are correct, the message to financial services firms seems to be clear: go green or risk being left behind. However, the firms that do so should be careful to ensure that they can back up their eco-conscious claims. The trend towards ESG-litigation shows no sign of slowing down.
The economic realities of ESG – click here
Embracing ESG transformation – click here
Authorised ESG & Sustainable Investment Funds: improving quality and clarity letter – click here
This publication is a general summary of the law. It should not replace legal advice tailored to your specific circumstances.
© Farrer & Co LLP, May 2022