Travers Smith's Sustainability Insights: Sustainability and private funds - is it possible to set the bar too high?

A regular briefing for the alternative asset management industry.

Proliferation of policies has become a fact of corporate life. Designed to mitigate a wide range of identified risks, company policies are now virtually compulsory for even the smallest business. Indeed, in a private equity-backed company, the investor-nominated directors would be well advised to ensure that any potentially significant liabilities are covered by a comprehensive policy. Data protection, competition law, health and safety, climate change and anti-corruption are some of the most common examples, but every company should carry out its own risk assessment and respond accordingly.

That's a good thing, of course. Countless workplace accidents and environmental catastrophes have been avoided by adherence to a well-designed policy. But it is also obvious that establishing a policy is only the start: ensuring that it is regularly reviewed, and applied consistently, is just as important as having the policy in the first place.

That principle – that a flawed or ignored policy can be worse than no policy – also applies to a private fund manager, and a recent UK Supreme Court case should serve as a timely reminder that taking responsibility for sustainability issues across the portfolio should be approached with care.

The reminder is timely because it is now virtually impossible to raise a European private capital fund without an ESG ("environmental, social and governance") policy, and due diligence questions will also probe a firm's approach to responsible investment. In fact, recent EU reforms now require an asset manager (including a private equity firm) that is regulated in the EU, or accessing EU-based investors, to disclose its approach to sustainability risk, and firms that make claims about the environmental or social characteristics of their product will be required to report annually on how they have measured up. The pressure to talk positively about ESG is definitely increasing, and many firms are busy beefing up their disclosures.

...But there are real dangers for firms that fail to put enough substance behind the claims that they make...

But there are real dangers for firms that fail to put enough substance behind the claims that they make. Regulators will look hard at potential mis-selling claims, and the temptation to over-reach during fundraising could give rise to onerous – and potentially embarrassing – reporting requirements later. One example is the EU's forthcoming Taxonomy Regulation, a binary classification system for environmentally-friendly activities, which will impose reporting requirements on firms that make claims about the environmental credentials of their funds. It is vital for affected firms to understand the scope of these obligations – not easy, given the lack of clarity in the EU rules.

Perhaps even more concerning is the potential for a private equity firm to be liable to third parties for failure to follow through on its commitments. Here the law varies from country to country and, in the UK at least, is developing. In a well-publicised recent case, the UK's highest court refused to dismiss a claim against Royal Dutch Shell, the UK parent company, for damages resulting from alleged leaks from a pipeline operated by Shell's Nigerian subsidiary. Although only a preliminary ruling on whether the case should proceed to trial in the UK, the court made it clear that normal principles of the law of negligence can operate to impose liability on a company that assumes operational management of certain aspects of the business of another, or promulgates group-wide policies and takes steps to ensure they are implemented. Furthermore, in an earlier case, the Supreme Court had also held that – even if one company does not actually exercise control over the activities of another – it can be liable "if, in published materials, it holds itself out as exercising that degree of supervision and control".

So far, these principles have only been applied by the Supreme Court in preliminary (jurisdictional) hearings to multi-national companies, and it is unlikely that most private fund managers would assume the same level of operational control over portfolio company activities as these corporate groups – which commonly adopt group-wide policies and procedures. Nevertheless, firms would be well advised to ensure that – where they accept responsibility for specified matters in their portfolio companies, or make claims to outsiders about those matters – their corporate governance systems match that level of responsibility and they understand the liability they may be taking on as a result of their policy framework. The risk may be particularly acute for emerging markets fund managers, but these cases underline the need for all firms to live up to their commitments, and not to over-state their degree of actual intervention in (for example) environmental or human rights matters.

More broadly, there is an overall trend in the UK courts to permit, for policy reasons, novel negligence-based claims to proceed where the claimants are seeking to impose liability up the value chain for alleged harms overseas. Whether those claims will ultimately succeed at trial remains to be seen, but the litigation risk landscape is shifting, bringing with it the potential for increased commercial, reputational and financial costs.

Policies are vital to manage risk, and disclosures about those policies are now commonplace. But, for a private fund investor, setting the bar too high – at a level the firm may struggle to reach – could itself be a significant risk, and one that should be overseen by the firm's senior management.

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