ESG Risks for Financial Institutions: Eliminating Significant "Gotchas"
In Short
The Background: Demand for environmental, social, and governance ("ESG")-aligned companies and investment products is transforming the investing landscape. Financial institutions will be at the forefront of this change, as public companies themselves, as intermediaries and facilitators of financial markets transactions with ESG-focused companies, and as developers and marketers of ESG-compliant investment opportunities demanded by institutional and retail investors.
The Issues: Although investor demand is growing, there is a lack of clarity around what constitutes ESG and how to measure compliance with ESG goals. This can create significant legal uncertainty and risk for financial institutions. Financial institutions are faced with the competing concerns of demonstrating to their stakeholders that they are committed to ESG principles, while not exposing themselves to undue litigation risk. ESG-related litigation and regulatory risks may arise from ESG-related disclosure statements, as well as where financial institutions serve as underwriters, lenders, investment advisors, and counterparties in connection with transactions that implicate ESG principles.
Looking Ahead: As ESG issues come into greater focus in the financial markets, an important issue to consider is how financial institutions determine whether an entity is ESG-aligned and what methodology and metrics are used to make that determination. While numerous entities are attempting to perform these evaluations, the lack of uniformity across ESG ratings and reporting, along with the differing levels of rigor by ESG ratings firms, creates potential risk for financial institutions attempting to rely on these determinations. In addition, financial institutions must evaluate their own ESG-related disclosures to make sure they are accurate and complete, and ensure that marketing communications are consistent with those disclosures.
Over the last several years, ESG issues have come into focus in the financial markets, with investors seeking more ESG investment options and, as a consequence, market participants devoting greater resources and assets to ESG lending and investing. The demand for ESG disclosures by companies and ESG investments will only increase. For instance, BlackRock CEO Larry Fink's recent annual letter to CEOs urged companies to include greater sustainability disclosures and focus on ESG factors when investing. Financial institutions must navigate the transition to consideration of ESG-related metrics while prudently minimizing the potential risks.
This Commentary identifies potential litigation risks financial institutions may face in light of the increased focus on ESG and the growing demand for ESG investment opportunities. ESG-related risks for financial institutions fall into three high-level categories: (i) risks based on their own public ESG-related statements; (ii) supply chain risks; and (iii) risks based on activities as a lender, underwriter, or investment advisor.
Risks Based on ESG-Related Statements
As investors continue to scrutinize whether companies are complying with their own ESG-related statements, financial institutions face particular risk relating to "S" in ESG, including stated intentions relating to diversity, financial inclusion for underserved populations, and other aspirations of social justice. These public statements present litigation risk if a company fails to meet its stated goals or is thought to be inaccurately representing its ESG alignment. In addition, boards of directors may face claims that they are not engaging in adequate governance and controls to ensure stated goals are achieved.
But potential claims are not just limited to standard disclosure and breach of fiduciary duty claims; consumer protection and unfair competition statutes have been used to challenge ESG statements in company reports, and the False Claims Act has been used to challenge claims of sustainable products and packaging. And, for consumer-facing financial institutions, disclosure claims could lead to an additional cause of action for alleged discriminatory behavior.
ESG-related statements may also pose regulatory risks for financial market participants, which can expect increased regulatory scrutiny regarding their ESG compliance. Indeed, Gary Gensler, President Biden's pick to head the SEC, plans to establish a regulatory framework for socially responsible investments. And, while federal securities laws currently do not require the disclosure of ESG data except in limited circumstances, potential liability could arise from voluntarily making materially misleading or false ESG-related disclosures.
Supply Chain Risks
Litigation and regulatory risks related to ESG are not limited to the companies themselves. Financial institutions must also consider ESG issues with respect to vendors and other third-party service providers in their supply chain; that is, whether the vendors supporting them are ESG-aligned or meeting ESG targets. As one example, pursuant to the Alien Tort Statute and the Trafficking Victims Protection Act, companies can face liability for human rights violations committed abroad by entities in their supply chain. Financial institutions may also face risks in their supply chain related to environmental pollution, labor disputes, and corruption.
