On April 9, 2021, the Securities and Exchange Commission’s (“SEC”) Division of Examinations[1] published a Risk Alert[2] regarding its review of ESG investing.  As investor demand has increased for investment products and services that incorporate environmental, social, and governance factors (“ESG”), the SEC has increased its focus on advisor practices related to ESG investing. The alert summarizes the ESG-related areas the SEC will examine in 2021, provided the SEC’s observations on certain potential misleading statements by advisors regarding ESG investing processes. The alert also sets forth effective practices that the SEC has identified for advisors to consider. We have provided a high-level summary of the alert below.

In general, the Division encourages advisors promoting ESG investing to evaluate whether their disclosures and marketing claims are accurate and consistent with firm practices. Advisors should ensure that their approaches to ESG investing are:

  1. implemented consistently throughout the firm
  2. adequately addressed in the firm’s policies and procedures
  3. subject to appropriate oversight by compliance personnel.

In addition, firms should consider taking steps to document and maintain records relating to important stages of the ESG investing process. Each of these items will be reviewed in SEC examinations related to ESG investing, as described below.

SEC examinations of firms claiming to engage in ESG investing will focus on:

  • Portfolio management: examinations will include a review of firms’ policies, procedures, and practices related to ESG and their use of ESG-related terminology; due diligence and other processes for selecting, investing in, and monitoring investments in view of firms disclosed ESG investing approaches; and whether proxy voting decision making processes are consistent with ESG disclosures and marketing materials.
  • Performance advertising and marketing: examinations will include a review of firms’ regulatory filings; websites; reports to sponsors of global ESG frameworks (if applicable); client presentations; and responses to due diligence questionnaires, requests for proposals, and client/investor-facing documents, including marketing materials.

In examinations previously conducted by the SEC, the staff observed potentially misleading statements regarding ESG investing and a general lack of formal processes and procedures, as noted below.

Staff observations of potentially misleading statements regarding ESG investing processes:

  • Portfolio management practices were inconsistent with disclosures about ESG approaches in firm documents such as Form ADV Part 2A or other client-facing documents. For example:
    • Advisors lack of adherence to global ESG frameworks where firms claimed such adherence.
  • Controls were inadequate to maintain, monitor, and update clients’ ESG-related investing guidelines, mandates, and restrictions. An example:
    • Advisors lacked adequate controls for the implementation and monitoring of clients’ negative screens (for example, prohibitions on investments such as alcohol, tobacco, or firearms) and did not have adequate systems to consistently update clients’ negative screens and client preferences to favor certain industries or issuers.
  • Proxy voting was inconsistent with the advisors’ stated approaches. For example:
    • Public statements that ESG related proxy proposals are independently evaluated on a case-by-case basis to maximize value, while internal guidelines generally did not provide for such case-by-case analysis.
    • Public claims regarding clients’ ability to vote separately on ESG-related proxy proposals, but clients were never provided such opportunities.
  • Firms made unsubstantiated or potentially misleading claims regarding ESG approaches. For example:
    • Marketing material for ESG-oriented funds that touted favorable risk, return, and correlation metrics without disclosing material facts regarding significant expense reimbursement the funds received from the fund-sponsor, which inflated returns.
    • Unsubstantiated claims by advisors regarding their substantial contributions to the development of specific ESG products when their roles were inconsequential.
  • Advisors had inadequate controls to ensure that ESG-related disclosures and marketing were consistent with the firm’s practices. For example:
    • Compliance programs did not address adherence to global ESG frameworks to which the firms claimed to be adhering.
    • Policies and procedures were insufficient to ensure firms obtained reasonable support for ESG-related marketing claims.
    • Policies and procedures did not provide for adequate oversight of ESG-focused sub-advisors.
    • Advisors had difficulty in substantiating adherence to stated investment processes, such as supporting claims made to clients that each fund investment had received a high score for each separate component of ESG (i.e., environmental, social, and governance), when relying instead on composite ESG scores provided by a sub-advisor.
  • Compliance programs were less effective when compliance personnel had limited knowledge of relevant ESG-investment analyses or oversight over ESG-related disclosures and marketing decisions. For example:
    • Compliance controls and oversight for reporting to sponsors of global ESG frameworks and responses to requests for proposals and due diligence questionnaires appeared ineffective.
    • Compliance controls regarding performance metrics included in marketing materials (such as risk, returns, and correlation metrics) were weak and lacked adequate compliance review of the data underlying those measures.

