The massive flow of assets into ESG-focused funds reflects the intense and growing demand for investment products that enable investors to put their values into action while pursuing strong financial returns in their portfolios. The dramatic growth of the ESG funds sector has predictably attracted the attention of regulators, commentators and the private plaintiffs’ bar. The SEC’s Division of Enforcement last year formed a Climate and ESG Task Force to, among other things, “analyze disclosure and compliance issues relating to investment advisers’ and funds’ ESG strategies” and ESG related issues have moved to the forefront of exams conducted of registered investment advisers. States have similarly demonstrated an increased focus on ESG regulations: a dozen state attorneys general, including those of California and New York, sent a letter to the SEC last year that called for increased ESG-related disclosures for climate-related financial risks by “all SEC-regulated firms.” Notably, foreign regulators have been ahead of their U.S. counterparts in focusing on ESG disclosures; in particular, the Sustainable Finance Disclosure Regulation (SFDR) in the European Union will require disclosure of ESG considerations by all funds. The head of the SEC’s Climate and ESG Task Force has emphasized that its review of ESG fund disclosures and marketing materials will be guided by “long-standing principles of materiality and disclosure” in assessing potential violations of the securities laws or advisers’ fiduciary duties.
The growing ESG fund sector has also been the subject of recent public criticism from various quarters, particularly claims of greenwashing leveled against climate-focused funds, from media outlets including Time, USA Today, The Economist, Reclaim Finance, and Responsible Investor. According to the sponsors of a number of published studies, like As You Sow, InfluenceMap, and Morningstar, many funds with a sustainable or “green” investment thesis are not living up to their names and promises, because their portfolio holdings are not sufficiently aligned with specified standards for addressing climate change. Indeed, SEC Chair Gary Gensler published a video on March 1, 2022 in which he expressed skepticism about whether many ESG-focused funds live up to their names, asserting that the investing public does not have sufficient information to evaluate ESG funds. In his video, Mr. Gensler asserts that the process for selecting an ESG fund should be as straightforward as purchasing a carton of milk labelled fat-free and suggests that he would cause the SEC to pursue new disclosure rules for ESG-focused funds.
For its part, the private plaintiffs’ bar has initiated a number of actions asserting greenwashing claims, although the focus of these claims to date has not been ESG funds, but rather allegations that operating companies, including corporations in the oil and gas, mining, and consumer goods sectors, are making misleading claims about the climate-friendliness of their operations or the products they manufacture. See, e.g., Jochims v. Oatly Group AB, 1:21-cv-06360 (S.D.N.Y. Oct. 26, 2021) (order granting motion to dismiss claims that an oat milk company made materially false and misleading statements about the company’s sustainability); In re Vale S.A. Sec. Litig., 2020 WL 2610979, at *9 (E.D.N.Y. May 20, 2020) (alleging securities law claims that a mining accident demonstrated a Brazilian mining company’s sustainability and safety claims were misleading); Ramirez v. Exxon Mobil Corp., 334 F. Supp. 3d 832 (N.D. Tex. 2018) (denying a motion to dismiss claims that Exxon made material misstatements about proxy costs for carbon).
What do these trends mean for litigation exposure faced by ESG funds and their advisers and boards? Specifically, can we anticipate that private plaintiffs’ lawyers and securities regulators will fix their sights on ESG funds, embracing the greenwashing criticism by public commentators as a basis for launching a wave of securities fraud litigation and enforcement actions? Not necessarily. For a number of reasons, assertions that climate-focused ESG funds are “not as green as they should be” may prove challenging for the plaintiffs’ bar in establishing valid securities law claims in the fund context. ESG fund disclosures differ in fundamental ways from the ESG disclosures of typical operating companies. In light of these differences, as well as established securities law principles governing fund litigation, the types of theories recently asserted against operating companies will not be readily transportable to the ESG fund setting, as discussed below.
