Recent initiatives by the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) evidence the agencies' increasing intent to play significant roles in the ESG space.
On April 9, the Division of Exams (Exams) published an ESG Risk Alert (Risk Alert), describing areas where it is focusing in examinations of investment advisers' and funds' ESG products and services. Separately, on March 17, Rostin Behnam, Acting Chair of the CFTC, announced the establishment of the Climate Risk Unit (CRU) "to support the [CFTC's] mission by focusing on the role of derivatives in understanding, pricing, and addressing climate-related risk and transitioning to a low-carbon economy."
The SEC's Risk Alert is premised on its observation that, in recent years, investor demand has driven the offering of various ESG options, including registered investment companies and pooled investment vehicles, as well as separately managed accounts. The Risk Alert gives examples of what Exams considers to be deficient ESG-related compliance programs and disclosures by advisors and funds in connection with such offerings. Exams also provides examples of what they consider to be effective ESG compliance and disclosure practices.
The CFTC's CRU imitative, on the other hand, is not directed at any particular segment of CFTC registrants. Rather, it is meant to "accelerate early CFTC engagement in support of industry-led and market-driven processes in the climate — and the larger ESG — space critical to ensuring that new products and markets fairly facilitate hedging, price discovery, market transparency, and capital allocation."
Key Takeaway for SEC-Registered Funds and Advisers: Most of the observations in the Risk Alert are not unique or even new to ESG investing. Essentially, the messages in the Risk Alert are simple:
As noted in the Risk Alert, "the variability and imprecision of industry ESG definitions and terms can 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 . . . . Actual portfolio management practices of investment advisers and funds should be consistent with their disclosed ESG investing processes or investment goals."
The CFTC's CRU initiative follows publication of the CFTC's Market Risk Advisory Committee's Climate-Related Market Risk Subcommittee's September 2020 report on "Managing Climate Risk in the U.S. Financial System" (the Report). The publication of the Report marked the first time a US financial regulator released a report or statement that highlighted the risks of climate change from a financial stability perspective.1
The Risk Alert follows a number of other ESG-focused initiatives by the SEC.
For example, on March 4, the SEC announced the creation of a Climate and ESG task force under the purview of the SEC's Division of Enforcement that will, among other things, "analyze disclosure and compliance issues relating to investment advisers' and funds' ESG strategies." Also, on March 3, Exams identified ESG issues as a 2021 exam priority for investment advisers and investments.2
On April 12, SEC Commissioner Hester M. Pierce issued a public statement responding to the release of the Risk Alert, noting that "as with many other ESG-related matters, this risk alert raises questions of its own . . . ." She also stated that ESG strategies are not unique in that "advisers and funds should not make claims that do not accord with their practices, and our examiners will be looking for that consistency between claims and practice. Our examiners are not—and will not be in this space—merit regulators. The SEC's role is not to assess whether any particular strategy is a good one, but to ensure that investors know what they are getting when they choose a particular adviser, fund, strategy, or product."
Deficiencies and Weaknesses Noted in the Risk Alert
In the Risk Alert, Exams provided the following as examples of weak or deficient practices, among others:
Effective Compliance and Disclosure Practices in Risk Alert.
Some examples of effective practices identified in the Risk Alert were having:
The CFTC's CRU Imitative
The CFTC's CRU will be comprised of staff from across the CFTC's operating divisions and offices and "represents the [CFTC's] next step in response to what has become a global call to action on tackling climate change." In addition to conducting research and engaging in outreach with relevant market participants and other stakeholders, the CRU may engage in discussions with exchange, clearinghouses and market participants related to new and emerging risks prompted by climate change and assist efforts to encourage the creation of "relevant and reliable climate-related market risk data resources."
What Funds and Advisers Should Do Now
The SEC's focus on ESG investing is clearly not going away anytime soon and will most likely intensify. Firms and their compliance professionals should carefully review, and revise as appropriate, their policies, procedures and practices, including ESG disclosures in marketing materials, Forms ADV, fund offering documents and advisory agreements, along with reviewing their ESG proxy voting practices.
The full SEC Risk Alert is available here.
The CFTC announcement regarding creation of its CRU is available here.