Dentons - Sustainability and corporate governance in the financial markets

The ESMA implementation timeline for the regulation of sustainable finance (updated on 26 September 2022) is clear evidence that both policy makers and regulators are committed to the transition to a greener economy. Indeed, their actions thus far have been to ensure a regulatory framework capable of supporting and promoting this transition by integrating environmental, social and governance (ESG) factors across the safeguards and backstops set forth for exercising financial services and asset management. In particular, the European Supervisory Authorities (ESAs) have been working on—through their Joint Committee—specific Regulatory Technical Standards (RTS) with regard to disclosing and presenting sustainability-related information about the development of their business.

Consider first that, on 30 September, the ESAs extended the scope of those standards to include fossil gas (natural gas) and nuclear energy activities. Bearing in mind the social and economic turmoil of these times of war in Ukraine, it is important to remember that the aim of the amendments is full transparency about investments (in the gas and nuclear industries), which tends to unify the debate on the nature of the relevant interests and the necessary means to guide intermediaries towards actions that—are not only correct with respect to the rights of clients, but—ensure the safeguarding of the social welfare of the world’s population and the preservation of the biodiversity of our planet. Therefore, these RTS clearly go beyond the traditional concept of the relationship between ethics and finance, extending as far as aiming to influence the organizational structures of the intermediaries, as well as the objects of investment of clients.

In addition, on 10 October 2022, ESMA announced its strategic priorities for the next five years, with a view to strengthen supervision, enhance protections for retail investors, foster effective markets and financial stability, enable sustainable finance, as well as to facilitate technological innovation and effective use of data. This strategy suggests that sustainability will also fundamentally affect how supervisors’ operate—with an increased sensitivity towards an investment’s environmental impact, and will increase their ability to interfere in the strategic choices of financial firms and asset managers. In this respect, ESMA’s technical advice on MiFID II proposed to incorporate ESG considerations within firms’ processes, systems and controls in order to ensure a greener investment and advisory process.

The attention the strategic priorities give to this pattern stems from recent crisis experiences, during which critical environmental and social issues emerged, emphasized by a management model oriented towards the short term. It is clear that the regulatory reaction to this pattern initially focused on enhancing the role of “virtuous stakeholders”—in order to make them privileged interlocutors of management—and then concerned itself with hardening the operational discretion of directors in the environmental sphere. Indeed, market operators must take into account that ESMA’s institutional strategy includes supporting the transition to a more sustainable economic and financial system. In this respect, the program of activity of any intermediary must take into account the priorities included in ESMA’s Sustainable Finance Roadmap. In other words, the governance of financial products will require the effectiveness and integrity of ESG information as well as compliance with an improved ESG regulatory framework. All the above will also affect the role of investors in financing the transition to a greener economy, provided that institutional investors are showing a specific sensitiveness to such goal.

As a result, it is foreseeable that ESMA will further strengthen its role as a data and information hub in the EU and will focus on extending the effective use of data in financial market supervision to support the goal of financial sustainability. In this respect it is worth noting ESMA’s comments to the European Financial Reporting Advisory Group’s public consultation on the first set of draft European Sustainability Reporting Standards (ESRS) in which it delivered specific technical remarks on the details of the draft standards. All the above highlights the need for market operators to take account of, to the greatest extent possible, any global initiatives, while remaining compliant with the EU’s legal framework and sustainability objectives.

Hence, ESMA’s proposal that investment firms be duty-bound to disclose all conflicts of interest that could be detrimental to the interests of adopting environmentally sustainable practices, that they be socially responsible, and (or) that they have good corporate governance, comes into consideration. From a law and economics perspective, it is possible to agree with ESMA’s proposal requiring financial firms to consider sustainability risks when establishing risk management policies and procedures. Furthermore, the product governance of ESG profiles must also be considered. This is the ground for proposing that manufacturers and distributors consider clients’ ESG preferences within the investment product’s target market and within the mandatory product review process.

This leads to an understanding of the changes to the MiFID II-delegated acts to integrate sustainability factors, risks and preferences into investment firms’ regulatory obligations. Obviously, this is one of a considerable set of initiatives (in line with the Italian code of self-discipline of 2020) aimed at promoting the principle of sustainability, which jeopardizes the goal of profit “at any cost.” Indeed, ESMA is working on updating its Guidelines on product governance and suitability requirements in order to apply this principle.

