Two recent cases have added fuel to this fire. Last year the US Securities and Exchange Commission (SEC) mounted an investigation into the level of ESG quality reviewing scoring of many of BNY Mellon’s funds. Finding numerous investments did not have an ESG quality review score, it hit the bank with a $1.5m fine for mis-statements and omissions. This case concluded on 22nd May 2022. Just over a week later, Deutsche Bank subsidiary DWS, had its Frankfurt office raided by the German financial regulator BaFin (a case the SEC helped on). The City of London Police also led a co-ordinated raid on parent Deutsche Bank’s offices in London. The prosecutor said, according to a Morningstar report: “Contrary to the information in the sales prospectuses of DWS funds, ESG criteria were actually only taken into account in a minority of investments, but were not taken into account in a large number of investments ("prospectus fraud")".
Fund reliability
Previously assumed, the trustworthiness of ESG funds, and the regulatory risk to banks and fund managers of omissions and inflations in ESG credentials, are now in question. “Arguably,” said Seb Kirk, co-founder and CEO of GaiaLens, an ESG analytics platform for institutional investors, “consumers can take comfort from the fact the German financial regulator and the US SEC have both launched different raids, linked to allegations of greenwashing, on major asset managers over the last two months”.
GaiLens believes, with the addition of the EU Sustainable Finance Disclosure Regulation, (SFDR) which provides a reporting framework and process for ESG labelling of funds (Article 8, Article 9 etc), scope for being caught out for greenwashing will increase from next year. The EU SFDR will be applied by April 2023, after further scrutiny by the EU Parliament and the EU Council.
According to GaiaLens’ own research, SFDR rules have already been adopted by 10 per cent of the largest Western European asset owners. The SFDR will be used increasingly by financial market participants when disclosing sustainability-related information.
Today’s Delegated Regulation already specifies the exact content, methodology and presentation of the information to be disclosed, improving its quality and comparability. Under these rules, financial market participants will have to provide detailed information about how they tackle and reduce any possible negative impacts that their investments may have on the environment and society in general. The UK’s SDR (Sustainability Disclosure Requirements) is set to mirror the EU SFDR. All will help to assess the sustainability performances of financial products.
Risk management
Banks and investment managers forced to comply with the rules will be scanning for risks. The biggest worry will be over-stating how many of their funds are ESG compliant or ‘ESG integrated’ following both the DWS and BNY Mellon cases.
With SFDR going live next year, there will be a real danger of mis-labelled funds as Article 8 or 9, when some might only be Article 6, GaiaLens pointed out. More than 20% of corporate calls now involve discussion about ESG performance according to asset manager PIMCO.
But lack of ESG reporting standardisation still makes it tough to evaluate ESG performance of funds or companies. GaiaLens’ Seb Kirk believes there needs to be “accelerated and further cooperation and integration of ESG reporting frameworks and SFDR, along with the EU taxonomy”.
The latter, he adds, is gaining rapid adoption now in Western Europe “which can only be a good thing”. “In our view, the DWS case will accelerate adoption of increasingly rigorous ESG reporting frameworks and as the regulators on both sides of the Atlantic start to bare their teeth,” Kirk said.
Armed with new enforceable regulation like SFDR, “we have scope for a major initial crackdown which will further accelerate greater transparency and more robust and comparable ESG performance disclosure,” he added.
Green taxonomy
UK regulators are consulting on a green finance taxonomy this year, with the first of the Screening Criteria (Climate Change Adaptation and Mitigation) to be finalised in October to December. Some have questioned whether it should have been done quicker to prevent mis-selling.
But Andy Pettit, director of policy research at Morningstar argued “speed is not the most important criterion”. He said: “We’ve seen the challenges and complexities the EU has been navigating in developing a taxonomy and it’s important to learn from those.”
He added: “At the same time, UK regulators have to be conscious of minimising confusion for consumers and additional cost and complexity for firms by developing a taxonomy with significant differences without good reason.”
One fund researcher who did not wish to be named suggested some fund managers face extra risks. He said: “We know fund managers that invest in the mid and small cap company space, who admit privately their ESG integration with those companies is much less prevalent”.
Small and mid cap companies lack analyst coverage, so fund managers who invest in them face having to do 300 to 400 company meetings a year to discern what’s going on with them.
When it comes to ensuring ESG practices are being met, or pushing for them to be, this becomes even more difficult. The researcher added: “Do they engage with these companies with respect to the number of female diversity directors? With respect to the CEO to average worker pay ratio? Maybe not.
And those are sorts of things which are getting much more common in large cap investing, but then large cap companies actually have ESG responsible teams to deal with that.”
Darius McDermott, managing director at fund researcher Fund Calibre and Chelsea Financial Services, a financial broker, said investment managers are “definitely feeling the pressure from the wider community but also the investor base to prove ESG credentials”.
He added: “This is not a fad or phase. We are fairly early into it being mainstream. Maybe in five years we won't be talking about ESG because it will be fully integrated into all investment processes.”
Ultimately the regulatory risk of this transition is “that people don't do what they say,” he said, “but this is a very hot subject in the UK asset management industry, if you say you're a carbon neutral fund, or whatever, you have to be able to evidence that and to be able to enter into engagement. You have to have credentials in place”.
Exposure to mis-selling
How exposed banks and investment firms are to ESG fund mis-selling will depend on their book of ESG funds and what they have said about them.
Alan Hughes is head of law firm Foot Anstey’s Retail Financial Services sector. He said as a species of claim, ESG mis-selling would be no different from other potential mis-selling. “However,” he added, “the lack of a clear and robust, market standard framework against which ESG claims/credentials can be measured (in the UK at least) means there is increased potential for uncertainty, and therefore for disputes/legal challenges in this area”.
If everyone was measuring ESG claims against exactly the same criteria there would be less of a grey area than is currently the case. He added: “Compliance teams at any firm selling investments based on ESG credentials should be establishing their own systems, procedures and controls for doing so in a way which does not incur unnecessary mis-selling risk.”
Potentially the Financial Services Compensation Scheme (FSCS) would cover the costs of ESG fund mis-selling claims in the case of a firm default. If that were to happen FSCS fees may have to rise. Hughes pointed out for a claim to be eligible for FSCS compensation, it must be "in connection with" the firm’s regulated activity and there must also be a civil liability on the part of the firm in default (i.e. the FSCS needs to be satisfied that such a liability exists).
He added: “This civil liability can arise, for example, from a breach of regulatory requirements and/or from a breach of other contractual, tortious or other common law duties, that is regardless of FCA rules, if you can establish the firm owed you some kind of legal duty, breached that duty and that breach caused you loss. If then the subject matter is "in connection with" the firm's regulated activities, a claim is possible.”
For example, a claim could be based on "misrepresentation" if claims made in relation to ESG credentials were relied upon and proved to be false or misleading, either deliberately or negligently so. However, Hughes added it is “probably too early to say” if the level and volume of these type of claims is likely to be significant enough to cause a rise in FSCS fees.
As ESG goes mainstream, are the City of London Police, the SFO, and Action Fraud ready to deal with this type of fraud? Hughes said: “The law of fraud is broad and flexible, and will plainly extend to any fraud relating to ESG claims.” It is, he added, probably too early to consider whether changes to the law are required or desirable at this stage. He said: “As with any developing area of fraudulent activity, like for example the increase in online fraud via automated push payments, it is often a case of the relevant authorities developing their playbooks within the framework of existing law, which can take time, depending on available resources.”
