Securities and Exchange Commission examiners are finding “unsubstantiated” and "potentially misleading" statements and questionable practices from some investment advisors, investment companies and private funds offering ESG products and services, according to a new agency risk alert.

Explosive growth in investor demand, product proliferation and advisor use, coupled with a lack of standardized ESG definitions, present certain risks, the Division of Examinations said in the alert.

“Firms claiming to be conducting ESG investing need to explain to investors what they mean by ESG and they need to do what they say they are doing. This same rule applies no matter what label an adviser puts on its products and services,” acting SEC Chair Allison Herren Lee said in a statement.

As with any other investment strategy, advisers 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 adviser, fund, strategy, or product,” Herren Lee added.

SEC examiners found portfolio management practices were inconsistent with how firms disclosed their ESG approaches to clients in disclosures, including Form ADV and other investor-facing agreements, proposals and even due diligence questionnaires.

For example, the staff noted firms lack of adherence to global ESG frameworks where firms claimed such adherence, and also observed funds holding investments from issuers with low ESG scores inconsistent with the firms’ stated approaches.

“Like any other strategy, we are looking to see whether the disclosure and the marketing around the strategy matches up with what’s happening in practice,” Kristin Snyder, Co-Deputy Director of the SEC’s Division of Examinations said at the recent 2021 Investment Advisor Association Compliance Conference. “As an example, if a firm is stating that they exclude certain stocks . . . do they have mechanisms in place to ensure that those securities are being excluded from the portfolio?” she asked

Examiners discovered unsubstantiated or otherwise potentially misleading claims regarding ESG approaches in a variety of contexts. For instance, the staff noted marketing materials for some ESG-oriented funds that touted favorable risk, return, and correlation metrics related to ESG investing without disclosing material facts regarding the significant expense reimbursement they received from the fund-sponsor, which inflated returns for those ESG-oriented funds.

The staff also observed unsubstantiated claims by advisers regarding their substantial contributions to the development of specific ESG products, when, in fact, their roles were very limited or inconsequential.

Harmonizing ESG disclosures is critical when preparing for an SEC exam, Mark Perlow a partner at Dechert, a global law firm said at the IAA conference. “ESG is probably one of the biggest secular trends that we as a firm have been seeing. The SEC has not been ignoring this trend” and has made ESG a priority for the Division of Examinations again this year.

Recent SEC exams also found compliance programs are not well-designed to guard against inaccurate ESG-related disclosures and marketing materials or prevent violations of SEC regulations, and a lack of controls to match clients' ESG-related investing guidelines, mandates, and restrictions, such as negative screens.

Some firms claimed to have formal processes in place but did not have policies and procedures, did not implement them, or failed to document clear ESG-related investment decisions.

SEC examiners also found proxy voting practices inconsistent with stated approaches or misleading statements on ESG-related proxy proposals.

For example, the staff observed public statements that ESG-related proxy proposals would be independently evaluated internally on a case-by-case basis to maximize value, while internal guidelines generally did not provide for such case-by-case analysis. The staff also noted public claims regarding clients’ ability to vote separately on ESG-related proxy proposals, but clients were never provided such opportunities, and no policies concerning these practices existed.

Advisors should consider how their approach to ESG will affect trading and proxy voting in addition to portfolio management and marketing and ensure disclosure and practices are consistent across the enterprise, Michelle Jacko, Managing Partner and CEO of Jacko Law Group stressed.

The staff will continue to examine firms “to evaluate whether they are accurately disclosing their ESG investing approaches and have adopted and implemented policies, procedures, and practices that accord with their ESG-related disclosures,” the agency said.