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Article | FI Observer

Misrepresentations in the Age of Sustainable Investing

Risk & Insurance Considerations for Asset Managers

Financial, Executive and Professional Risks (FINEX)
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By Anthony Rapa | January 23, 2020

After nearly a decade of tight margins, industry consolidation, and a race to the bottom on fees, sustainable investment presents asset managers with a genuine opportunity for organic growth.

To keep pace with demand and differentiate themselves in an increasingly-crowded marketplace, firms are racing to launch new and progressively more complex fund and wealth management offerings which take environmental, social, and governmental (ESG) factors into account. While these new offerings are key to success in the era of sustainable investing, care must be taken to identify and manage the downside risks.

One such risk is that of misrepresentation – essentially, that an asset manager’s ESG offering may not be as clean, green, or sustainable as advertised.

In this article, we will discuss the basis for misrepresentation allegations, identify key sources of risk, and examine potential policy wording and coverage issues which may exist under present Directors & Officers (D&O) and Errors & Omissions (E&O) corporate insurance programs.

Sources of Misrepresentation-Based Risk

In many ways, the sources of misrepresentation risk for ESG investing are no different than those of more traditional investment strategies.  In this respect, a gender diversity-focused fund which invests in a company with an all-male board faces the same misrepresentation risk as a small cap exchange—traded fund (“ETF”) that invests in a Fortune 100 company.

Yet it might also be said that the risk of misrepresentation in the context of ESG investing is more acute simply because mistakes in this area are presently so easy to make. Take for example an ESG mutual fund which, although purporting to exclude fossil fuels, invests in oil services providers. Such an alleged misrepresentation, which could be characterized as a sort of “greenwashing” the environmental or climate credentials of an investment offering, may occur because of some error or omission by a fund, sponsor, or investment adviser. It may also be caused, notwithstanding efforts to the contrary, by the present lack of reliable, uniform ESG data available1 to investors and their advisers. Or an error may occur due to simple misunderstanding due to the growing list of non-standardized terms such as “sustainable investment,” “responsible investment,” and “ethical investment” which permeate the industry and creates the potential for confusion between investors and their advisers.

Regardless of the cause, the rapid growth of ESG investing likely means asset managers will have to contend with allegations of misrepresentation for the foreseeable future. Whether or not such allegations are well-founded, the resulting customer complaints, litigation, and regulatory scrutiny will create significant monetary and reputational costs that must be properly managed in order to capitalize on ESG’s opportunities. Sources of ESG-based claims might include:

  1. 01

    Breach of professional obligations

    • Launching, Rebranding, and Administering Registered ESG Funds

    Not surprisingly, mutual funds serve as one of the prime vehicles for those seeking ESG-focused investment options. As demand for ESG investments grows2, firms will continue to sponsor and launch new and ever-more diversified and specialized mutual funds to keep up with demand. In addition, some firms have sought to breathe new life into underperforming funds by rebranding them with an ESG strategy3. The growth, development, and administration of these funds will be key to the success of asset managers offering ESG-focused options to customers.

    As stated above, this risk is not unique to ESG funds. Like all mutual funds, registered ESG funds must set forth investment objectives and strategy in that fund’s prospectus. In the United States, failure to invest in firms that meet the criteria set forth in the prospectus may expose funds, board members, trustees, sponsors, and advisers to liability under federal securities laws. Allegations of breach of fiduciary duty may also arise under state law. And of course, this risk continues throughout the life of a fund, as asset managers and advisers work to ensure that a fund’s investments remain consistent with its announced purpose.

    The unique risk presented by ESG funds is that of sudden and, in many ways, unchecked growth. Anxious to capitalize on the opportunity that sustainable investing has presented them, there is a risk that asset managers and consumers may simply fail to understand what type of investment a fund is expected to make and, just as significantly, how to gauge success. As the number of ESG-focused public funds continues to grow, so too will the risk that the sustainable or ethical investment strategy announced in a fund’s offering documents or prospectus will fail to materialize. Naturally, this may lead to claims of misrepresentation.

    • Private Funds

    Demand for ESG options in the world of private funds is growing steadily. And, like their publicly traded and available cousins, private funds (private equity, hedge funds) cannot escape the possibility that customers and investors will allege ESG-related misrepresentations.

