In the US Securities and Exchange Commission staff’s most recent guidance addressing environmental, social, and governance (ESG) investing, the staff of the Division of Examinations released an April 9 Risk Alert noting observations made during recent examinations of investment advisers and funds (both registered and private) engaged in ESG investing.
The Risk Alert highlights certain deficiencies and internal control weaknesses observed by the staff, as well as observations regarding what the staff viewed as effective practices related to the management and oversight of ESG investing activities. The Risk Alert also summarizes certain ESG-related areas on which the Division of Examinations (Examinations) intends to continue to focus in its examinations of investment advisers and funds. In an April 12, 2021, statement, US Securities and Exchange Commission (SEC) Commissioner Hester M. Peirce offered her thoughts on the Risk Alert and cautioned that the Risk Alert should be considered with some additional context, discussed below.
Although ESG investing has been around for decades, it has gained considerable momentum in recent years. In response to the growing investor appetite for ESG funds, and associated investment product innovation and growth from advisers and sponsors, Examinations has included ESG investing in its published examination priorities for the last two years. In the Risk Alert, Examinations provides insight into its ESG examination focus areas and observations of both deficient (or weak) and effective practices surrounding advisers’ and funds’ ESG activities.
In the Risk Alert, Examinations acknowledges the challenges presented by the ESG investing landscape. It notes that funds and advisers employ a wide variety of ESG investment strategies without the benefit of standardization in terminology, investing approaches, issuer disclosures, and data. The Risk Alert highlights that this combination of variability and imprecision has the potential to mislead investors or cause investor confusion.
It is important to note that, as of the date of the Risk Alert, the SEC has not released any formal rules or guidance regarding ESG investing or the marketing of ESG strategies. Additionally, Examinations does not take a position on the relative merits of any ESG investment approaches or of any global ESG reporting frameworks. The Risk Alert does, however, mention adherence to global ESG frameworks multiple times—focusing on the importance of adhering to a global ESG framework if a fund has committed to do so in its disclosures.
Division of Examinations’ Focus Areas
According to the Risk Alert, Examinations staff will continue to focus on ESG disclosure and compliance practices, including the following:
- Portfolio management practices, including whether investment processes align with ESG disclosures and whether proxy voting processes are consistent with ESG disclosures and marketing materials.
- Performance advertising and marketing, including reviewing regulatory filings, websites, client presentations, and similar materials, as well as reports to sponsors of global ESG frameworks, to the extent a firm has committed to provide such reports.
- Compliance programs, including written policies and procedures, and associated compliance oversight, and a review of ESG investing practices and disclosures.
Deficient Practices Observed
The staff observed a number of practices surrounding ESG investing, some of which, in its view, presented risks of misleading and/or confusing investors. These observations included the following:
- Disclosure Issues: ESG investing practices and fund holdings that were inconsistent with client disclosures. One example highlighted a lack of adherence to global ESG frameworks where disclosures included a commitment to such adherence.
- Control Issues: Inadequate controls governing the implementation of ESG aspects of client guidelines, mandates, and restrictions. For example, the staff observed inadequate monitoring of clients’ criteria to exclude holdings in certain companies or industries (negative screens). The staff also observed advisers’ over-representation in marketing materials of the ability to effectively implement and monitor clients’ ESG preferences, including negative screens.
- Proxy Voting Claims vs. Policies and Practices: Inconsistencies between proxy voting policies and procedures and public ESG-related proxy voting claims, which may have resulted in inconsistent proxy voting.
- Misleading or Baseless Marketing Claims: Unsubstantiated or potentially misleading claims regarding a number of ESG investing practices in marketing materials. Additionally, inadequate controls to ensure the information disclosed in marketing and other materials is consistent with current ESG practices. Observations here included lack of adherence to global ESG frameworks, unsubstantiated claims regarding investment activities, and inadequate documentation to justify investment decisions and issuer engagement activities.
- Weak Compliance Programs: Compliance programs that lacked adequate ESG policies and procedures. Staff observations focused on firms that are substantially engaged in ESG investing yet are lacking in ESG-specific elements in their policies and procedures regarding compliance review and oversight.