While the alert provided a lengthy discussion of the deficiencies and weaknesses described above, the staff also noted practices that appeared to be reasonably designed and implemented. The following are examples of ESG-related practices the staff felt would be helpful to advisors.

 Staff observations of effective practices include:

  • Disclosures that were clear, precise, and tailored to a firm’s specific approaches to ESG investing such as:
    • Advisors are prominently stating that their ESG investing approach involved relying on unaffiliated advisors to conduct the underlying ESG analysis and allocate client assets among ESG-oriented mutual funds managed by those unaffiliated advisors.
    • Clear disclosures in client-facing materials where clients were offered choices among standardized portfolios focused on particular ESG issues, or alternatively customized separately managed accounts designed to accommodate particular client preferences.
    • ESG factors could be considered alongside many other factors. For example, firms could still satisfy the requirements of certain global ESG frameworks while making investments that appeared to be inconsistent with ESG investing. Clear and prominent disclosures regarding such practices notifying clients and investors that adherence to certain global ESG frameworks did not necessarily alter long-standing and seemingly contrary investment strategies.
    • Explanations regarding how investments were evaluated using goals established under global ESG frameworks, such as investment statements posted on advisor websites, client presentations, and annual reports detailing how firms approached the U.N.-sponsored Principles for Responsible Investment or Sustainable Development Goals and the quantitative information on the local impacts of investments.
  • Policies and procedures that addressed ESG investing and covered the firm’s relevant practices including:
    • Investment policies and procedures that addressed specific documentation to be completed (e.g., research, due diligence, selection, and monitoring).
    • Contemporaneous documentation of the ESG factors considered in specific investment decisions. Where multiple ESG investing approaches were employed at the same time, specific written procedures, due diligence documentation, and separate specialized personnel provided additional rigor to the portfolio management process.
  • Compliance personnel that are knowledgeable about the firm’s ESG-related practices provided more meaningful reviews of a firm’s disclosures and marketing materials, including:
    • Testing the adequacy of ESG-related policies and procedures;
    • Evaluating whether the firm’s portfolio management processes aligned with stated ESG investing approaches; and,
    • Testing the adequacy of documentation of ESG related investment decisions and adherence to clients’ investment preferences.

Conclusion: Firms engaging in ESG investing or developing ESG strategies should pay particular attention to this very detailed SEC Risk Alert. Foreside encourages advisors to review their practices and written policies and procedures, as well as address the issues discussed in the Risk Alert.

Postscript: On April 12, 2021, Commissioner Peirce drafted a separate statement stating that the alert, along with the SEC’s companion documents on Climate and ESG Risks and Opportunities, needs context. Going on to state, among other things, “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. As with any other investment strategy, advisors 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. Our examiners are not—and will not be in this space—merit regulators. The SEC’s role 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 advisor, fund, strategy, or product.” Additionally, Peirce stated, “Another question raised by the risk alert is do firms need a special set of policies and procedures for ESG? The answer to this question is no. Firms need not have a separate set of policies and procedures for any investment strategy. Rather, firms’ policies and procedures should be designed around the firm’s investment strategies, whatever those strategies are.”[3]



[1] Formerly known as the Office of Compliance Inspections and Examinations or OCIE.

[2] https://www.sec.gov/files/esg-risk-alert.pdf

[3] https://www.sec.gov/news/public-statement/rethinking-global-esg-metrics

This article is not a solicitation of any investment product or service to any person or entity.
The content contained in this article is for informational use only and is not intended to be and is not a substitute for professional financial, tax or legal advice.