UK: Pension Trustees And ESG-Related Litigation Risk ESG: Ensuring Sound Governance

ESG: Ensuring Sound Governance

1. Introduction
2. Background
3. Litigation risk in investment decision making - McGaughey v USS
4. Litigation risk attaching to public statements
5. Conclusion

1. Introduction

1.1 This briefing summarises the potential ESG-related litigation risks that pension trustees face in relation to:

2.6 In practice, this means the scope for ESG considerations within a pension scheme's investment strategy will often depend upon identifying "financially material" ESG factors and integrating these into the scheme's investment decision-making. This means trustees need to adopt and run governance systems that are genuinely effective in helping them to identify relevant ESG factors and weigh these alongside other financially material (relevant) factors to build a rounded investment decision. This requires joined-up support from advisers and can sometimes be helped by specific training, for example on emerging issues and investment practices. For more detail on this, please see our chapter in the International Comparative Legal Guide to ESG Law: "ESG and UK Pension Schemes: a matter of governance".

3. Litigation risk in investment decision making - McGaughey v USS

3.1 The recent case of McGaughey v Universities Superannuation Scheme Limited highlights more clearly than ever the exposure to ESG litigation risk that pension trustees now face, and the importance of trustees' assessment, review and communication of climate risks and targets (and other relevant ESG factors) as a matter of good governance.

3.2 The McGaughey case was a derivative action (i.e. brought in the name of the company) against the directors of the corporate trustee of the Universities Superannuation Scheme ("USS"). The claim was brought by two academics, members of the USS, who alleged, among other things, that the directors had breached their statutory duties to the trustee company by failing to cause it to create a credible divestment plan for fossil fuel investment. The two claimants were members of the USS but not shareholders in the trustee company. They claimed to have wide support from scheme members and to have met their legal fees with crowd funding from over 11,000 donors.

3.3 In particular, the claimants alleged that the USS continued to invest directly and indirectly in fossil fuels and that, although it announced in mid-2021 that its ambition was to be carbon neutral by 2050, the directors had failed to form an adequate plan to deal with the financial risks involved in such investments. The claimants argued that this constituted a breach of the directors' duty to the company to act for proper purposes, including making investments that avoid significant risk of financial detriment to the scheme, the beneficiaries and the company, and to promote the success of the company having regard to its long-term interests. Alternatively, the claimants argued that the directors had failed to take into account a number of relevant considerations in failing to have a plan and that, in the light of those considerations (which included the Paris Agreement and the results of an ethical investment survey), the directors were in breach of their duties under the Companies Act 2006 by failing to make an immediate plan.

3.4 Derivative claims of this type are highly unusual in the pensions space and are one of the few potential exceptions to the normal rule that where there is a corporate trustee, liability for the actions of the trustee company stop at the company entity and do not attach to individual directors. They are also an exception to the general rule that claims in respect of loss to a company should be brought by the company and not by its shareholders. As such, they need the court's permission to proceed, and in McGaughey the High Court refused permission in May 2022 on the basis that the claimants had not been able to make out an initial case that the trustee company had suffered or would suffer an immediate financial loss as a consequence of the directors' alleged failure to cause the trustee company to adopt an adequate plan for the long-term divestment of the USS' investments in fossil fuels.

3.5 In contrast to the very limited evidence submitted by the claimants, the corporate trustee board adduced detailed evidence to support their position that they had complied with their duties. This included details of the trustee company's investment strategy for the USS and how the investment powers had been exercised over the past 20 years, including:

3.5.1 publishing a discussion paper on climate change;

3.5.2 taking legal advice and publishing it on the scheme website so members would understand the framework for investment decisions;

3.5.3 conducting a survey of members; and

3.5.4 adopting a set of principles to guide the scheme towards net zero, as well as policies for working with the companies in which they invested in the meantime.

3.6 The court found that these goals and actions were well within the discretion of the trustee in exercising its investment powers.

3.7 The claimants in McGaughey also asserted that some of the trustee directors had put their own interests or beliefs before the interests of USS members and the trustee company but the court found that this allegation was not borne out.

