The SEC’s April 9, 2021 Risk Alert issued by the Division of Examination highlights the SEC’s increasing attention focused on investment strategies integrating ESG investment strategies. While ESG investing is not new, it has surged in recent years and now accounts for an estimated $17 trillion of professionally managed assets – a 42% increase since 2018.
Alongside increased investor interest and activity, investment advisors and managers have launched new investment strategies to address and build ESG strategies and products. In the U.S., ESG investment activity has been a largely unregulated ecosystem. The industry itself – including related nonprofit and multi-lateral organizations – has developed frameworks and approaches, resulting in distinct, although increasingly intersecting reporting methodologies and management techniques.
Given the rise in strategies and increasing allocations toward ESG-oriented products, the SEC and U.S. government’s involvement presents new considerations for those managing these strategies and products. As noted in the Risk Alert, these strategies include an increased integration of ESG diligence; negative, positive, or norms-based screens; engagement to improve ESG practices; and generation of measurable social and environmental outcomes, such as impact investing.
Regardless of the specific method with which firms are approaching ESG strategies, the Risk Alert highlights an overarching concern: ESG claims are often not supported by appropriate management, policies, and processes. In short, the Risk Alert asserts that if a fund claims it is operating in accordance with certain ESG strategies, such claim should be sufficiently justified.
Significantly, the Risk Alert does not pass judgment on specific approaches to ESG strategy or framework and instead focuses on process. In particular, the Division of Examination highlights the following areas of potential ongoing focus and as opportunities for improvement.
- Alignment of Portfolio Management and Disclosures. If a fund is claiming an ESG approach, the fund’s approach to portfolio management should align with required disclosures, whether within regulatory filings or as investor-facing marketing materials. In particular, the SEC notes that if the fund is claiming alignment with industry-developed global frameworks, such as the UN Principles of Responsible Investment or the Sustainable Development Goals, then the fund should be managed in a way that aligns with those frameworks. Importantly, this alignment should extend to the underlying investments. For example, whether the fund utilizes a proprietary evaluation tool or third-party frameworks, reporting from portfolio investments should track those standards, and ultimately, the fund should be able to report against those standards.
- Inadequate Controls for ESG Related Investing Directives: If a client maintains a directive, such as a negative screen, the fund must maintain adequate controls to fulfill that directive. The SEC noted that “weaknesses in policies and procedures governing implementation and monitoring of” ESG-related directives along with inadequate systems to “consistently and reasonably” track these directives led to risk that these guidelines and mandates would not be sufficiently maintained.
- Proxy Voting Inconsistency. Along the same lines, the Risk Assessment highlights discrepancies between public statements and actual policies regarding proxy voting. Proxy voting policies should align with implemented practices and if an investment adviser claims to offer clients the opportunity to vote separately on ESG-related proxy proposals, that offer should be provided, rather than simply being a marketing strategy.
- Unsubstantiated and Potentially Misleading Claims. With the increasing popularity of ESG strategies, marketing materials often present aspirations as accomplishments. The Risk Alert directs that ESG disclosures must present an accurate and comprehensive picture of how ESG investing strategies factor into risk, return, and correlation metrics. In particular, when making performance claims, ESG disclosures should account for the role in which the fund sponsor may have played regarding expense reimbursements for product development and accurately present a fund’s contribution to sector development, rather than conflating involvement in a meeting with a material role in a concept’s development.
- Inadequate Controls. Central to an effective ESG policy, ESG-oriented funds should have compliance mechanisms to be able to evaluate appropriate adherence to ESG frameworks. These controls should track through ongoing compliance as well as marketing – which should be updated in a timely fashion and include only claims that can be substantiated, rather than broad and nebulous claims.
- Compliance Programs Don’t Appropriately Address Relevant ESG Factors. While presenting an ESG-oriented strategy, funds may not have appropriate policies and policies that map investment approaches to frameworks or intended results. This manifests in and is exacerbated by the lack of professionals sufficiently knowledgeable about ESG matters. The Risk Alert implies that even if a fund collects data on ESG, if the fund doesn’t have the appropriate expertise to analyze, interpret, and report on that data, not only is that information not valuable, but the ESG information may be misleading or misinterpreted.
Recent Statements by Commissioner Peirce
On April 12, 2021, SEC Commissioner Hester Peirce issued a statement in response to the Risk Alert. While she commended the staff for seeking to aid firms and their compliance officers in assessing their ESG claims and practices preemptively in their own organizations, she also noted that the Risk Alert needed additional context.
For example, she noted that the Risk Alert’s discussion of how the SEC will review advisers’ proxy voting processes should be read in conjunction with their two earlier proxy voting interpretive releases in mind. While not applicable only to advisers using ESG strategies, SEC’s interpretive releases remind advisers that proxy voting is subject to advisers’ fiduciary duty and must be undertaken in the client’s best interest. Ms. Peirce also notes that firms do not need to have a separate set of policies and procedures for any investment strategy but “[r]ather, firms’ policies and procedures should be designed around the investment strategies the firm employs, whatever those strategies are.”
She also observed that “[t]he staff’s role is not to second-guess investment decisions through an SEC-created ESG scoring system; rather, it is to understand whether firms are adhering to their own ESG claims. If those ESG claims include relying on proprietary or third-party scoring services, the staff will want to understand the due diligence the adviser has done on that scoring service, as well as the work the firm does to ensure its adherence to the framework it has chosen.”
This Risk Alert is one in a series of U.S. governmental notices and actions taken with an increasing focus on ESG. Overall, this new focus suggests a need for funds and companies to put more attention to the content and process of ESG-related matters, not just relaying on framing, but focusing on decision-making, accountability, and ongoing oversight. This Risk Alert calls for increased and clear and consistent communication by funds both to clients and to the public around ESG strategies, processes and performance. Compliance personnel should also be familiar with the firm’s business so that they can build and operate an effective ESG compliance program for the firm. Due diligence should also be taken with respect to any proprietary or third-party scoring services that the firm relies on in making ESG claims. In short, ESG investment strategies and voting processes are not viewed any differently by the SEC and should be subject to the same controls and standards that apply to advisor investment strategies and voting processes generally.
 US SIF Trends Report 2020 Executive Summary, available at https://www.ussif.org/files/US%20SIF%20Trends%20Report%202020%20Executive%20Summary.pdf.
 In fact, Commissioner Hester M. Peirce has noted recently in a public statement concerning disclosure metrics, that while common disclosure metrics “sounds good, common metrics demonstrating a joint commitment to a better, cleaner, well governed society. Common disclosure metrics, however, will drive and homogenize capital allocation decisions. A single set of metrics will constrain decision making and impede creative thinking.” https://www.sec.gov/news/public-statement/rethinking-global-esg-metrics
 Advisers Act Section 206(4) and Rule 206(4)-1(a)(5) thereunder prohibit an investment adviser from, directly or indirectly, distributing advertisements that contain any misrepresentation of a material fact or are otherwise misleading.
 See Commission Guidance Regarding Proxy Voting Responsibilities of Investment Advisers, Release No. IA-5325 (Aug. 21, 2019), 84 Fed. Reg. 47420 (Sept. 10, 2019) and Supplement to Commission Guidance Regarding Proxy Voting Responsibilities of Investment Advisers, Release No. IA-5547 (July 22, 2020). Both documents are on-point because the risk alert explains that examinations will look at “whether proxy voting decision-making processes are consistent with ESG disclosures and marketing materials.”
 For example: https://www.sec.gov/oiea/investor-alerts-and-bulletins/environmental-social-and-governance-esg-funds-investor-bulletin.