by Matthias Plötz 13 March 2023

Whenever new legislation hits the road, unease about enforcement rides shotgun. Yet, while regulatory prosecution is a real concern, ESG carries with it another, potentially economically more devastating threat: private litigation.

It is enabled by several contributing factors, as Chris Boyne, partner at Debevoise & Plimpton, observes: “Claimant firms and the courts have become more sophisticated, resulting in – among other things – a growing familiarity with the use of group claims, which have some similarities to US class-action lawsuits. Additionally, activist investors are using litigation tools, such as the derivative claim procedure, to force changes in companies’ ESG strategies.”

Dedicated litigation funders such as Aristata Capital are mission-driven. The firm wants to “fund high quality litigation in order to achieve measurable social and environmental impact” by “harnessing the power of private capital to drive systemic change at scale”.

And their legal advisers are gearing up in their own right. Mishcon de Reya houses ‘Mishcon Purpose’, an initiative that, among other things, aims to “identify, build and fund litigation claims that drive constructive societal change and deliver measurable positive impact”. The firm is not alone – another large international law firm has partnered with litigation funds to provide sufficient capital for ESG-related claims. Finally, Katten has launched an ESG risk and investigations practice, which comprises expertise in ESG, corporate compliance and internal investigations.

While activists and philanthropic organisations are a likely claimant base against PE firms, with increasing amounts of regulation there is also greater scope for investors to sue GPs on the basis of non-compliance, misrepresentation and contractual breaches.

Prepare for trouble...
Potential lawsuits can go down a variety of routes and, at the fund level, it is currently harder to predict their nature. At particular risk are funds marketed as conducting ESG-positive investments or being ESG-aligned as they will likely constitute initial targets.

One possibility is a contractual claim arising out of M&A deals. “ESG factors are now a part of due diligence. Subsequently, there is a possibility for PE firms to incur contractual liability given the increasing use of reps and warranties to manage ESG risk,” says Boyne.

“Counterparties may allege a breach of contract if it transpires that the reps and warranties in respect of ESG issues were false or misleading.” It has further been suggested that LPs might use allegations of non-compliance with ESG criteria to exit non- or underperforming funds and issue claims for compensation.

Similarly, private parties could sue for misrepresentation of a fund’s ESG disclosures and criteria. Compulsory ESG commitments as laid out in the SFDR or SDR are not the only potential source of legal firepower here. While PE funds are not signatories to the Paris Agreement and therefore not strictly bound by it, legal threats could arise from funds’ presentation as being Paris-aligned while not actually being so.

Finally, it is important to keep in mind that regulatory scrutiny and private litigation are not necessarily exclusive, particularly around claims of misrepresentation. While the regulator might issue sanctions on the basis of alleged greenwashing, third parties can simultaneously sue for misrepresentation of a fund’s ESG disclosures and criteria.

...and make it double
A much clearer threat is posed by litigation at the portfolio level. PE teams sitting on the boards of their portfolio companies are vulnerable to derivative claims alleging a breach of fiduciary duty for mismanagement and failing to take into account ESG risks.

While such claims face significant procedural and evidential hurdles, making it hard to get them off the ground, personal litigation remains a powerful tool. Even if claims are ultimately unsuccessful, they can nonetheless lead to the changes in behaviour that NGOs and other claimants are seeking, as well as legal precedent that lays the fundament for future proceedings.

In the UK specifically, claimants could additionally take action under Section 90 or 90A of the Financial Services and Markets Act 2000. In short, these provisions allow investors, buyers, sellers or holders of securities who suffer losses due to untrue or misleading statements or omissions from company statements, to sue and claim statutory remedies.

Class actions are uncommon in the UK but they are growing in numbers and, particularly where the regulator has stepped in and issued a fine for greenwashing, they lay strong grounds for private claimants to come forward.

Three-point safety belt
The bogeyman of litigation sounds very real at this point, however the risk of crashing into him on the road can be mitigated with the right headlights.

At the start of a fund’s life, it is important to ensure alignment between the LPs’ and GPs’ interests, as conflict can lead to accusations of non-compliance or greenwashing later down the line.

When acquiring a portfolio company, ESG issues should be included in the due diligence process, including a given asset’s existing policies and material contracts. If possible, data on an asset’s emissions and impact should come from a reliable, independent source to decrease the burden on the GP.

Once an asset has been acquired, PE staff appointed as directors to its board should stay on top of evolving fiduciary standards on ESG compliance. Especially where the fund itself is being represented as an ESG fund or ESG-compliant.

Reporting throughout the lifecycle should be done against recognised standards. Adopting globally accepted standards such as the UN Principles for Responsible Investment makes reporting less vulnerable to challenge.

While disclosing the subsequent reports might seem like painting a target on one’s back, transparency might reduce the likelihood of claims. Particularly if the GP can provide a definition of ESG as it pertains to their investment strategy, how assets are targeted, how due diligence is executed and how monitoring is conducted.

It should not be forgotten that litigation used to drive economic changes is not necessarily a bad thing. However, it does pose an economic and, if initiated by LPs, reputational risk. From claims arising out of a GP’s contractual relationship over derivative action to group and compensation claims, all roads lead to the courtroom. But with a diligent approach to LP relationships, fund formation, asset selection and reporting against internationally recognised standards, PE firms have a multitude of safety belts at their disposal to ensure their security, should the car crash.

Categories: AnalysisESGESG policyESG regulationESG updateFundraising & fund structuringFund docsODD / DDQOutsourcingLegal & compliance advisoryRegs & ComplianceRegulatory update

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