Why are ESG issues at the heart of financial institutions’ concerns today when the uncertainty caused by a succession of crises tends to place priorities elsewhere?

There are many reasons for which ESG is nowadays a central concern for financial actors.

The most obvious one, from a lawyer’s perspective, is that institutions are facing several rules and regulations that mandatorily require them to take sustainability factors and criteria into account – be it as part of their disclosure obligations, risk management requirements or product governance and investment suitability frameworks. Regulators are expecting compliance with these rules and regulations and are well equipped to sanction potential shortcomings, albeit they also acknowledge their complexity and still evolving nature.

But ESG is also increasingly becoming a litigation concern.  We have already started seeing a real wave of climate litigation claims, notably in the United States, Germany, the Netherlands and France, where companies are being criticized not only for disclosing sustainability statements deemed not aligned with reality, but also for failing to achieve disclosed ESG commitments, for the use of ambiguous wording in ESG disclosures and even for failing to make sufficiently ambitious ESG commitments.

These cases are often initiated by activist investors that acquire a minority stake in a company for the specific purpose of launching a lawsuit against the company and sometimes even its individual directors - there is thus a risk that this “litigation trend” is not likely to recede.

This, combined with the fact that any ESG-related litigation, regardless of its result, always entails reputational risks by tainting the company’s image, makes that companies are well advised to focus on litigation prevention, in terms of gearing up compliance and ensuring that the applicable ESG requirements are fully understood and implemented.

ESG regulation is also being compared to what has been implemented with the MiFID. Does this follow the same rationale?

Not really in my view.  Historically, MiFID was basically a reaction to the conduct of certain investment professionals, who sometimes exposed their clients to investment risks that these clients were not necessarily aware of or able to understand and that were serving the interest of the professional more than the interest of the client. In that sense, MiFID is a legal framework that first and foremost aims at regulating and harmonizing the conduct of financial advisers, managers, and infrastructures and accordingly at protecting the client.

ESG, on the other hand, is primarily a risk management tool, because ESG risks are drivers of existing risk categories for financial institutions. For example, credit risk can be exacerbated if the property of the borrower that was financed with its loan is destroyed by floods. In fact, it was noted that ESG risks are bad for business and that tackling them could enable a more efficient use of business assets to maintain company profitability over time. This is being achieved by channelling capital flows towards sustainable investments, by forcing investee companies to disclose their ESG risk exposure and strategy, by forcing investment service providers to raise private investors’ awareness and to educate them on the existence of sustainable products and by forcing large institutional investors to evaluate the ESG risks of their investments, notably for the purposes of calculating capital requirements.

Are MiFID developments forcing investment advisors to ask about investors’ ESG preferences?

Yes. Institutions managing or advising on investment products are, under the current rules, required to ask their clients, when verifying whether a given investment product is suitable for the clients, if the clients have any sustainability preferences. The manager/adviser must in this respect explain the concept of sustainability preferences to the client, which is not a meagre task and requires a good understanding of this complex topic.

If the client has sustainability preferences, the manager/adviser must recommend or invest into products that correspond to such preferences.

If the manager/adviser is not able to offer products that correspond to the client’s preferences, the client must be made aware of such product shortage and may then decide either not to invest at all or to adapt his/her sustainability preferences.

What is important to bear in mind, however, is that the client is not forced to have sustainability preferences: he/she may simply say “I don’t care” or “I want to invest in products that are not sustainable”. The client remains hence still free to choose his/her investment product.

Why is it important to have a legal advisor to address these issues?

It is true that an important aspect of today’s ESG debate consists for companies in the definition and implementation of an ESG strategy – and this is typically the area of expertise of ESG consultants, who notably help with business structure evaluation, ESG program definition, branding and communication.

The starting point, however remains in my view with the lawyer, because, before deciding on the adoption of an ESG strategy, and before communicating about such strategy and implementing the latter by assessing which activity or investment is sustainable or not, companies need to understand what is legally required from them: what are the legal obligations imposed upon them, what are the risks linked to non-compliance, and how do these ESG obligations and risks interact with the general legal framework applicable to them.

Only a lawyer can help in assisting with these matters, especially because the ESG legal framework is particularly complex, considering the number of requirements involved, which stem from several texts, which in turn are not always consistent, and which have different scopes of application and different timelines.

Therefore, I would say that, when it comes to dealing with ESG concerns, there is simply no way around a lawyer!

Listen to the podcast Arendt We Live #8 The 7 myths of ESG .