This Advisory is the fifth in a series concerning environmental, social and governance (ESG) considerations for the financial services industry and other companies. As discussed in our prior ESG advisories (Parts I, II, III, and IV), these writings reflect the combined effort of the firm's Environmental Practice Group, Financial Services Group, and Securities Group, with insights from other practice areas at the firm. This installment in the series addresses issues related to both ESG-related disclosures and the whistleblower program of the US Securities and Exchange Commission (SEC or Commission), and it includes the viewpoints of our partner Jane Norberg, who is the former Chief of the SEC's Office of the Whistleblower.
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On August 25, 2021, The Wall Street Journal reported that the SEC and the United States Attorney's Office for the Eastern District of New York are investigating greenwashing allegations made by the former head of sustainability of Deutsche Bank AG's asset-management arm, DWS Group (DWS), including allegations that DWS overstated how much it used sustainable investing criteria to manage its assets. DWS disclosed in its 2020 annual report that it invested more than half of its $900 billion in assets using a system called ESG integration, where companies are graded using ESG criteria. According to The Wall Street Journal, however, an internal assessment done a month earlier said that only a fraction of these assets applied the ESG integration process and that there was no quantifiable or verifiable ESG-integration for key DWS asset classes.
These allegations raise key considerations concerning the intersection of two high-priority matters for the SEC: (i) the adequacy and accuracy of ESG-related disclosures and (ii) the strengthening of the SEC's whistleblower rules to encourage whistleblowers to come forward. In this Advisory, we analyze this intersecting landscape and its implications and practical considerations.
Recent Signs of the SEC's Aggressive Approach to ESG-Related Misconduct
Since the 2020 presidential election, ESG investing and disclosure standards have repeatedly made financial news headlines, been the subject of many regulatory agency initiatives and newly-formed committees, and frequently served as a centerpiece of senior government officials' speeches.
Indeed, the SEC has signaled that it will aggressively investigate ESG-related misconduct using whistleblower tips. On March 4, 2021, the Commission announced the creation of the Climate and ESG Task Force in its Division of Enforcement, which is comprised of 22 enforcement attorneys and specialists who will analyze disclosure and compliance issues relating to "investment advisers' and funds' ESG strategies." The task force is charged with evaluating and pursuing whistleblower complaints on ESG-related issues. To highlight the SEC's interest in receiving these whistleblower complaints, the announcement included a link to the Commission's online portal which can be used to submit ESG-related tips, referrals, and complaints.
On April 9, 2021, the SEC's Division of Examinations issued a Risk Alert detailing staff observations from recent examinations of investment advisers, registered investment companies, and private funds engaged in ESG investing. These observations included "some instances of potentially misleading statements regarding ESG investing processes and representations regarding the adherence to global ESG frameworks" as well as "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," despite claims to the contrary.
On September 1, 2021, the Chair of the SEC, Gary Gensler, issued the Commission's most recent warning about ESG disclosures in prepared remarks made to the European Parliament Committee on Economic and Monetary Affairs. Chair Gensler stated that, " Many funds these days brand themselves as 'green,' 'sustainable,' 'low-carbon,' and so on. I've directed staff to review current practices and consider recommendations about whether fund managers should disclose the criteria and underlying data they use to market themselves as such."
Despite the SEC's aggressive enforcement posture on ESG disclosures, Gensler's recent remarks indicate that the SEC is still considering development of specific ESG disclosure requirements for ESG funds or funds that claim to incorporate ESG criteria into their investment strategies. Any enforcement action, therefore, would be based on existing, generally-applicable regulations that lack this specificity. For example, Rule 35d-1 under the Investment Company Act of 1940, the "Names Rule," requires a fund to invest at least 80% of its assets in the type of investment, industry, or geographic region suggested by its name. When applied to ESG funds and disclosures, there is significant ambiguity as to what is an ESG fund and what constitutes an ESG investment. As Commissioner Elad Roisman observed last year, "[i]n recent years, asset managers have proliferated in their creation of products labeled as 'ESG,' 'Green,' or 'Sustainable,'" but "there is no universal definition for any of these terms, and such products' investment philosophies and holdings can vary widely."
The SEC's Enhanced Use of Its Whistleblower Program as an Enforcement Tool
The SEC's Office of the Whistleblower (OWB) was formed in 2011, one year after the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) amended the Securities Exchange Act of 1934 by directing the SEC to pay monetary awards to eligible individuals who voluntarily provide original information leading to successful enforcement actions that result in monetary sanctions over $1 million and successful related actions. 15 U.S.C. § 78u-6. Awards range between 10% and 30% of the money collected. Dodd-Frank and the SEC's implementing rules include confidentiality protections for whistleblower submissions and prohibit employers from retaliating against whistleblowers for providing information to the SEC. 17 C.F.R. §§ 240.21F-7; 15 U.S.C. § 78u-6(h)(1).
