No recent investment trend has garnered as much regulatory, investor, and media attention as investment strategies that purportedly adhere to environmental, social and governance (ESG) principles. Investment firms that market ESG strategies must take immediate action to review investment and disclosure policies to avoid alienating potential institutional clients or incurring the wrath of the regulators. It will be a “bad look” to be accused of “greenwashing” your funds by marketing ESG without the underlying investment bona fides.
Sustainable funds and other products tied to ESG principles have been capturing a growing share of investors’ assets, with global inflows into this category estimated at more than $80.5 billion in 2020. According to Morningstar, at the end of 2020 there were 392 sustainable open-end funds and exchange-traded funds available to US investors; that’s 30% more than in 2019 and a four-fold increase over the past 10 years. Both retail and institutional investors are driving this trend. More and more RFPs from pension funds, foundations and other institutions are asking prospective managers to support claims of ESG investing experience, expertise, and track record.
Such significant growth in ESG-related investing makes this an area of regulatory interest. The U.S. Securities and Exchange Commission (SEC) is going full throttle in its efforts to protect investors from misleading practices and claims related to ESG issues. In early March, the Commission announced the creation of a 22-person Climate and ESG Task Force with a mandate to proactively identify ESG-related misconduct. As stated in the SEC’s announcement, the group’s initial focus, “…will be to identify any material gaps or misstatements in issuers’ disclosure of climate risks under existing rules. The task force will also analyze disclosure and compliance issues relating to investment advisers’ and funds’ ESG strategies.”
Although the SEC has previously shown an interest in probing issuers that allegedly down-played risks related to climate change and greenhouse-gas regulations, this ESG initiative represents an expanded emphasis on what might constitute deceptive claims by fund managers and investment advisers who advertise ESG-friendly strategies, but may fail to “practice what they preach.”
The Risk: Misleading ESG Claims
The fact that the new task force is housed within the Division of Enforcement, and the sheer size of the group devoted to this initiative, portend significant SEC enforcement actions. For those investment firms and funds that claim to adhere to ESG principles, it will be essential to be aware of the compliance risks in misrepresenting their ESG credentials. (FYI, the terms ESG investing, impact investing and sustainable investing are often used interchangeably.)
The Challenge: Defining ESG Investing
A significant challenge for investment managers is that there is still no widely agreed-upon definition of ESG investing. The SEC really hasn’t defined what it means, and there is no established case law or enforcement record on ESG claims per se. As a result, investment firms could be thrust into an enforcement position of having to defend esoteric definitions that mean different things to different people (and lawyers). It seems likely that the SEC will draw upon existing regulations and case law as it seeks to establish a basis for bringing claims related to misleading ESG-related claims.
For example, investment firms should consider cases and statements brought under Rule 35d-1 of the Investment Company Act, known as the “Names Rule”, which requires funds not to use materially misleading names. Also, the SEC has brought several cases over the years where an advertised investment strategy was not consistent with the actual portfolio management. As an extreme (and amusing) example, in a 2014 enforcement case, the SEC barred from the industry an investment adviser that failed to disclose that he based his strategy on the lunar cycles and the “gravitational pull between the Earth and the moon.”
One way to avoid potential future problems is to specifically define what you mean by ESG investing and then invest accordingly. For example, is your investment approach based on using exclusionary screening to avoid sectors, companies or practices (coal producers, so-called “sin stocks,” etc.) that fail to meet specific ESG criteria? Or, do you take a more inclusive approach by seeking to invest in companies that have been selected for positive ESG performance? Regardless of your fund’s particular approach, it should be clearly described in offering documents, the Form ADV, and other publicly available communications. As you prepare disclosure, avoid vague or equivocal language that the SEC usually takes exception to, such as “may”, “in certain circumstances”, and “ordinarily.”
Measurement, Reporting And “Walking The Talk”
It also will be important to specify, to the extent possible, how your fund measures and reports on the ESG impact of its investments. This will not only help protect the firm in the event of an SEC action, but also will enable investors to make better informed decisions in the increasingly crowded ESG investing market. The most successful ESG players have created ESG measures, in addition to pure performance, that they report to clients on a quarterly basis.
Once an investment manager has defined its ESG principles and practices, it should be willing to “walk the talk” and actually invest in accordance with its own stated guidelines. The composition of the fund’s portfolio will be a major indicator of its commitment to ESG investing, of course. But, it also may be important to be able to demonstrate that the firm incorporated ESG principles in its voting behavior on proxy proposals and/or its engagement with company managements regarding environmental, social and governance matters. Relatedly, the fact that a fund bases its managers’ incentives in part on ESG factors also may be evidence that its ESG principles are more than mere marketing-speak.
The new focus on ESG will place an extra burden on already overworked compliance officers. As this is a new area of interest, it may be advisable for some funds to consider working with a firm that provides specialized outsourced chief compliance officer or consulting services based on experience with ESG matters by representing a number of investment manager clients.
As ESG becomes an ever larger part of the investment marketplace, the SEC and institutional investors are clearly concerned that it will become a marketing exercise and not an integral part of fund management. Ultimately, investors themselves will enforce compliant behavior in this regard, by avoiding those funds and managers that fail to live up to their stated ESG objectives. This market discipline, along with the SEC’s expected focus on ESG enforcement, and the challenges of defining sustainable investing, make it essential for fund managers and their compliance teams to take immediate action to avoid future ESG-related missteps.
Todd Cipperman is founder, principal and CEO of Cipperman Compliance Services.