Navigating the ESG landscape: Practical insights for investment fund managers
ESG investment funds represent a growing business opportunity for investment fund managers, with concurrent regulatory and litigation risks. This article provides investment fund managers with practical guidance to understand and mitigate such risks.
Regulatory scrutiny is increasing: three settlements and counting
The starting point for any regulatory or litigation risk against an investment fund manager will be its ESG investment fund’s prospectus, other disclosure required by securities law, and sales communications, including website disclosures.
In Canada, the adequacy and accuracy of disclosure concerning ESG investment funds has come under increasing regulatory scrutiny. In April 2023, staff of the Ontario Securities Commission (“OSC”), which regulates most investment funds in Canada, cautioned funds that consider ESG to a limited extent that a fund’s prospectus and sales communications should “accurately reflect the extent to which a fund is focused on ESG.” The OSC staff’s warning followed last year’s guidance from the Canadian Securities Administrators (“CSA”) on ESG-related fund disclosures that focused on funds whose investment objectives reference ESG factors and funds that use ESG strategies. Our firm’s prior article on the CSA guidance is here.
There are already three notable global settlements concerning ESG investment funds that provide important lessons for Canadian investment fund managers trying to reduce regulatory risks.
In one settlement in 2022 against an investment fund manager (BNYMIA), the US Securities and Exchange Commission (“SEC”) determined that the manager’s representations about conducting an ESG “quality review” as part of its investment selection process for the relevant fund was not always accurate as of the time of the investment. The fund’s prospectus stated the following about ESG’s role in the investment process:
“Integrated into the investment process, [the Sub-Adviser] has a well-established approach to responsible investment. This process includes identifying and considering the Environmental, Social and Governance (ESG) risks, opportunities and issues throughout the research process via [the Sub-Adviser’s] proprietary quality reviews, in an effort to ensure that any material ESG issues are considered.”
The SEC found, despite there being no such express representation, that a “reasonable investor” reading the foregoing “could mistakenly conclude that all portfolio holdings selected by the manager’s sub-adviser were subject to an ESG quality review.” In reality, the sub-adviser could (and did) select portfolio investments that were not subject to an ESG “quality review”.
In another 2022 settlement with a different manager (GSAM), the SEC found that despite the manager representing that it would use a “proprietary ESG questionnaire” and a “materiality matrix” as part of its ESG investment process for the relevant ESG fund, it had “relied on previously conducted ESG research” and completed the ESG questionnaires after making investment decisions.
In 2023, a settlement was reached between a German consumer watchdog and another manger (DWS) concerning allegations that the manager had misled investors about the extent to which ESG factors were considered when making investment decisions. Other investigations were continuing. The allegations against DWS became public after a whistleblower complaint, which led to German law enforcement officials raiding DWS’s offices in mid-2022 and to the resignation of its CEO thereafter. Eventually, DWS reduced by 75 percent the amount of assets it claimed to be ESG, eliminated its ESG framework, and improved its ESG disclosures.
Practical considerations to mitigate disclosure-related risks
An investment fund manager must appreciate that a fund’s disclosure may be “read purposively” as “consumer protection documents” that are “not intended to be parsed by investors”.
As a starting point, the ESG investment fund’s name and disclosure should not overemphasize the impact that ESG factors may have on the investment process. If, for instance, ESG factors will play a limited role in that fund’s investment process, may not trump other investment selection factors or may not always be considered, then potential investors should not be given a different impression. As the SEC’s settlement with BNYMIA demonstrates, regulators are willing to act on implied representations.
On the other hand, an investment fund manager should take great care when describing ESG factors that are core to a fund’s investment process. Relevant considerations include the following: Are the ESG factors described in the prospectus exhaustive? If not, have all material factors been described? How are ESG factors weighed compared to traditional investment factors? How are different ESG factors themselves weighted? How are conflicts between ESG factors resolved when considering a particular investment or industry (for instance, “poor” diversity or social impacts vs. “good” environmental impact)? How does an investment fund manager screen investments when a company’s ESG disclosure is lacking, based on estimates or third party information or ESG disclosures in companies in the same industry are not comparable?
