On April 9, 2021, the U.S. Securities and Exchange Commission (SEC) Division of Examinations released a risk alert for investment advisers and funds related to environmental, social and governance (ESG) investing. The ESG Risk Alert provides (i) observations of deficiencies and internal control weaknesses from examinations of investment advisers and funds regarding ESG investing, (ii) effective practices from such examinations, (iii) risk areas to assist firms in developing and enhancing their compliance practices, and (iv) continued staff focus areas on ESG investing during examinations.
Observations of Deficient Practices
The ESG Risk Alert identifies instances of potentially misleading statements regarding ESG investing processes and representations regarding the adherence to global ESG frameworks, including the following observations:
- Inconsistency between portfolio management practices and disclosures of ESG approaches.
- Weaknesses in policies and procedures governing ESG-related directives and inadequate controls to maintain, monitor and update clients’ ESG-related investing guidelines, mandates and restrictions.
- Differences between ESG-related proxy voting claims and internal proxy voting policies and procedures.
- Unsubstantiated or potentially misleading claims regarding ESG investing in a variety of contexts.
- Inadequate controls over public disclosures and marketing materials to ensure that ESG-related disclosures and marketing materials are consistent with firm practices.
- Compliance programs that failed to address relevant ESG issues, such as ESG investing analyses, decision-making processes or compliance review and oversight.
Observations of Effective Practices
The ESG Risk Alert also highlights instances where investment advisers and funds had in place disclosures that accurately conveyed aspects of the firms’ approaches to ESG investing and maintained policies and procedures that appeared to be reasonably designed with respect to their particular approaches to ESG investing. These effective practices observed by the staff include the following:
- Disclosures that were clear, precise and tailored to the firms’ specific approaches to ESG investing, such as (i) simple and clear disclosures that were prominently stated on client-facing materials, (ii) disclosure regarding practices where firms could still satisfy the requirements of certain global ESG frameworks while making investments that appeared to be inconsistent with ESG investing, and (iii) explanations of how investments were evaluated using certain goals established under global ESG frameworks.
- Policies and procedures that addressed ESG investing and covered key aspects of the firms’ relevant practices, specifically including detailed written procedures, due diligence documentation and insight from separate, specialized personnel to the portfolio management process.
- Compliance personnel that were knowledgeable about the firms’ specific ESG-related practices, which included personnel who provided more meaningful reviews of public disclosures and marketing materials, tested the adequacy and specificity of existing ESG-related policies and procedures, evaluated whether certain portfolio management processes aligned with stated ESG investing approaches and tested the adequacy of documentation of ESG-related investment decisions and adherence to client investment preferences.
Continued Focus Areas for the Division of Examinations
As a result of these observations, the SEC staff will continue to examine firms claiming to engage in ESG investing with a focus on, among other matters, reviewing the following:
- Portfolio management, such as firm policies, procedures and practices related to ESG and the use of ESG-related terminology, due diligence and other processes for selecting and monitoring investments with respect to the firm’s disclosed ESG investing approaches and whether proxy voting processes are consistent with firm ESG disclosures and marketing materials.
- Performance advertising and marketing, including the firm’s regulatory filings, websites, reports, presentations, requests for proposals, responses to due diligence questionnaires and certain other marketing materials.
- Compliance programs, including the firm’s written policies and procedures and their implementation of ESG investing practices and disclosures.
Recent Statements by Commissioner Peirce
On April 12, 2021, SEC Commissioner Hester Peirce issued a statement in response to the ESG Risk Alert. In her statement, she commended the SEC staff for seeking to aid firms in assessing their ESG practices. However, she stated that the ESG Risk Alert needed context and sought to answer potential questions raised by the ESG Risk Alert. In particular, she clarified that ESG investment strategies are not unique in the eyes of the SEC examiners. Rather, as with any other investment strategy, examiners will be looking to ensure that advisers and funds are not making claims that do not accord with their practices. She further stated that firms do not need a special set of policies and procedures for ESG, but instead should design their policies and procedures around the investment strategies the firm employs, whatever those strategies are. Finally, she clarified that the staff’s role is not to second-guess investment decisions through an SEC-created ESG scoring system, rather, it is to understand whether firms are adhering to their own ESG claims.
On April 14, 2021, Commissioner Peirce also issued a statement expressing concerns about efforts to move toward a common set of ESG disclosure metrics. She stated that standardized ESG disclosure metrics may result in homogenized capital allocation decisions and impede creative thinking. She also highlighted how ESG factors will continue to evolve and are not readily comparable across issuers and industries and described how a standardized ESG framework could potentially undermine the original objectives of the ESG movement.
Practice Points and Tips
The ESG Risk Alert encourages firms to evaluate whether certain disclosures and marketing materials related to ESG investing are accurate and consistent with firm practices. Advisers should review whether their approaches to ESG investing are (i) implemented consistently throughout the firm, (ii) adequately addressed in the firm’s policies and procedures, and (iii) subject to the appropriate oversight by compliance personnel. Such review should also encompass the ESG practices of any unaffiliated advisers or other third parties, if applicable. Commissioner Peirce’s statement in response to the ESG Risk Alert makes the connection that the SEC staff’s focus on ensuring that advisers and funds are accurately disclosing what they do — and doing what they disclose — is not unique to ESG. While this may be true, it is safe to say that ESG is a focus of the SEC, and the Biden administration overall. The SEC’s focus on the legal and regulatory reforms for ESG investing is likely to continue given the rapid growth and demand in ESG products and services, combined with the risks associated with the absence of a standardized global framework for ESG investing (and the debate surrounding whether such a framework is necessary). Advisers and fund sponsors should consider reviewing their ESG-related disclosures, policies and procedures, and investment practices in light of the release of the ESG Risk Alert.