The same attention should be paid to the growing importance of the main amendments reflected in the ESMA Guidelines on sustainability. It is useful to also consider that collecting information from clients on sustainability preferences increases the possibility to understand the attractiveness of the different types of sustainable investment products and to what extent they are able to support financing by sustainable enterprises. However, the proliferation of regulatory (and other kinds of) references to sustainability is becoming so broad that it can be misleading for market operators; that said, assessing sustainability preferences can support financial firms in identifying a range of sustainable products (suitable for their clients and compliant with the client’s sustainability preferences).

When assessing organizational requirements, it is essential to reread the rules of conduct concerning institutional investors and issuers. Utility, efficiency and risk aversion are used to describe the need to promote profit that is sustainable over the long term, when all needs tend to converge towards the goal of maintaining adequate stability and sustainable growth. Hence, financial firms will need to restate their work practices in order to focus on sustainability topics and keep appropriate records of the sustainability preferences of their clients and other relevant stakeholders.

As the rise of a new consciousness about the environment involves the management of new risks, such management must be properly regulated and supervised. Along with this need to protect the environment is a need to protect civil rights and financial resilience (through adequate corporate governance). The focus is then directed towards transparency, stability, solvency and competition. This means a need to align current regulations to strengthen sustainable actions and to adequately and comprehensively address environmental risks in the provision and consumption of financial services.

In this respect, it is worth mentioning The Logic of Collective Action: Public Goods and the Theory of Groups, by American economist and political scientist Mançur Lloyd Olson, Jr. This book may provide a solid background for understanding that a significantly popular preference for ESG compliant financial products will undoubtedly be based on how each investor individually benefits. Indeed, it seems that investors—as members of large groups—do not act in the common interest unless they are motivated by personal gains (economic, social, etc.). In other words, there is the need to provide incentives to align private actions and their sustainable outcomes. Nevertheless, ESMA recommended amending relevant requirements to ask all UCITS management companies and AIFMs to consider sustainability risks in their internal processes, systems and controls.

Furthermore, implementing a law to regulate sustainability may seem to be a contradiction, but it is acceptable that strict regulation and broad innovation are not opposites, as both tend to improve the social welfare (the former, by protecting individual’s rights, while the latter promotes easier operational standards). Anyway, it is clear that asset managers should devote sufficient resources to the integration of sustainability risks and ensure that management is responsible for the integration of sustainability risks. In this respect, it is worth noticing that fund managers should also consider sustainability risks in their due diligence processes.

And to address the regulatory perspective, it’s worth recalling that the final versions of the Delegated Acts were published in August 2021. At the time they were designed to complement the obligations in the Regulation on sustainability-related disclosures in the financial services sector (SFDR) and the Taxonomy Regulation, incorporating sustainability issues and considerations into the EU financial services regulatory framework, including the UCITS Directive and the AIFMD. However, the waves of global crises beginning in the new millennium may have jeopardized citizens’ trust in the value of market efficiency. Indeed, from the point of view of the investors (i.e. those who felt the effects of the battle between the failure of the financial markets and the limits of economic policies), the directive on corporate sustainability due diligence is a demonstration that an enhancement of corporate social responsibility can lead to a significant enhancement of public oversight of private of business in the name of protecting interests deemed superior.

Therefore, for sustainability purposes, organizational arrangements must be adapted to the nature and size of the enterprise, and they must implement traditional norms. However, can the adequacy of organizational arrangements be evaluated on their merits? In other words, does the business judgment rule also apply to enterprise organization decisions? After all, the acts of an organization assumes a discretionary choice of the directors, and therefore in this sphere—in the absence of specific precepts—directors go under the business judgment rule. While it is true that the need for sustainability requires the management of any business risks, it is also true that this choice must be convenient for directors as well as shareholders of the firm.

The transactions involved in sustainable finance raise issues of a new type, while the investments will be connected with new features that refer to new risks (related to the absence of public supervision of their actual impact on the environment). That said, it is clear that the environmental issues cross territorial, governmental, and personal boundaries (which the financial markets were subjected to in the 20^th century, when the role of nation states and their sovereign powers were predominant). Today, it is worth considering the idea that the liberalization process that started in the 1990s is now going envelop the globe and then promote a generalized convergence towards a structural change in the business and organization of intermediaries that will need to develop models of governance leading them and their clients to move beyond the mere application of rational investment formulas and to assume the role of responsible influencers that direct the flow of investments towards intergenerational socio-environmental goals.