As countries around the world move from voluntary to compulsory ESG disclosure regimes and stricter ESG regulation, thoughts are turning to the legal questions evolving within this fast-developing area of the investment space.
This is happening in the context of rapid developments in environmental policy and higher expectations in terms of companies’ ESG disclosures in the lead-up to this November’s UN climate change conference COP26, as well as increased scrutiny on business practices and portfolio holdings, and the harm these can cause.
Litigation will increasingly become something to be added to investors’ toolkits, but fund groups should also be aware of how it can be used against them.
Fund groups under scrutiny
Square Mile Investment Consulting and Research’s chief operations officer Jock Glover says some asset managers are being cautious in choosing Sustainable Finance Disclosure Regulation categories for their funds amid concerns of getting it wrong and then needing to downgrade or, worse, face litigation.
He says: “When it comes to classifying funds as SFDR Article 9 compliant – in effect having sustainable investment as the fund objective – some groups are taking their time for fear of making an error in haste and ending up subject to legal action for misrepresentation.”
In July this year, fund groups won a second reprieve for the date the regulatory technical standards (RTS) are applied under SFDR. The RTS will now apply from July 2022 instead of January 2022.
Bloomberg Intelligence’s senior government analyst Sarah Jane Mahmud says this may seem like a win for fund groups operating in Europe but, in fact, amounts to greater legal risk for them.
“First, we believe the delay raises legal risk – highlighted by the regulatory probes into DWS’ sustainability disclosures – because managers are operating in a vacuum as to how they should categorise their funds,” she explains. “Second, the delay suggests the new standards will be highly complex and compliance will take more time.”
The case Mahmud refers to is the recent report that DWS Group is being investigated by the US Securities and Exchange Commission (SEC) over greenwashing. It is based on claims by the former head of sustainability at DWS, who alleged in an interview with the Wall Street Journal that the asset manager overstates how the firm uses sustainable investing criteria to manage its investments.
See also: How have fund managers been interpreting the Article 8 label under SFDR?
‘This area is rife for class action’
Lorraine Johnston, partner at Ashurst, explains one way in which litigation could be carried out by pointing to the Financial Conduct Authority’s recent consultation paper, A New Consumer Duty, which puts an obligation on UK financial services firms to consider consumer duty through all products and services, and any harm that may be caused to consumers.
“Towards the end of that consultation paper,” says Johnston, “it allowed an extension of a private right of action to individuals. It would grant individuals a private right of action against regulated firms for breaches by those regulated firms, not just of specific rules but of principles that would include this consumer duty.”
According to Ashurst barrister Anna Varga, this has caught the attention of claims management firms. “There are two principles that do lend themselves well to that type of litigation, which are to do with fair, clear and sufficiently detailed information – that is principle six and seven [of the FCA’s Principles for Businesses handbook],” she says.
“This area is rife for class action and if that private right is turned on, you can see how the same bit of information put out to lots of retail clients gives rise to a possibility of a class action. This may be of some interest to claims management firms that may be seeking out class actions in the climate litigation space.”
Johnston adds all communications about a fund must be thoroughly backed up: “There has to be substance to everything you are doing, disclosing and saying, and that’s about going through your governance and operations frameworks, ensuring this all accords with that classification or with those disclosures you are making. It’s not just about sticking a label on the fund and shipping it off.”
Varga agrees, saying you can expect aspirational statements to be “poked and prodded” by more and more people interested in checking they match what is happening on the ground. She highlights financial institutions are aware of the increasingly litigious sophisticated NGOs bringing cases against corporations and governments. Institutions, therefore, appreciate the risk of aspirational statements coming back to bite them, and this could lead to a raising of standards rather than a diluting of the statements.
When asked by ESG Clarity, the FCA said it would not speculate on the risk of litigation but did offer this for any firms who are concerned the UK’s sustainability disclosure regime may bring with it additional risk of legal action: “We are currently consulting on our proposals and are interested in hearing from a wide range of stakeholders. We would urge asset managers who have concerns to raise them with us as part of these consultation exercises.”
Investors bite back
Although the prospect of litigation is largely viewed as the stuff of nightmares for many corporates, it could be used as an ESG tool by investors. Quilter Cheviot’s director of responsible investment
Gemma Woodward says: “Rather than being seen as a barrier, the global climate movement sees the courts as an essential tool to hold both companies and government to account for their climate record.”
She cites the rising number of climate-related cases going through the courts – 1,000 in the past six years alone: “Considering the risks of climate litigation is an essential component of ESG due diligence. Climate change is a major legal and reputational risk, and while legal challenges used to be the preserve of the oil majors in the US, they are now going mainstream with more and more companies exposed.”
Investors are beginning to use litigation against companies on climate-related grounds.
“For many years it has been really important that fund managers can be trusted by investee companies so there can be open and frank exchanges – as far as legally as possible,” says SRI Services director, founder of Fund EcoMarket and ESG Clarity editorial panellist Julia Dreblow.
“This has meant lots of conversations have gone on behind closed doors and often this has worked well.
“We are now getting to a point where well-informed investors recognise that multiple environmental crises are closing in on us. The need for stronger responses, such as litigation, will increasingly be seen as a legitimate option where company behaviours may trigger significant financial losses to investors.”
Last year, for example, investors filed a class-action claim against the Australian government for not disclosing the material climate risks associated with its government bonds.
Pension asset owners are also not afraid to use litigation as an engagement tool. The Swedish pension fund AP7 lists legal action as one of four engagement methods, alongside actions at general meetings, engagement dialogue and public blacklisting.
In 2019, the fund used the courts to take on the social and governance failings of Alphabet, parent company of Google, suing it for sexual misconduct. The case included an investigation of how the board handled the situation.
More recently, non-profit ClientEarth reported takeaway app JustEat and cruise company Carnival to the FCA in the UK for failing to disclose material risks around climate change to investors. It claimed the companies were not meeting their legal obligations, by saying they were taking action to reduce their carbon footprints but neglecting to include any details of this in their 2020 reporting.
Some of the world’s biggest polluters are also under scrutiny, with oil companies dragged into court. In May this year, Royal Dutch Shell was ordered to cut its global carbon emissions by 45%, compared with 2019 levels, by the end of 2030. The case was brought by Friends of the Earth and more than 17,000 co-plaintiffs.
According to corporate law firm Travers Smith, we are seeing a trend where climate change litigation is now regularly being pushed to new limits. A note written by Heather Gagen, partner in the dispute resolution department, head of risk and operational regulatory Doug Bryden and senior associate in the dispute resolution department James Danaher, explains: “Many recent claims are attempts to push the law to new limits. Claimants are asking courts effectively to create new law to combat the climate crisis.”
We are seeing a rapidly changing market and regulatory environment in sustainable finance and all eyes are on whether the players involved can bring the major transformations needed to avoid the worst of climate, ecological and societal breakdown. Some legal fallout seems inevitable, but perhaps the threat of it itself is useful for those steering a path through the chaos.
