While the popularity of ESG investing shows no signs of slowing down, impending regulatory changes could spell trouble for over half of ESG funds currently in operation, say Counsel Kate Gee and Associate Alasdair Marshall at specialist disputes law firm Signature Litigation.
The UK's Financial Conduct Authority (FCA) has made clear its intention to ‘clean up' the ESG fund sector from misleading funds which brand themselves as ‘ESG-friendly' but, in practice, do not adhere to ESG standards. In doing so, the FCA may open the door for claims from dissatisfied investors.
ESG Funds & the FCA's Proposals
2022 saw UK investment into ESG funds reach a record £91bn, up from £56bn just two years earlier. However, the sector has been plagued by ESG funds which benefit from the popularity, but do not uphold the standards, associated with the ESG label.
The FCA is now demanding that fund managers come good on claims made in relation to sustainability and good governance when communicating with investors. Under the new rules, only ‘true' ESG funds will be allowed to brand themselves as such, so that investors are not deceived by so-called ‘greenwashing', in which misleading, inaccurate or over-stated claims are made (or even implied) in order to boost a business' ESG credentials, without basis.
Under the FCA's proposed reforms, the ‘one size fits all' ESG tag will be replaced by three more specific terms for funds to deploy: ‘sustainable focus', ‘sustainable improver', and ‘sustainable impact'.
• Sustainable focus funds will need to invest at least 70% of capital in companies or government bonds that meet a ‘credible' threshold of environmental and/or social sustainability.
• Sustainable improver funds will have to clearly state in which areas they will and will not invest, and also outline their policies to influence for the better companies in which they own stock.
• Sustainable impact funds will be required to ‘articulate a theory of change', and regularly keep investors informed about their performance in helping to drive such progress.
By reframing a fund's official purpose in this way, the FCA hopes to bring sought after clarity to investors, with many admitting to being both confused and sceptical when surveyed about the current system.
Under the new rules, any fund with investments that run contrary to the fund's stated ESG aims would be automatically excluded. Critics argue the regulations are too strict and could cut out an estimated 60-70% of funds currently active in the sector. Supporters maintain that the FCA is acting entirely in line with both moral and environmental norms: investors will be better shielded from deceptive marketing by fund managers, and funds will be obliged to make good on their ESG promises. In response to criticism of its plans, the FCA described its actions as creating ‘guardrails', comparing its proposed labelling system with those used in the food industry and elsewhere to safely guide consumers.
What does this mean for ESG disputes in the UK?
These regulatory reforms will put funds' public statements and fund managers' investment decisions under a more powerful microscope by regulators and investors alike.
Firms are advised to take note of the heightened risk of legal action, and to scrutinise their own ESG statements and underlying activities. One need only look at the recent filings with the US securities regulator in which Shell was accused of misrepresenting its renewable energy investment claims, thereby purportedly misleading investors.
The complaint saw Shell's name added to a growing list of major firms accused of greenwashing, including Nestlé, Exxon Mobil, and Coca Cola, as activists and investors call on companies not to overstate their ESG credentials and to keep their ESG promises.
The FCA's measures come in the wake of increased ESG and climate change reporting requirements across the globe, as changing public and investor attitudes to global warming leads to mounting pressure on politicians and regulators.
Against this backdrop, companies and their directors are facing increased liability from legal claims brought in relation to climate-related disclosure and breach of fiduciary duty. Such actions may take the form of significant group litigation on behalf of investors who (for example) made investments on the basis of false or misleading eco-statements which, when exposed, create losses for the fund or company.
As rules tighten across the ESG spectrum and the costs associated with meeting increasingly stringent compliance requirements rise, there will be plenty of operators who, having assessed the increased risk, decide to exit the space and establish themselves in a less politically-charged sector. Further, rising insurance premiums linked to potential adverse legal actions by investors, will put off many existing and potential operators in this market.
However, for those who remain active in the space, regulatory scrutiny will increase and become more difficult to avoid. The FCA's new measures are just one of many reforms the sector will undergo as the climate challenge heats up.
In the meantime, companies active in the sector must ensure: (1) their underlying operations align with public statements regarding their ESG credentials, to avoid claims they have misled investors; and (2) comply with the new FCA regulations if they wish to continue benefitting from ESG status.
By counsel Kate Gee and associate Alasdair Marshall at specialist disputes law firm Signature Litigation.
