On November 15, 2022, the U.S. Securities and Exchange Commission (SEC) published a press release providing an overview of its 2022 enforcement activities. The SEC stated that it had filed 760 enforcement actions in fiscal year 2022, which was a 9% increase from last year. The civil penalties, disgorgement, and pre-judgment interest ordered in SEC actions were $6.44 billion, the most in the SEC's history and almost double the amount from fiscal year 2021. Of the total money ordered, civil penalties, which totaled $4.194 billion, were the highest on record.
The SEC highlighted, among other areas of enforcement focus, its ESG-related enforcement efforts. In this regard, the SEC stated that the Division of Enforcement applies principles regarding materiality, accuracy of disclosures, and fiduciary duty, as codified in federal statutes, regulations, and case law. The press release highlighted three SEC enforcement actions:
- An action charging a registered investment adviser for materially misleading statements and omissions about its consideration of ESG principles in making investment decisions for certain mutual funds;
- A litigated matter charging a large iron ore producer with allegedly making false and misleading claims to local governments, communities, and investors about the safety of its dams prior to the collapse of a particular dam in South America; and
- Charges against a robo-adviser that had marketed itself as providing advisory services compliant with Islamic, or Shariah law, but did not adopt and implement written policies and procedures addressing how it would assure compliance with that law on an ongoing basis.
More recently, the SEC charged a registered investment adviser for ESG policy compliance failures involving investment strategies that were marketed as ESG strategies. With respect to a certain ESG strategy, the SEC found that the adviser did not adopt written policies and procedures governing how the adviser evaluated ESG factors as part of the investment process until after the strategy had been introduced. With respect to all of the ESG strategies, once the adviser adopted written policies and procedures relating to the ESG investment process, it failed to follow them consistently. For example, the SEC found that the adviser's policies and procedures required its personnel to complete a questionnaire for every company the adviser planned to include in the investment portfolio before the investment was selected, but instead personnel completed many of the ESG questionnaires after investment was selected and relied on previous ESG research, which was often conducted in a different manner than what was required in its policies and procedures.
Sanjay Wadhwa, Deputy Director of the SEC's Division of Enforcement and head of its Climate and ESG Task Force, commented that when advisers brand and market strategies and products as ESG, advisers "must establish reasonable policies and procedures governing how the ESG factors will be evaluated as part of the investment process, and then follow those policies and procedures, to avoid providing investors with information about these products that differs from their practices." Andrew Dean, Co-Chief of the Enforcement Division's Asset Management Unit added that this enforcement action "reinforces that investment advisers must develop and adhere to their policies and procedures over their investment processes, including ESG research, to ensure investors receive the advisory services they would expect to receive from an ESG investment."
The enforcement actions against investment advisers echo sentiments conveyed by the Division of Examinations in an April 2021 risk alert (see also our previous blog post here).
Key takeaways for investment advisers from the above enforcement actions and the related risk alert include the need to adopt and implement reasonable and appropriate:
- written policies and procedures governing how ESG factors will be used and evaluated in the investment strategy and process;
- controls regarding compliance with those policies and procedures;
- controls regarding how these strategies are marketed and described; and
- controls to promote consistency between how the strategies are actually implemented and how they are marketed and described.
Of particular importance is the fact that the new marketing rule under the Advisers Act is now the lens through which the marketing of many ESG strategies and products must be viewed. The new rule, among other things, imposes seven general prohibitions, which will provide the SEC with another potential violation in these types of cases and pose specific challenges for marketing ESG strategies and products. Specifically, under the new marketing rule, an "advertisement" (as defined broadly in the new rule) may not:
- Include any untrue statement of a material fact, or omit to state a material fact necessary in order to make the statement made, in the light of the circumstances under which it was made, not misleading;
- Include a material statement of fact that the adviser does not have a reasonable basis for believing it will be able to substantiate upon demand by the Commission;
- Include information that would reasonably be likely to cause an untrue or misleading implication or inference to be drawn concerning a material fact relating to the investment adviser;
- Discuss any potential benefits to clients or investors connected with or resulting from the investment adviser's services or methods of operation without providing fair and balanced treatment of any material risks or material limitations associated with the potential benefits;
- Include a reference to specific investment advice provided by the investment adviser where such investment advice is not presented in a manner that is fair and balanced;
- Include or exclude performance results, or present performance time periods, in a manner that is not fair and balanced; or
- Otherwise be materially misleading.
Given the scrutiny that the SEC will apply to an investment adviser's ESG-related disclosures, it will be critical that investment advisers take into account the learnings from the recent enforcement activity. The price of non-compliance is not only monetary, but also reputational damage.
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