3.8 It is worth emphasising here that there will usually not be any single right or wrong decisions when it comes to investment strategy. Instead, there will be a range of reasonable decision-making, and trustees will need to satisfy themselves that they are within that range based on decision-making that is supported by appropriate governance, as outlined above. Wherever they alight upon that spectrum of reasonable decisions, the McGaughey case highlights the importance of having detailed evidence in relation to investment decisions, including evidence that appropriate processes existed and were followed, and that decisions, and the basis for them, including any advice which was taken, were appropriately documented.

3.9 The Court of Appeal (CoA) heard an appeal of the High Court's decision in June 2023 and resoundingly rejected permission to appeal on all grounds, describing the claim as one that was "bound to fail". Fundamentally, the CoA found that the judge at first instance was correct to determine that there was no loss and that as a result the claim was not a derivative action (because there was no harm for which a remedy was being sought).

3.10 The CoA held that the claim was in fact most akin to a beneficiary derivative action or an administration action. Those procedural routes, however, would have necessitated the claimants seeking to represent scheme members with the same interest as theirs and joining representative defendants in relation to different interests from within the scheme. The CoA posited that the claimants attempted to "shoe-horn this action into the straitjacket of a common law multiple derivative claim" in order to avoid these difficulties.

3.11 The CoA then seemingly sought to shut the door on potential copycat claims against pension trustees, by stating in terms that the fact that the claimants were scheme members did not place them in a position which is analogous to the position of a shareholder in a company derivative action. In particular, the judgment noted that the action amounted to the claimants "seeking to interfere with the decision making" of the trustee company whilst attempting to "challenge [its] management and investment decisions...without any ground upon which to do so".

3.12 The McGaughey claimants' attempted use of a derivative action in the context of a pension scheme trust was both novel and bold, but this is typical of the current trend of claimants seeking innovative ways to bring ESG-related litigation. Although the claim fell at the first hurdle, that is unlikely to deter claimants from trying to challenge trustee directors' conduct on environmental and other ESG-related matters by reference to statutory duties, and we are likely to see further such attempts by claimants in the future. The McGaughey case also shows how those defending such claims, even if the claim is weak or unsubstantiated, will have to provide disclosure and face public scrutiny of board strategy and decision-making, which, as noted above, may be seen by some claimants as a victory in itself.

3.13 As well as litigation through the courts, we are also seeing ESG-related complaints made to the Pensions Ombudsman. In 2021, a member of the Shell Contributory Pension Fund (Mr D), who was backed by activist ClientEarth, complained that the trustee had failed to provide him with information relating to how the potential risks arising from climate change were being taken into consideration by the scheme, including the scheme's investment strategy and risk management framework. The Ombudsman rejected the complaint, finding that there had been no breach of any disclosure duty or maladministration. Again, the salient point here is that the scheme could provide substantive evidence of having considered climate risks in some detail, and had offered to engage directly with the member about this. Generally, then, such complaints should not succeed where trustees have properly considered the relevant issues, documented their approach, and complied with their legal obligations to provide information to members, but Mr D's complaint is a good example of how activists (here ClientEarth) are finding novel routes to apply pressure and generate publicity.

4. Litigation risk attaching to public statements

4.1 Notwithstanding pension trustees' own appetite (or not) for making public statements in respect of ESG-related issues, they may face pressure (from both internal and external stakeholders) to publicise their position and are now subject to specific ESG disclosure obligations. The detail of those obligations is beyond the scope of this briefing, but in summary, for all but the smallest schemes they include a requirement to publish Statements of Investment Principles ("SIPs") (which detail the policies controlling how a scheme invests, including consideration of financially material ESG and climate factors) and Implementation Statements ("ISs"). Larger schemes also face TCFD reporting requirements.

4.2 In 2022, the Government published highly ambitious statutory and non-statutory guidance which seeks to promote a step change in industry practice around stewardship and other related matters, including through reporting via the IS. Among other things, this encourages trustees to consider and explain how (or why) their chosen approaches are in the best interests of the scheme's members. Separately, the Pensions Regulator announced in March 2023 that it will be focusing more on "climate and ESG non-compliance", which will involve checking that trustees of in-scope schemes have published SIPs and ISs, and it has explicitly stated that a failure to comply risks enforcement action. It has published detailed guidance for pension trustees to help them understand and meet the reporting requirements to which they are subject.