    At the outset, a firm looking to raise capital for a sustainable investment fund runs the risk of misrepresenting its activities in the initial private placement memorandum and other offering documents. Misrepresentations may also occur during the process of acquiring or investing in portfolio companies. As with public funds, the ESG quality of a fund’s investments will be subject to increased scrutiny and potential liability. For example, were it revealed that a private fund purporting to invest solely in venture companies run by women or minorities breached its mandate, investors might file suit for breach of contract or breach of fiduciary duty. In much the same way, the continued operation of portfolio companies using an ESG strategy is another source for potential disputes. Finally, upon exiting from a portfolio company via a public offering or other mechanism, representations made concerning the sustainability of a company’s operations or governance could give rise to claims by regulators, investors and, if a public offering, the general public via securities laws.

    • Advisory Fees

    Section 36 (b) of the 1940 Investment Company Act4 vests fund advisers with a fiduciary duty with respect to fees received for their services. As ESG fund offerings and advisory relationships continue to grow and evolve, we may see a new wave of ESG-based advisory fee lawsuits in the years to come.

    For instance, the continued growth of and reliance upon ESG-specific sub-adviser arrangements may lead to fee litigation. To keep up with investor demand and capitalize on the opportunity, asset managers have been pouring resources into their sustainable investing operations. Given the speed of change some firms choose to make use of sub-advisers to provide services and advisory services which a firm is simply not-yet capable of providing. Alternatively, a firm with substantial in-house ESG capabilities may find new sources of revenue acting as a sub-adviser for less experienced firms. Either way, the fees paid to or through advisers for work performed in connection with ESG funds may be called into question by investors. In such instances, investors may call into question why an adviser received a larger percentage of a fee than the sub-adviser with ESG-experience.

    In addition to who receives advisory fees, the size of those fees may also be called into question. Due to the present lack of data standardization, ensuring that a stock, bond, or other investment is in accordance with an ESG fund’s investment objectives may require more diligence and research on the part of the adviser. In compensation for performing more work, investment advisers might understandably seek to charge a higher fee. At the same time, the investment objectives of many ESG offerings are focused on societal and environmental benefit, as opposed to pure short-term return on investment. Particularly when viewed through the lens of the Investment Company Act’s fiduciary standard, investors may argue that a higher advisory fee for a lower financial return is, under certain circumstances, a breach of the adviser’s fiduciary duties.

    • Breach of Contract/Breach of Fiduciary Duty

    As ESG offerings evolve rapidly, advisers must carefully and clearly identify investment objectives.   Especially in the world of ESG, where investor confusion over terms like carbon neutral versus net zero can create a mismatch between investor intent and an asset manager’s actions, the potential for misrepresentation-based claims are high.  Under the Investment Advisers Act of 1940, advisers owe customers a fiduciary duty with respect to their strategies and client relationships. Where the scope of an adviser’s client agreement is tailored to address the role ESG investing plays in a given portfolio (along with specific metrics and data used to quantify compliance) it is easy to see how allegations of breach of contract and fiduciary duty might arise. This failure to appreciate or fully understand a client’s particular investment objectives may in and of itself create enough ambiguity to spawn costly and time-consuming litigation when investments fail to perform as expected.

  2. 02

    Breach of obligations to shareholders and stakeholders

    ESG misrepresentations can present a risk to an asset manager that is derivative of the firm’s larger operations – that is, the failure of ESG offerings to perform leading to customer complaints and regulatory scrutiny which has an effect on the company’s bottom line and, ultimately, stock price. In this instance, the failure of ESG offerings in a professional sense will creep into the boardroom, leading to claims against directors and officers due to the company’s financial underperformance.

    There is also a risk that an asset management firm’s own operation may itself be viewed as an ESG-based misrepresentation, leading to claims by shareholders or other stakeholders. Shareholders and society in general are continuing to pressure boards to create and implement ESG-friendly internal policies and to conduct business operations with an eye towards sustainability. Recognizing this new reality, in August 2019 the Business Roundtable issued an updated Statement on the Purpose of a Corporation5 calling on member organizations to recognize a broader commitment to all stakeholders. Particularly in the current elevated, event-driven securities environment, such claims are ripe for litigation.

    Great care must be taken by public companies in making representations concerning ESG initiatives and compliance. Any public facing statement, or statement likely to be read by the investing public, creates the risk of running afoul of securities laws. Even when ESG disclosures are not required, voluntary statements, if deemed material, can lead to securities litigation. This is particularly worrisome in the world of ESG, where investor and public demand compels firms to opine on formation and compliance with ESG even if legislation does not yet require it. Firms should not underestimate the appetite of the plaintiff bar to identify alleged securities violations.

