On April 9, 2021 the U.S. Securities and Exchange Commission ("SEC") Division of Examinations ("Division"1) released a Risk Alert2 highlighting observations from recent examinations of investment advisers, registered investment companies, and private funds (collectively, "firms") offering investment products and financial services that incorporate environmental, social, and governance ("ESG") factors. SEC Commissioner Hester M. Peirce also issued a statement on the Risk Alert3 and a statement addressing global ESG metrics.4
The Division notes that investor demand for ESG products and services has increased in recent years, leading to an increase in firms offering ESG investment options. However, the Division also noted that "[t]his rapid growth in demand, increasing number of ESG products and services, and lack of standardized and precise ESG definitions present certain risks." The Risk Alert is intended to provide transparency around the Division's focus areas during examinations addressing ESG investing5 and is further intended to highlight risk areas and assist firms in developing and enhancing their compliance practices in this area. The Risk Alert also provides the Division's observations of (1) deficiencies and weaknesses in internal controls and (2) effective practices identified from examinations of firms engaged in ESG investing.
Areas of Focus for Examinations Addressing ESG Investing
Examinations of firms involved in ESG investing will focus on whether such firms "are accurately disclosing their ESG investing approaches and have adopted and implemented policies, procedures, and practices that accord with their ESG-related disclosures." Among other areas, the Division will focus on the following:
- Portfolio management. The Division will review firms' policies, procedures, and practices related to ESG, including due-diligence and proxy-voting policies.
- Performance advertising and marketing. Examinations will review firms' regulatory filings, websites, client presentations, and other client-/investor-facing documents such as marketing materials.
- Compliance programs. Division staff will review firms' written policies and procedures, including the implementation and oversight thereof.
Observed Deficiencies and Weaknesses in Internal Firm Controls
During recent Division examinations of firms engaged in ESG investing, Division staff noted certain deficiencies including the following:
- portfolio-management practices that were inconsistent with disclosures about ESG approaches;
- controls that were inadequate to implement and monitor the ESG-related directives of the firms' clients or funds;
- inconsistencies between public ESG-related proxy-voting claims and internal proxy-voting policies and practices;
- unsubstantiated or otherwise potentially misleading claims regarding ESG investing and approaches;
- inadequate controls to ensure that ESG-related disclosures and marketing are consistent with a firm's practices;
- compliance programs that did not adequately address the relevant ESG issues, such as ensuring that firms adhere to ESG frameworks to which the firm claimed to adhere or ensuring that the firms obtained reasonable support for ESG-related marketing claims; and
- less effective compliance programs due to compliance personnel with limited knowledge of relevant ESG-related investment analyses or oversight over ESG-related disclosures and marketing decisions.
Observed Effective Practices
The Division's examinations of firms engaged in ESG investing also noted some effective practices, including the following:
- providing clear, precise disclosures that are tailored to the firms' specific approaches to ESG investing and align with the firms' actual practices;
- crafting policies and procedures to address ESG investing and cover key aspects of the firms' ESG practices; and
- integrating compliance personnel into the firms' ESG-related processes and ensuring that compliance personnel are knowledgeable about the firms' ESG approaches and practices, which assists those personnel in review of ESG-related marketing materials and other client-/investor-facing documents.
The Risk Alert emphasizes the importance of providing clear and prominent disclosures. For example, the Division noted that some "firms could still satisfy the requirements of certain global ESG frameworks while making investments that appeared to be inconsistent with ESG investing," which means that for those firms, "adherence to certain global ESG frameworks did not necessarily alter long-standing and seemingly contrary investment strategies."
Statements of Commissioner Peirce
On April 12, 2021, Commissioner Peirce released a statement addressing the Risk Alert. She emphasized "that 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" and that the role of the SEC "is not to assess whether any particular strategy is a good one, but to ensure that investors know what they are getting when they choose a particular adviser, fund, strategy, or product." Firms that offer ESG investment strategies, like any other targeted investment strategy, should ensure that their public claims are consistent with their internal policies and practices.
On April 14, Commissioner Peirce released another statement addressing ESG, focused on the "mounting pressure to embrace a single global set of [ESG] metrics, which would facilitate international capital flows and issuers' reporting obligations." Commissioner Peirce argued that "[a] single set of metrics will constrain decision making and impede creative thinking" and that "global reliance on a centrally determined set of metrics could undermine the very people-centered objectives of the ESG movement by displacing the insights of the people making and consuming products and services."
Firms that seek to engage in ESG-related investment programs and activities should review the Risk Alert and consider whether any amendments may be necessary to their compliance programs according to the guidance provided by the Division.
1. The SEC's Office of Compliance Inspections and Examinations was renamed the Division of Examinations in December 2020. See "SEC Statement on the Renaming of the Office of Compliance Inspections and Examinations to the Division of Examinations" (Dec. 17, 2020), available at https://www.sec.gov/news/public-statement/joint-statement-division-examinations.
2. SEC Division of Examinations Risk Alert, "The Division of Examinations' Review of ESG Investing" (Apr. 9, 2021), available at https://www.sec.gov/files/esg-risk-alert.pdf.
3. Hester M. Peirce, Comm'r, SEC, "Statement on the Staff ESG Risk Alert" (Apr. 12, 2021), available at https://www.sec.gov/news/public-statement/peirce-statement-staff-esg-risk-alert.
4. Hester M. Peirce, Comm'r, SEC, "Rethinking Global ESG Metrics" (Apr. 14, 2021), available at https://www.sec.gov/news/public-statement/rethinking-global-esg-metrics.
5. The SEC's 2021 Examination Priorities include a focus on ESG investing. See SEC Division of Examinations, "2021 Examination Priorities" (Mar. 3, 2021), available at https://www.sec.gov/files/2021-exam-priorities.pdf. We also released a client alert on the 2021 Examination Priorities, available at https://www.winston.com/en/thought-leadership/2021-sec-examination-priorities.html.
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