First published by RPC in February 2022.
Whilst banks and other financial institutions have responded positively to the increased demand for such funds, forays into greener, more socially conscious landscapes will not come without associated litigation risk.
The increased prevalence of ESG funds and other investment products will come with greater scrutiny of the processes involved in selecting and marketing those products. By its very definition, ESG can encompass a smorgasbord of values, practices and subject areas; this ranges from reducing harmful environmental practices and identifying supply chains connected with modern slavery issues, to implementing anti-bribery and anti-corruption policies. Consequently, creating a uniform framework for assessing levels of ESG-compliance can be challenging given the disparate and broad-ranging legal and policy guidance in existence.
Various ratings agencies such as the Dow Jones Sustainability Index, MSCI ESG Research, Sustainalytics and Thomson Reuters ESG Research Data (amongst others) provide scoring systems based on ESG performance. Whilst in theory these are useful mechanisms for making informed assessments about companies’ ESG practices, scoring systems can use inconsistent methodologies and assessment criteria and so consistency and transparency problems persist. In June 2021, the Sustainable Finance Taskforce of the Board of the International Organisation of Securities Commissions published a “Report on Sustainability-related Issuer Disclosures”, calling for the implementation of “a global corporate sustainability reporting architecture”. The report also referenced IOSCO’s report on “Sustainable Finance and the Role of Securities Regulators and IOSCO”, which had highlighted “(i) multiple and diverse sustainability frameworks and standards, including on sustainability-related disclosure; (ii) a lack of common definitions of sustainable activities; and (iii) greenwashing and other challenges to investor protection"(1).
In July 2021, Alan Miller, the chief investment officer of SCM Direct published a blog post on the SCM Direct website entitled "Does ESG stand for Extra Strong Greenwashing, Legal & General?"(2). In it, he accused Legal & General Investment Management's ESG China CNY Bond Ucits ETF as being "the most flagrant example of greenwashing in the UK". Citing the Ten Principles of the UN Global Compact initiative relating to the alignment of businesses with behaviours and practices promoting human rights, fairer labour standards, preservation of the environment and anti-corruption, Miller argued that the ETF fell woefully short of ESG-compliance given its connection with the Chinese government and associated breaches of the Ten Principles that occur within the country. Additionally, Miller noted that the ETF holds the same bonds as non-ESG funds, but through a practice of 'tilting' "applies JESG issuer scores to adjust the market value of index constituents from the baseline J.P. Morgan China Aggregate Index". The area is ripe for controversy.
Rise of ESG litigation in recent history
Litigation in ESG-related areas has increased in recent years. Strategic litigation in an environmental context has seen a sharp rise; the “UN Global Climate Litigation Report: 2020 Status Review”(3) notes that as of 1 July 2020, at least 1,550 climate change cases were filed in 38 countries In fact, various environmental charities exist for the sole purpose of bringing environmental challenges, such as UK-based organisation ClientEarth, which currently has “168 active cases tackling the most pressing environmental challenges"(4).
The recent case of the Netherlands branch of Friends of the Earth, acting alongside various other NGOs and individual claimants against Shell is a key example of one of the group litigation claims that have sprung up in an ESG context. This case resulted in a judgment requiring Shell to cut carbon emissions by 40% within ten years(5). Clearly companies are now facing greater scrutiny for longstanding and thus unchallenged practices and Court users are finding innovative ways to hold companies to account.
Shareholder activism has also seen a rise in recent years; corporate shareholders have shown increasing interest in scrutinising the extent to which companies have considered ESG factors in their decision-making.
By way of international example, in November 2021, the Federal Court of Australia granted Guy and Kim Abrahams (as trustees for the Abrahams Family Trust) access to documents relating to the Commonwealth Bank of Australia's decision to pursue various projects including an oil pipeline in the USA and a gas project in Queensland(6). Disclosure of these documents was requested under the Australian Corporations Act, on the grounds that the decision to pursue them failed to take into account the bank's Environmental and Social Framework, Environmental and Social Policy and the Paris Agreement. The Environmental and Social policy and framework had been implemented as a result of a previous challenge by Abrahams against the bank in 2017; Abrahams had alleged that the bank had failed in its 2016 annual report to disclose climate-related business risks.
Whilst there has, as yet, been no ESG claim against a financial institution in UK, the trend worldwide is for this to increase, especially given the fact that in the UK, climate reporting is now a requirement for premium listed companies in their annual reports for the period of January 2021 onwards, and it is now mandatory for large businesses to disclose their climate-related risks and opportunities, in line with the Taskforce on climate-related Financial Disclosures recommendations.
In this context, banks and financial institutions face increasing demands to alter their practices. The pressure group Market Forces, for example, encourages investors to invest strategically in order to persuade banks and pension funds abandon fossil fuel investments altogether.
Nature of potential claims
Investors who choose to place their money in ESG funds will be particularly sensitive to any information coming to light that indicates companies selected for ESG funds have not lived up to expectations, or have been selected on the basis of flimsy criteria. On 19 July 2021 the FCA published a letter from Nick Miller, Head of the Department for Asset Management Supervision, to chairs of authorised fund managers, setting out expectations on the design, delivery and disclosure of ESG and sustainable investment funds. With increasing consumer demand and the pronounced increase in funds seeking to accommodate investor preferences, it was noted that "we are concerned by the number of poor-quality fund applications we have seen and the impact this may have on consumers". By way of example a key consideration was that "fund names are subject to restrictions and they must not be misleading. Where a fund uses 'ESG', 'green', 'sustainable', 'responsible', 'ethical', 'impact' or related terms in its name, this could be misleading unless the fund pursues ESG/sustainability characteristics, themes or outcomes in a way that is substantive and material to the fund's objectives, investment policy and strategy’"(7). The FCA are evidently concerned with greenwashing issues and the danger of marketing products that do not live up to their ESG promises; this may prove to be ripe ground for future litigation claims of misrepresentation and mis-selling.
Another potential area for ESG-related litigation may arise in the context of investors who have purchased securities relying on statements made by issuers that turn out to be false or misleading. Such shareholders could have claims under section 90 and 90A of FSMA; these sections offer compensation for false or misleading statements in relation to listing particulars, prospectuses and published information. A particular instance in which loss could arise is if misleading statements relating to ESG-compliance are in fact false and the market value of securities falls as a result. Such claims may prove ripe ground for group litigation and/or representative actions under CPR 19.6. Additionally, given that environmental issues generally affect a great number of individuals, group litigation in an environmental context (such as the aforementioned case against Shell) may become increasingly prevalent. This trend may in turn be a key area of opportunity for litigation funders.
Conversely, fixation on sustainability at the cost of financial performance could also be a catalyst for disputes. Terry Smith, founder of Fundsmith, in an annual letter to investors noted that "Unilever seems to be labouring under the weight of a management which is obsessed with publicly displaying sustainability credentials at the expense of focusing on the fundamentals of the business…a company which feels it has to define the purpose of Hellmann's mayonnaise has in our view clearly lost the plot". Whilst Smith kept his Unilever shares because he believed that the company's "strong brands and distribution will triumph in the end", his comments indicate a concern about the financial cost of pursuing ESG compliance over business success.
Undoubtedly the scene is set for further contentious action. A recent survey of corporates found that reputational damage was perceived as the biggest ESG-related risk but that litigation risk was also on their radar.
The original perspective can be found here.