The U.S. Securities and Exchange Commission’s Division of Examinations (Exams) recently issued a Risk Alert discussing observations from recent examinations on how investment advisers, registered investment companies, and hedge funds approach environmental, social, and governance (ESG) investing.  According to the Risk Alert, examinations will focus on:

  • Portfolio management practices relating to ESG (in other words, how firms incorporate ESG factors into the investment process), and the use of ESG-related terminology;
  • Due diligence and other processes for selecting, investing in, and monitoring investments based on a firm’s disclosed approach to ESG investing;
  • The extent to which proxy voting practices are consistent with ESG disclosures and marketing materials;
  • Advertising and marketing claims relating to ESG; and
  • The adoption and implementation of written policies and procedures, compliance oversight, and review of ESG investing practices and disclosures.

Our observations:

  • Definition around what ESG means is critical.  The Risk Alert makes clear that the SEC staff’s ESG focus is motivated not only by the rapid growth in investor demand and increasing numbers of ESG products and strategies, but by the potential for confusion (particularly for retail investors) resulting from the lack of ESG definition standards.  This makes it increasingly important for firms to “clearly and consistently” explain how they define ESG and use ESG-related terms – i.e., how they name and describe investment objectives, and market funds and investment strategies.  Firms will also need to maintain records substantiating that they are implementing ESG investment processes in a manner consistent with those definitions.   
  • SEC examination and enforcement activity will precede rulemaking.  The SEC is currently reevaluating existing guidance on public company disclosure on climate change, and will no doubt consider other ESG-related rulemaking in the future.  However, Exams (and the Enforcement Division) need not wait for rulemaking.  Absent specific rules around ESG, the SEC staff will focus on enforcing the more general anti-fraud principles such as Advisers Act Section 206 (fiduciary duty and the 2019 interpretation regarding standard of conduct for investment advisers) and the associated rules governing false or misleading statements to existing or prospective investors (Advisers Act Rule 206(4)-8), the advertising rule (Advisers Act Rule 206(4)-1), and the compliance rule (Advisers Act Rule 206(4)-7), among others.  This means that examinations and enforcement actions for the foreseeable future will focus on the accuracy and adequacy of disclosure, the completeness of written policies and procedures relating to ESG, and the degree to which ESG practices are consistent with those disclosure and written policies and procedures.  Exams will closely coordinate with Enforcement, particularly the newly created Climate and ESG Task Force, in identifying referrals from examinations for enforcement investigations.
  • Consider whether the integration of ESG in the investment process is consistent with the firm’s broader messaging around ESG.  It is clear from the Risk Alert that the Exams staff will be evaluating a firm’s practices against the full range of ESG-related communications that a firm may publish, including regulatory filings (e.g., public company filings), reports to sponsors of global ESG frameworks, general website statements, responses to DDQs, client and investor-facing materials.  Firms should get ahead of this by reviewing whether ESG investment practices are consistent with their broader commitments, aspirational statements, and corporate communications.  Alternatively, consider “clear and prominent” disclosures to notify clients and investors that ESG factors are considered alongside many other factors and will “not necessarily alter long-standing and seemingly contradictory investment strategies.”
Author

Jennifer serves as the Co-chair of Baker McKenzie's Financial Regulation and Enforcement Practice in North America. Jen is an experienced investment management lawyer with particular focus on investment adviser regulation and the convergence of investment advisory and brokerage services. She regularly represents clients before the US Securities and Exchange Commission (SEC), both in seeking interpretative guidance and in managing examination and enforcement matters. Jen is a leading practitioner in digital investment advice and the use of FinTech in the asset management industry.

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Amy serves as the Co-Chair of Baker McKenzie's North America Financial Regulation & Enforcement Practice, which provides clients with a full range of regulatory advice and enforcement counseling. Amy also serves on the steering committees of the Firm's Global Financial Services Regulatory and Global Financial Institutions Groups.

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Peter K.M. Chan is a member of Baker McKenzie’s North American Financial Regulation and Enforcement Practice, which provides our clients with a full range of regulatory advice and enforcement counseling. Peter brings two decades of experience at the US Securities and Exchange Commission (SEC) to his litigation and counseling work. His tenure at the SEC, as well as a stint as Special Assistant US Attorney in the Northern District of Illinois, have given Peter experience with civil and criminal matters.

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Jonathan is an associate in Baker McKenzie’s North American Financial Regulation and Enforcement Practice, which provides our clients with a full range of regulatory advice and enforcement counseling.