Environmental, social, and governance (“ESG”) criteria are standards for a company’s operations that socially conscious investors use to screen potential investments. Recall that on March 4, 2021, The Securities and Exchange Commission (“SEC”) announced the creation of a Climate and ESG Task Force in the Division of Enforcement. Kelly L. Gibson, the Acting Deputy Director of Enforcement, will lead the task force and oversee a Division-wide effort, with 22 members drawn from the SEC’s headquarters, regional offices, and Enforcement specialized units. The ESG Task Force will develop initiatives to identify ESG-related misconduct proactively but will be limited to enforcing existing disclosure requirements rather than formulating additional ESG-related disclosures. The task force will also coordinate the effective use of Division resources, including using sophisticated data analysis to mine and assess registrants’ information to identify potential violations. Also, the Task Force will evaluate and pursue tips, referrals, and whistleblower complaints on ESG-related issues and provide expertise and insight to teams working on ESG-related matters across the Division.
In a March 15 speech at the Center for American Progress, SEC Acting Chair Allison Herren Lee made clear that “no single issue has been more pressing for me than ensuring that the SEC is fully engaged in confronting the risks and opportunities that climate and ESG pose for investors, our financial system, and our economy.”
John Coates, Acting Director, Division of Corporation Finance, on March 11, 2021, made remarks at the 33rd Annual Tulane Corporate Law Institute. He said, There remains substantial debate over the precise contents and details of what ESG disclosures might or should encompass. Part of the difficulty is in the fact that ESG is at the same time very broad, touching every company in some manner, but also quite specific in that the ESG issues companies face can vary significantly based on their industry, geographic location, and other factors.
Coates outlined seven questions about ESG disclosure that need to be answered:
- What disclosures are most useful?
- What is the right balance between principles and metrics?
- How much standardization can be achieved across industries?
- How and when should standards evolve?
- What is the best way to verify or provide assurance about disclosures?
- Where and how should disclosures be globally comparable?
- Where and how can disclosures be aligned with information companies already use to make decisions?
Well, not too long after the Task Force was announced and remarks/statements were made by the SEC on April 9, 2021, the SEC released a Risk Alert (“Alert”). In the Alert, the SEC observed investment advisers, registered investment companies, and private funds engaged in environmental, social, and governance investing, making “potentially misleading statements” regarding ESG investing processes and adherence to global ESG frameworks. The staff noted, despite claims to have formal processes in place for ESG investing, a lack of policies and procedures related to ESG investing; policies and procedures that did not appear to be reasonably designed to prevent violations of law, or that were not implemented; documentation of ESG-related investment decisions that were weak or unclear; and compliance programs that did not appear to be reasonably designed to guard against inaccurate ESG-related disclosures and marketing materials.
Below is additional information regarding these observations.
- Portfolio management practices were inconsistent with disclosures about ESG approaches. The staff observed portfolio management practices that differed from client disclosures in required disclosure documents (e.g., Form ADV Part 2A) 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 lack of adherence to global ESG frameworks where firms claimed such adherence and also observed fund holdings predominated by issuers with low ESG scores – as measured, for example, by a sub-adviser’s proprietary internal scoring system – where such predominance appeared inconsistent with those firms’ stated approaches.
- Controls were inadequate to maintain, monitor, and update clients’ ESG-related investing guidelines, mandates, and restrictions. The staff noted weaknesses in policies and procedures governing implementation and monitoring of the advisers’ clients’ or funds’ ESG-related directives. For example, the staff observed that advisers did not have adequate controls around implementing and monitoring 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. Nor did advisers have adequate systems to consistently and reasonably track and update clients’ negative screens leading to the risk that prohibited securities could be included in client portfolios. The staff also noted that client preferences to favor certain industries or issuers had not yet been effectuated because of challenges with implementation and monitoring, despite contrary marketing claims touting processes for implementing clients’ positive screens.
- Proxy voting may have been inconsistent with advisers’ stated approaches. The staff observed inconsistencies between public ESG-related proxy voting claims and internal proxy voting policies and practices. 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. At the same time, internal guidelines generally did not provide for such case-by-case analysis. The staff also noted public claims regarding clients’ ability to vote separately on ESG-related proxy proposals. Still, clients were never provided such opportunities, and no policies concerning these practices existed.
