Environmental, social, and governance issues have gained increasing relevance in the financial world. Beyond the well-known green bonds, which are subject to a dedicated regulatory framework at the European Union (EU) level (the EU Green Bond Standard Regulation (EU 2023/2631)), sustainability-linked bonds are also growing in popularity. Their flexible structure makes them attractive to issuers and investors alike. However, the lack of a specific regulatory legal framework either on global and at the EU or national level opens the door to potential abuse, particularly greenwashing.
Structural features of sustainability-linked bonds
According to non-mandatory Sustainability-Linked Bond Principles provided by the International Capital Market Association, sustainability-linked bonds are fixed-income securities whose returns depend on the achievement of specific sustainable objectives, so-called ‘sustainability performance targets’. The progress of their achievement by the issuer is measured through specific ‘key performance indicators’. If the issuer fails to meet the targets by a given date, this triggers the activation of a ‘step-up’ mechanism, increasing the interest paid to bondholders in relation to the bond.
The step-up mechanism should, in theory, incentivize issuers to meet their sustainability goals. However, the reality is more complex. Given the lack of dedicated regulatory framework, subscription agreements often contain clauses that exclude or limit liability for sustainability failures by issuers.
Furthermore, issuers might choose not to meet their sustainable targets if paying the higher interest is cheaper than actually investing in sustainability. The issue worsens when shareholders are also bondholders, as they can influence non-compliance to trigger step-ups, thereby securing higher financial returns.
Rethinking private law remedies
In light of the lack of a dedicated regulatory framework, we now discuss the potential for using private law remedies. The first category of remedies to consider are ‘caducatory remedies’, which can either terminate the contract or make it invalid.
(i) Invalidity due to defective consent
The subscription agreement of the bond may be annulled for defective consent, specifically in cases of fraud. For example, in Italian law, this can happen in case of decisive fraud (dolo determinante) where the investor would not have subscribed had they known the true (non-sustainable) nature of the investment (Article 1439, Italian Civil Code). French law provides the remedy of nullity for the case where a party would not have contracted due to a defect of consent such as error, fraud, or duress (Articles 1130 and 1131, Code Civil). In English law, the relevant concept is that of ‘misrepresentation’ (Misrepresentation Act 1967), which is a false statement of fact made by one party which induces another to enter into a contract, which may also lead to the annulment of the agreement.
However, these remedies face practical challenges: the slow pace of litigation, especially in Italy, may result in a ruling after the bond matures; the bondholder may have to return interest coupons paid by the issuer; the quantification of damages can be difficult.
(ii) Contract termination
Another option available to the bondholder is exercising the right of termination, claiming that the failure to meet sustainability targets constitutes a material breach. However, in Italy this remedy typically requires judicial involvement, which can be lengthy and procedurally complex. Legal proceedings may last longer than the bond’s life, and termination could be also seen as a disproportionate response, as it can determine the obligation to return also interest coupon already paid by the issuer (see e.g. for Italian law, article 1458 Italian Civil Code and, for French Law, article 1224 Code Civil).
Compensation: toward an innovative legal interpretation
We argue that damage compensation for failure to meet sustainability targets may provide a more promising legal path:
(i) The step-up as liquidated damages
The ‘step-up mechanism’ potentially envisaged as part of the bond’s structure may be interpreted as a liquidated damages clause, capping the amount of compensation. In some jurisdictions, such as Italy and France, courts are allowed to intervene in contractual terms. If the step-up amount is disproportionately low compared to the actual loss suffered by the bondholder, the judge may increase the amount to ensure fair compensation. This approach helps align the financial structure of the bond with investor protection standards.
(ii) Difficulty in quantifying damages
Assessing damages can be challenging, especially when the harm is not only financial but related to unfulfilled sustainability outcomes. Nevertheless, a claim could be made that the bondholder suffers harm due to the issuer’s failure to deliver on sustainability commitments, and that the bondholder shares a part of the widespread public interest in the achievement of such sustainable objectives.
Green bonds’ contractual documentation typically includes use-of-proceeds clauses. Sustainability-linked bonds do not, according to the Sustainability-Linked Bond Principles and consolidated market practice. However, an equitable compensation remedy could be applied, even as a form of punitive damages, reflecting the investor’s proportional interest in the failed sustainability objective by the issuer.
To overcome the challenges posed by damages’ quantification, we suggest the following formula as a possible criterion for calculating the compensation:
D = C* [(I / C) * 100] / 100
and therefore
D = I
Where:
- D = damage suffered by investor;
- I = investor’s contribution to the bond;
- C = total cost of achieving the promised sustainable target.
This amount would be added to repayment of capital invested, interests payments, minus any compensation already received through the step-up mechanism.
Potential liability of the board
If the failure to meet sustainability targets arises from decisions made by the board, they may also be personally liable for the damages suffered by bondholders (if not covered by the business judgment rule) (see e.g., for Italian Law, art. 2395 Italian Civil Code and, for French Law, art. 1843-5, 1, Code civil and articles L223-22, 3 and L225-252 Code comm.).
The weakness and strength of private law
To ensure that these bonds effectively contribute to fostering the integration of sustainability within financial markets, a regulatory intervention would be essential. Such intervention could take steps from existing voluntary guidelines or best practices in this field (such as the Sustainability-Linked Bond Principles) and be further elaborated in the form of a clear set of statutory rules at EU or national level, or binding standards inspired by the EU Green Bond Standard Regulation. In the absence of dedicated legislation, creative interpretation of existing remedies provided under private law (such as contractual enforcement) remain crucial to ensure more responsible corporate behaviour by issuers and more effective protection of bondholders.
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This blog post is based on the paper presented at the SMART Network Symposium, Sustainability is (Still) Possible! Governing Market Actors for a Safe and Just Space, 18-19 September 2025, at the University of Turin.
