Unintended ESG and Greenwashing risk for funds

Like each of the other two ‘greenwashing’ pecuniary penalty proceedings ASIC has pursued to date, the Vanguard proceeding concerned representations made in relation to exclusionary investment screening. Exclusionary screening of investments is an approach to ESG investing that involves the removal from a given portfolio of particular sectors or specific security issuers that are considered to be inconsistent with a relevant investment philosophy. For an ‘ethical’ or ‘ESG’ fund, the product issuer will typically identify social responsibility criteria and apply screens reflecting those criteria against a given investible universe. The screening methodology is typically developed by a third party, with research houses providing analysis of relevant security issuers that determines whether the issuers fail the screening criteria, in which case their securities are  excluded from the relevant fund.

Exclusionary ESG screening can be complex in practice and ensuring marketing materials, product information and formal disclosure accurately describe the operation of these screens may give rise to significant challenges.

The ‘Vanguard Ethically Conscious Global Aggregate Bond Index Fund (Hedged)’ (Fund) was established in 2018, to provide a low-cost option for investing in a diversified range of international bonds tracking the ‘Bloomberg Barclays MSCI Global Aggregate SRI Exclusions Float Adjusted Index’ (Index). The Index applied various exclusionary screens to remove securities where the issuer was involved in certain activities that were inconsistent with the ESG aims of the fund. In turn, the Fund would hold a representative sample of securities from the Index with a view to matching the overall Index’s return. 

Vanguard marketed the Fund on the basis that it was an ‘ethically conscious’ fund and securities that failed applicable ESG screening criteria would be removed from the Index and therefore the Fund. Vanguard’s PDSs relevantly stated that the Index excludes companies with ‘significant business activities involving fossil fuels, nuclear power, alcohol, tobacco, gambling, weapons, adult entertainment and a conduct related screen based on severe controversies’. Other materials, including Vanguard’s website, a media release, an online presentation and a YouTube interview, also variously referred to the exclusion of relevant securities from the Index and/or the Fund based on ESG considerations.

In early 2021, Vanguard identified that its PDS disclosure misdescribed the exclusionary screening applied to the Index and the Fund. Because a significant proportion of the issuers of securities in the Index were unresearched, securities from those issuers were not subject to exclusionary screening and were included by default. The PDSs did not refer to this significant limitation to the ESG screening. Vanguard placed the Fund’s ETF securities into a trading halt, issued corrective disclosure and self-reported the matter to ASIC in accordance with its breach reporting obligations. ASIC commenced an investigation, which culminated in ASIC commencing a civil penalty proceeding against Vanguard in the Federal Court in July 2023.

In the penalty proceeding, ASIC alleged Vanguard’s PDSs for the Fund, as well its website, media release and the online presentation and YouTube interview, were misleading and contravened sections 12DB(1)(a) and 12DF(1) of the Australian Securities and Investments Commission Act 2001 (Cth). Vanguard admitted that the relevant materials conveyed representations that securities were researched and screened to remove from the Index (and therefore the Fund) those that violated applicable ESG criteria, in circumstances where screening limitations meant that a significant proportion of securities in the Index and the Fund were from issuers that were unscreened, leading to the inclusion of securities from issuers that failed to meet the applicable ESG criteria, contrary to those representations.

However, an issue arose as to whether Vanguard’s statements in the Fund PDSs and website conveyed a representation that all securities in the Index and Fund were subject to exclusionary screening (as alleged by ASIC), or only that securities issued by companies were subject to exclusionary screening (as Vanguard contended). While both contended representations were incorrect, on ASIC’s view the scope of the misrepresentation was significantly wider and incorrectly conveyed that government and treasury bonds were screened. The parties proceeded to a liability hearing in March 2024 on this relatively narrow – though significant – issue.

ASIC contended at the liability hearing that, while the PDSs and website referred to the Index screening out ‘companies’ engaged in certain activities, in context this conveyed a broader representation that all securities were screened. This, it was said, arose from the use of ‘issuers’ and ‘companies’ interchangeably, without disclosing that ‘companies’ is a sub-set of ‘issuers’ – said by ASIC to be a misleading omission by silence. ASIC submitted that because the Fund was described as ‘ethically conscious’, this – along with various ‘suitability’ statements in the PDSs – conveyed an impression to the ordinary reader that ESG screening for the Fund was complete rather than partial. ASIC also contended that other representations outside the PDSs and website that were not limited to ‘companies’ (which representations were admitted by Vanguard) provided ‘context’ to the PDS representations, as did the contents of fact sheets issued by the index provider Bloomberg.

The Court found wholly in favour of Vanguard on the disputed issue. Justice O’Bryan held that Vanguard’s use of the words ‘issued by companies’ clearly conveyed that the ESG screening was applied to corporate entities and did not give rise to the broader representation contended for by ASIC. This was particularly so given the immediately preceding wording, in which Vanguard had expressly differentiated between different classes of bonds (relevantly, those issued by governments, government related entities and companies). ASIC’s contentions to the contrary were described by the Court as ‘strained and, in some instances, conceptually flawed’.