Under current SEC rules, the prescribed ESG-related disclosures of operating companies are fairly narrow in scope. For investors, the principal ESG-related disclosure focus area is climate risk, although there also are disclosure requirements and/or guidance specific to conflict minerals, resource extraction, mine safety, board diversity, human capital, pay ratio and cybersecurity. Today, environmental disclosures largely are pursuant to the SEC’s general principles-based disclosure framework and grounded in materiality. As the SEC explained in its 2010 Interpretive Guidance on Disclosures Related to Climate Change, these disclosure obligations under the 1933 and 1934 Acts primarily relate to the potential impact on the company of climate change and regulatory developments to address climate change. In the last several months, the SEC has sought to encourage enhanced climate-risk disclosure consistent with the current disclosure framework by publishing a sample comment letter on this topic and commenting on climate-related disclosures in selected public filings. Required climate-risk disclosures are poised to increase, with the SEC proposing new climate-related disclosure rules on March 21, 2022, which will require increased reporting on companies’ greenhouse gas emissions, climate risks, the impact of those risks on financials, and management of and strategies to mitigate those risks.
A large number of public companies also make substantial voluntary sustainability and corporate social responsibility disclosures—these go well beyond those required by SEC rules—on their websites and/or in stand-alone “corporate social responsibility” (CSR) or “corporate sustainability” reports. These disclosures increasingly include both historical quantitative metrics and forward-looking targets and are aligned with third party frameworks. Many companies also voluntarily submit environmental and other information to third party rankers and raters.
In the operating company context, allegations of greenwashing are most likely to assert that the company has over-stated the climate-friendliness or other positive impact of its operations, products, or initiatives—such as the carbon footprint of its products or the impact of projects it would finance with a “green bond.” From a securities liability exposure perspective, with the increase in quantitative ESG disclosures, these types of representations will increasingly be susceptible to measurement and verification, and could have a readily-provable impact on the company’s share price if shown to be over-stated.
By contrast, ESG funds, like all registered investment companies, are subject to a different set of prescribed disclosure requirements than operating companies under the Investment Company Act of 1940 and other securities laws. For example, the new proposed SEC rules will apply to public operating companies but not registered funds, although the SEC may propose additional rules targeting registered funds in the future. Registered ESG funds include open-end mutual funds, exchange traded funds (ETFs), and a relatively small number of closed-end funds. As of 2020, the ICI identified 592 ESG-focused mutual funds and ETFs with assets of $465 billion. In 2021 alone, 38 funds with sustainability mandates were launched in the U.S., 29 of which were equity funds and 25 were ETFs.
In their required public disclosures, registered ESG funds describe their investment objective (typically a combination of financial return objectives and incorporation of stated ESG principles in security selection), the investment approach fund managers will take in seeking to achieve those objectives (i.e., the process they will follow in building a portfolio of securities that will provide investment returns and further the fund’s stated ESG principles), and the risks that may affect their ability to meet these combined objectives. Significantly, as required by law, registered funds also regularly disclose their full portfolio holdings. Open-end mutual funds must disclose their portfolio holdings at the end of each fiscal quarter, while ETFs are required to disclose their portfolio holdings each day. 17 C.F.R. § 270.30b1-5 (requiring registered management investment companies to file each quarter form N-Q, which discloses the fund’s portfolio holdings); 17 C.F.R. § 270.6c-11(c)(1) (describing ETF portfolio holdings disclosure requirements). The types of representations that have been the focus of greenwashing litigation against operating companies are not the types of statements that funds historically have had a basis or reason to make.
For example, unlike an operating company that might tout the environmental sustainability of its business model and disclose greenhouse gas emissions reduction targets and a net zero commitment, a climate-focused fund is more likely to explain how its investment process weights the relative carbon impact—as well as the relative financial performance—of the companies it considers for the portfolio. In describing its investment process, a fund will often disclose the industry classifications and research services its adviser utilizes in making ESG-focused investing determinations, or, alternatively, the metrics and criteria the adviser has developed in-house. From a securities liability perspective, it would be challenging for a shareholder-plaintiff to plausibly allege—at least based on typical fund litigation evidence like portfolio holdings or performance results—material misrepresentations in such process descriptions.
