There is much anticipation and perhaps anxiety as the market awaits the commencement of what appears likely to be the pursuit by the Australian Securities and Investments Commission (ASIC) of a range of “greenwashing” cases. That anticipation and anxiety was fuelled by recent media reports that ASIC “is conducting at least two investigations into ‘greenwashing’, including a publicly listed company” and “has several inquiries underway into several listed entities, super funds and managed funds, with some at very early stages and others that are more advanced”.[1] Other than the broad topic of “greenwashing”, no other details of these investigations are known.
We know that one of ASIC’s priority areas is to reduce the risk of harm to consumers of financial products “caused by poor product design, distribution and marketing”. [2] To deliver on this priority, ASIC intends to engage with market participants, and undertake surveillance and enforcement action for misleading or deceptive conduct that involves the misrepresentation of the “performance, risk and nature” of financial products.[3] Focusing on the offering and promotion of financial products, what cases might attract regulatory investigation and enforcement action?
This issue will be discussed across 3 articles. This article uses the examples described in INFO 271[4], informed by overseas experience, to develop archetypal cases that ASIC might pursue. The second article will focus on cases that might arise outside of INFO 271, including the design and distribution obligations in Part 7.8A of the Corporations Act 2001 (Cth), portfolio management practices and controls, and proxies. The third article will focus on cases that might arise from regulated documents such as prospectuses and product disclosure statements. Superannuation will be discussed in separate articles.
A QUICK RECAP
In Article 3 on climate change litigation, the following working definition of “greenwashing” was proposed:
“the practice of misrepresenting the extent to which a financial product or investment strategy is environmentally friendly, sustainable or ethical”, where the misrepresentation amounts to misleading or deceptive conduct under the Corporations Act[5] and the Australian Securities and Investments Commission Act 2001 (Cth) (the ASIC Act).[6]
It was also suggested ASIC would investigate and potentially pursue enforcement action where the “greenwashing” amounts to misleading or deceptive conduct (as interpreted under the statutory provisions[7]) and[8] there exists “actual or potential…significant harm” to investors, markets and the financial system[9] (amongst other factors) [10].
So with this in mind, what specific aspects of the offering and promotion of financial products and services might ASIC investigate for “greenwashing”?
LABELLING AND TERMINOLOGY
Using ESG related terms (e.g. green, ESG, sustainable, ethical) in the labels of financial products has attracted regulatory investigations into DWS Investment GmbH (in Germany and the USA) and Goldman Sachs (in the USA). In Goldman Sachs’ case, the reported allegation is that several of Goldman Sachs’ mutual ESG labelled funds (the Goldman Sachs ESG Emerging Markets Equity Fund, Goldman Sachs International Equity ESG Fund, and the US Equity ESG managed account) did not adopt ESG investment strategies.[11]
The investigation of Goldman Sachs’ circumstances by the Securities and Exchange Commission (SEC) is unlikely to be unique to the USA. In line with INFO 271, ASIC identifies the alignment of the label with the underlying investment strategy (approach to stewardship or asset holdings) as a way to avoid “greenwashing”. The overarching theme being that the financial product is “true to label”. [12] This will also involve adequately defining the sustainability-related term used in the label. This is because sustainability-related terms mean different things to different people and there is yet no standardised and universally accepted definition of those terms.
SCREENING CRITERIA
Pax World Management Corp is a registered investment adviser and provides investment advisory services to four Funds[13] in the USA. The Funds offered socially responsible investment products, which employed a negative screen that excluded “sin-stocks”, that is, companies that derived revenue from military, alcohol, tobacco or gambling (the SRI Restrictions). Pax breached the SRI Restrictions by purchasing several “sin-stocks” it either did not screen or failed to satisfy the SRI Restrictions. The SEC issued administrative and cease and desist proceedings against Pax for materially misleading statements.[14] Pax agreed to pay a civil penalty of $500,000.[15]
More than likely, Pax’s conduct would have attracted ASIC’s attention. It is prima facie misleading or deceptive because the conduct departed in a material way from the promoted SRI Restrictions. Another way to view this conduct is that the screening criteria adopted could not have been understood by investors. Providing sufficient information to allow investors a proper understanding of the screening criteria is a critical way ASIC suggests “greenwashing” can be avoided. This will involve proper disclosure on:[16]
- the product’s sustainability related investment screening criteria;[17]
- whether the particular investment screen(s) applies only to a certain product offering or to the issuer as a whole;[18]
- any screening exceptions or qualifications.[19] ASIC expresses caution in relation to using exceptions and qualification to “rectify otherwise misleading impression[s]”.
