REGULATORY MONITOR SEC Update - Willkie Farr & Gallagher LLP
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The Investment Lawyer
Covering Legal and Regulatory Issues of Asset Management
VOL. 28, NO. 8 • AUGUST 2021
REGULATORY MONITOR
SEC Update
By Benjamin J. Haskin, Elizabeth P. Gray and Benjamin B. Allensworth
SEC Issues Risk Alert Highlighting Despite the SEC leadership clearly com-
ESG Deficiencies at Investment municating the importance of ESG issues to the
Advisers agency, there remains uncertainty about what the
The Staff of the Securities and Exchange final scope and requirements of any SEC rulemak-
Commission’s (SEC) Division of Examinations ing will look like. The SEC’s Spring 2021 Unified
(Division) published a risk alert on April 9, 2021,1 Agenda of Regulatory and Deregulatory Actions,6
highlighting observations of the Division Staff and other releases have provided some suggestions
(Staff ) from its recent examinations of investment for what aspects of a regulatory framework could
advisers, investment companies, and private funds look like in response to the rapid increase in ESG
that offer environmental, social, and governance investing.7 The risk alert provides more concrete
(ESG) investment products and services (collectively, guidance to regulated firms regarding the Staff’s
firms). The risk alert provides examples of what the expectations under the existing regulatory frame-
Staff views as deficient practices and internal control work, which is important in light of the agency’s
weaknesses as well as effective practices that the Staff heightened focus on ESG issues, including creation
observed during recent examinations of firms. In of the Climate and ESG Task Force in the Division
addition, and consistent with the Division’s March of Enforcement. The SEC announced the creation
3 publication on 2021 examination priorities,2 the of the Climate and ESG Task Force on March 4,
risk alert provides guidance to firms on the ESG- 2021, and appointed senior enforcement official
related areas the Division will continue to focus on Kelly Gibson as its leader. The task force said its ini-
during examinations. tial focus will be to identify any material gaps or
The risk alert is the most recent in a series of pub- misstatements in issuers’ disclosure of climate risks
lications and statements by Commissioner Allison under existing rules and to analyze disclosure and
Herren Lee, Commissioner Caroline Crenshaw, compliance issues relating to investment advisors’
and the Staff regarding ESG issues,3 further demon- and funds’ ESG strategies.8
strating the importance placed on the topic by the
agency and the Biden administration more gener- Risk Alert
ally.4 Importantly, Chairman Gary Gensler has also At the beginning of the risk alert, the Division
expressed support for increasing the SEC’s focus on notes that investor demand for investment products
ESG issues.5 and financial services incorporating ESG factors2 THE INVESTMENT LAWYER
has recently increased, and that investment advisers during examinations of investment advisers and
have responded to the increased demand by offering funds engaged in ESG investing, many of which
potential investors a variety of products that use a related to marketing or disclosures concerning ESG
range of ESG investment approaches. The Division investing and proxy voting, including the following:
explains that a lack of standardized ESG definitions,
combined with this rapid growth in demand for, and ■ Portfolio management practices that were incon-
approaches to, ESG investment products can lead to sistent with disclosure: The Staff identified mis-
investor confusion, especially for retail investors. leading statements regarding firms’ adherence to
Notably, while the risk alert focuses on ESG- global groups’ standards (for example, United
specific issues, the key themes running through the Nations-sponsored Principles for Responsible
risk alert reflect long-standing SEC expectations for Investment (UNPRI)). In addition, the Staff
regulated entities. These key themes are: (1) portfo- observed fund holdings that consisted predomi-
lio management and internal processes must match nately of issuers with low ESG scores, which
disclosures that firms provide to clients and inves- appeared to be inconsistent with disclosures
tors; (2) firms must have adequate data and records made to investors and clients.
to support claims made to clients and investors, ■ Inadequate controls and documentation: The Staff
particularly performance-related claims; and (3) observed firms that had inadequate controls
compliance personnel need to have a sufficient level for implementing, monitoring, and tracking
of knowledge of and involvement with an adviser’s updates to client directives to exclude certain
activities to provide adequate oversight of those holdings (negative screens) or client prefer-
activities. These themes are consistent with state- ences for certain holdings (positive screens),
ments from the SEC’s Division of Enforcement’s despite claims to have such client screens. The
ESG Task Force that ESG enforcement will be Staff attributed inconsistencies between actual
based on existing rules, guidance and long-stand- firm practices and disclosures and a lack of
ing principles of materiality and disclosure. documentation of ESG investing decisions
In addition to highlighting what the Staff views and issuer engagement efforts to weaknesses in
as deficiencies and effective practices, the risk alert internal controls.
