Institutional investors in Australia are under unprecedented regulatory scrutiny regarding their environmental and social investment commitments and this has significant legal implications for the funds in which they invest. This will have flow-on implications for pooled funds in other jurisdictions to the extent that they have Australian investors or where these regulatory developments are emulated by regulators in other jurisdictions.
The Australian corporate regulator has claimed high-profile scalps after certain regulated funds marketed to retail investors were found to have engaged in ‘greenwashing’ as a result of their environmental and social disclosures being misleading and deceptive.
This raises the spectre of increased scrutiny on disclosures and commitments by managers of private equity, private credit, infrastructure, real estate and venture capital products (Private Funds) in relation to environmental issues. This is not just because institutional investors (like pension funds) that invest in Private Funds are engaged investors who are attempting to drive positive environmental and social change. There is currently heightened risk of Private Funds being found liable for greenwashing. There are three reasons for this.
The laws against misleading and deceptive conduct apply to all, including Private Funds.
The investment activities of a Private Fund could be the root cause of one of the institutional investors in that Private Fund being fined for greenwashing.
For the above reasons, there is a heightened prospect of scrutiny and disputes over a Private Fund’s own disclosures and side letters to the extent they contain commitments by the Private Fund to avoid particular investments and to make certain undertakings (e.g. due diligence, monitoring and reporting activities) for environmental, social or governance reasons.
In this article we offer actionable guidance to help both fund managers and investors adhere to their respective environmental, social and governance (ESG) principles, taking into account insights from rulings in the recent court cases - being (i) Australian Securities and Investments Commission v LGSS Pty Ltd [2024] FCA 587 (the Active Super case), and (ii) Australian Securities and Investments Commission v Mercer Superannuation (Australia) Limited 2024 [FCA] 850 (the Mercer Super case).
The daisy-chain of ESG commitments
Private Funds may wish to make their own environmental, social and governance (ESG) commitments for their own reasons but cannot do so in isolation.
Institutional investors (like superannuation funds) that invest into Private Funds will often have already made public commitments to their own stakeholders as to what types of investments they will avoid on ESG grounds. To ensure they can abide by those commitments and avoid greenwashing, those institutional investors will increasingly seek to extract assurances from Private Funds that investments by the Private Funds will not lead to any breaches of the institutional investor’s pre-existing ESG commitments. Those assurances will typically be documented in a side letter if not already confirmed through the Private Fund’s documentation. This phenomenon is less likely in the public or retail fund space, since those funds tend to be offered on a largely ‘take it or leave it’ basis.
When it comes to implementing an ESG strategy, managers of Private Funds therefore always need to be conscious of three things: (i) their own responsible investment policy (RI Policy); (ii) what is contained in their fund documents; and (iii) what has been agreed with investors in their side letters.
Fund manager considerations
Be careful what you say, wherever you say it: In the Active Super case, the formal documentation produced by the manager with respect to the investment opportunity (i.e. the carefully worded product disclosure statement (PDS) wasn’t solely where greenwashing issues were found, and the court also scrutinised what was discussed by Active Super personnel in interviews, social media posts and presentations, i.e. informal communications. In the Mercer Super case, online videos and website content gave rise to greenwashing by oversimplifying the types of investments that were excluded from the portfolios, omitting key details that were included in their formal investment policies. There are two learnings here for Private Funds.
It is crucial that the offering documents for Private Funds are very carefully reviewed to the extent they contain ESG-related commitments, even though those documents might typically be considered unregulated disclosure documents.
It is equally crucial that informal marketing communications (including investor presentations, media releases and media interviews) are also carefully reviewed to the extent they contain ESG-related commitments.
Detail matters: Flashy and catchy slides or social media posts illustrating a fund’s responsible investment initiatives may be useful in piquing investors’ interest but, if they oversimplify matters and are not technically correct in every situation, this can amount to greenwashing on account of being misleading. Any social media, press statements or panel discussions at industry events that a fund manager engages in should always be strictly in line with the fund’s RI Policy or, at the very least, it should be clearly signposted that particular definitions and exceptions may apply and where to find out those details. In the Active Super case, the oversimplification of information in marketing materials and statements made by Active Super personnel were found to be misleading when compared to the RI Policy of the fund. As such, fund managers should not water down any representation concerning ESG, especially for marketing purposes. Active Super’s marketing materials stated there was ‘no way’ the fund would invest in “tobacco, nuclear weapons, gambling etc” [sic]. This proved problematic given the oversimplification didn’t provide any revenue limits or other considerations and the court applied the reasonable person test when reviewing this point. In his judgment, Justice O’Callaghan stated:
If such a consumer was told, as they were told, that there was No way that [Active Super] would invest in tobacco or gambling, he or she would not search around for some investment policy that might qualify such statements.
Fund managers should ensure that their RI Policy is not just a document that sits on a website but rather a document that is integrated into every aspect of the way they manage their business and into every external statement they make about their ESG commitments. In the Active Super case, despite the RI Policy being available on Active Super’s website (allegedly “only two clicks away”), the court did not consider that Active Super’s RI Policy was sufficiently discoverable by a reasonable person because there were no cross-references to the policy. As a result, common sense definitions, exceptions and leeway afforded by their formal policy did not cure the misleading nature of oversimplified statements that had been made elsewhere.
