Broker-Dealers and the ABCs of ESG

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In Short

The situation: Investors are increasingly focused on environmental, social, and governance ("ESG") factors when opening investment accounts and/or making investment decisions.

The result: Most guidance regarding ESG investing is geared towards investment advisers and issuers with little discussion of how ESG investing may impact broker-dealers' relationships with their customers.

Looking ahead: In situations where a customer expresses a desire for ESG factors to be taken into account with respect to investment recommendations, broker-dealers may want to consider implementing a process to ensure those preferences are considered as part of the know-your-customer ("KYC") process and customer-specific suitability determinations. In addition, broker-dealers should be considering how Regulation Best Interest ("Reg BI") will impact their recommendations to retail investors who have specific ESG requirements.

Much has been written about responsible investing and the increasing focus by institutional and retail investors on ESG issues when making investment decisions. Though significant guidance exists regarding how investment advisers as fiduciaries should take action to navigate the risks associated with ESG investing, little has been written regarding the role of broker-dealers with respect to investors and ESG-focused investment objectives. Despite this lack of guidance, existing rules require that broker-dealers consider, from the very beginning of a customer relationship, any expressed ESG focus and interests of its investor customers.

Broker-Dealer Obligations

Financial Industry Regulatory Authority ("FINRA") Rule 2090 sets forth a broker-dealer's KYC obligations and requires a broker-dealer to use reasonable diligence to know essential facts regarding its customers. According to FINRA, facts that are essential to KYC include, among others, those required to effectively service the customer's account. For example, if a customer expresses a clear desire for ESG factors to be taken into account, that would become a fact essential to effectively servicing the customer account. Consequently, the initial request from the customer and any updated responses should be considered throughout the life of the account so applicable adjustments may be made to ensure the broker-dealer can effectively service the account.

According to FINRA Rule 2111, a broker-dealer recommending a transaction or investment strategy to a customer is required to make a "customer-specific" suitability determination, which means that it must have a reasonable basis to believe the recommended transaction or investment strategy is suitable for that particular customer based on information it obtains through reasonable diligence in establishing the customer's investment profile. Among other things, the investment profile includes a customer's investment objectives and risk tolerance. An increased number of investors are including ESG factors in their investment objectives. As a result, a broker-dealer would need to consider whether it has a reasonable basis to believe that a particular recommended investment meets the investor's ESG criteria and is suitable for that customer given the customer's investment objectives.

To make matters more challenging, there exists no single set of consistent and clear factors to define ESG or provide a standardized framework for determining the status of an investment as "ESG-compliant." The lack of a standard ESG definition or minimum requirements makes it difficult for investors to evaluate an issuer's ESG status and disclosures for investment purposes. Because there is no industry standard or single set of factors to define ESG, a broker-dealer that accepts accounts with stated ESG preferences should consider establishing with the customer clear guidelines or factors (e.g., which may include reference to an ESG index) to apply when considering whether an investment meets its customers' various ESG preferences (e.g., a broker-dealer might look to suggested standards presented by, for example, the Task Force on Climate-Related Financial Disclosures or the Sustainability Accounting Standards Board). It is possible that factors that satisfy one customer's ESG investment objectives would not necessarily satisfy another's—thus requiring the broker-dealer to be flexible in the application of additional criteria.

With respect to Reg BI, which will become effective June 30, 2020, a broker-dealer whose customer has specified a preference for ESG-focused investments must consider the customer's request without placing the broker-dealer's own interests, financial or otherwise, ahead of the customer's. Of course, what the foregoing will mean in actual practice remains to be seen. In response to specific industry comments on the application of non-economic factors to the investing mix, the SEC was clear in stating that cost, while always relevant to a recommendation, "should never be the only consideration." Other factors such as highly personalized non-economic factors also should be considered in formulating a recommendation consistent with the best-interest standard.

A broker-dealer should carefully consider how any customer's expressed preference for ESG factors to be taken into account works in tandem with the broker's existing suitability and KYC obligations. An overlooked investor preference, for example, could result in a recommendation being deemed unsuitable. Similarly, in meeting its KYC obligations, a broker-dealer should not overlook its customers' stated ESG preferences (i.e., "essential facts" necessary to effectively service the account) in opening and maintaining customer accounts. Finally, with respect to Reg BI, a broker-dealer will need to consider its customer's specific requests and put the customer's interests ahead of its own when making recommendations.

Three Key Takeaways

  1. Increasingly, investors are seeking investments that meet certain ESG criteria.
  2. If a customer articulates ESG investing restrictions at account opening or during the relationship, broker-dealers should consider those restrictions—like any other customer suitability consideration—when making recommendations to the customer. In light of Reg BI, broker-dealers will need to consider not only the customer's investing requests and restrictions, but place them ahead of the broker-dealer's own interests when making related recommendations.
  3. One of the characteristics inherent in ESG is that the concept can certainly be understood by one person to mean something very different from the way it is understood by another person. Where one of those people is a brokerage customer and the other is the broker, the differences in interpretation can result in a mismatch between customer desires and investment recommendations. Therefore, unless and until a standardized set of ESG factors are defined, broker-dealers that accept accounts with stated ESG preferences should consider establishing with the customer clear guidelines or factors (e.g., which may include reference to an ESG index) to apply when considering whether an investment meets its customers' various ESG preferences.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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