By Aaron Franklin

The United States has the deepest, most liquid capital markets in the world, attracting issuers from across the globe. To sell to US investors, these issuers must comply with US securities laws, entailing a more rigorous diligence and disclosure process. Issuers must weigh the benefits of increased demand against the additional costs, but the outcome should not depend on whether the bonds will be green or otherwise have sustainability credentials.

The US securities laws that apply to bond deals include a variety of rules on who can issue and purchase bonds, such as the registration requirements in the Securities Act of 1933, the Trust Indenture Act of 1939, and the Investment Company Act of 1940. But the real concern for bond issuers and underwriters is the threat of investors claiming securities fraud under the Securities Exchange Act of 1934, using “Rule 10b-5.” In general, a plaintiff is entitled to damages under Rule 10b-5 if a bond issuer or underwriter misrepresented or omitted a material fact in connection with the purchase or sale of the bond, with the intent to deceive or with recklessness, and the plaintiff lost money by relying on that misrepresentation or omission. This right to litigate for “material omissions” does not exist in most other jurisdictions, even where contractual fraud claims are possible. To avoid lawsuits under Rule 10b-5, issuers and underwriters (and their legal counsel) typically spend more time and effort (relative to deals not sold to US investors) investigating the affairs of the issuer and ensuring the offering disclosure is sufficiently robust.

Rule 10b-5 applies to the sale of any security, including a green bond. Green bonds, for the less familiar, are constituted by disclosure. The issuer informs potential purchasers of how the bond connects to certain underlying sustainable activities, but the bond itself does not include contractual agreements related to the sustainability credential. Most often, the issuer tells the market the proceeds will be used to finance projects that meet defined sustainability criteria, thereby justifying the credential. National laws do not define what may be labelled with sustainability credentials (outside of certain issuers in China) and the market polices the boundaries of what constitutes “green” or “sustainable” underlying activities. One of the key benefits of issuing a green bond is to maximize and diversify investor demand.

The main Rule 10b-5 risk, as it applies to green bonds, is therefore that an investor will purchase a green bond in reliance on intentionally or recklessly misleading disclosure related to the sustainability credentials and then lose money when the revelation of such misleading disclosure leads to a drop in the resale value of the bonds. This could certainly happen, just as any securities issuance could involve fraud and bad actors. But this is far from an unmanageable risk for green bond issuers and underwriters in good faith. In fact, because green bonds are disclosure based, issuers can minimize Rule 10b-5 risks with a few common sense principles.

  1. Green bond issuers should describe, not characterize, the underlying sustainable activity. Descriptions, such as “the proceeds will finance geothermal energy projects,” provide a verifiable basis for investors to decide whether to buy a bond. Characterizations, such as “the proceeds will finance sustainable energy projects,” are more open to challenge as reasonable minds can differ on what projects would be eligible.
  2. Green bond issuers should disclose the risks related to the sustainability credentials. The risks may include that positive sustainability outcomes will not be achieved, such as planned carbon dioxide emissions not taking place. The risks could also include that the sustainability credentials will not satisfy the investor’s particular requirements, such as the proceeds financing nuclear energy when the investor disagrees with characterizing such use as sustainable. Finally, the risks could include that the market may not agree, or may later cease to agree, that the sustainability credentials are appropriate.
  3. Avoid omissions of disclosure that would be material to the sustainability credentials. Green bond issuers may be tempted to emphasize the positive and omit the environmentally questionable aspects of their operations, but such omissions open the door to Rule 10b-5 risks.

Ensuring that the issuer’s disclosure conforms to the above also helps underwriters reduce their Rule 10b-5 risks. Underwriters have an additional way to reduce their risks related to green bond issuances, which is by demonstrating they performed due diligence and therefore cannot be considered reckless with respect to any misrepresentation or omission. To do so, underwriters should ensure that their diligence of a green bond issuance covers not only customary commercial and financial aspects of an issuer’s operations, but also the aspects relevant to the sustainability credential. Underwriters can look for instances of past malfeasance, undisclosed negative externalities, impracticable plans or other red flags to ensure that the sustainability credentials are credible.

In deciding whether to sell to US investors, bond issuers should weigh the benefits of uniquely deep and liquid capital markets against the costs of complying with the US legal regime. When that regime is understood properly, however, bond issuers should not be deterred from adding a green label. The benefits of doing so, including maximizing and diversifying investor demand, are similar to the benefits of accessing the US capital markets and require little if any marginal effort.