SEC Division of Examinations Issues Risk Alert Regarding ESG Investing

The staff of the SEC’s Division of Examinations (Division) released a risk alert on April 9, 2021 (Risk Alert).¹ The Risk Alert discusses the staff’s observations following its recent examinations of investment advisers, as well as registered investment companies and private funds (collectively, funds), that engage in ESG investing. The Risk Alert includes a number of important considerations for investment advisers and funds (collectively, firms) that consider ESG factors across the broad spectrum of ESG-related investment strategies, and emphasizes the staff’s now-acknowledged focus on ESG investing because of its growing popularity with investors.

Background

The Division’s examination priorities for both 2021 and 2020 have included an explicit focus on ESG investing, although ESG-focused examinations had started well before these public acknowledgements. The Risk Alert notes that the staff’s examination focus on ESG investing has had a broad reach, extending to all types of ESG-related investment strategies – ranging from integrated ESG investing (where one or more ESG factors are considered alongside traditional financial factors) to impact investing (where a goal is to generate one or more measurable ESG-related benefits), as well as other variations of ESG investment strategies (e.g., “applying negative, positive, or norms-based screens to investments,” sometimes also referred to by the U.S. industry as “exclusionary investing,” or selecting “companies that have demonstrated a commitment to a particular ESG factor,” sometimes referred to by the U.S. industry as “inclusionary investing”).²

The Division observed that a “lack of standardized and precise definitions present certain risks.” According to 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, especially when offering products or services to retail investors.” The remainder of the Risk Alert is essentially a discussion of findings and recommendations based on these observations, and it provides a roadmap for future examinations and for asset managers to review their disclosures and practices going forward.

For further information regarding ESG investing generally, please refer to the presentations and articles on Dechert’s ESG webpage.

Focus of Risk Alert

The Risk Alert details the staff’s “observations of deficiencies and internal control weaknesses from examinations of investment advisers and funds regarding ESG investing … [and] observations of effective practices from such examinations.” The Risk Alert also makes clear that the “staff will continue to examine firms to evaluate whether they are accurately disclosing their ESG investing approaches and have adopted and implemented policies, procedures, and practices that accord with their ESG-related disclosures.” According to the Risk Alert, areas of focus will include:

• Portfolio management, including: ESG-related policies, procedures, and practices; the use of ESG-related terminology; and “due diligence and other processes for selecting, investing in, and monitoring investments in view of the firm’s disclosed ESG investing approaches”;
• Performance advertising and marketing materials, including reports to sponsors of voluntary global ESG frameworks and responses to due diligence questionnaires; and
• Compliance policies and procedures and their implementation.

Staff Observations of Effective ESG Investing Practices

In the Risk Alert, the staff identified certain effective practices that firms may find “helpful” when drafting and implementing effective disclosures, investment processes, controls, and compliance policies and procedures, including:

• Making clear, precise, and tailored disclosures that are consistent with a firm’s actual ESG-related practices, which can be summed-up in the principle “say what you do, and do what you say.” For example, the staff cited approvingly “investment statements posted on adviser websites, client presentations, and annual reports detailing how firms approached the U.N.-sponsored Principles for Responsible Investment or Sustainable Development Goals, including quantitative information on the local impacts of investments.”
• Implementing policies and procedures that address ESG investing and “key” aspects of a firm’s ESG-related practices. For example, the staff cited approvingly “detailed investment policies and procedures that addressed ESG investing, including specific documentation to be completed at various stages of the investment process (e.g., research, due diligence, selection, and monitoring).”
• Having “compliance personnel that are knowledgeable about the firms’ specific ESG-related practices.” For example, the staff observed that knowledgeable compliance personnel appeared to provide “more meaningful” reviews of ESG-related disclosures and marketing materials, and that firms that integrated these individuals into their ESG-related processes “were more likely to avoid materially misleading claims in their ESG-related marketing materials and other client/investor-facing documents.”

