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Public issuers and investment funds are facing growing pressure from regulators, investors and other stakeholders to integrate ESG into their business and investment decisions. In this episode of the Continuity podcast, Partners Andrea Laing and Ryan Morris discuss litigation risks related to ESG disclosure and the role of regulators.

Transcript

Yula:

Hi, I’m Yula Economopoulos.

Jordan:

And I’m Jordan Virtue, and this is the Continuity podcast.

Yula:

With focus on climate change heightening, regulators, investors and other stakeholders are looking more closely at organizations to ensure they’re meeting environmental, social and governance requirements.

Jordan:

And if companies miss ESG targets, they could face legal repercussions.

Yula:

Today, we are joined by Andrea Laing and Ryan Morris, Partners in our Litigation & Dispute Resolution group, who will be talking to us about ESG from a securities litigation perspective.

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Jordan:

Ryan, I’m sure most businesses know what ESG is and are likely taking steps to meet disclosure requirements, but can you give us a brief synopsis?

Ryan:

ESG refers to environmental, social and governance criteria, and investors are increasingly considering these criteria in determining whether they want to invest in an issuer or a financial product such as an investment fund. So, ESG concerns can range from the environmental impacts of manufacturing or resource extraction to labour practices, operations in certain areas of the world, board composition, board renewal and say-on-pay issues. Basically, ESG is turning into a strategic business imperative in Canada.

Jordan:

Thanks, Ryan. Can you tell us why ESG is a litigation risk?

Ryan:

From a securities litigation risk perspective, we’re seeing ESG’s impact primarily on two types of entities. The first is investment funds, and often these funds purport to prioritize ESG criteria and to attract investors with those criteria. And the second category is public issuers, and the concern, of course, is their disclosure of their ESG practices and their compliance with that disclosure, and directors and officers of those issuers are likely to be included in those issuers if litigation does ensue. So, that, if we think about it, sounds like a pretty narrow cross-section of the market, but it’s actually growing very quickly. The assets under management in Canadian-listed ESG-focused funds accounted for about just one per cent of the total assets under management in Canada. That’s about C$22-billion in these ESG funds out of about a total of C$2-trillion in assets under management in Canada for 2020. That was up 37 per cent over 2019. There’s currently no specific requirements for disclosure on the environmental and social fronts, but those types of requirements are under consideration, and a rapidly increasing number of issuers are formulating and following their own internal ESG disclosure policies. Public issuers and investment funds appear to be subject to litigation primarily in civil actions and regulatory enforcement proceedings. On the civil front, these actions are likely to be brought by shareholders who are alleging either insufficient disclosure on ESG issues or failure to comply with ESG disclosure. And the regulatory enforcement proceedings, of course, would be brought by regulators, again, dealing primarily with disclosure issues.

Jordan:

Andrea, what can you tell us from a regulatory perspective? Are regulators, like the Ontario Securities Commission, paying attention?

Andrea:

Yes, the Ontario Securities Commission and other Canadian securities regulators have taken note of the increased demand for ESG-related investment products in recent years. OSC staff are quite concerned about the risk to investors posed by greenwashing. “Greenwashing” involves the making of exaggerated or unsubstantiated disclosures about an issuer’s ESG-related practices and achievements. The term greenwashing generally connotes intentional or at least reckless misconduct. But Canadian securities regulators are also concerned about inconsistency in ESG terminology across jurisdictions and within industries. Even very conscientious issuers and funds may be using vague or inconsistent language about ESG-related practices and metrics, and this can make it very difficult for investors to compare and contrast ethical investment opportunities. At the moment, the regulatory focus seems to be centred on ethical funds and whether asset managers are truly vetting their portfolios ensuring that investments are consistent with disclosed investment strategies. However, we also expect individual public issuers are going to invite regulatory scrutiny if they cannot substantiate ESG claims they’re making in their disclosures. Canadian securities regulators are coordinating with one another and their counterparts in other jurisdictions to develop guidance. They’re also engaging in public education initiatives and identifying problematic ESG disclosure practices through disclosure sweeps. While we haven’t seen any Canadian enforcement activity around ESG disclosures yet, we think that’s probably just a matter of time.