- Unsubstantiated or otherwise potentially misleading claims regarding ESG approaches. The staff observed unsubstantiated or otherwise potentially misleading claims regarding ESG investing in a variety of contexts. For instance, the staff noted marketing materials for some ESG-oriented funds that touted favorable risk, return, and correlation metrics related to ESG investing without disclosing material facts regarding the significant expense reimbursement they received from the fund sponsor inflated returns for those ESG-oriented funds. The staff also observed unsubstantiated claims by advisers regarding their substantial contributions to the development of specific ESG products when, in fact, their roles were very limited or inconsequential.
- Inadequate controls to ensure that ESG-related disclosures and marketing are consistent with the firm’s practices. The staff observed inconsistencies between actual firm practices and ESG-related disclosures and marketing materials because of a weakness in controls over public disclosures and client/investor-facing statements. For example, the staff observed a lack of adherence to global ESG frameworks despite claims to the contrary, unsubstantiated claims regarding investment practices (e.g., only investing in companies with “high employee satisfaction”), and a lack of documentation of ESG investing decisions and issuer engagement efforts. Also, the staff observed failures to update marketing materials timely (e.g., an adviser continuing to advertise an ESG investment product or service that is no longer offered).
- Compliance programs did not adequately address relevant ESG issues. 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. For instance, the staff identified compliance programs that did not address adherence to global ESG frameworks to which the firms claimed to be adhering. The staff also noted a lack of policies and procedures to ensure firms obtained reasonable support for ESG-related marketing claims and observed inadequate policies and procedures regarding oversight of ESG-focused sub-advisers. Firms also had difficulties in substantiating adherence to stated investment processes, such as supporting claims made to clients that each fund investment had received a high score for each separate component of ESG (i.e., environmental, social, and governance), when relying instead on composite ESG scores provided by a sub-adviser.
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. For example, compliance controls and oversight for reporting to sponsors of global ESG frameworks and responses to requests for proposals and due diligence questionnaires appeared to be ineffective. Also, the staff noted weaknesses in compliance controls regarding performance metrics included in marketing materials (such as risk, returns, and correlation metrics) and a lack of compliance review of the data underlying those measures.
Despite the above, there were also observations of effective practices. The SEC encourages market participants promoting ESG investing to clients, prospective clients, investors, and prospective investors to evaluate whether their disclosures, marketing claims and other public statements related to ESG investing are accurate and consistent with internal firm practices.
Enforcement and Being Proactive
Remember, in December 2020, the SEC settled charges against The Cheesecake Factory and warned it “will continue to scrutinize COVID-related disclosures to ensure that investors receive accurate, timely information.” No matter how the cake is sliced, there appears to be a consensus that more aggressive enforcement is coming. So what should you do now? Here are some suggestions.
- Designate a senior member of management who will be accountable for this initiative.
- Focus and then focus again. Take an inventory of what you may already be doing.
- Review the company’s strategy – short and long term. Determine the barriers, obstacles, and hurdles that could prevent the company from achieving its goals.
- Identify ESG risks and the effectiveness of internal controls and policies designed to mitigate risk. The risk assessment should evaluate not only legal risk but also potential reputational harm.
- Update the enterprise-wide risk assessments accordingly to include company-specific ESG risks.
- Address gaps identified during the risk assessment review by implementing new, revised, or enhanced internal controls, along with policies and procedures.
- Ensure the board of directors is educated and aligned.
- Understand this initiative can not a “paper” exercise.
- Develop a measurement system and reporting structure.
- Operationalize the initiative.
- Ensure training is done and built into the compliance program and internal audit plan.
- Review disclosures to ensure that ESG issues are being reported accurately.
- Look at what your peers are doing to address ESG issues.
- Ensure the accuracy of statements made by the company in public-facing materials – media.
- Focus. Don’t let this initiative detract you from other key risks!
I welcome your thoughts and comments.
April 9, 2021, SEC Division of Examinations Risk Al