Staff Observations of Potentially Problematic ESG Investing Practices

In the Risk Alert, the staff noted that it “observed some instances of potentially misleading statements regarding ESG investing processes and representations regarding the adherence to global ESG frameworks.” The staff also suggested that the following observations represent compliance deficiencies and weaknesses:

• Having inconsistencies between disclosed ESG investment practices and actual investment practices. For example, the staff noted that some firms that claimed adherence to global ESG frameworks did not do so.
• Failure to have adequate controls to maintain, monitor, and update clients’ ESG-related investment guidelines, mandates, and restrictions. For example, the staff observed advisers that “did not have adequate controls around implementation and monitoring of clients’ negative screens (e.g., prohibitions on investments in certain industries, such as alcohol, tobacco, or firearms), especially if the directives were ill-defined, vague, or inconsistent.”
• Failure to have adequate controls to ensure that ESG-related disclosures and marketing materials are consistent with the firm’s practices. For example, the staff observed “a lack of documentation of ESG investing decisions and issuer engagement efforts.”
• Failure to have compliance programs that adequately address relevant ESG issues. For example, the staff observed that “some firms substantially engaged in ESG investing lacked policies and procedures addressing their ESG investing analyses, decision-making processes, or compliance review and oversight.” 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.”
• Using unsubstantiated or otherwise potentially misleading claims regarding ESG approaches.
• Voting proxies in a manner inconsistent with the firm’s stated approach (where applicable). For example, the staff observed “public statements that ESG-related proxy proposals would be independently evaluated internally on a case-by-case basis to maximize value, while internal guidelines generally did not provide for such case-by-case analysis.”

Implications for Advisers and Funds and Key Takeaways

The Risk Alert offers firms engaged in, or considering engaging in, ESG investing a helpful roadmap for designing, implementing and/or reviewing ESG-related disclosures, investment processes, controls, and compliance policies and procedures. This will allow firms to assess whether any enhancements are necessary or appropriate given the staff’s continued focus on ESG investing, before the staff’s focus turns to enforcement in this area.³

Although the Risk Alert notes that the “Division’s interest in the accuracy and adequacy of disclosures provided by advisers and funds offering clients ESG investment strategies is the same as it would be for advisers and funds offering any other type of investment strategy,” the staff’s observations included in the Risk Alert suggest heightened staff scrutiny of ESG investing. As with other strategies, firms should use terms clearly and consistently in disclosures to avoid potential investor confusion, particularly when any product is marketed to retail investors. If current processes are not appropriate to cover ESG-specific considerations, new or enhanced controls and procedures should be implemented to ensure investment practices are consistent with any ESG-related investment guidelines, mandates or restrictions, as well as disclosures. As noted above, firms may encounter problems if they disclose aspirational ESG standards or disclose their adherence to a third-party framework (including a global ESG framework) if the substance behind the aspirations and claims cannot be readily demonstrated.⁴

The Risk Alert also underscores the importance of involving compliance and other personnel in a firm’s ESG program.

Footnotes

1) SEC Division of Examinations, Risk Alert, The Division of Examinations’ Review of ESG Investing (Apr. 9, 2021). The Division of Examinations was formerly known as the Office of Compliance Inspections and Examinations (OCIE).
All statements in this OnPoint as to the intent or plans of the Division are based on the text of the Risk Alert.
2) While the Risk Alert acknowledges the broad spectrum of ESG-related investment strategies, it is important for advisers to remember, as also noted in the Risk Alert, that, as with any other type of investment strategy, ESG-related investment strategies must be managed in manner consistent with an adviser’s fiduciary duties, as shaped by relevant investment agreements, provided that there is full and fair disclosure and informed consent. In this regard, and for a general discussion of ESG investing, see ESG Investing: Considerations for U.S. Registered Investment Advisers.
3) On March 4, 2021, the SEC announced the creation of a Climate and ESG Task Force in the Division of Enforcement.
4) While firms might not need to adopt specific compliance policies, procedures or controls for ESG-related investment strategies, firms should review their existing framework to assess whether any enhancements are necessary or appropriate to address specific ESG-related considerations.