- Compliance Personnel: The staff noted observations that compliance programs were less effective when compliance personnel responsible for oversight of ESG investing activities did not have significant expertise in ESG investment analysis.
Several Effective Practices Observed
The staff also highlighted several categories of practices that they characterized as “effective” related to ESG investing, disclosures, and compliance policies and procedures. The staff included a sampling of these practices in the Risk Alert, which is not intended to be a comprehensive list:
- Clear and Tailored Disclosures: Clear and tailored disclosures that aligned with a particular firm’s or product’s actual ESG investment practices. The staff listed several specific examples here:
- Where an ESG approach utilized unaffiliated advisers for ESG analysis—this was clearly stated in client communications. The staff also noted clear client communications regarding choices between standardized ESG portfolios or customized separately managed accounts.
- Where ESG factors are only one component of the management of a portfolio, this is made clear in disclosures. For example, a fund could be adhering to a given global ESG framework, while also holding investments that may seem inconsistent with such framework. Clear disclosures that explain such an investment approach put clients and investors on notice of, and explain, this outcome.
- Where global ESG frameworks are incorporated into an investment process, the staff noted disclosures and explanations in website statements, client presentations, and other materials that detail how investments are evaluated under global ESG frameworks.
- Effective Compliance Programs: Compliance policies and procedures that adequately address ESG investing, including procedures that resulted in documentation of how ESG investments are evaluated, selected, and monitored. The staff also noted that, where multiple ESG investing approaches were employed at the same time, enhanced procedures and documentation, as well as “separate specialized personnel,” were beneficial to the portfolio management process.
- Knowledgeable Compliance Personnel: Having compliance personnel who are knowledgeable about ESG-related practices made it more likely that a firm’s claims in ESG-related marketing materials would not be materially misleading. Knowledgeable compliance personnel also appeared to be better positioned to ensure that ESG investing practices were properly disclosed and adhered to.
In light of the staff’s noted observations in the Risk Alert, advisers and fund sponsors should consider reviewing their ESG-related disclosures, procedures, and investment practices. This review should also encompass the ESG practices of any unaffiliated advisers or other third parties, as applicable. In general, SEC staff will expect that funds and advisers are actually following the ESG investment practices that they are disclosing to investors and prospective investors.
Examinations’ approach to ESG investing is consistent with how the SEC Division of Enforcement (Enforcement) is probing ESG issues as well. In a recent interview, Acting Deputy Director of Enforcement and head of the new SEC Climate and ESG Task Force Kelly L. Gibson confirmed that the Task Force would be approaching its work in the context of existing rules and guidance, focusing on disclosures being accurate and not misleading and on advisers adhering to their fiduciary duties. Ms. Gibson said that the Task Force would be utilizing data analytics—focusing on all publicly available information such as Forms 10-K, public statements, and website information, as well as prospectuses and marketing materials—and fielding tips and complaints from potential whistleblowers.
COMMISSIONER PEIRCE’S STATEMENTS
On April 12, 2021, Commissioner Peirce issued her own statement in response to the April 9, Risk Alert. In her statement, she commended Examinations staff for their efforts and also expressed her view that the Risk Alert requires context. It merits mention that the current SEC commissioners are not all aligned in their views of the SEC’s role in ESG investing oversight and regulation. Three commissioners released statements earlier this year reflecting their differing views.
Commissioner Peirce cautioned that ESG is not unique as compared to other investment strategies or approaches and noted that none of the observations included in the Risk Alert are ESG-specific. For example, funds should ensure that all statements and claims about investment strategies in public and client disclosure documents are consistent with a firm’s actual practices. She also emphasized the point made in the Risk Alert that neither the SEC nor the staff take any view on the relative merits of one ESG investment approach over another, or on ESG investing generally.
Commissioner Peirce also cautioned that Examinations’ discussion regarding proxy voting should be considered along with existing SEC proxy voting guidance. Specific to certain effective practices noted by Examinations staff, and the potential to imply otherwise, Commissioner Peirce noted that firms are not required to have in place ESG-specific policies and procedures, nor are firms required to designate ESG-specialized compliance personnel. A firm’s compliance personnel should be sufficiently knowledgeable in all aspects of a firm’s business in order to oversee an effective compliance program. On April 14, Commissioner Peirce issued a separate statement eschewing the concept of a universal standard of ESG metrics, which she believes would “constrain decision making and impede creative thinking.” This statement stands in opposition of Acting Director of Corporation Finance John Coates’ recent statements that the SEC “can and should” lead the way in developing a standardized global framework for ESG.