Moreover, ESG funds vary significantly from one another in the approach they take to incorporate ESG principles into their investment process. As part of an ongoing industry-wide effort in the U.S. to standardize terminology for registered funds, industry groups have proposed some basic categories of investment approach. These efforts appear to be coalescing around three categories described by the Investment Company Institute (ICI) as “ESG exclusionary,” “ESG inclusionary” and “Impact.” ESG exclusionary funds exclude companies or sectors that fail to meet certain criteria or that do not align with the fund’s objectives, such as categorical prohibitions on industries like weapons manufacturing, gambling, alcohol or fossil fuels. Conversely, ESG inclusionary funds actively pursue positive sustainability-related outcomes and financial performance through a focused investment thesis that tilts their portfolios according to the relevant ESG factors—without necessarily excluding particular sectors. Funds pursuing impact investing strategies seek to generate positive, measurable, and reportable ESG impacts alongside a financial return, often including through activism in the operating companies in which they invest; these impact funds are defined by their measurement, management and reporting of these impacts.
These categories closely track those published by the UK Investments Association and the Institute of International Finance; in contrast, some industry participants have suggested further breakdown of these categories with additional labels like “limiting ESG risk” and “seeking ESG opportunity,” or the inclusion of categories that identify funds that utilize “corporate engagement & shareholder action,” “norms-based screening,” and “sustainability themed/thematic investing.” Thus, even among ESG funds, there can be substantial variation in the types of disclosures made, given the variation in funds’ approaches to incorporating ESG principles in their investment processes and the funds’ ESG and investment goals.
By way of example, an “ESG Exclusionary” sustainable equity fund might explain that its investment process seeks to screen out of the portfolio all oil and gas companies and other companies engaged heavily in fossil fuel production or heavy use, such as utilities. An “ESG Inclusionary” sustainable fund might explain the relative weighting given to oil and gas companies in the portfolio based on their progress towards reducing their net carbon impact (while not excluding them outright). An “Impact” fund might explain its objective to invest primarily in companies whose products will have a measurable positive impact on the environment (while not necessarily excluding any types of companies). Similarly, an “ESG bond fund” might take an Exclusionary approach, declining to invest in any bond issued by oil, gas or utility companies, whereas a green bond fund with an Inclusionary or Impact approach might consider a bond of a high-emitting company if the project financed by the bond appeared likely to bring about net reductions in emissions.
Assertions of “greenwashing” by ESG funds need to account for what funds are actually required to—and consistently do—disclose, and the variations in how different funds pursue sustainability objectives alongside financial returns. Recent published assertions of greenwashing attempt to apply one-size-fits-all metrics to funds which fail to account for these differing investment approaches. These assertions are often based on a flawed premise: they grade how “green” a fund’s holdings are, as measured by the grader’s selected yardstick, rather than assess whether the fund is managed consistent with the manner described in its prospectus and other disclosures—the appropriate metric under the securities laws.
Such studies ignore the fundamental fact that different sustainable-focused funds have very different investment approaches to meet different investor preferences, and attempting to rank these funds on a single-variable margin of “greenness” is not only misleading to the investing public, it also has no basis under the securities laws. A shareholder asserting a securities law claim against a fund must plausibly allege that the fund’s disclosures contained material misstatements or omissions that would mislead a reasonable investor about the nature of the fund, its investment approach, or the risks that the fund might not meet its objectives, in light of the total mix of information available to the investor about the fund. In assessing claims of misleading disclosures, courts will recognize that the total mix of information available includes the description of the fund’s specific approach to incorporating ESG factors (e.g., exclusionary vs. inclusionary) and the fund’s regular disclosure of the securities it holds.
One recent example is particularly instructive in demonstrating what can be missed in attempting to compare ESG investment products that might have varying and divergent investment approaches by design. A recent report authored by University of California, San Diego business students and sponsored by As You Sow (AYS), a non-profit shareholder advocacy organization, sought to develop and apply a simplified analysis for identifying alleged greenwashing by ESG investment products. The report examined 94 mutual funds and ETFs with “ESG” in their name. It sought to use natural language processing to analyze the use of key words in certain sections of the funds’ prospectuses and then compared how those words were used to the ESG grade that AYS assigned to each fund for a number of ESG categories; AYS’s ESG ratings give funds a grade of A through F in categories including Fossil Free Funds, Gender Equality Funds, Weapon Free Funds, Tobacco Free Funds, and Prison Free Funds. The report found that it could not differentiate between language used by “good” ESG funds—ones that received all C or higher grades across all metrics relied upon by AYS—and the language used by “bad” funds—ones that received at least one D or F grade.