states that the Division will prioritize: (1) policies, ■ Proxy voting practices inconsistent with disclosure:
procedures, and practices related to ESG, and firms’ The Staff identified ESG-related proxy voting
use of ESG-related terminology; (2) due diligence disclosures that were inconsistent with internal
and other processes for selecting, making, and proxy voting policies and practices; for example,
monitoring investments in view of firms’ disclosed claims that the firm would assess ESG-related
approaches to ESG; (3) firm regulatory filings, web- proxy proposals on a case-by-case basis or per-
sites, reports to sponsors of global ESG frameworks, mit clients to vote separately on ESG-related
and communications to clients and prospective cli- proposals without having processes consistent
ents regarding firms’ ESG practices; (4) proxy vot- with those disclosures.
ing decision-making processes; and (5) compliance ■ Unsubstantiated or misleading ESG claims: The
oversight of firms’ ESG investing practices and Staff observed firms touting favorable risk,
disclosures. return, and correlation metrics of ESG prod-
ucts without disclosing significant expense
Deficiencies Observed by the Staff reimbursement they received from the prod-
The Staff stated that they had observed numer- uct’s sponsor, inflating the stated returns of
ous deficiencies and internal control weaknesses the product. The Staff also observed firmsVOL. 28, NO. 8 • AUGUST 2021 3
overstating their contributions to creating ESG good disclosure practices, such as making clear
products. when an adviser was relying on unaffiliated sub-
■ Compliance programs not tailored to ESG: The advisers for ESG analysis and asset allocation
Staff also observed firms lacking adequate and when an adviser was offering standardized
policies and procedures to address their ESG ESG portfolios or customized, separately man-
investing analyses, decisionmaking processes, aged accounts designed to accommodate client
or compliance review and oversight. The Staff preferences.
identified specific areas that were not adequately ■ Disclosure that ESG factors could be considered
addressed in compliance programs, including: among other factors: The Staff observed that
— actual adherence to global ESG frameworks disclosure of such practices served to notify cli-
to which a firm claimed to be adhering; ents that firms could adhere to identified global
— ensuring firms obtained reasonable support ESG frameworks while making certain invest-
for ESG-related marketing claims; ments or pursuing investment strategies that
— oversight of ESG-focused sub-advisers; and are seemingly inconsistent with those global
— substantiating adherence to stated invest- frameworks.
ment processes, such as supporting claims ■ Detailed disclosures about how firms comply with
made to clients that each fund investment UNPRI or Sustainable Development Goals. The
had received a high score for each separate Staff noted that these disclosures included quan-
component of ESG, when relying instead titative information on the local impacts of
on composite ESG scores provided by a investments.
sub-adviser. ■ Policies and procedures that addressed ESG invest-
■ Compliance personnel with limited knowledge ing and covered key aspects of the firms’ relevant
about ESG: The Staff observed that firms with practices. The Staff highlighted detailed invest-
compliance personnel that had limited knowl- ment policies and procedures that addressed
edge of ESG investment analyses or oversight ESG investing, including specific and contem-
over disclosures and marketing decisions had poraneous documentation to be completed at
less effective compliance programs. The Staff various stages of the investment process. The
specifically noted weaknesses in oversight related Staff also noted that specific written procedures,
to reporting to sponsors of global ESG frame- due diligence documentation, and separate spe-
works, responses to requests for proposals and cialized personnel at firms that employ multiple
due diligence questionnaires, and performance ESG investing approaches at the same time pro-
metrics included in marketing materials (includ- vided additional rigor to the portfolio manage-
ing data underlying those metrics). ment process.
■ Compliance personnel that are integrated into ESG
processes: The Staff observed that firms that inte-
Effective Practices Observed by the grate compliance personnel into ESG processes
Staff and had compliance personnel who are knowl-
The Staff also provided examples of effective edgeable about ESG approaches and practices
practices that they observed during examinations, provided better oversight of disclosures and
including the following: testing of ESG-related policies and procedures.
Furthermore, these firms were more likely to
■ Simple, clear disclosures of firms’ approaches to avoid materially misleading claims in their cli-
ESG investing: The Staff noted examples of ent-facing materials.