In a prior Advisory, we analyzed how the SEC's fiscal year 2020 was a record-breaking year for the OWB in terms of whistleblower tips received and awards paid, and how fiscal year 2021 (which ends on September 30, 2021) will set new records. Moreover, on September 15, 2021, the SEC announced that the whistleblower program has now surpassed $1 billion in awards to individuals who provided information under the program since its inception. The number of tips, value of awards paid, and recent statements by Chair Gensler signaling his intent to strengthen the whistleblower rules underscore that the SEC views whistleblower tips as an important tool for the enforcement of the securities laws.
Convergence of the Two Landscapes: Implications and Practical Considerations
In light of these recent, converging ESG and whistleblower developments, there is likely to be an increase in internal and external whistleblower complaints concerning ESG disclosures and related issues. The SEC's focus on ESG-related funds and disclosures highlights the need for companies to take prompt action once they receive an internal report of potential misconduct regarding climate or other ESG disclosures. As a result, ESG-related funds, publicly traded companies, regulated entities, and other companies would be well-advised to consider the following:
- Internal Whistleblower Communications. Treat internal whistleblowers who report potential ESG disclosure misconduct in the same way as any other whistleblower who reports potential securities violations. Indeed, according to the SEC's 2020 Annual Report to Congress on the Whistleblower Program, 84% of SEC whistleblower awardees reported their concerns internally, in many cases to a direct supervisor, before or at the same time they reported out to the SEC. Companies should acknowledge whistleblowers and engage in appropriate communications if a whistleblower does not submit an internal report anonymously. A lack of communication following submission of an internal tip can result in misunderstandings and often a report out to a government agency.
- Internal Reporting Framework. Take steps to ensure that the current internal reporting framework for potential securities violations is sufficiently robust and flexible to identify, respond to, and investigate potential ESG disclosure misconduct. Companies that are able to conduct thorough internal investigations showing a clear, robust response to an internal tip will be better poised to effectively self-correct and have a defensible position if regulators or law enforcement later become involved.
- Public Reporting Procedures. Disclosure committees and audit committees of public companies should include ESG-related disclosure as an agenda item for discussion when developing, evaluating, and finalizing earnings releases, periodic reports, proxy statements, and other public disclosures. In particular, companies should recognize that the SEC is closely scrutinizing the use of generalities and should resist the temptation of "gilding the lily." ESG-related disclosures should have the same factual support as would be expected of all other public company disclosures.
- ESG Policies, Procedures, and Internal Controls. Consider conducting a risk assessment review of ESG policies, procedures, and internal controls. In particular, in light of the deficiencies noted in the SEC's Risk Alert, consider developing or reviewing current policies and procedures related to ESG investing and testing internal ESG-related controls for adequacy and proper functioning. Ensure that compliance programs are reasonably designed to capture inaccurate ESG-related disclosures or marketing materials.
- Whistleblower Policies and Training. Ensure that whistleblower policies and training are up-to-date. Review policies for clear mechanisms for internal reporting. To be effective, internal whistleblower policies should reflect a zero tolerance approach to retaliation so employees can feel comfortable reporting internally rather than externally in the first instance. Communicate the policy to your workforce. Target anti-retaliation training to middle management who are usually the first line recipients of tips from their direct reports.
- Encouraging Internal Reporting for a Remote and Hybrid Workforce. Consider a refresh on internal reporting campaigns for remote and hybrid workers to encourage and support internal reporting. Given the record numbers of whistleblower tips reported to the SEC during the pandemic, a fresh approach to internal reporting may be warranted. Provide clear reporting mechanisms that instill confidence, including anonymous reporting options.
Arnold & Porter's Financial Services and Securities Groups will continue to work with the Environmental Practice Group to monitor climate-related and other ESG developments in the financial services sector and to develop best practices for the firm's financial institution clients. If financial institutions or other companies are seeking advice on how to reduce risk related to whistleblowers or how to incorporate ESG factors—including climate-related considerations—into their business strategy, risk management, or disclosure processes, please contact any author of this Advisory or your regular Arnold & Porter contact.
*Andrew Johnson contributed to this Advisory. Mr. Johnson is a graduate of the University of California Hastings College of the Law and is employed at Arnold & Porter's Washington, DC office. Mr. Johnson is admitted only in California. He is not admitted to the practice of law in Washington, DC.
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