Significantly, however, AYS’s “good” and “bad” fund ratings in each category are based on scorecards that look primarily to fund holdings in a number of categories, regardless of whether the fund actually claims to avoid holdings in those categories as part of its stated investment approach. The Fossil Free Funds rating, for example, is based on the aggregate percentage of the fund’s holdings in companies identified by a handful of outside organizations as oil, gas and coal producers, owners of carbon reserves, and large consumers of fossil fuels (e.g., utilities). The ratings do not otherwise examine the funds’ investment strategies, sustainability objectives, or approaches to achieving those objectives.
At most, this grading system could assess the success of funds with an exclusionary approach in screening out companies considered to be non-green investments using a specified metric. However, it cannot accurately capture the truthfulness of an inclusionary fund that seeks to supplement traditional energy investments with alternative, renewable sources; nor would it reflect the intentions of an impact investing fund that seeks to leverage its ownership in a corporation to promote positive change from within. Put simply, not every “green” fund must be fully divested of fossil fuel-related stocks in order to comply with its stated and disclosed investment objectives. And even within the realm of exclusionary funds, such a reductionist ranking cannot properly consider the specific criteria identified by that fund as necessitating exclusion. Instead, any analysis of a fund’s ESG success must be based on the disclosures made to the public regarding its own objectives and whether they have been met.
Notwithstanding the lack of basis in the securities law standards, claims like AYS’s of widespread “greenwashing” in the fund industry could trigger the plaintiffs’ bar to launch a wave of costly meritless litigation and ultimately be counterproductive for the sustainable investment movement.
Tellingly, the report concluded that “the linguistic pattern of the prospectus of the fund has a relatively low correlation with its ESG rating”—in other words, the study’s AI-based language analysis of fund disclosures was inconclusive. Nevertheless, media reporting on the study described it as finding that “60 of 94 ESG funds failed to adhere closely to the principles of environmental, social and governance investing.”
This dissonance between the report’s clear statement of inconclusive results and the media’s interpretation of the report highlight the dangers of unsupported claims of greenwashing based on inconclusive or misdirected analyses. The news media amplify the message that ESG funds are somehow misleading investors, but fail to engage with the underlying claims—thus ignoring one-dimensional grading systems and the less-than-rigorous methodologies.
In a similar vein, SEC Chair Gary Gensler’s March 1, 2022 video, published on Twitter as part of his “Office Hours with Gary Gensler” series, lumps ESG funds into a single category, treating them all as synonymous with “green,” “sustainable,” or “carbon-neutral” funds. He suggests that selecting an ESG fund should be more like selecting “fat-free” milk at a grocery store, where the grams of fat, an objective measurement, can easily be ascertained by looking at the nutrition facts on the carton. But according to Chair Gensler, in the context of ESG investing, “there is currently a wide range of what asset managers might mean by certain terms, and what criteria they might use.” He therefore concludes: “It is easy to tell if milk is fat-free, it might be time to make it easier to tell whether a fund is really what they say they are.”
Chair Gensler’s simple analogy ignores the many different ways that ESG funds can pursue their goals and the range of investor values these products seek to represent. Unlike fat-free milk, for which the truthfulness of that descriptor can be ascertained by looking at one line on a nutrition label, ESG funds cannot be evaluated or compared based on a single, objective metric. ESG investors are not “shopping” for a uniform type of product that can be compared and thus “labeled” based on a single component like grams of fat. Just as grocery customers select differing baskets of goods based on their various tastes and dietary needs (not just on fat content), so too ESG fund investors come to the market with widely varying values and financial goals they wish to see represented in their investment baskets. Allowing for a variety of different ESG products that pursue ESG objectives in different ways provides investors with numerous options to meet their distinct goals. This is no different from how the fund sector has long offered funds with widely varying investment objectives and strategies to meet the varying financial goals and risk tolerances of the investing public.