Institutional Risks as a Financial Market Participant
Financial market participants also face ESG-related risk due to their unique roles as lenders, investors, and in other fiduciary capacities. For instance, financial market participants that engage in direct lending to companies or underwriting of ESG transactions may face potential reputational risk and legal liability for funding companies that are misrepresenting ESG compliance or are affirmatively violating environmental or governance laws. On the other hand, financial institutions must consider antitrust issues and avoid agreements not to lend to or otherwise avoid certain companies because of ESG concerns.
There are also risks inherent in analysis and monitoring of compliance with ESG disclosures in transaction documents or with respect to the level and nature of ESG-related due diligence. While many companies have begun publishing sustainability reports on their websites or incorporating ESG disclosures into their SEC filings, it is unclear whether, depending on the circumstances, underwriters can rely on these disclosures or take them at face value. Lenders and underwriters of ESG transactions also must consider how to balance standard repayment risks and credit analysis with ESG performance, and they may ultimately face litigation risks if an investment does not perform as well as anticipated.
Moreover, ESG securitizations offer new roles, such as sustainability agent or sustainability coordinator, which will continue to evolve over time. Financial institutions considering serving in these new ESG-related roles will need to carefully review the transaction documents to ensure that the duties and limitations of any such roles are appropriately defined and are subject to exculpatory provisions and other protections. Securitization parties, including the sustainability agent, may face risk with respect to choosing specific ESG factors and benchmarks to focus on, especially given that there are few standard terms for these financings and a plethora of methodologies for evaluating ESG factors, making any market practice or consensus elusive at this time. Similarly, counterparties in the new but growing market for sustainability-linked financial derivatives should also take care in negotiating and agreeing to sustainability targets that trigger various credits, discounts, or penalties in such transactions.
Financial market participants that invest or direct investments in ESG funds as a wealth management advisor or fiduciary may also face several unique risks with respect to ESG issues. First, these companies are likely to face inquiries and scrutiny regarding their "scoring" or evaluation of ESG investments, as well as the type of diligence conducted prior to making ESG-based investments. As with other investments, companies that invest in ESG funds on behalf of clients face a potential risk that negative outcomes might be attributed to failure to properly evaluate or consider ESG risks. In addition, investors in ESG funds face litigation risks based on their own disclosures to their potential clients regarding ESG metrics and how such metrics are incorporated into the investment decision-making process.
Mitigating ESG-Related Risks
Despite the risks, there is no doubt that the financial markets will continue to respond to increased concern about ESG alignment and increased demand for ESG investments. In order for financial institutions to adapt and thrive, below are some suggestions to mitigate ESG-related risks.
Mitigation of Entity-Level Risks. Financial market participants can mitigate risks related to ESG by conducting a legal review of existing disclosures and evaluating their ongoing relevance or possible obsolescence. Companies should also devote sufficient resources at senior levels to ESG oversight and consider coordinated working groups responsible for ESG issues and disclosures, including oversight of ESG risks specific to financial transactions. And these efforts should be integrated into a company's regular risk management exercises, and corporate boards should continually review how ESG-related goals and actions align with the overall corporate strategy. In addition, financial market participants can also mitigate ESG-related institutional risks by having a clear and consistent message and demonstrating incremental progress.
Mitigation of Disclosure Risks. Financial institutions should ensure that their public reports and disclosures—both mandatory and voluntary—accurately reflect ESG issues and considerations. With respect to ESG-related statements, companies should develop internal controls to ensure the accuracy of their public disclosures, use disclaimers where appropriate, and use estimates and aspirational statements to demonstrate incremental progress.
Mitigation of Supply Chain Risks. Financial institutions can also mitigate supply chain risks by determining which standards and practices they expect suppliers to meet and then conducting regular monitoring of existing and emerging supply chain risks to ensure those standards are met. Financial institutions may also consider including codes of conduct and ESG incentives in contracts with members of their supply chains to further mitigate supply chain-related ESG risks. In addition, supply chain management risk should be incorporated into traditional business risk mitigation plans to ensure that financial institutions develop and maintain ESG-aligned supply chains.
Three Key Takeaways
- Uncertainty around the standards or methodology for measuring and determining ESG-alignment may create risk for financial institutions.
- Financial institutions face litigation and regulatory risks based on their own ESG positioning as well as their role as financial market participants in ESG-related financings and transactions.
- Certain litigation risks may be mitigated by engaging in a careful and deliberate review of ESG-related disclosures and commitments as well as utilizing forward-looking statements to articulate aspirational objectives.
