ESG investing may be a growing investment trend, but it’s also a growing litigation risk, a recent report from law firm Seyfarth Shaw claims.
“With increasing and sprawling rulemaking and private plaintiff actions, we see ESG issues touching every aspect of most businesses,” Seyfarth lawyers say in the firm’s annual Commercial Litigation Outlook. “Protecting the organisation will require significant monitoring, proactive engagement, integration of organisational interests and resources, and creative and knowledgeable partners to help navigate these particularly choppy waters.”
The Seyfarth team sees SEC regulation as firms’ greatest risk, followed by Federal Trade Commission advertising cases, anti-ESG legislation in several states, an EPA crackdown on polluters, and shareholder class-action lawsuits, the report states. Part of the problem, the lawyers say, is that ESG investments are expanding before the terms and limits of “ESG” have been laid out.
“As more organisations undertake endeavours to obtain ‘green’ financing, conduct ESG-focused due diligence, obtain ESG based valuations, build sustainable construction projects, and reduce energy consumption through commercial lease incentives, interested parties will look for material misstatements and omissions, and will consider litigation,” the report states.
Hostages to fortune
The Seyfarth report doesn’t focus only on private fund advisers. But it includes them, and other experts have warned the industry that its ESG litigation risks are on the rise.
Seyfarth partner Chris Robertson, who concentrates his practise on financial services firms, is one of several experts who say the Commission’s proposed investment adviser ESG disclosure rule will create significant compliance challenges and risks. But regulators already have rules on the books – especially the new marketing rule – that have created substantial additional risks and headaches for compliance professionals, Robertson says.
Many firms, or their portfolio companies, have signed climate pledges or made claims about thier ESG standards. As regulators, or the industry itself, refines or narrow reporting standards, some of those firms may be asking if they can keep their promises.
“You have an ongoing obligation to make sure whatever disclosures are out there are accurate,” Robertson says. If market conditions require a change in investment philosophy that may run counter to your previous ESG public statements or commitments, “Now you’re in a pickle: You know what you’ve previously said is no longer true. If you correct those prior statements, you’re increasing your risk of a challenge to what you said previously. If you don’t change it, that’s a huge risk that only increases the longer you stay silent.”
Regulators have already brought a handful of “greenwashing” cases. They’ve also issued risk alerts about fund advisers and their ESG policies. Robertson says he expects ESG “to be a big part of the exam cycle” this Spring. “My understanding of the adviser examinations last cycle was it was more about general marketing and advertising, anticipating mandatory implementation of the marketing rule, versus ESG policies, proxies and disclosures,” he says. “I think those three things are going to be a bigger part of the exam cycle this time around.”
That work may already be underway, says Debbie Franzese, who leads Seward & Kissel’s private fund ESG practise. “We have seen questions during routine SEC exams where the SEC has said, ‘are you a signatory to a particular third-party organisation such as Net Zero?’, and then they’ve asked the organisation for documents to support the efforts to comply with the principles of those third parties,” she tells affiliate publication Regulatory Compliance Watch. “It’s not like the SEC is policing a third-party’s reporting requirements, but they may be looking for material misstatements: ‘You’ve publicly signed on to this pledge but you don’t have the documentation to support the reporting requirements?’”
Show your work
Franzese and her colleagues have just written a chapter on ESG compliance for a new securities textbook. She says firms should take three steps. The first is to tailor your firm’s policies and procedures as closely to your firm’s business lines as possible. That means you should start by listening to the investment team. “How do they think about these issues?” she says.
“How do they think about it when they’re looking at initiating a new position versus a position they hold?” Franzese adds. “What kind of information do they use? Do they use an ESG score? How do they use it? Is it a risk management question for them? If it’s a private company, because there really isn’t consistent information, how are they looking at very comparable information? How does the investment team, generally, document their work? Is it an actual deal memo, or is just kind of a free-flowing conversation?”
Once you’ve figured out how your firm thinks about ESG, it’s important to show your work, Franzese says. Get the investment team, and everyone else, involved in explaining methodologies, metrics, everything in plain English, and keeping records of it all.
“You want to make sure you have a good-faith basis for how you feel you comply with each of the objectives,” she says. “For some of those climate pledges, for instance, there may be reporting that’s required. You want to make sure the reporting is done in a way that really reflects the organisation’s practises. If you say, ‘We’re going to be net zero by 2035’, explain how you’re going to get there, and how you’re going to measure it.”
Finally, you’ll want to make sure you and the compliance team stay on top of your firm’s ESG lines – reviewing, and re-reviewing deal memos, prospectuses and the like. When it’s time to disclose, it might be worth over-disclosing, following the rules on retail fund advisers, Franzese says.
“The rules for private funds only address what goes into your ADV,” she says. “But it can be valuable to consider what the SEC says should be in a prospectus for a registered fund. If the SEC has indicated disclosure is material in that context, it’s hard to see how it’s not also material in the private fund offering memo context.”
Seyfarth’s Robertson says, whatever the SEC decides to do with its rule proposals, fund advisers want to give themselves “room to breathe” on their ESG policies. “You want to give yourself the flexibility to report that you’re considering and valuing ESG, but don’t be so specific about what you’re doing that you’re committing to something you may not be able to stay with,” he says. “The SEC itself has acknowledged that ESG is a big, broad term. As the term refines and defines itself, be cognisant and careful about how much you commit to statements about either your investment policy as it relates to ESG or your proxy voting philosophy.”