ESG Investing: Marketing, Implementation, and Compliance
April 23, 2021
On April 9, 2021, the SEC’s Division of Examinations (the “Division”) published a Risk Alert highlighting its observations from its recent examination of investment advisers, registered investment companies, and private funds offering environmental, social, and governance (“ESG”) products and services (the “Risk Alert”). See SEC Risk Alert, The Division of Examinations’ Review of ESG Investing (Apr. 9, 2021).
The Risk Alert comes shortly after the launch of the SEC Climate and ESG Task Force1, and it is the latest in a series of SEC responses to the growing investor demand for ESG products and services. Generally speaking, “ESG investing” (sometimes described as “socially responsible investing” or “impact investing”) refers to investment strategies that focus on, or take into account, environmental, social, and governance aspects of investments.
The SEC reiterated that ESG products and services are not governed by new or unique rules. Rather, ESG-related activities of investment advisers and ESG products are analyzed by the SEC under the existing regulatory framework, including obligations to provide full and fair disclosure, act in the best interest of the clients, and comply with antifraud rules of the US Investment Advisers Act of 1940, as amended (the “Advisers Act”).2 For investment advisers marketing ESG products, an important aspect of satisfying these obligations is ensuring that any ESG-related disclosures they make are consistent with their actual practices.
In the Risk Alert, the Division described common deficiencies in marketing and implementation of ESG investment strategies, and provided examples of effective ESG practices. The key takeaways are summarized below.
The Division identified several deficiencies in ESG practices, all of which highlight the need for careful and knowledgeable review of ESG disclosures and ESG investment practices. These deficiencies include:
- Discrepancies between ESG-related disclosures and actual portfolio management practices;
- Inadequate control and monitoring of clients’ ESG-related investing guidelines, mandates, and restrictions;
- Inconsistences between disclosures of ESG-related proxy voting and actual proxy voting practices;
- Misleading and unsubstantiated ESG disclosures in marketing materials; and
- Inadequate compliance programs, including programs that fail to properly oversee the implementation of ESG policies and procedures.
The SEC provided some specific examples of the above deficiencies, such as:
- Advertising adherence to certain ESG standards or investment restrictions, but failing to screen and monitor portfolio investments for compliance with such standards or investment restrictions;
- Advertising that investors will get to vote on ESG-related proxies on a case-by-case basis, but failing to ensure that actual proxy voting procedures accommodate any investor input;
- Claiming that ESG factors are considered in screening, due diligence, selection, and monitoring of portfolio investments, but failing to implement practices adequately designed to identify and analyze ESG scores of portfolio investments;
- Compliance programs run by personnel with limited knowledge of ESG strategies and investment processes of the relevant adviser; and
- Failure to involve compliance personnel in reviewing ESG-related disclosures and marketing decisions.
Effective ESG Practices
The Division shared practices that may be helpful to address the identified deficiencies. Some of these practices include:
- Consistent ESG-related disclosures at every stage of an investment process, including in regulatory filings, marketing materials, due diligence questionnaire responses, and other documentation completed at various stages of investing;
- ESG disclosures consistent with actual investment practices;
- Simple and clear disclosures regarding the firms’ ESG investment strategies, particularly in client-facing materials, including disclosing whether an investment adviser or the investment adviser’s particular portfolio will focus on specific ESG issues;
- Disclosing any permitted departures from the advertised ESG policies and procedures prior to investors’ decision to invest;
- With respect to separately managed accounts, offering a customized ESG investment strategy designed to accommodate client preferences;
- Having compliance policies and procedures reasonably designed to implement and monitor ESG strategies;
- Ensuring that compliance personnel are knowledgeable about an investment adviser’s ESG-related marketing, strategies, and practices; and
- Involving compliance personnel in an investment adviser’s specific ESG-related processes.
ESG investing will remain a focus of Division examinations in 2021, especially as both the sophistication of participants in ESG investments and the size of ESG-focused investment portfolios continue to grow. The Division will continue to examine whether ESG investing policies and strategies are accurately disclosed and whether portfolio investments are managed in accordance with such disclosures. The Division’s work will be complex as ESG investment goals are rapidly evolving, reflecting worldwide efforts to frame common ESG investment principles. At the same time, the SEC is in the early stages of developing a potential framework for ESG disclosure metrics, including defining core elements of ESG investment goals. This process is not without controversy as SEC Commissioners have questioned the feasibility of introducing common qualitative goals, given the difficulty in comparing such goals across various investments and industries.3 We expect to provide further updates in the near term as these rulemakings evolve.
1 The task force is expected to use sophisticated data analysis to identify potential violations related to climate and ESG disclosures, such as, for example, material gaps or misstatements in issuers’ disclosure of climate and ESG related risks.
2 See Section 206 of the U.S. Investment Advisers Act of 1940, as amended (the “Advisers Act”). Investment advisers also have antifraud liability with respect to communications to clients and prospective clients under Advisers Act Section 206. See Commission Interpretation Regarding Standard of Conduct for Investment Advisers, Release No. IA-5248 (June 5, 2019), available at https://www.sec.gov/rules/interp/2019/ia-5248.pdf. Advisers Act Rule 206(4)-8 prohibits advisers to pooled investment vehicles from making false or misleading statements to existing or prospective investors in those pooled investment vehicles (e.g., investors in a registered investment company or private fund).
3 See Public Statement of the SEC Commissioner Hester M. Peirce, “Rethinking Global ESG Metrics,” April 14, 2021, available at: https://www.sec.gov/news/public-statement/rethinking-global-esg-metrics.
This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. Alicja Biskupska-Haas, an O’Melveny partner licensed to practice law in New York, Tracie Ingrasin, an O’Melveny partner licensed to practice law in New York, Marina G. Richter, an O’Melveny counsel licensed to practice law in New York and Russia, and Chani Gatto-Bradshaw, an O’Melveny associate licensed to practice law in New York, contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.
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