Besides overstating their sustainability credentials, fund boards run a risk of under-reporting when funds have genuinely strong ESG substance, says Silke Bernard, a Linklaters funds partner.
For European investment funds, the direct responsibility for sustainability disclosures and reporting lies with the ‘Financial Market Participant’, which in most cases will be its alternative investment fund manager (AIFM), management company or portfolio manager. But the ultimate responsibility for the running of a fund business is on the fund’s board of directors, which means directors – including independent ones – have an important role to play.
From the point of view of corporate and financial services law, an investment fund’s board has final responsibility for all its activities, even if technically, the duty to provide information under the EU’s Sustainable Finance Disclosure Regulation (SFDR) falls to the fund’s appointed AIFM or management company (ManCo). Directors cannot wash their hands of responsibility and say it’s not down to them – they need to take their role extremely seriously and could well engage their own liability if they don’t get it right…
Struggling to provide evidence
In reality, it’s clearly more than just a question of monitoring that the ManCo or AIFM is doing its job, according to the book. Against a backdrop of constant regulatory change following the introduction of the SFDR level 2 measures, with many leading asset managers downgrading sustainability-oriented funds from Article 9 to Article 8, and accusations of greenwashing being bandied around, board members have a key role to make sure the right questions are being asked and that they receive satisfactory answers.
We have seen cases where AIFMs or ManCos were putting forward an ambitious ESG positioning, claiming the highest quality of the ESG assessment processes and scoring models they use, but when being asked for evidence, some of them struggled to clearly explain and document the applied model. In most of these cases, the ESG intentions are absolutely there, and they are indeed of highest standards, but sometimes people had to realise that their model and available data don’t precisely match with the regulatory requirements under SFDR.
This may be the time when directors may wish to jump in with critical questions: How can we actually measure what is being stated? How can we prove what the fund is promising? Can we put that in an audit trail? If the auditors or regulators come in to test us, can we satisfy them? Can we demonstrate what is really being done?
I have seen a few clients deciding to eventually scale down the disclosures and promises they planned to make, even though they are extremely convinced about the quality of what they’re doing. Although they take ESG really seriously, they were not always able to provide full evidence of what they were doing and how well they were doing it.
Easy to accuse
These days, there is a high risk of being accused of greenwashing, and businesses are exposed to significant reputational damage even if they have robust ESG processes in place but are simply struggling to provide data and demonstrate that their green promises are being fulfilled.
The problem we have right now is that greenwashing is not clearly defined – it’s very much in the eye of the beholder. For instance, an environmental protection organisation recently claimed that most banks were guilty of greenwashing, according to the organisation’s own standards – but it turned out that these are not the same as applicable legal standards. It’s so easy to accuse a certain company of greenwashing until we have clear and universal standards, which will take some time.
The reputational risk should not be underestimated. Greenwashing claims will very easily make it into the headlines. We’ve seen the accusations against prominent asset managers, which made a lot of noise in the press. Whether or not the accusations are true, once a company has been publicly accused in the press, it is very difficult to get back to the normal running of the business and even more to rebuild a green image in the eyes of investors.
Under-promising is also a risk
There are other things fund boards need to be on guard against – like what is sometimes called ‘green bleaching’. That’s when funds that are actually very active in the green or social field understate their claim to sustainability characteristics simply to avoid having to make the required SFDR disclosures. For instance, we have seen climate change innovation funds that were tempted to categorise themselves under Article 6 just because they don’t want the burden of reporting, relying on the fact that their investors anyway know what they are doing and don’t need additional ESG disclosures. Under-promising can also be misleading in legal terms – just like over-promising.
In the new ESG world, fund boards need to spend quite a bit of time when new products are launched to understand the ESG profile of a new product and to find the right approach with regard to what they are disclosing, no more and no less than what is actually being done. Directors have an oversight duty, and it is in their own interest to closely oversee that the AIFM or ManCo is getting it right. If they fail, they may very well end up being blamed themselves under their ultimate responsibility for failures to adequately disclose ESG characteristics or to make adequate reporting.
Silke Bernard is a Luxembourg investment funds partner at Linklaters LLP Luxembourg.
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