More granularly, for each ESG factor that is part of the investment process, what criteria or metric is used to assess that factor? And, is the criteria or metric always used before an investment decision is made? In its settlement with GSAM, the SEC noted that while the manager had conducted ESG research, it “was not uniformly applied across issuers”, the “research differed from the policies and procedures”, and sometimes “it used a different scoring system” that relied on third party data with proprietary weighting applied, despite representing that a proprietary methodology would be applied.
There is no regulator-endorsed or universally accepted rating for ESG factors across investment funds in Canada. The ESG ratings of private third parties could be used by investment fund managers but the underlying methodology may not be independently verifiable, the results may not be reliable, and the results may differ depending on the third party being used. An investment fund manager that uses private ratings should perform due diligence on rating criteria and methodology and consider whether such usage and its limitations should be disclosed. Similarly, an investment fund manager that uses a proprietary rating methodology should consider whether such usage and its limitations should be disclosed.
An investment fund manager should also consider whether its ESG investment fund’s disclosure should, out of caution, reserve the manager’s right to make select investment decisions without applying one or more ESG factors. If so, the manager should consider how its exercise of discretion will be described, and whether it should periodically disclose and explain any significant exceptions.
The investment fund manager should consider how to describe the impact its consideration of ESG factors may have on the fund’s expected performance and risk. Like any investment fund, an ESG investment fund will be exposed to macro-economic and portfolio-specific risks. However, an ESG investment fund may also be exposed to risks in its ability to construct a portfolio that meets its specified objectives due to circumstances outside its control (e.g., accuracy and, reliability of, and lack of comparable ESG disclosures of companies, ratings provided by third parties, etc.).
The lessons above apply to sales documents as well. The SEC’s settlements with BNYMIA and GSAM compared the representations made in sales communications (RFP responses and pitch books) with the processes that were actually followed.
Practical considerations to mitigate operational/compliance risks
Investment fund managers should adopt reasonably detailed policies, procedures and controls to ensure that (a) its relevant funds’ disclosure is accurate and complete, (b) any representations made about how ESG will factor into the investment selection process are followed through on, (c) periodic testing occurs of how and when ESG factors are applied to investment decisions, (d) relevant employees and agents are trained on the policies and procedures, and (e) contemporaneous records are maintained to document the foregoing.
The investment fund manager should also adopt policies to ensure that its personnel is continuously up to date on ESG regulatory developments affecting funds. Regulators in the UK and EU, for example, are rapidly developing labelling and disclosure requirements for ESG and sustainable funds.
For instance, in the SEC settlements with BNYMIA and GSAM noted above, the SEC found that the managers had failed to adopt and implement policies and procedures reasonably designed to prevent inaccurate or materially incomplete statements in the relevant funds’ prospectuses about how investments would be selected for the relevant ESG fund. In the GSAM settlement, the SEC noted that after adopting the policies, the manager “failed to consistently follow them”.
An investment fund manager should also consider whether its ESG review of investments in an ESG investment fund should be periodically refreshed. In the SEC’s settlement with GSAM, the SEC found that the manager did not update its questionnaires annually to monitor its holdings in the relevant ESG fund, contrary to its policy and procedures.
Even when appropriate policies and procedures exist, the investment fund manager should ensure that its employees and those of any relevant sub-advisors involved in the investment selection process are appropriately trained on their obligations. In its settlement with GSAM, the SEC found:
“During the Relevant Period, GSAM FE did not provide its staff with sufficient guidance concerning the applicability and scope of the 2018 policies and procedures that covered the ESG investment process. GSAM FE staff’s understanding of its obligations to complete questionnaires was inconsistent with the 2018 policies and procedures and marketing materials disseminated to third parties. For example, some GSAM FE staff believed completion of the questionnaire optional; others believed that they could be completed sometime after the position had been added to the portfolio.”
