SEC Exam Observations: ESG Investing Risks

April 13, 2021

WHAT HAPPENED?

Recently, the U.S. Securities and Exchange Commission released a Risk Alert outlining specific compliance concerns associated with environmental, social, and governance (ESG) investing. With these investment products increasing in popularity across capital markets, the SEC is expanding efforts to provide advisers with comprehensive guidance on compliance considerations for participating in the ESG marketplace. Below are key takeaways from the SEC’s Risk Alert:

KEY TAKEAWAYS

ESG-Specific Examination Practices

• During an examination of your firm’s ESG practices, examiners will review ESG-related policies and procedures, due diligence practices for selecting new investments, and proxy voting processes.
• Marketing materials and performance advertising will be assessed to determine whether advisers employ proper disclosures and follow global ESG frameworks, if applicable. These materials may include due diligence questionnaires, regulatory filings, websites, and other public-facing documentation.
• Advisers’ compliance policies and procedures and the execution of proper ESG practices and disclosures will be reviewed during these exams.

Observations from Recent Exams

• Some of the examined advisers’ portfolio management practices were inconsistent with the ESG disclosures provided to clients, including those reported in Form ADV.
• Inadequate controls for upholding clients’ ESG-related directives were found. For example, some advisers were found not to have proper mechanisms in place to track clients’ negative screens or prohibitions on investments, like those including alcohol, tobacco, or firearms.
• Inconsistencies between advisers’ proxy voting practices and stated ESG approaches were observed. These included advisers publicly stating clients’ ability to vote on ESG-related items with no follow-through or policies to support these claims.
• Misleading claims about ESG approaches were made by some of the examined advisers. These sometimes included marketing materials with inflated risk and return metrics or unsubstantiated statements regarding adviser contributions to ESG development.
• Insufficient controls were in place to confirm ESG-related disclosures and marketing matched firms’ actual practices.
• Advisers’ policies and procedures did not appropriately address ESG practices. For example, some advisers claimed to follow global ESG frameworks but did not have policies and procedures in place to support these programs.
• Exam staff noted that firms with compliance staff who had less ESG-specific knowledge also had less effective compliance programs overall.

Positive Exam Observations and Effective Compliance Practices

• Some of the examined firms had clear, concise, and accurate ESG disclosures. These included tailored disclosures regarding how some investments may be inconsistent with ESG requirements, but still fit into the use of a global ESG framework, for example.
• Comprehensive and complete policies and procedures for handling ESG investing were observed among some advisers. These practices included firms completing documentation throughout the investment process at various stages, like research, due diligence, selection, and monitoring.
• Firms with compliance personnel who were more knowledgeable and well-informed about ESG investing had stronger compliance programs and more meaningful ESG oversight than other firms.

WHAT DOES THIS MEAN FOR ME?

As ESG investing gains momentum across the financial industry, examiners and regulators are placing more attention on potential compliance risks associated with these products. Your firm may be seeking to adopt a global ESG framework like the Equator Principles, Principles for Responsible Investment (UNPRI), or CFA Institute’s impending ESG Disclosure Standards for Investment Products; if so, your firm should plan to fully integrate these principles into its compliance program. If your firm participates in ESG investing and currently claims to follow a global ESG framework, your compliance program should support this claim with thoroughly documented policies and procedures. In addition to adopting industry standards, completely and continuously training key personnel on ESG topics will further minimize the risk to your firm and clients.

Review the SEC’s full Risk Alert for more in-depth information about ESG compliance risks and how they may affect your firm.