    Boards of public risk managers should also consider the risk posed by activist institutional investors. 2019 saw levels of shareholder activism globally remain at elevated levels, with roughly 205 campaigns through August and 76 claimed board seats. As ESG issues continue to grow as a source of activist attention6, allegations of ESG-based whitewashing in corporate practices and procedures will increasingly serve as the basis of or substantial part of activist campaigns in the years ahead. Boards should therefore take great care to ensure investor-facing representations concerning ESG initiatives remain accurate, while actively engaging shareholders, especially institutional investors with a history of activism, on those initiatives.

  3. 03

    Regulators

    ESG investing also presents asset managers with significant regulatory risks. At the federal level, Washington has been slow to pass new laws specific to ESG. Although legislation is pending on Capital Hill, the current political environment makes passage or implementation in the near future highly unlikely. The Securities and Exchange Commission (SEC) has likewise been largely silent on ESG from a substantive prospective, though it did issue guidance on climate change back in 20107. Nevertheless, asset managers would be mistaken to conclude that ESG investing is flying under the SEC’s radar.

    The SEC’s Office of Compliance Inspections and Examinations (OCIE) 2020 examination priorities8 includes a close look at the “…accuracy and adequacy of disclosures provided by [investment adviser] offering clients new types or emerging investment strategies, such as strategies focused on sustainable and responsible investing, which incorporate environmental, social, and governance (ESG) criteria.” Right on que, The Wall Street Journal reported in December 20199 that the SEC’s Los Angeles office sent exam letters to firms offering ESG investments. The article states that the letter seeks information on the criteria used by adviser to determine an investment’s ESG bona fides and the methodology used for making actual investment decisions. Combined with recent comments by an SEC commissioner10 calling into question the value of ESG as an investment objective, it is not hard to imagine that ESG investing will someday soon become the focus of a regulatory enforcement action.

    Firms should likewise take care not to ignore the risks posed by state-level actors who, faced with a perceived lack of action in Washington, have been extremely active on the topic of ESG investment. With respect to substantive laws, non-compliance of which may create the sort of mismatch that leads to whitewashing allegations, there have been many significant developments. Laws dealing with good corporate governance practices, such as California’s landmark 2018 law mandating gender equity on corporate boards, executive compensation relative to the average worker, and tax transparency, present asset managers investing in companies that purport to be run ethically and fairly with significant risks. State regulators have also been active on ESG issues, with the efforts of the California and New York Attorneys General being particularly front and center11. Finally, though not a regulatory risk per se, the role of state governments as large, activist ESG investors12 must likewise be taken into account.

Risk & Insurance Considerations

To fully realize the opportunities presented by ESG investing, asset managers must embark on a wholistic approach to risk. This includes a thorough understanding of ESG’s place in a firm’s professional operations and attention to risk identification and mitigation.

For those risks which cannot be eliminated or lessened, balance sheet protection via a firm’s Corporate D&O, Investment Adviser E&O, and Fund D&O/E&O insurance programs is essential. Considerations in this space may include:

Breadth of cover: 3 points to consider

  • Pollution, environmental, and nuclear exclusions - Often overlooked in the professional liability world, these exclusions could become particularly relevant with respect to ESG investing. Generally, these exclusions preclude coverage for actual or alleged release of pollutants, radiation, flooding, or other tangible or threatened environmental damages. When paired with broad “based upon, arising out of, or related to” preambles, these exclusions could be used to limit or deny coverage for claims where the underlying investment or misrepresentation is even tangentially related to the enumerated perils.
  • Cost of Corrections (CoC) - this valuable coverage allows asset managers to resolve potential claims in order to head off customer demands or litigation.  With respect to ESG investing, CoC could allow firms to quickly sell a non-confirming investment at a loss, or to remedy a breach of a sustainable investment mandate, while passing the associated costs onto their insurance program. CoC coverage, however, is far from standard across the industry, and great care must be taken when reviewing notice obligations, coverage triggers, and other provisions.
  • Investigations - with the prospect of heightened regulatory scrutiny of ESG offerings and investments, coverage for investigations will continue to serve as an important risk management tool for asset managers. Attention should be paid to exactly what sort of investigations are covered by a policy, however. Typical “formal” investigations cover is written with the SEC’s formulaic and predictable investigation process in mind. Even there, it’s possible for a firm to incur millions of dollars in costs during the “informal” stage of an SEC investigation. This may be of concern to investment advisers, who may be subjected to increased scrutiny as to the methodology used to select a client’s ESG offerings due to the current lack of data standardization. Moreover, state regulators and Attorneys General often conduct their own investigations on a more informal basis, raising the prospect that some or all incurred costs may be uninsurable.

