Overseeing Sustainable Investment Funds: The Duties of Fund Boards

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Brandon Horwitz

The year 2022 may well be remembered as the year when ‘greenwashing’ became more than just a potential risk and was seen to impact firms as evidenced by regulatory enforcement in Europe and the USA. A number of asset managers were in the headlines for failures relating to shortcomings between how they described the environmental and other sustainable credentials of the investments in their portfolios vs. the underlying reality. These include well-known names being charged by the SEC in the USA and being investigated by Bafin in Germany.

In its letter to chairmen of Authorised Fund Managers (management companies of authorised funds) (19 July 2021), FCA gave examples of applications for authorisation of ESG funds which had clearly failed the greenwashing test. These included:

  • A proposed passive fund that had an ESG-related name but which FCA found misleading as it was looking to track an index that did not hold itself out to be ESG-focused.
  • A fund claiming to have a sustainable investing objective but which would include significant holdings in high-carbon emission energy companies, with no stated rationale for doing so. (But, interestingly, the FCA accepts that an ESG fund could be designed with the express purpose of taking a stewardship approach that supported companies transitioning to lower or net zero emissions).

Regulation continues to emerge to address these issues, with examples including the established European Sustainable Finance Disclosure Regulation (SFDR) (which continue to evolve), upcoming UK Sustainability Disclosure Requirements (SDR) and proposed US regulation relating to disclosures about ESG investment practices.

A key question which arises is where accountability lies for ensuring that an investment fund ‘does what it says on the tin’, including meeting any specific ESG or ‘sustainable investing’ features.

The answer is typically that the buck stops with the board of the authorised fund manager responsible for the fund. While detailed investment, marketing and disclosure activities will be undertaken by executive teams, regulators ultimately hold fund boards* accountable.

So what can and should fund board directors do to ensure they exercise effective oversight of sustainable investment funds? A number of helpful insights emerge from a research project which I undertook last year in my Fund Boards Council role. This research explored regulatory expectations and current practices by fund boards across six European and Asia Pacific jurisdictions and interviews with 25 people involved with fund boards (mainly executive and non-executive directors).

The first challenge we identified was the simple fact that it was unclear as to what role fund boards should play when it comes to ensuring that sustainability promises are kept. The degree of involvement by fund boards was generally very low and it generated quite a lot of debate in our interviews. We identified a number of actions which could help to address the challenges which arise, including:

  • ensuring that funds have clearly articulated sustainable investing policies, especially in terms of how these policies help to achieve a fund’s objectives;
  • ensuring that the fund board understands and has confidence in their investment manager’s approach to assessing sustainability; and
  • ensuring that the arrangements to monitor fund performance explicitly consider sustainability.

As well as suggesting actions, we also highlighted specific examples of Management Information which we think fund boards should see in order to test the effectiveness of these actions.

The next theme we explored was regulation, where our second major finding was that some fund boards were relatively remote from how relevant regulatory compliance activities were being addressed – things like labelling, disclosures and oversight requirements.

Some of the people we interviewed were simply not aware of how relevant regulations were being met, naturally leaving them exposed to significant risk, as ultimately, they will be held accountable for any shortcomings in compliance. We identified that fund boards can address this risk by satisfying themselves that sustainability requirements are properly incorporated into product governance frameworks and that the controls around fund documentation and mandatory reporting remain effective.

A common theme in our discussions was sustainability data, especially given how key data is to reporting. It is widely acknowledged that there are significant challenges today in the quality and maturity of ESG data. So, we suggested that fund boards ensure that they are aware of the limitations of the sustainability data being used, as well as what data integrity controls are in place.

This led to our identifying a general theme of how firms manage regulatory risks and data risks, and we quickly realised that overseeing sustainability actually impacts risk management in general for fund boards. This is because of how fund managers are increasingly being required to consider and disclose how they have assessed sustainability risks - and climate change risks in particular - at both an entity and product level.

Our research revealed that some fund boards may not have adequately considered how sustainability risk is managed in portfolios or how sustainability is included in the way the fund board considers risk management in general. We suggested that fund boards should ensure that sustainability risk is incorporated appropriately into both their investment manager’s approach to portfolio management and their entity’s frameworks and governance concerning Enterprise Risk Management. By doing this, fund boards can help ensure that all relevant risk management functions are effectively addressing sustainability-related risks. This includes the role of risk functions in assessing key controls such as those which aim to ensure that funds are ‘true to label’, which in turn helps to address the risk of greenwashing.

Finally, we looked at the composition of fund boards themselves. Our research identified that some fund boards were still at an early stage on their journey of knowledge and understanding of the different approaches to sustainable investing. We suggested that fund boards remedy these issues swiftly, for example by undertaking board assessments to identify and address gaps in sustainable investment fund knowledge, skills and experience. We also suggested that some fund boards may benefit from recruiting a subject-matter-expert on sustainability.

As the market for sustainable investment funds evolves in coming years, it will be essential that those charged with overseeing them, especially fund boards, evolve their approach to keep pace and to mitigate risks to consumers, as well as to their own businesses.

* ‘Fund Board’ is used here to mean the board responsible for the fund, whether that is the manco board or a board of an incorporated or free-standing fund.