Bates Research | 04-23-21

SEC Elevates ESG in New Alert Focusing on Disclosures, Observations and Effective Practices

On April 9, 2021, the SEC Division of Examinations (“the Division”) issued a risk alert to review compliance deficiencies concerning environmental, social and governance (“ESG”) product and service offerings by investment advisers, registered investment companies, and funds. The emphasis on ESG-related compliance in the alert follows from the agency’s elevated focus on climate change as an emergent priority (see Bates post on SEC’s 2021 Priorities). It also stems from a host of moves by SEC Acting Chair Allison Herren Lee on the subject, including the creation of an ESG taskforce, the issuance of investor guidance on ESG funds, and the adoption of a new strategic approach, among others.

In a significant number of directed actions, the SEC has communicated that it intends to move aggressively to encourage ESG investing and to develop frameworks for compliance. In this article, we highlight current compliance triggers in the context of recent SEC ESG-related activity.

SEC Division of Examinations Risk Alert on ESG

In its priorities report issued in March 2021, the SEC described how firms are “increasingly offering investment strategies that focus on sustainability.” Financial products referred to as “socially responsible,” “ESG-conscious” or “sustainable” are sold to investors as part of open-end funds and ETFs. The Division stated then that it will continue to examine these products and strategies to determine the consistency and adequacy of their disclosures, the potential for false or misleading statements in advertising, and to “review proxy voting policies and procedures and votes to assess whether they align with the strategies.”

The latest Division alert emphasized the demand side of the ESG discussion. The Division asserted that investors are demanding “investment products and financial services that incorporate environmental, social, and governance factors” and that firms are responding to that demand by “expand[ing] their various approaches to ESG investing and increas[ing] the number of product offerings across multiple asset classes.” The Division noted that this dynamic presents enhanced marketing and compliance risk, due in part to the “lack of standardized and precise ESG definitions,” which can create retail investor confusion if advisers and fund managers do not disclose and communicate consistently and effectively. Mitigating that risk is, ostensibly, what is driving the SEC’s efforts.

ESG Observations

In recent examinations, the Division stated it found: (i) inconsistencies between portfolio management and ESG disclosure; (ii) inadequate internal controls for maintaining, monitoring and updating ESG guidelines and practices and advisers’ or funds’ ESG directives; (iii) inconsistencies between proxy voting and advisers’ or funds’ approaches on ESG-related directives; (iv) misleading claims and inadequate controls over marketing and disclosures; and (v) inadequate policies and procedures to address ESG analyses, decision-making processes, compliance review, and oversight.

In brief, the Division warned firms to ensure that their “disclosures, marketing claims, and other public statements related to ESG investing are accurate and consistent with internal firm practices.” Further, the Division urged firms engaging with ESG products and services to focus their compliance and oversight efforts on portfolio management, performance advertising and marketing, and internal program controls.

At a recent SIFMA webinar focusing on FINRA’s exam priorities, Division Director Peter Driscoll noted that ESG exams are now happening in LA, Chicago and Boston. While there are no plans for a national initiative, he anticipates other offices to follow suit. The Director also highlighted staff’s ESG focus. He said that staff will examine disclosures and whether a company’s advertising overstates a company’s actual ESG strategy. “We are looking at what the firms are saying and how they are defining ESG (a benchmark or standard), whether the activities are meeting the firm’s statements and whether the firms maintain consistent policies and procedures,” he said.

SEC Leadership and Other SEC Activity

The Division’s focus on ESG-related compliance is only one portion of a much broader initiative begun by SEC Acting Chair Allison Herren Lee, who has been a singular proponent of greater disclosure in ESG investing. On March 15, 2021, she asked for public comment to inform SEC staff on developing a new reporting framework that would provide “consistent, comparable, and reliable information on climate change.”

In that broad request, the Acting Chair asked for feedback on standardized metrics on climate risk—possibly different metrics for different industries—possible future rules and forms changes, and tailored guidance for items that fall under ESG (e.g. workforce diversity, board member independence, voluntary sustainability reporting, corporate political spending, and proxy disclosures). She also asked for feedback on whether the SEC should implement a "comply or explain framework”; whether there should be ESG certification requirements placed on the CEO, CFO, or other corporate officers; and disclosures concerning the connection between executive or employee compensation and climate change risks. (Comments are due mid-June.)

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Making the Case and Moving it Forward

The Acting Chair has also taken several steps to position the agency for a deeper dive into these areas. On March 3, 2021, the SEC established an ESG Task Force within the Division of Enforcement intended to "proactively identify ESG-related misconduct." Among other mandates, the Task Force will focus on material omissions or misstatements in issuer disclosures relating to climate risks under existing regulations, but it will also use data analysis to detect potential violations, and will review and assess tips, referrals and whistleblower complaints concerning ESG issues.

Beyond these efforts, on February 26, 2021, the SEC issued an Office of Investor Education and Advocacy (“OIEA”) bulletin on ESG funds. The North American Securities Administrators Association (“NASAA”) also issued their own “Informed Investor Advisory on ESG” in April.

The SEC multi-Division response to ESG concerns, including the efforts by the Division of Examinations, the Task Force under the Division of Enforcement, and the OIEA, are captured and organized under a newly launched ESG web page: "SEC Response to Climate and ESG Risks and Opportunities."

Some Pushback

Acting Chair Lee’s ESG agenda has faced some detractors. In a recent speech, SEC Commissioner Hester Peirce expressed concern over the prescriptive nature of the SEC response and, in particular, on an embrace of a single set of ESG metrics. Senate Banking Committee Ranking Member Pat Toomey (R-PA) has also stated his concerns over a move toward creating a new regulatory framework for ESG more generally.

Conclusion

The speed at which ESG has become the highest of priorities for the SEC should make compliance officers everywhere take note. The SEC gave firms their ESG homework: evaluate disclosures, marketing claims, and other public communications to ensure they “are accurate and consistent with internal firm practices;” make sure ESG practices are consistent across the firm and are “adequately addressed” in policies and procedures; make sure to document and maintain ESG records and ensure proper oversight of it all. Firms would be prudent to prepare. This will be on the exam.

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