Sufficiency of cover: 3 points to consider

  • Limits – In a way, what goes up must come down. Whether or not sustainable investing presents a “new” risk to asset managers, the growing influx of capital and demand for investment options begs for a closer look at program structure and limits. Benchmarking – determining adequate limits based on what one’s peers purchase – alone may not be the most appropriate manner in which to determine the full extent of a firm’s risk and adequate insurance protections.
  • Cover for New Funds - as firms look to launch increasing numbers of sustainable investment offerings, attention should be paid to a policy’s coverage threshold for new funds. Depending on the policy wording and size of a new fund, coverage may be extended automatically and on a blanket basis. However, larger funds and certain policy language may call for new funds to be specifically added to a policy in order to qualify for coverage.
  • Cover for Latent Claims – all too often thought of in terms of climate change or environmental-based situations, ESG encompasses a broad range of issues including workplace culture. As evidenced by the #MeToo movement, society has absolutely turned a corner for the better as to what sort of conduct will and won’t be tolerated in the workplace. With respect to insurance coverage, however, this can create problems when conduct that was the subject of previous, privately addressed claims under general liability or other coverage lines (such as EPL) becomes public years later and leads to a securities or derivative claim against a firm and its leadership. Non-standardized solutions exist in the marketplace which can help insurance coverage in such instances.

Managing claims: snatching victory from the jaws of defeat

Coordination - the story in the world of professional liability risks over the last few years has been the spread of insurance claims to what once were discrete, insular policies or programs. Employment risk can become a cyber concern when employee privacy or personally identifiable information is involved. And in the world of sustainable investing, professional liability claims concerning the adequacy of investment options can quickly become a boardroom concern. Care must be taken not only to ensure the placement of appropriate policy limits containing beneficial language, but to ensure that, when necessary, different policies will work in concert and not create gaps in coverage.

Conclusions

Core to our practice in the Global Financial Institutions Claim Practice is the axiom that the best way to win an insurance coverage dispute is to not have one. While this is often easier said than done in the world of professional & management liability insurance, the risk of ESG-based misrepresentations does present such an opportunity. The rapid growth of investment offerings and volume of investment inflows begs for closer examination of program limits, policy wording, and consideration of the place of insurance within a more wholistic risk management program. With insurance market conditions for financial institutions still somewhat favorable, now is the perfect time to revisit professional & management liability insurance programs to ensure a tight-fit between an organization’s risk transfer priorities and policy wording.

Please see below the sources in the order they are used in the document:

  1. https://www.bloomberg.com/professional/blog/demand-esg-investing-grows-need-high-quality-data/
  2. https://www.thinkadvisor.com/2019/04/22/asset-managers-answer-the-growing-call-for-esg-investments/?slreturn=20200022095755
  3. https://portfolio-adviser.com/franklin-templeton-repositions-fund-focus-climate-change/
  4. https://www.icimutual.com/system/files/Section%2036%28b%29%20Litigation%20Overview.pdf
  5. https://www.businessroundtable.org/business-roundtable-redefines-the-purpose-of-a-corporation-to-promote-an-economy-that-serves-all-americans
  6. https://www.hrpolicy.org/news/story/blackrock-state-street-ceo-letters-to-companies-focus-on-corporate-purpose-human-capital-and-culture-16309
  7. https://www.sec.gov/rules/interp/2010/33-9106.pdf
  8. https://www.sec.gov/about/offices/ocie/national-examination-program-priorities-2020.pdf
  9. https://www.sustainableinvest.com/esg-funds-draw-sec-scrutiny/
  10. https://www.sec.gov/news/speech/speech-peirce-061819
  11. https://www.cnbc.com/2019/12/10/exxon-did-not-mislead-investors-a-new-york-judge-ruled-on-tuesday.html
  12. https://news.bloomberglaw.com/banking-law/insight-14
Author

Anthony Rapa

Anthony Rapa is a member of the Willis Towers Watson FINEX Global Financial Institutions Claims Advocacy team.


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