Yula:

Ryan, I understand there’s case law in the U.S. that deals with ESG-related securities litigation. How do you see things playing out in Canada based on outcomes south of the border?

Ryan:

Perhaps the highest profile cases in the U.S. were launched by the state attorneys general in New York and Massachusetts. Those cases were based on state securities law. Some similar cases have been filed in the U.S. by private litigants. Relatively few of those have progressed. The SCC has also prosecuted in respect to disclosures related to the compliance of diesel vehicles on emissions fronts. In Canada, I think we will start to see shareholder civil claims, regulatory proceedings and possibly even some shareholder activism related to ESG issues.

Yula:

So, what are some of examples of the type of work you’ve come across in your practice?

Ryan:

To date, we haven’t seen specific ESG-related securities litigation or securities regulatory enforcement proceedings in Canada, but there are some important bellwethers that we are monitoring. For starts, there are proposals under consideration by the CSA and other organizations to strengthen ESG-related disclosure requirements, which, of course, will provide a foothold for possible regulatory enforcement down the road. We’re also seeing ESG-focused investment funds gain popularity, and those funds are imposing a discipline on public issuers in terms of disclosure and compliance. As institutional investors, those funds are in a position to require ESG accountability on a scale that individual investors can’t match. What we’re seeing now in Canada, though, is public issuers and fund managers looking to take proactive steps to avoid ESG-related litigation. And what they’re doing is focusing on internal policies, internal procedures and disclosure practice and determining what steps they can take to be sure that ESG-related issues are recognized at an early stage where possible. And, of course, this is the approach that we’re recommending and that we, at Blakes, are happy to assist with.

Yula:

Andrea, do shareholders really care about ethical investing, and can they pursue companies for overstating their commitments or ability to reach certain ESG targets?

Andrea:

The short answer is yes. Many investors clearly do want to invest their money in companies that adhere to ESG-related values such as sustainability. The enormous growth in the ethical funds industry is surely reflective of intense demand amongst retail investors. However, there are many unanswered questions as to how investors’ disappointment in finding out that an issuer or a fund isn’t living up to its professed ESG values may play out in civil litigation contexts.

Yula:

So, how are damages measured when ESG commitments or targets aren’t met?

Andrea:

That’s an excellent question. Some aspects of the ESG investment landscape are truly new and unique, and conventional legal rules for determining damages may not necessarily provide remedy. This is because a company that adheres to strong ESG values could be less profitable initially than a company that does not invest in sustainability or ensure suppliers adhere to ethical practices. This can create incentives for companies to greenwash, and a company with poor ESG performance could provide superior returns for investors. Of course, if a company’s share price goes down because it didn’t meet ESG-related requirements, a more traditional damages analysis will apply and equate to the loss in share value. For example, if an ESG failure resulted from some catastrophic event like an environmental disaster that the company is responsible for cleaning up, that means the company will incur remediation and legal costs, and it can be expected that it’s share price will go down. But what if poor performance against ESG targets actually increases profits? Can investors who made money from corresponding share-price gains still recoup damages for misrepresentation? This issue rarely arose in the past because share-price losses have always been seen to be a required element of a misrepresentation claim. But I think this is a conundrum courts will have to grapple with very soon. Research shows that most investors in ethical investment products expect those products to be more profitable over the long run. However, we could start to see investors dumping shares because they are unhappy with a company’s ESG record irrespective of profitability. While that would be a real paradigm shift, we could see the day.

Yula:

Andrea and Ryan, thank you for bringing more awareness to the litigation risks associated with ESG performance.

Jordan:

Listeners for more information on our Securities Litigation group, please visit blakes.com.

Yula:

Until next time stay well and stay safe!