HEADLINE CLAIMS
The example ASIC provides of a headline claim is a promotional statement that “we do not invest in tobacco products”.[20] Headline claims in “absolute terms” [21] risk being misleading or deceptive. But so too can headline claims not expressed in “absolute terms”. This can sometimes arise because it “will not always [be possible to] include all necessary information”[22] in a headline claim. ASIC recognises this difficulty but cautions on using “exceptions and qualifications” especially where used “to rectify an otherwise misleading impression” and “are inconsistent with the headline claim”.[23]
Pax’s headline claim was that the SRI Restrictions prohibited investment in companies, relevantly, that engaged in “military activities”. [24] While not the subject of SEC sanction, the headline claim may have been misleading under Australian jurisprudence because contrary to the “absolute” headline claim, the Funds were permitted under the SRI Restrictions to invest in companies that derived less than 5% of their gross sales from military contracts.[25]
INCORPORATION OF SUSTAINABILITY RELATED FACTORS INTO INVESTMENT DECISIONS
In making investment decisions some advisers and funds consider ESG factors alongside many other factors, such as macroeconomic trends or company-specific factors like a price-to-earnings ratio, to seek to enhance performance and manage investment risks (i.e. an ESG integration fund). Others focus on companies that have demonstrated a commitment to a particular ESG factor, such as companies with policies aimed at minimizing their environmental impact (i.e. an ESG-focused fund). Some advisers and funds consider ESG factors by applying negative, positive, or norms-based screens to investments. Others focus on engaging with companies to improve specific ESG-related practices including sustainability, climate, and faith-based investing. Still others invest to generate measurable ESG-related benefits, known as impact investing. [26]
Whichever approach is taken, ASIC’s guidance is that the “methodology and policy” for integrating sustainability related considerations into investment decisions and stewardship activities “should be disclosed and clearly explained.” This includes disclosure and clear explanation of: [27]
- the sustainability-related considerations taken into account;
- how the sustainability-related considerations are incorporated into investment decisions and stewardship activities (e.g. screens);
- the weighting system that prioritises and evaluates certain sustainability factors.
The SEC’s Commissioner Roisman adds a further useful insight which could be read with ASIC’s guidance. Commissioner Roisan suggests disclosure of these matters: [28]
- Are “E,” “S,” and “G” weighted the same when selecting portfolio companies?
- Does the fund intend to subordinate the goal of achieving economic returns to non-pecuniary goals, and, if so, to what extent?”
INDEX
Indices that track the ESG performance of companies and financial products are evident in the market place.[29] But unlike “significant financial benchmarks” such as the S&P/ASX 200, ESG indices are largely unregulated[30]. The absence of regulation and an agreed taxonomy can present challenges to avoiding regulatory enforcement action.
One issue of concern ASIC has highlighted is the need to accurately disclose the issuer’s capacity to influence the composition of the index.[31]
METRICS
There are several ESG ratings firms in the market. MSCI, ISS ESG and Sustainalytics to name a few. Investors rely upon ESG ratings to make investment decisions. Companies rely on ESG ratings to highlight and validate their positive ESG impact. Funds rely on ESG ratings to develop portfolios to attract retail investors seeking ESG investments.
ASIC’s guidance is that if you rely on sustainability-related metrics (such as ESG scores) to evaluate whether a new or existing investment aligns with your product's investment objective or strategy, the following should be disclosed[32]:
- the extent to which the metrics are used to evaluate new and existing investments in implementing your investment objective or strategy;
- the sources of your sustainability-related metrics, including whether these are based on your own proprietary methodologies or from certain third-party providers;
- a description of the underlying data used to calculate your sustainability-related metrics, and the calculation methodologies for those metrics; and
- any risks or limitations arising from reliance on the metrics (where applicable).
The content or particulars of this guidance might involve the disclosure of several matters including:[33]
- what does the ESG rating measure? Retail investors might assume that ESG ratings measure the impact of the company on the environment and society. But that is not always the case. Some ESG ratings measure the impact that financially material societal and environmental factors have on the company; [34]
- what does the ESG rating or score mean? Some rating agencies use an AAA to CCC rating or a A+ to D- rating or a 1 to 100 score with 100 either being a high or low ESG quality;[35]
- is the ESG rating an “industry-relative ESG quality” measure or an “absolute quality” measure;[36]
- what methodology was used to calculate the ESG score? This might include disclosure of the variables used, the weight attached to the variables, and the presence and treatment of data gaps;[37]
- what subcomponents of “E”, “S” and “G” were measured? For example, in calculating the “E” score did that involve an assessment of the company’s contribution to climate change; reliance on natural resources; generation of waste; and potential to use environmental technology to improve operations and sales. [38]
The recent investigation by the US State of Missouri (along with 18 other States) into Sustainalytics, a subsidiary of Morningstar Inc., provides an example of a regulatory investigation into a ratings agency. The allegations being investigated are whether[39]:
- Sustainalytics’ flagship ESG Risk Rating product breached consumer protection laws by giving poor ESG scores to companies involved in the Israeli economy because those companies were assumed to be complicit in human rights abuses;
- Sustainalytics’ assessments are based on anti-Israel sources of information such as Human Rights Watch and Amnesty International; and
- Sustainalytics is furthering the anti-Semitic boycott, divestment, and sanctions movement.
