What Is the SEC Looking for During ESG-Related Exams?
The SEC's Division of Examinations issued a Risk Alert highlighting observations from recent examinations of investment advisers, registered investment companies, and private funds offering investment products and financial services that incorporate environmental, social, and governance (ESG) factors...
What Is the SEC Looking for During ESG-Related Exams?
<strong>The SEC's Division of Examinations issued a Risk Alert highlighting observations from recent examinations of investment advisers, registered investment companies, and private funds offering investment products and financial services that incorporate environmental, social, and governance (ESG) factors.</strong>..
On April 9, 2021, the Securities and Exchange Commission’s (SEC) Division of Examinations issued a Risk Alert highlighting observations from recent examinations of investment advisers, registered investment companies, and private funds offering investment products and financial services that incorporate environmental, social, and governance (ESG) factors. According to the SEC, the Risk Alert is intended to highlight risk areas and assist firms in developing and enhancing their compliance practices assessing disclosed ESG claims.
As the SEC highlights, the rapid growth in demand, increasing number of ESG products and services, and lack of standardized and precise ESG definitions present certain risks. Its Risk Alert addresses deficiencies and internal control weaknesses regarding ESG investing that the Division observed in its exams of investment advisers and funds; it also provides observations of effective practices from such examinations.
On April 12, 2021, Commissioner Hester M. Pierce published a “statement” on the staff’s ESG Risk Alert, reminding firms and their compliance officers that the Risk Alert has a “context”. In her view, the issuance of an ESG specific risk alert “should not be interpreted as a sign that ESG investment strategies are unique in the eyes of examiners.” (Emphasis added). Continuing, Commissioner Pierce advised that (1) SEC examiners are not must regulators and (2) “SEC’s role is to ensure that investors know what they are getting when they choose a particular adviser, fund, strategy or product.” Importantly, Ms. Pierce stated that firms do not need a special set of policies and procedures for ESG, but that a firm’s disclosures about its investment strategy regarding an ESG firm should “match reality”. Pierce’s “statement” clearly enunciates that the SEC staff’s role isn’t to “second guess investment decisions through an SEC-created scoring system”, but to verify whether firms adhere to their ESG claims.
SEC ESG Focused Examinations
The SEC included ESG disclosures on both its 2020 and 2021 Examination Priorities and will continue to examine firms to evaluate the accuracy of firm’s disclosures of its ESG investing approaches, adopted and implemented policies, procedures, and practices that are consistent with their ESG-related disclosures. As set forth in the Risk Alert, the Division of Examinations (Division) focused on and noted effective compliance practices in these areas:
- Portfolio management: Exams will include a review of the firm’s policies, procedures, and practices related to ESG and its use of ESG-related terminology; due diligence and other processes for selecting, investing in, and monitoring investments in view of the firm’s disclosed ESG investing approaches; and whether proxy voting decision-making processes are consistent with ESG disclosures and marketing materials.
- Performance advertising and marketing: Exams will include a review of the firm’s regulatory filings; websites; reports to sponsors of global ESG frameworks, to the extent the firm has communicated to clients and potential clients a commitment to follow such frameworks; client presentations; and responses to due diligence questionnaires, requests for proposals, and client/investor-facing documents, including marketing materials.
- Compliance programs: Exams will include a review of the firm’s written policies and procedures and their implementation, compliance oversight, and review of ESG investing practices and disclosures.
Compliance Deficiencies Observed Related to ESG Investing
The SEC Risk Alert states that, during examinations, Division staff observed instances of potentially misleading statements regarding ESG investing processes and representations regarding the 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 was weak or unclear; and compliance programs that did not appear to be reasonably designed to guard against inaccurate ESG-related disclosures and marketing materials,” the Division wrote. Below are several other observations:
- 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; and
- Compliance programs did not adequately address relevant ESG issues.
The key message from the SEC is that advisers and firms need to follow through with what they say they are going to do. That means disclosures, marketing materials, and other public statements related to ESG investing must be accurate and consistent with internal practices.
Effective Practices Related to ESG Investing
The Risk Alert also highlighted what firms and advisers are doing well with regard to ESG investing. As the SEC noted, “Advisers and funds may find these practices helpful in addressing the compliance issues identified above.”
Below are specific practices that the SEC highlighted as effective:
- Disclosures that were clear, precise and tailored to firms’ specific approaches to ESG investing, and which aligned with the firms’ actual practices: The Risk Alert stressed the importance of simple and clear disclosures regarding the firms’ approaches to ESG investing; clear and prominent disclosure that ESG factors could be considered alongside many other factors in an investment strategy; and explanations regarding how investments were evaluated using goals established under global ESG frameworks.
- Policies and procedures that addressed ESG investing and covered key aspects of the firms’ relevant practices: The Risk Alert specifically highlighted the use of detailed investment policies and procedures that addressed ESG investing and included specific documentation to be completed at various stages of the investment process (e.g., research, due diligence, selection, and monitoring).
- Compliance personnel that are knowledgeable about the firms’ specific ESG-related practices: The Risk Alert emphasizes that when compliance staff was integrated into firms’ ESG-related processes, firms appeared to: provide more meaningful reviews of firms’ public disclosures and marketing materials; test the adequacy and specificity of existing ESG-related policies and procedures, if any (or assess whether enhanced or separate ESG-related policies and procedures were necessary); evaluate whether firms’ portfolio management processes aligned with their stated ESG investing approaches; and test the adequacy of documentation of ESG-related investment decisions and adherence to clients’ investment preferences.
The Risk Alert and Commissioner’s statement are the latest in a series of actions that the SEC has taken to address investor risks related to climate and ESG investing. The SEC is also encouraging investors and others to report ESG-noncompliance through its whistleblower process. Advisors have been reminded of their responsibilities to have internal firm practices that assure the accuracy of disclosures, marketing materials, and public statements involving ESG investing. We encourage firms that offer ESG-related products and services to regularly monitor legal updates in this area and to update your risk assessments and compliance activities accordingly.
If you have questions, please contact us
If you have any questions or if you would like to discuss these issues further,
please contact Paul A. Lieberman or the Scarinci Hollenbeck attorney with whom you work, at (201) 896-4100.
SEC, Division of Examinations, “2021 Examination Priorities” (Mar. 3, 21), https://www.sec.gov/files/2021-exam-priorities.pdf.
 Hester M. Peirce, Commissioner, SEC, Lucy’s Human: Remarks at Virtual Roundtable on The Role of Asset Management in ESG Investing Hosted By Harvard Law School and the Program on International Financial Systems, https://www.sec.gov/news/speech/peirce-lucys-human-091720.
 See, Commissioner Elad Roisman’s critique, characterizing recent initiatives as “departures” from established SEC practices.
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About Author Paul A. Lieberman
Paul A. Lieberman has a distinguished legal practice devoted to client-centric representation in the financial services industry, including broker-dealers, investments advisers, public and private investment companies, insurance companies, registered representatives, financial advisers, agents and associated staff.
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