Copyright © 2021 by CCH Incorporated. All Rights Reserved.4 THE INVESTMENT LAWYER
Conclusion discussing the 2021 Examination Priorities is avail-
The Division, through the risk alert, offers valu- able at https://www.sec.gov/files/2021-exam-priorities.
able insight into the specific areas of focus related pdf.
to ESG investing that it will concentrate on during 3
Our client alert discussing recent communications
examinations of firms, with a particular focus on from the SEC on ESG is available at https://www.
marketing activities, fund and adviser disclosures, willkie.com/-/media/files/publications/2021/03/secdivi-
and compliance procedures (including oversight sionofexaminationsreleases2021priorities.pdf.
procedures of third parties). While there is consider- 4
It is important to note, however, that the enhanced
able uncertainty as to how the SEC will apply this SEC focus on ESG issues does not have unani-
guidance in practice, firms engaged in ESG invest- mous support within the agency. For example, fol-
ing may wish to review their policies and procedures lowing the release of the risk alert, Commissioner
and consider whether revisions or enhancements are Hester M. Peirce issued a statement on April 12,
warranted based on the guidance in this risk alert, 2021 in which she cautioned that the ESG-specific
including whether specific ESG-related compliance risk alert should not be interpreted as a sign that
and/or oversight procedures are necessary. Further, ESG investment strategies are unique in the eyes
firms may wish to review their marketing materials of examiners. Hester M. Peirce, “Statement on the
and investor disclosures regarding ESG investing and Staff ESG Risk Alert” (April 12, 2021), available
proxy voting, given the SEC’s focus on these areas. at https://www.sec.gov/news/public-statement/peirce-
In light of the close working relationship between statement-staff-esg-risk-alert. Commissioner Peirce’s
the Division of the Division of Enforcement, and recent statement is consistent with views she has
the multi-disciplinary approach of the ESG Task expressed following other recent SEC releases on
Force, firms should expect coordination between the ESG issues.
two Divisions on these ESG initiatives. 5
Mr. Gensler reportedly indicated during his confir-
mation hearing that both investors and issuers would
benefit from more robust disclosures regarding cli-
Mr. Haskin and Mr. Allensworth are part- mate risk. See Tory Newmyer, “President Biden’s SEC
ner and counsel, respectively, in the Asset Pick Signals Companies Could Face Wave of New
Management Group, and Ms. Gray is a partner Disclosure Rules,” The Washington Post (March 2,
in the Litigation Department and Co-Chair of 2021).
the Securities Enforcement Practice Group of 6
The SEC’s Spring 2021 Unified Agenda of
Willkie Farr & Gallagher LLP. The authors wish Regulatory and Deregulatory Actions (June 11,
to express their gratitude for the assistance of 2021), available at https://www.reginfo.gov/public/
Alexis Hassell in writing this article. do/eAgendaMain?operation=OPERATION_GET_
AGENCY_RULE_LIST¤tPub=true&agencyC
NOTES ode=&showStage=active&agencyCd=3235&csrf_token
1
The Division of Examinations’ Review of ESG =7CE97CC2D49C9B6B70868F7B2752E582C86F
Investing, Division of Examinations Risk Alert (April 1945A4A46F34426C18AF1ABE101E611318F64B
9, 2021), available at https://www.sec.gov/files/esg-risk- 67159C3A36E7556BD0FB872C8F.
alert.pdf. 7
See, e.g., Recommendations of ESG Subcommittee
2
2021 Examination Priorities, Division of of the SEC Asset Management Advisory Committee
Examinations, available at https://www.sec.gov/ (July 7, 2021), available at https://www.sec.gov/files/
files/2021-exam-priorities.pdf. Our client alert amac-recommendations-esg-subcommittee-070721. pdf.VOL. 28, NO. 8 • AUGUST 2021 5
8
Our client alert discussing the creation of the Climate publications/2021/03/sec_sharpens_focus_on_esg.
and ESG Task Force in the Division of Enforcement pdf.
is available at https://www.willkie.com/-/media/files/
Copyright © 2021 CCH Incorporated. All Rights Reserved.
Reprinted from The Investment Lawyer, August 2021, Volume 28, Number 8,
pages 16–19, with permission from Wolters Kluwer, New York, NY,
1-800-638-8437, www.WoltersKluwerLR.com
Copyright © 2021 by CCH Incorporated. All Rights Reserved.You can also read
