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US SEC building in Washington, D.C., 2008 Chip Somodevilla/Getty Images
US SEC building in Washington, D.C., 2008

SEC Examiners Warn Advisors of ESG Missteps

The commission's Division of Examinations said it had found examples of 'potentially misleading statements' concerning ESG processes, according to a recent risk alert.

Investment advisors and firms that use ESG strategies should make sure their investment process is disclosed and consistent, and their marketing materials should reflect what they actually offer, according to a new SEC risk alert.

The alert, published on Friday by the commission’s Division of Examinations (DOE), offers a glimpse at what examiners are finding when probing firms about how they’ve incorporated ESG into their business models. Earlier this year, the division said the issue of climate-related risks was one of its 2021 exam priorities. 

“In response to investor demand, investment advisers and funds have expanded their various approaches to ESG investing and increased the number of product offerings across multiple asset classes,” the risk alert read. “This rapid growth in demand, increasing number of ESG products and services, and lack of standardized and precise ESG definitions present certain risks.”

The risk alert said examiners of advisory firms would focus on all “policies, procedures and practices related to ESG and its use of ESG terminology,” as well as performance advertising and marketing and compliance programs. 

According to the alert, the DOE found some instances of “potentially misleading statements" made by advisory firms. Monitoring ESG-related investing mandates and restrictions remained a problem for some firms, the commission said. In some instances, the DOE found advisors didn’t have controls in place to monitor clients’ negative screens, like prohibitions on particular industries, particularly if the advisors’ directives “were ill-defined, vague or inconsistent.” Additionally, advisors often lacked systems to track and update clients’ negative screens, meaning client-prohibited securities may still wind up in their portfolios.

The boost in ESG popularity makes marketing and disclosures a particularly important focus from a compliance standpoint, according to Douglas Kamin, a managing director with Foreside, a consulting firm specializing in compliance for advisors, brokers and institutions. If firms claim they’re using an ESG approach or touting ESG products, they need to ensure that any client-facing documents or marketing are truly an accurate measure of their practice, including any third-party products, he said.

“They may mention or market that they have an ESG process, but then they’re not documenting what their actual ESG process is,” he said. “Or, if they’re using ESG-oriented ETFs or mutual funds, do they read the full prospectus to make sure the fund fits with their strategy and doing what they purport to do?” 

In addition to highlighting problem spots, the DOE acknowledged instances where firms were getting it right. Examiners found some firms had “simple and clear disclosures” clarifying that in separately managed client accounts, their ESG approach would include relying on unaffiliated advisors to conduct the ESG analysis and allocate client assets accordingly.

“Furthermore, 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,” the risk alert read.

The SEC recently unveiled an “all-agency approach” in response to the investor uptick in ESG interest, including a new enforcement task force looking into climate-related risks, direction from acting Chair Allison Herren Lee for the Division of Corporation Finance to strengthen its focus on climate-related disclosures in public company filings, as well as a new website detailing the commission’s initiatives. Kamin noted that regardless of a firm’s investment approach, the compliance issues outlined in the risk alert could apply to any strategy, and he found it interesting the SEC was specifically citing ESG.

“I think (ESG’s) become so popular,” he said. “We have explosions of new mutual funds, ETFs and separately managed accounts where people are offering this as a service."

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