On April 9, the Division of Examinations issued a Risk Alert to highlight observations from its recent exams of investment advisers, registered investment companies, and private funds offering ESG products and services. The Division expressed concern over the variability and imprecision of industry ESG definitions and terms, stating that it could “create confusion among investors if investment advisers and funds have not clearly and consistently articulated how they define ESG and how they use ESG-related terms.” Specific issues identified by the staff included:
- Potentially misleading statements regarding the adherence to global ESG frameworks, and portfolio management practices that were otherwise inconsistent with disclosures about ESG approaches.
- Inadequate controls to maintain, monitor and update clients’ ESG-related investment guidelines, mandates and restrictions. This included inadequate controls around implementing clients’ negative screens and positive screens.
- Proxy voting that is inconsistent with advisers’ stated approaches. This included both inconsistencies between public and internal proxy voting policies, and inconsistencies between public claims regarding clients’ ability to vote separately on ESG issues and the reality that clients were not provided such opportunities.
- Unsubstantiated or potentially misleading claims about ESG investing. For example, the staff observed marketing materials that touted favorable risk, return or correlation metrics without disclosure of potential conflicts, and observed advisers claiming substantial contributions to specific ESG products when their roles were very limited or inconsequential.
- Inadequate controls to ensure that ESG-related disclosures and marketing are consistent with the firm’s practices. This included, among other things, a lack of documentation of ESG investing decisions and issuer engagement efforts and a failure to timely update marketing materials.
- Compliance programs did not adequately address relevant ESG issues. The staff observed, among other things, a lack of policies and procedures to ensure firms obtained reasonable support for their ESG-related marketing claims and observed inadequate policies and procedures regarding oversight of ESG-focused sub-advisers. The staff also observed that compliance programs were less effective when compliance personnel had limited knowledge of relevant ESG-investment analyses or oversight over ESG-related disclosures and marketing decisions.
Going forward, the Division staff will continue to examine firms’ ESG investment approaches and practices, focusing on, among other things: (1) portfolio management, including reviewing the use of ESG terminology, due diligence efforts and ESG-related disclosures; (2) performance advertising and marketing, including reviewing regulatory filings, websites and reports in response to ESG frameworks and marketing materials; and (3) compliance programs, including reviewing the processes and procedures for ESG investing.
What Does This Mean? The Division also provides details on the advisers and funds that it observed with effective practices; from that, we can pull key recommendations not only for advisers and funds but also for public companies.
- Just because the frameworks are inconsistent, does not justify being inconsistent with your chosen framework. The ESG space has been a bit of a “choose your own adventure” situation for years. While there are favorites emerging among the many frameworks, standards and guidelines, it is still the case that advisers, funds and companies can often choose their approach to various ESG matters and how those matters are weighed and prioritized. However, it is crucial that organizations be consistent with any disclosed framework and approach, and be clear and honest about any material deviations or exceptions.
- ESG should not be used solely as a marketing tool, and ESG commitments should be treated as operational and financial commitments. ESG is hot, hot, hot right now. While investors currently have a voracious appetite for more ESG investment options and stakeholders are putting intense pressure on companies to provide more ESG disclosures, it is our strongly held belief that eventually ESG concepts will be incorporated into how we fundamentally think about the value of any organization, and its financial considerations, strategy and operations. Until that day, there is often going to be a gap between the image an organization wants to portray from an ESG perspective, and the reality of their financial considerations, strategies and operations. Organizations that do the hard work of integrating ESG considerations into their day-to-day functions will be better positioned to create disclosures that are consistent with their financial, strategic and operational reality. For organizations that are still in the process of integration, it is important that the organization be clear about where they are in the process without overstating their progress.
- Making ESG disclosures? Show me your ESG disclosure controls. As we have touched on before, it is imperative that an organization that discloses ESG efforts have the disclosure controls to match. Public disclosures should not be created outside of the context of detailed conversations about those disclosures with the organization’s internal controls/internal audit functions, finance department, auditors, and legal counsel.
As a reminder, V&E’s ESG Taskforce is a uniquely cross-functional team dedicated to helping companies proactively understand, manage, and, where appropriate, disclose their ESG risks and opportunities. Covering a broad range of topics and issues, including climate change, clean and sustainable energy, human rights, cybersecurity, and investor relations, the ESG Taskforce draws upon significant capabilities in our governance, environmental, labor and employment, and cyber/data teams. Below are a selection of the ESG Taskforce’s recent thought pieces and presentations on ESG developments and trends.