Be clear about the commitment: As noted above, Private Funds often make two kinds of ESG-related commitments. First, they may have their own set of commitments that they have formulated and adopted internally. Secondly, there may be bespoke commitments that have been negotiated into side letters with particular institutional investors in the Private Fund. It is essential that there is complete certainty about the scope of both types of commitments. One aspect to be clear about is whether the Private Fund’s commitments only limit the Private Fund’s direct investments into portfolio companies or whether they also limit the kinds of investments that might in turn be made by the portfolio companies. Precision is required as to the sectors or revenues that are precluded. In the Active Super case, there was a dispute whether restrictions aimed at tobacco covered tobacco production, manufacture, sales or possibly even tobacco packaging and printing. Similarly, there was a dispute over whether restrictions aimed at gambling covered lotteries too. There can also be disputes over whether commitments and restrictions only apply at the time of acquiring an investment or whether they must be complied with at all times, or from time to time based on an agreed frequency.
Lowest common denominator: Fund managers need to understand from the outset how their own RI Policies are implemented and what they are willing to do in order to cater for their investors’ own requirements.
There are several trade-offs that need to be managed.
On the one hand, tight ESG commitments that preclude investments being made if relatively small amounts of revenue are generated from contentious sectors might strike a chord with some institutional investors. That said, this narrows the Private Fund’s investable universe. On the other hand, setting higher revenue limits (i.e. the point at which an investment becomes impermissible) makes for a wider investable universe but may potentially underwhelm institutional investors.
Wherever a Private Fund lands with regard to its own limits, some institutional investors may insist on stricter commitments via the side letters they negotiate. A Private Fund may potentially find itself in a position where the entire fund is bound by the strictest set of side letter commitments, particularly where there is no structural flexibility to create sidecars for a subset of investors with certain precluded investments.
Once all the relevant ESG commitments are finalised, a Private Fund could consider setting their internal compliance limits even tighter still, to minimise the risk of inadvertently breaching a ‘hair trigger’ and by identifying early any investments at risk of breaching a limit. Fund managers could be slapped with a fine or face disgruntled institutional investors should their non-compliance result in their own investors receiving a fine - a sink or swim moment for any investor relations relationship.
Investor considerations
Know what your limits are: When proposing side letter or fund document restrictions on a fund manager, it is important for an investor to know what their own RI Policy entails or what their obligations are to their underlying investors and/or members (if any). If the commitments which an institutional investor extracts from their Private Funds leave open the possibility of investments that violate the institutional investor’s own commitments, the institutional investor will carry residual greenwashing risk. Given the number of investors that will require a fund manager to adhere to (often slightly varied) ESG restrictions, it is common for the fund manager to try and fit all investors into ’one box’ to create a single ESG standard for the fund manager to have to apply in its investment process. However, being strong armed by a fund manager into a certain ‘box’ could mean that the investor ends up agreeing to standards that are weaker than what their internal RI Policy allows. This prospect should be borne in mind when institutional investors formulate (or update) the ESG commitments contained in their own RI Policy to allow for this foreseeable scenario.
Outside of Australia, fund managers adopt an ‘excuse’ mechanic so they are able to treat investors on a case-by-case basis and exclude certain investors from investments that have the potential to breach those investors’ internal RI Policies or side letter commitments. In Australia, the regulations relating to commonly used Private Fund structures do not allow for excuse rights and therefore fund managers adopt a blanket ban approach.
Understanding what an investor’s internal RI Policy restrictions relate to is helpful both for the investor and for the fund manager to ensure compliance. As an example, if an investor’s RI Policy states that an investment cannot derive any revenue from alcohol, would an investment in a SAAS provider that generates a large portion of its revenue from alcohol breach this restriction? Therefore, when investors are offered the ’box’ in which the fund manager wants them to fit, understanding exactly what the internal RI Policy restricts is key.
Ensure appropriate controls: In the case of listed investments, it is common for ESG commitments (and the associated negative screens) to be applied at the time of inception and also regularly thereafter. In Private Funds markets, it is standard practice that negative screenings are generally only performed at the time that investments are made as fund managers generally seek to avoid moving compliance targets. Given this status quo, investors do not necessarily push that the negative screenings are carried out at periodic intervals during the life of the investment. While this may be standard practice in the market for Private Funds, it is still important that the practice is consistent with the commitments that have been made in their own RI Policy or governing documents. Either institutional investors should be satisfied that (i) their own commitments do not require the ongoing or periodic screening of existing Private Fund investments, (ii) their commitments at the time of their initial investment into the Private Fund only needs to be satisfied at that time regardless of any amendments to their own RI Policies or, (iii) alternatively, they should endeavour to negotiate assurances that the Private Fund will indeed conduct period re-screening of the Private Fund’s investments at an acceptable frequency or for the institutional investor to be able to provide the Private Fund with any updates to their RI Policy from time to time.
What happens when things go wrong: Unlike in public markets, investors are typically locked into their Private Funds for the term of the fund and liquidity isn't readily available - therefore, if an investment is made that breaches an investor’s internal RI Policy, there is little the investor can do to limit the exposure to that investment. Given this dynamic, investors should consider upfront what this scenario would mean in practice and seek to build in protections into their side letters if their own RI Policy is breached. This could be in the form of a ‘best efforts’ provision to, in the event of such breach, (i) procure a liquidity event for the investor (i.e. through a secondary sale of the interests), (ii) transfer their interest to an alternative investment vehicle so the affected investor is no longer exposed to the investment (an approach generally adopted by US managers) or (iii) dispose of the investment. Unless an institutional investor’s RI policy and commitments allow for this sort of leeway and response, the institutional investor may nevertheless carry a residual risk of greenwashing.
While we are yet to see Australian regulator enforcement for greenwashing offences against Private Funds managers, given the global nature of the Private Markets, the lessons learned from the Active Super case are equally applicable to both Australian managers and those global funds that the various institutional investors invest in.