[1] “ASX-listed company investigated by ASIC for greenwashing” by John Kehoe. Australian Financial Review, 22 August 2022.
[2] ASIC Corporate Plan 2022-26 at pp.4 and 7.
[3] ASIC Corporate Plan 2022-26 at p. 13.
[4] INFO 271 (How to avoid greenwashing when offering or promoting sustainability-related products)
[5] Sections 769C, 1041E, 1041F, 1041H of the Corporations Act 2001 (Cth)
[6] Sections 12BB, 12DA, 12DB, 12DC, 12DF and 12DG of the Australian Securities and Investments Commission Act 2001 (Cth)
[7] See fn.1 and 2 above
[8] INFO 151 (ASIC’s approach to enforcement)
[9] INFO 151 also references “widespread public harm”
[10] See further discussion in INFO 151 (ASIC’s approach to enforcement)
[11] Goldman Sachs Facing SEC Heat for 'Greenwashing' ESG Funds - Wall Street Whistleblower
[12] ASIC Information Sheet 271 (INFO 271) issued in June 2022. See also RG 234. These views were recently emphasised by ASIC’s Chair, Mr Joseph Longo, in a speech to the Committee for Economic Development for Australia (23 August 2022).
[13] Pax World Balanced Fund ($1.9 billion in assets under management), Pax World Growth Fund ($100 million in assets under management), Pax World High Yield Fund ($70 million in assets under management) and Pax World Money Fund
[14] Sections 203(e) and (k) of the Investment Advisers Act 1940; and sections 9(b) and (f) of the Investment Company Act 1940.
[15] In the matter of Pax World Management Corp., before the Securities and Exchange Commission (Administrative Proceeding File 3-13107). Florence E. Harmon (Acting Secretary).
[16] ASIC Information Sheet 271 (INFO 271) issued in June 2022. See also RG 234
[17] ASIC Information Sheet 271 (INFO 271) issued in June 2022. See also RG 234
[18] ASIC Information Sheet 271 (INFO 271) issued in June 2022. See also RG 234
[19] ASIC Information Sheet 271 (INFO 271) issued in June 2022. See also RG 234
[20] ASIC Information Sheet 271 (INFO 271) issued in June 2022: “Are your headline claims potentially misleading?”
[21] ASIC Information Sheet 271 (INFO 271) issued in June 2022: “Are your headline claims potentially misleading?”
[22] ibid
[23] ibid
[24] In the matter of Pax World Management Corp., before the Securities and Exchange Commission (Administrative Proceeding File 3-13107). Florence E. Harmon (Acting Secretary).
[25] Ibid. The actual terms of the negative screen were:
- companies appearing on the US Department of Defence list of 100 largest contractors (a copy of which may be obtained from the Office of the Secretary, Department of Defence) if…5% or more of the gross sales of such companies derive from contracts with the US Department of Defence;
- other companies contract with the US Department of Defence if…5%...or more of the gross sales of such companies are derived from contracts with the US Department of Defence.
[26] SEC’s Risk Alert entitled “The Division of Examinations’ Review of ESG Investing” dated 9 April 2021
[27] ASIC Information Sheet 271 (INFO 271) issued in June 2022. See also Regulatory Guide 234
[28] Keynote Speech to the Society for Corporate Governance National Conference by Commissioner Roisman SEC.gov | Keynote Speech at the Society for Corporate Governance National Conference
[29] e.g. S&P/ASX200 ESG Indes, S&P Developed Ex-Australia LargeMidCap Carbon Control Index, S&P 500 ESG Index and FTSE4Good Index.
[30] The S&P/ASX200 is regulated under the ASIC Corporations (Significant Financial Benchmarks) Instrument 2018/420.
[31] ASIC Information Sheet 271 (INFO 271) issued in June 2022. See also RG 234
[32] ASIC Information Sheet 271 (INFO 271) issued in June 2022. See also RG 234
[33] “ESG Ratings: A compass without Direction” by David F. Larcker et al. Stanford Closer Look Series, 2 August 2022.
[34] ibid. at p. 2
[35] ibid. at pp. 3-4
[36] ibid. at p. 4
[37] ibid. at pp. 4 and 5
[38] ibid. at p. 4
[39] “Morningstar is Probed by Missouri Over ‘Woke’ ESG, Israel Bias Concerns” by Hadriana Lowenkron. Bloomberg news, 4 August 2022.