While one of the Bloomberg fact sheets referred to in Fund PDSs was found to be misleading, ASIC did not allege Vanguard itself made or re-stated the contents of the fact sheets. The Court held that the fact sheets were not matters of context that could affect the meaning of Vanguard’s statements in its PDSs and on its website, nor could other separate representations by Vanguard made in different forums have that effect. The Court considered that ‘none of the so-called contextual matters relied on by ASIC altered the plain meaning of the impugned statements in Vanguard’s PDSs and on its website’.

With the Court accepting (in light of Vanguard’s admissions) that the balance of ASIC’s case on liability was established, declarations of contravention were made and the matter was listed for further hearing on the question of relief.

The issue of penalty was contested and proceeded to a hearing on 1 August 2024.

ASIC submitted at the penalty hearing that an aggregate penalty of $21.6 million should be ordered, incorporating a proposed 10 per cent discount for co-operation as well as a 10 per cent reduction by reference to the ‘totality’ principle. Vanguard accepted that a ‘substantial’ penalty should be ordered but submitted that an aggregate penalty in the range of $9 million to $11.25 million (incorporating a 25 per cent discount for co-operation) would be appropriate.

Vanguard adduced and relied on detailed affidavit evidence, including the extensive steps subsequently taken by Vanguard to prevent a repetition of the contravening conduct.

The day after the hearing, the Federal Court handed down its separate penalty decision in ASIC v Mercer Superannuation (Australia) Limited [2024] FCA 850, which approved an agreed penalty of $11.3 million for similar ‘greenwashing’ misleading representations relating to exclusionary screening. The parties to the Vanguard proceeding were given the opportunity to file written submissions in relation to the implications of the Mercer judgment. 

ASIC sought to distinguish the Mercer penalty outcome from what it sought in the Vanguard proceeding on various grounds, while acknowledging that there is little to be gained by comparing penalties in different cases with different facts. In particular, ASIC contended that the longer period over which the misleading statements were made by Vanguard, the additional number of courses of conduct, the fact many of Vanguard’s representations were contained in formal PDSs, the larger value of the Vanguard Fund and Vanguard’s higher revenue and net profit, the fact that penalty was agreed in Mercer and that the size of the penalty imposed reflected the level of Mercer’s cooperation were distinguishing considerations. ASIC submitted these features pointed towards substantially higher penalties being appropriate and to the extent it could provide guidance, the Mercer decision lent support to the appropriateness of the $21.6 million penalty sought by ASIC against Vanguard.

The Court handed down its penalty decision in the Vanguard proceeding on 25 September 2024. Justice O’Bryan ultimately imposed on Vanguard an aggregate penalty of $12.9 million, incorporating a 25 per cent co-operation discount. The parties’ respective positions, and Justice O’Bryan’s judgment in relation to penalty for each course of conduct, are summarised in the following table:

Contrary to ASIC’s submissions, the Court found that while some of the representations (being the media release, YouTube and FNN presentation representations) were made recklessly, the representations in Vanguard’s Fund PDSs and on its website could not be characterised in this way. This was because the PDS and website representations were to the effect – as determined at the liability hearing – that securities issued by companies were researched and screened against applicable ESG criteria and the circumstances that rendered those narrower representations inaccurate were ‘more subtle’. There was no evidence Vanguard’s employees were conscious of the relevant limitations during the relevant period. His Honour nonetheless observed that the contraventions ‘should be regarded as serious’, concerning as they did the ‘principle distinguishing feature of the Fund, being its “ethical” characteristics’.

The Court found Vanguard co-operated ‘fully’ with ASIC in respect of the proceeding, notwithstanding Vanguard contested (successfully) one issue on liability and did not agree on penalty with ASIC. His Honour noted the ‘high level of co-operation Vanguard has shown in both ASIC’s initial investigation and in this proceeding’ and acknowledged the ‘desirability of encouraging the co-operation of contraveners in proceedings such as these, where such co-operation reduces the cost and burden of the proceeding to the Court, ASIC and the community’.

The Vanguard penalty decision represents, after Mercer, the second civil penalty outcome obtained by ASIC in relation to ‘greenwashing’. ASIC’s third civil penalty ‘greenwashing’ case, against the trustee of Active Super, is set down for a penalty hearing on 17 December 2024. As ASIC has been allocated additional federal funding of $10 million over four years from 2024-25 specifically to investigate and take enforcement action in relation to greenwashing and sustainability misconduct, it can reasonably be expected that further civil penalty proceedings (as well as less punitive enforcement action like infringement notices) will shortly be pursued by ASIC in this space.

Notwithstanding Vanguard’s relevant breaches were not intentional, it self-identified and self-reported the relevant breaches to ASIC, it immediately corrected the misleading PDS disclosure following its identification, Vanguard subsequently took significant steps to uplift its PDS review processes to prevent future recurrence, ASIC did not contend that the contraventions caused any financial loss to investors, and Vanguard fully co-operated with ASIC at all relevant times, Vanguard has been ordered to pay a substantial civil penalty exceeding (as noted by the Court) Vanguard’s annual profit in Australia for the whole of its business in FY18 – albeit in an amount significantly lower than ASIC had sought.

With ‘greenwashing’ and other misleading conduct in relation to sustainable finance remaining a key enforcement priority for ASIC, it has never been more important to ensure product disclosure and marketing materials in relation to ESG matters are carefully reviewed for accuracy and, in the case of exclusionary screening of investments, the operation of ESG screens (including any risks or limitations associated with the screening process) is well-understood and fairly and accurately described.