The SEC wants investment advisers to strengthen compliance practices related to environmental, social, and governance (ESG) investing, which is increasingly popular.
“This rapid growth in demand, increasing number of ESG products and services, and lack of standardized and precise ESG definitions present certain risks,” the SEC’s Division of Examinations wrote in a risk alert for ESG investing that examiners released on April 9.
“For instance, the variability and imprecision of industry ESG definitions and terms can create confusion among investors if investment advisers and funds have not clearly and consistently articulated how they define ESG and how they use ESG-related terms, especially when offering products or services to retail investors. Actual portfolio management practices of investment advisers and funds should be consistent with their disclosed ESG investing processes or investment goals,” examiners continued.
Regulators emphasized that their concern lies in the consistency with which advisers disclose ESG investing processes and goals, or rather the lack thereof—and not in the merits of a firm’s ESG investments themselves.
“Firms claiming to be conducting ESG investing need to explain to investors what they mean by ESG and they need to do what they say they are doing. This same rule applies no matter what label an adviser puts on its products and services,” SEC Commissioner Hester Peirce said in a follow-up statement on the staff ESG risk alert.
The SEC’s intensifying interest in ESG investing reflects its emphasis on protecting retail investors, said Margie Webber, director of regulatory compliance for RegEd. “Examiners want firms to apply the same rigorous compliance efforts to ESG investing as they do to other investments.”
ESG Compliance Concerns
Examiners cited the following examples of deficiencies and internal control weaknesses in firms’ current compliance efforts for ESG investing in their risk alert.
- Portfolio management practices that differ from disclosures about ESG approaches
- Weaknesses in policies and procedures governing implementation and monitoring of the advisers’ clients’ or funds’ ESG-related directives
- Unsubstantiated or otherwise potentially misleading claims regarding ESG approaches
- Inadequate controls to ensure that ESG-related disclosures and marketing reflect the firm’s practices
- Lack of policies and procedures addressing ESG investing analyses, decision-making processes, or compliance review and oversight
- Limited knowledge of relevant ESG-investment analyses or oversight of ESG-related disclosures and marketing decisions among compliance personnel
Though firms do not need a special set of policies and procedures for ESG investing, they should design their policies and procedures around whatever investment strategies they employ and comply accordingly, Peirce stated.
“As with any other investment strategy, advisers and funds should not make claims that do not accord with their practices, and our examiners will be looking for that consistency between claims and practice,” she said.
Effective Practices for ESG Compliance
Examiners also included the following examples of effective practices in their risk alert so that firms can develop and enhance their compliance practices.
- Disclosures that were clear, precise, and tailored to firms’ specific approaches to ESG investing, and which aligned with the firms’ actual practices
- Policies and procedures that addressed ESG investing and covered key aspects of the firms’ relevant practices
- Compliance personnel that were integrated into firms’ ESG-related processes and knowledgeable about firms’ ESG approaches and practices
“The compliance personnel in these 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,” examiners wrote in their risk alert.
Like with any area of importance, examiners expect firms to support ESG investing with effective policies and procedures and adequate disclosures, RegEd’s Webber said. “As usual, examiners want firms to comply with their practices internally and to be forthcoming in their communications externally.”
Strengthening Compliance for ESG Investing
The SEC will watch firms closely as ESG investing grows, Peirce stated. “This alert comes as many financial firms are finding gold in the green—they are offering ESG products because it is lucrative to do so. Therefore, as I have noted previously, asset manager accountability in the ESG space is important.”
In concluding their risk alert, examiners wrote, “The Division encourages market participants promoting ESG investing to clients, prospective clients, investors, and prospective investors to evaluate whether their disclosures, marketing claims, and other public statements related to ESG investing are accurate and consistent with internal firm practices.
“Additionally, firms should ensure that their approaches to ESG investing are implemented consistently throughout the firm where relevant and are adequately addressed in the firm’s policies and procedures and subject to appropriate oversight by compliance personnel.”
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