Aside from broad assertions of widespread greenwashing across the ESG funds sector in studies like AYS’s, the discussion above highlights the challenges posed by asserting securities violations based on such theories—even if focused on a single fund—when applying established principles from fund-related securities law authority.
It would be difficult in most cases to plausibly allege a materially misleading misstatement or omission in a fund disclosure on the theory that a “green” fund is not “green enough.” Plaintiff-shareholders claiming to have been misled are deemed to have read a fund’s full disclosures, and must explain how they were misled about the fund or its risks in light of the “total mix of information” available to them. See, e.g., Basic Inc. v. Levinson, 485 U.S. 224, 231–32 (1988) (“[T]o fulfill the materiality requirement ‘there must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.’”). For example, a shareholder could not claim to have been misled by the word “green” in a fund’s name to believe the fund would never invest in oil or utility companies, if the fund’s prospectus explained how its investment process would be applied to such companies (without necessarily screening them out altogether) and the fund’s regular holdings reports clearly disclosed holdings in these types of companies. Likewise, an investor could not claim to have been misled by a “green bond” fund holding securities of carbon-emitting companies, so long as the bonds’ issuers and projects aligned with the stated investment objectives and process articulated in fund disclosures.
Further, like all funds, ESG funds include in their disclosures detailed explanations of the risks that could prevent the fund from meeting its objectives—both financial results and ESG-related goals. Just as a fund’s financial results may be highly dependent on macroeconomic and portfolio-specific risk factors (e.g., inflation, interest rates, credit risk), so too various risk factors can affect a fund’s ability to construct a portfolio that meets its specified ESG objectives (e.g., technological advances, government policy on ESG disclosures, accuracy of company disclosures). The law is well-established that securities liability does not attach when a fund’s financial under-performance results from the manifestation of a fully-disclosed risk. See, e.g., Olkey v. Hyperion 1999 Term Tr., Inc., 98 F.3d 2, 9 (2d Cir. 1996) (“This court has consistently affirmed Rule 12(b)(6) dismissal of securities claims where risks are disclosed in the prospectus”) (collecting cases). The same will hold true for alleged failures to meet stated ESG objectives resulting from risks that the funds fully disclosed.
Moreover, plaintiff-shareholders in securities litigation would be required to allege and establish causation—that is, that a drop in the fund’s share price was caused by the alleged misstatement or omission in the fund’s disclosures. See, e.g., Dura Pharm. v. Broudo, 544 U.S. 336, 343 (2005) (noting that securities laws exist, “not to provide investors with broad insurance against market losses, but to protect them against those economic losses that misrepresentations actually cause”). Given that a fund’s share price is determined by the value of the securities in the portfolio, rather than by investor sentiment as with typical secondary market trading in operating companies, it can be difficult to establish such a causal link in any case between a fund’s disclosures and its share price. Doing so would likely be even more difficult where the disclosures in question relate to the incorporation of ESG considerations in the investment process, rather than typical financial risks.
For the ESG investing movement to reach its full potential, there must be room in this highly-regulated marketplace for an array of investment options to meet the variety of ESG values and priorities held by investors. Just as different types of fixed income funds exist to satisfy investors’ varying appetites for financial risk and return (e.g., municipal, core, high-yield), so too a flourishing ESG fund sector will have room for various approaches to responsible investing to respond to investors’ varying value sets. Clear disclosure of each fund’s distinct investment approach remains the key to aligning fund objectives with the full panoply of investor values. Increasing industry use of standardized disclosures, as the SEC appears poised to require, will help investors more readily distinguish among types of ESG funds, and thus more effectively compare and contrast among true peer groups. But the use of inconclusive studies and litigation as tools to pressure fund managers to pursue particular favored approaches to ESG investing—especially without due regard for funds’ disclosed objectives and approaches—will find little support in the securities laws, and will ultimately serve to undermine the responsible investing movement.