The settlements noted above do not indicate regulatory interest in assessing the robustness of the ESG review process undertaken as part of the investment process. Investment fund managers can pursue investment goals, including those of ESG investment funds, using different processes. This makes it exceedingly difficult to objectively evaluate the merits of any given investment selection process. Nevertheless, in our view, it is possible that a securities regulator may assess an investment fund manager’s ESG review process in circumstances where that process is so lacking as to clearly undermine its value. In rare cases, a process may be so lacking as to expose the manager to misrepresentation allegations.
No class actions yet. Yet.
While ESG-related class actions remain uncharted waters in Canada, there are recent examples in other jurisdictions in which fund managers have faced civil actions for misleading or unsubstantiated statements about the potential impacts of their ESG funds.
In Canada, investment fund managers are increasingly being sued by investors in class actions compared to a decade ago. In the last few years, investment fund managers have been sued for alleged improper payments of trailing commissions, engaging in closet indexing, and negligent design of an investment product, among other theories. Recently, class actions against investment fund managers have proceeded to trial on two occasions. In both matters, the courts considered allegations such as breaches of fiduciary, trust and other duties owed to investors (see our articles on both lawsuits here and here).
We expect class counsel to remain active against investment fund managers and apply existing theories to ESG fact patterns. Allegations in such lawsuits could include:
- Materially misleading disclosure
- Charging disproportionate fees compared to non-ESG funds with similar (or better) risk/return profiles
- Failure to disclose the risks and costs associated with ESG investments
- Failing to supervise and monitor the implementation of the stated ESG strategies
- Failing to achieve ESG metrics such as carbon reduction which are part of the stated ESG Strategies
Allegations that an ESG fund is not “green enough” – i.e., its ESG review process is lacking—have so far not met with success and may be difficult to prove. In Turpin, the class alleged that the investment fund manager was not sufficiently active managing its Canadian equity fund. The case failed because, among other reasons, the class was unable to use metrics to second-guess the portfolio manager’s bona fide decisions that were informed by adequate research and contemporaneously documented.
Another challenge for plaintiffs in lawsuits against managers of ESG investment funds will be proving causation and damages. Even assuming that an ESG fund’s prospectus misstates its investment objectives or investment strategies, it does not necessarily follow that the fund’s performance would have been materially higher ‘but for’ the misrepresentation. To get around this, class counsel may fashion theories grounded in trust law and equity that seek to disgorge management fees from the managers of ESG investment funds, especially because such funds can cost as much as 40% more than a traditional actively managed equity fund.
In addition to the practical considerations noted above, a manager should have general knowledge about its peers practices, as the court held in Fischer. In relation to ESG investment funds, this may mean having an awareness of the disclosure practices of other managers’ ESG funds, the ESG factors that those funds consider, and the fees that those funds charge.
 In this article, we use the term “ESG investment funds” to describe investment funds, including private and public investment funds such as mutual funds and ETFs, that expressly consider environmental, social and/or governance factors as part of their asset allocation and investment selection process. This is necessarily simplistic as we do not distinguish between ESG investment funds that have varying intensity of ESG investment objectives and strategies.
 CSA Staff Notice 81-334 – ESG-Related Investment Fund Disclosure (“CSA Staff Notice 81-334”), https://www.osc.ca/sites/default/files/2022-01/csa_20220119_81-334_esg-related-investement-fund-disclosure.pdf
Fischer v. IG Investment, 2023 ONSC 915 at para. 154.
 Baden-Württemberg Consumer Centre v Dekabank, Regional Court of Frankfurt, see “German fund company sued for “greenwashing” (February 23 2021); Verbraucherzentrale Baden-Württemberg e.V. v. Commerz Real Fund Management S.à.r.l.
Turpin v TD Asset Management Inc., 2022 BCSC 1083.
Fischer v. IG Investment, 2023 ONSC 915.