ESG in the investment process: Mitigating litigation risk
By Adam Brown; Stuart Doxford, Simmons & Simmons
Published: 20 September 2021
In this article we explore the litigation risks arising from incorporating environmental, social and governance (ESG) into investment decisions. We look at this issue through the lens of hedge funds and private credit funds and we use the term ‘investment manager’ with that focus in mind.
In practice, relatively few such firms manage funds that are specifically ESG-focused. However, an increasing number of mainstream funds include some ESG integration and certain key regulatory developments nonetheless apply to many firms, and investors (generally) have increasing expectations on ESG issues. Recently we have seen increased regulatory focus with the UK FCA’s letter to authorised fund managers outlining its expectations on ESG and sustainable investment funds. This may indicate the direction of travel for managers of other alternative investment fund structures.
The relevant regulations and investor expectations cover several facets of how managers operate in practice, including:
- Whether the manager is required to take account of ESG issues when making investment decisions
- If so, how to go about addressing ESG issues within the investment process
It is important for investment managers to understand the risks to which they expose themselves when making these decisions. In this article we therefore examine those issues from a litigation risk perspective.
Is the manager required to take account of ESG issues when making investment decisions?
The starting point is whether an investment manager is required to take account of ESG. We view this issue in terms of potential regulatory requirements, contractual requirements, then in terms of broader fiduciary or tortious duties.
Starting with the regulatory position, for most hedge fund managers and private credit funds, the Article 4 requirement in the EU’s Sustainable Finance Disclosure Regulation (SFDR) to publish a statement concerning adverse impacts of investments decisions on sustainability factor may not apply. This is because the SFDR allows smaller firms to explain why they do not consider adverse impacts of its investment decisions on sustainability factors. However, under Article 3 of SFDR there may be a requirement to disclose polices on the integration of sustainability risks in investment decision making processes. There is scope for debate about whether the FCA might seek, in future, to impose directly applicable regulations that require the incorporation of ESG factors on the managers of hedge funds or private credit funds. The guiding principles that now apply to authorised fund managers (see briefing here) indicate the direction of travel for now.
As for the contractual position, it is critical for investment managers to look carefully at what has been agreed regarding ESG in offering documents, the investment management agreement, or any other document setting out the scope of investment mandate. Managers should be aware that an agreement to take account of ESG can be incorporated via cross-reference, for example by agreeing to adhere to an investor’s own stated investment principles (a common requirement of many institutional investors). If any of these sources contain a commitment to assess the likely adverse impacts of investment decisions on sustainability factors, that must then be borne out in reality. Failing to do so exposes the manager to litigation risk. This bears out a deceptively simple point: investment managers need to make sure that what they do in practice matches what they have promised to do.
Of course, there are shades of risk that can arise from the contractual position. For example, the manager should only make commitments that are within its control. Accordingly, it is safer to focus ESG commitments on process rather than outcome. A common example is that many investors are seeking to align their portfolios with the UN Sustainable Development Goals (SDGs), addressing economic, social and environmental developments. However, investment managers should be careful not to overcommit to macroeconomic targets (in the SDGs or otherwise) that are outside of their control.
As to broader fiduciary or tortious duties, there has been a discernible shift in how these duties might be interpreted. In the 1980s, the English Courts held that the “best interests” of investors were (exclusively) their best financial interests, without reference to moral considerations, and that investment managers must not fetter their discretion by reference to ‘extraneous’ factors. That can be contrasted with the widespread recognition (now) that ESG factors are considered financially material. We see this in a number of ways:
- The United Nations Environment Programme Finance Initiative concludes that investment approaches which consider ESG factors are permissible and may even be required.
- SFDR refers to ‘sustainability risk’ as an ESG event or condition that, if it occurs, could cause an actual or a potential material negative impact on the value of the investment.
- Various regulations (e.g., relating to pensions) define “financially material considerations” as including ESG factors.
The debate is therefore shifting to whether ESG due diligence forms part of essential investment risk management. An investor’s argument might be that investment managers should incorporate sustainability factors into their investment decisions to discharge their fiduciary duties. Whilst that position is so far untested, it is not as extreme a position as it might at first appear. Managers should bear in mind the following:
- The longer the investor’s time horizon, the stronger the argument that ESG is a risk management issue
- Portfolio companies can face huge damages claims from adverse ESG events, harming the value of the company. We are seeing an increase in ‘mass tort’ litigation, in which a group of claimants allege a duty of care against a major corporate. Such litigation against parent companies based on overseas human rights and environmental impacts has passed threshold admissibility challenges in the English, Canadian and Dutch courts.
- It is entirely possible that in future a company’s success (and share price) will increasingly depend on avoiding adverse ESG events.
The issue of whether an investment manager breached its duty of skill and care is always going to be highly fact sensitive. However, a core reference point is likely to be the extent of regulatory compliance. That is because regulation affects the interpretation of the scope of an investment manager’s private law duties, and it is harder for a manager to argue that it acted with reasonable skill and care if it falls short of regulatory requirements. Adherence to regulations is therefore an important step in managing litigation risk.
Looking to the future, if regulations relating to ESG in the alternative investment industry extend in scope, that will tend to signal an increase in litigation risks. We saw an indication of this direction of travel in July with the FCA publication of a letter that, although addressed to the chairs of managers of UK authorised funds, provides scope for read across into the alternatives space. When it comes to ESG, there is an element of race to the top, that will drag up the expectations on others.
Addressing ESG issues in the investment process
In our experience, a range of approaches have been taken by investment managers to incorporating ESG factors into investment decision making. These include:
- Proprietary scoring systems in determining ESG-level risks
- Focusing on ESG risk with similar scrutiny to other credit risks
- Developing frameworks to identify the ESG issues that are most relevant to a sector’s financial performance and performing due diligence on them
A particular challenge is of incomplete and inconsistent ESG data, since ESG disclosures by companies vary greatly, with not all companies tracking ESG key performance indicators and – even for those that do – considerable variation in the standards for tracking ESG impact.
This is where a systematic approach, backed up by good record keeping, can act to mitigate the litigation risk for the investment manager. If an aggrieved investor seeks to allege a breach of the manager’s tortious duty to exercise due skill, care and diligence, then the framework of policies, systems and records for investment decisions will provide a crucial line of defence.
Of course, another important defence is to give accurate disclosure that describes the role played by ESG due diligence in the investment process – this is doubtless a key part of litigation risk mitigation. In this regard, the SEC recently opened a major investigation into ESG processes, and related disclosures, at DWS Group, following whistleblower allegations by its former head of sustainability. This shows that enforcement activity is more immediate risk than some may appreciate.
For those that are in the early stages of the journey to incorporating ESG into the investment process, it is worth exploring the available materials and due diligence frameworks such as the UN Principles for Responsible Investments. This is likely to trigger thought processes that in turn lead to litigation risk mitigation.
This is undoubtedly a complex and fast-evolving area. For all the reasons explored above, it deserves careful treatment as an important risk management issue.