OTHER RECENT COMMISSION ESG ACTIONS
The Risk Alert and Commissioner Peirce’s statement are the most recent of a number of cross-agency actions taken by the SEC in response to the recent rapid growth and expansion of the ESG investing landscape, in an effort to become more informed on ESG investing practices and to enable effective oversight of ESG activities, where needed. Other actions have included the following:
- In February 2021, Satyam Khanna was appointed as “ESG and Climate Policy Advisor” at the SEC.
- Also in February, the SEC Office of Investor Education and Advocacy released an Investor Bulletin to educate retail investors on investing in ESG funds.
- On February 24, Acting SEC Chair Allison Herren Lee announced that she was directing the SEC’s Division of Corporation Finance “to enhance its focus on climate-related disclosure in public filings.”
- In March 2021, the SEC established the Climate and ESG Task Force within the Division of Enforcement.
- On March 11, Acting Director of the Division of Corporation Finance John Coates issued a statement noting that the “SEC can and should play a leading role in the development of a baseline global framework [for ESG].”
- On March 15, Acting SEC Chair Allison Herren Lee published a request for public input on climate change disclosures with a 90-day comment period.
- On April 14, Commissioner Peirce issued a statement expressing concerns that the establishment of “[a] single set of [ESG] metrics will constrain decision making and impede creative thinking.”
- Substantial work has been done over the last year by the ESG Subcommittee of the Asset Management Advisory Committee to develop recommendations regarding issuer ESG disclosures and next steps in SEC oversight of ESG investing.
 The Division of Examinations’ Review of ESG Investing (April 9, 2021) (Risk Alert).
 ESG used in this LawFlash, as well as in the Risk Alert, is intended to encompass other related and similar investment strategies including, but not limited to, “sustainable,” “socially responsible,” and “impact” investing.
 The Division of Examinations was formerly known as the Office of Compliance Inspections and Examinations (OCIE).
 See OCIE’s 2020 Examination Priorities; Examinations’ 2021 Examination Priorities.
 The Risk Alert provides Examinations’ observations of ESG investing practices in the context of well-established principles under the Federal Securities Laws, including the Investment Company Act of 1940, the Investment Advisers Act of 1940, and the rules adopted thereunder.
 E.g., the United Nations–sponsored Principles for Responsible Investment (UNPRI) and Sustainable Development Goals (SDGs).
 Risk Alert at 6.
 See SEC Press Release (Mar. 4, 2021).
 Statement on the Staff ESG Risk Alert, statement from Commissioner Hester M. Peirce (Apr. 12, 2021).
 Statement on the Review of Climate-Related Disclosure, statement from Acting Chair Allison Herren Lee (Feb. 24, 2021), and Enhancing Focus on the SEC’s Enhanced Climate Change Efforts, joint statement from Commissioners Hester M. Peirce and Elad L. Roisman (Mar. 4, 2021).
 See Commission Guidance Regarding Proxy Voting Responsibilities of Investment Advisers, Release No. IA-5325 (Aug. 21, 2019), 84 Fed. Reg. 47420 (Sept. 10, 2019), and Supplement to Commission Guidance Regarding Proxy Voting Responsibilities of Investment Advisers, Release No. IA-5547 (July 22, 2020).
 The SEC has also established a dedicated website to house all of their ESG-related work.
 See SEC Press Release (Feb. 1, 2021).
 Environmental, Social and Governance (ESG) Funds – Investor Bulletin (Feb. 26, 2021).
 See SEC Press Release (Mar. 4, 2021).
 Public Input Welcomed on Climate Change Disclosures, statement from Acting Chair Allison Herren Lee, (Mar. 15, 2021). Public comments submitted in response to the request will be available online.
 The Asset Management Advisory Committee (AMAC) was established in 2020 to provide the Commission with diverse perspectives on asset management and related advice and recommendations.
 See, e.g., Potential Recommendations of ESG Subcommittee (Dec. 1, 2020).