4.3 A particular concern in this regard is "greenwashing". Whilst that term is widely used, it lacks a uniform definition. Broadly speaking, however, it refers to the practice of making misleading or overstated claims about environmental or sustainability credentials.

4.4 Allegations of greenwashing are a live risk for pension trustees. As detailed above, the Pensions Regulator is increasing its activity in this space. In addition, regulators of other bodies including the FCA, the CMA, the ASA and the SEC have all recently increased their enforcement action on ESG issues:

4.4.1 the FCA has recently published its consultation paper on the new UK sustainability disclosure regime and investment labels (including a new "anti-greenwashing" rule which restates the existing rule that disclosure should be fair, clear and not misleading in an ESG-specific context);

4.4.2 the CMA has announced its first review of compliance with its Green Claims Code and an intention to take action against businesses it considers are greenwashing;

4.4.3 the ASA has censured a number of businesses for misleading advertisements regarding their green credentials; and

4.4.4 the SEC has launched an enforcement taskforce dedicated to climate and ESG issues having already opened a series of ESG-related enforcement actions involving financial services market participants.

4.5 It is difficult to be prescriptive as to the kind of statements by pension trustees that might attract greenwashing litigation risk, however speculative such a claim might be. That said, by way of broad guidance, trustees could consider the following:

4.5.1 ensuring statements to do with investment activity are consistent where they appear across multiple different documents (or within the same document);

4.5.2 where schemes have identified that they are divesting from companies which derive revenue from specific business activities (for example, fracking), clarifying whether schemes remain invested (whether directly or indirectly) in companies which carry out similar activities (for example, coal mining);

4.5.3 ensuring clarity and precision as to the characterisation of discretionary and automatic investment decisions, for example specifying automatic divestment versus active consideration of divestment; and

4.5.4 being realistic about the nature of any commitments or targets that are quoted, including whether these are binding and whether they may be kept under review.

4.6 A relatively recent addition to the ever-expanding ESG glossary is "greenhushing" i.e. when organisations choose not to fully communicate their ESG credentials, in the hope of avoiding scrutiny and potential litigation. Leaving aside the risks that greenhushing itself can bring, trustees do not in any event have the option of staying silent, either in terms of their regulatory reporting obligations or in practice.

4.7 Instead, given the clear benefits and opportunities afforded by articulation of a transparent ESG strategy and positive ESG-related statements, trustees should aim to address the relevant risks by careful verification of their statements alongside effective due diligence, as well as implementing processes which ensure that any asserted intentions do materialise.

4.8 In order to resist greenwashing and other ESG-related allegations more effectively, trustees should ensure that their public statements concerning ESG matters i) are clear and unambiguous; ii) are not misleading or overstated; and iii) can be independently verified and corroborated by underlying evidence. In doing so, it is crucial that a forensic and methodical verification exercise is undertaken and that sweeping statements that are difficult to substantiate are avoided. This approach can give trustees better scope, in terms of capacity and reputation, to pursue and execute ESG-related strategies and opportunities effectively and with confidence.

5. Conclusion

5.1 Trustees of UK occupational pension schemes need to be alive to the risk of ESG-related litigation as public focus on topics like climate change continues to increase. We can expect to see more novel claims like McGaughey as scheme members, other stakeholders and activist claimants look more closely at trustee decision-making and investment strategy in connection with ESG issues.

5.2 The key way in which trustees can manage ESG-related litigation risks is to have good governance systems in place, as those will provide a clear framework within which trustees' substantive decisions will be made, acted upon and monitored.

5.3 We can assist trustees in all aspects of managing ESG-related litigation risk, including identifying particular areas of risk and potential risk, advising on member engagement considerations, reviewing proposed reporting and disclosures, reviewing governance systems and policies, helping to plan and implement trustees' approach to ESG-related issues, and advising on member complaints and concerns. We recognise the importance of trustees being able to make decisions and carry out their responsibilities in relation to ESG considerations with confidence and without fear of litigation risk. We anticipate that ESG considerations will continue to be important to trustees and the issues will continue to evolve in the years to come.