I have written extensively about the new and hot business trend – environmental, social and governance programs (“ESG”).  The luster surrounding ESG has been a significant business trend and priority. Like any new trend, the SEC as an important protector of investor interests issued a Risk Alert for investment products and financial services that include ESG factors. 

Investors are demanding investment products and financial services that focus on ESG.  Investment advisers are responding to that demand offering investment options, including registered investment companies and pooled investment accounts. 

The SEC outlined risk concerns relating to these activities.  Some firms include ESG factors along with other traditional factors, such as macroeconomic trends or company-specific factors like a price-to-earnings ratio.  Other firms focus on ESG practices because they believe ESG-based companies will have higher investment returns. The SEC cited as examples, some ESG funds that select companies that have demonstrated a commitment to a particular ESG factor, and other ESG funds take into account ESG factors by applying negative, positive, or norms-based screens to investments. Others focus on engaging with companies with a goal of improving specific ESG-related practices.  In this area, advisers focus on a range of ESG themes including sustainability, climate, and faith-based investing. Still others invest with a goal of generating ESG-related benefits, known as impact investing.

The SEC’s risk alert identifies the increasing demand for advisory and investing ESG activity and its risk concern stemming from the lack of standardized and precise ESG definitions. The lack of clarity around various ESG definitions reflects the infancy of the ESG concept, the lack of regulation in this area, and the dangers of misrepresentation and misleading information provided to investors.

The SEC underscored the need for portfolio management practices and consistent definition of ESG information, returns and financial reporting guidance. The SEC’s Risk Alert identifies a number of deficiencies and internal control weaknesses generated through examinations of investment advisers and funds relating to ESG investing. In addition, the SEC’s Risk Alert provides guidance concerning issues for future examinations.

SEC examinations review a firm’s policies, procedures and practices related to ESG and consistent use of ESG terminology, due diligence for selecting, investing in and monitoring investments and whether proxy voting decision-making processes are consistent with ESG disclosures.

A separate area for examination includes performance advertising and marketing materials focused on firm claims of adherence to global ESG frameworks, client presentation and responses to due diligence questionnaires, requests for proposals, and client/investor-facing documents, including marketing materials.

The Risk Alert cited the fact that a number of investment advisers, registered investment companies, and private funds engaged in ESG investing, instances of potentially misleading statements and adherence to ESG frameworks. In several occasions, firms claimed to have robust policies and procedures surrounding ESG investing but actually lacked policies and procedures related to ESG investing, or implemented policies and procedures that did not appear to be reasonably designed to prevent violations of law.  In addition, SEC staff discovered instances where documentation of ESG-related investment decisions was unclear and compliance programs were poorly designed. 

Specifically, the SEC cited the fact that portfolio management practices were inconsistent with disclosures about ESG approaches.  The SEC staff observed portfolio management practices that differed from client disclosure documents and other client/investor-facing documents (e.g., advisory agreements, offering materials, responses to requests for proposals, and due diligence questionnaires). For example, the staff noted that firms did not follow global ESG frameworks despite claims of adherence and holdings by issuers with low ESG scores. 

With respect to internal controls, the SEC staff explained that firms maintained weak policies and procedures to implement and monitor advisers’ clients or funds ESG-related policies and procedures. The SEC staff also noted that firms made unsubstantiated or potentially misleading claims regarding ESG investing. In this regard, the staff cited inconsistencies between actual firm practices and ESG-related disclosures and marketing materials because of weak internal controls over public disclosures and client-facing statements.

The SEC staff noted that compliance programs did not adequately address ESG issues. In many cases, ESG focused investment companies lacked policies and procedures governing ESG investing analyses, decision-making processes, or compliance review and oversight.  In addition, the staff observed that compliance personnel had limited knowledge of relevant ESG-investment analyses or oversight over ESG-related disclosures and marketing decisions.