The SEC Risk Alert - What it means for ESG

Demand for ESG-driven (Environmental, Social, Governance) investment opportunities has increased dramatically over the last decade. According to the 2018 Trends Report, U.S. assets under management that use sustainable and ESG investment strategies grew from $8.7 trillion in 2016 to $12 trillion in 2018. Today, ESG investments continue to increase in comparison to traditional equity investments, and ESG investments are performing better than traditional equity funds.

Due to this rapid and growing interest in ESG, staff at the Securities and Exchange Commission (SEC) are discovering that just because a financial product says it is sustainable, doesn’t mean that’s true. Regulators at the SEC have recently issued a risk alert to raise investor awareness of potentially misleading statements discovered during recent examinations of investment companies that offer ESG products and services.

This move by the SEC is an important step toward enhanced ESG oversight. As ESG investing becomes more popular, investors are trying to understand how ESG-driven companies work within their portfolios as well as get a hold on related regulation and how to filter ESG data. To support these efforts, the agency has formed a Climate and ESG Task Force in the Division of Enforcement, is ramping up reviews of corporate climate-related disclosures, and has released a request for public comment on ESG and climate-risk disclosures.

The SEC’s move is part of a larger shift by financial regulators and policymakers regarding climate change. Climate change has been a priority for President Biden, who has called for companies to disclose their greenhouse gas emissions and plans to get the U.S. to net-zero emissions by 2050. While there are some political tensions surrounding the ESG conversation, it’s clear the SEC is going to concentrate on ESG for the foreseeable future.

The SEC Risk Alert: What does it mean?

The SEC reported, “staff observed some instances of potentially misleading statements regarding ESG investing processes and representations regarding the adherence to global ESG frameworks.” While these discoveries did not violate the law, the SEC cited “a lack of policies and procedures related to ESG investing” as well as weak documentation of ESG-related investment decisions and poorly designed compliance programs as some of the major issues.

The risk alert documents stated, “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.”

The staff found issues such as:

• Advisers did not have adequate controls for implementing and monitoring clients’ negative screens, such as prohibitions on investments in certain industries, including alcohol, tobacco, or firearms.
• Marketing materials for some ESG-oriented funds touted favorable risk and return and correlation metrics related to ESG investing without disclosing material facts such as expense reimbursement.
• Claims by advisers regarding their substantial contributions to the development of specific ESG products were unsubstantiated.

Because of this, the SEC is en route to enhancing its decade-old ESG guidance with a focus on climate-related disclosures in public company filings. During this process, the SEC is encouraging firms promoting ESG products to evaluate whether their disclosures, marketing claims, and other public statements related to ESG investing are accurate and consistent with internal firm practices.

New SEC guidance: What can companies expect?

SEC commissioner Hester Pierce said the role of SEC staff is not to second-guess investment decisions through an SEC-created ESG scoring system, but to understand whether firms are adhering to their own ESG claims. With this in mind, the SEC is reviewing its current guidance in order to revamp and align that guidance with other climate-focused initiatives being put in place by the current administration as well as global goals and standards covered under the Paris Climate Agreement.

The SEC stated, “Our Division of Enforcement will continue to identify, investigate, and bring actions against those who violate our laws and rules. Some of those violators might be public companies or advisers whose climate- or ESG-related statements are false or misleading, but such actions would not be based on any new standard; we have always pursued violations of our antifraud provisions. Either way, we must continue to review any alleged securities violations in light of the regulations and guidance in existence at the time of the conduct in question.”

The new Climate and ESG Task Force will begin developing initiatives to proactively identify ESG-related misconduct and reviewing the current ESG guidelines. This should not be seen as a disruptor or groundbreaking initiative, but rather a continuation of the work the SEC has been delivering for decades and as a much-needed update of climate-related and ESG reporting guidance in the U.S. Currently, the Commission has not voted on any new standards or expectations relating to climate-related disclosure.

The SEC plans to review how companies are disclosing climate-change risks and will work with companies to assess the extent to which they are complying with current climate disclosure guidance. These steps will help the task force evaluate and update their guidelines to create a more comprehensive framework. However, this process could take up to four years. In the meantime, the SEC has provided some examples of problematic and effective ESG practices.

The difference between problematic & effective ESG practices

The risk alert provided insight into “potential violations” and described a number of problematic practices the SEC has observed in recent examinations of investment advisers, registered investment companies, and private funds offering ESG products and services.

Problematic practices

The SEC stated some of the following practices could mislead investors into falsely believing that they invested in companies pursuing ESG strategies.

• Portfolio management practices were inconsistent with disclosures about ESG approaches.
• Controls were inadequate to maintain, monitor, and update clients’ ESG-related investing guidelines, mandates, and restrictions.
• Proxy voting may have been inconsistent with advisers’ stated approaches.
• Unsubstantiated or otherwise potentially misleading claims regarding ESG approaches.
• Inadequate controls to ensure that ESG-related disclosures and marketing are consistent with the firm’s practices.
• Compliance programs did not adequately address relevant ESG issues.

Effective practices

The SEC also recommended several effective practices that firms should adopt to avoid ESG violations, such as:

• Disclosures that are clear, precise, and tailored to firms’ specific approaches to ESG investing, and which aligned with the firms’ actual practices.
• Policies and procedures that address ESG investing and covered key aspects of the firms’ relevant practices.
• Compliance personnel who are knowledgeable about the firms’ specific ESG-related practices.

Open, fair, transparent ESG performance

Allison Herren Lee, acting chair of the SEC, said it best, "The bottom line is that businesses now actively compete for capital based on ESG performance, and that competition needs to be open, fair and transparent."

The SEC is advising firms to ensure that their approaches to ESG investing are implemented consistently throughout the company where relevant, adequately addressed in the firm’s policies and procedures, and subject to appropriate oversight by compliance personnel. Firms should also consider taking steps to document and maintain records relating to important stages of the ESG investing process.

Moving forward, companies that work toward ethical compliance through materiality assessments, utilization of globally recognized ESG frameworks, proper due diligence, and transparent communication will be better prepared to compete on the global ESG playing field.

ESG materiality assessments

With investors inquiring more and more frequently about what your company is doing in regard to responsible investment, how you treat employees and vendors, your dedication to sustainability initiatives, and other activities that fall under the ESG umbrella, it’s important to have answers to these questions.

An ESG materiality assessment empowers you to easily report on your current state and outline future initiatives while taking into consideration your business goals and risks. Download our guide to creating and extracting the maximum strategic value from an ESG materiality assessment.

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Sambhram Patel

In his role as a Senior Solutions Architect, Sam manages portfolio-wide projects for reporting frameworks such as GRESB, CDP, and the S&P CSA for multiple clients. Additionally, he helps drive asset-level sustainability by supporting projects such as LEED, ENERGY STAR, Fitwel, and utility benchmarking.

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