Reaction to the 2021 SEC Risk Alert
On April 9, 2021, the U.S. Securities and Exchange Commission published a risk alert, “The Division of Examinations’ Review of ESG Investing” to provide public information on the deficiencies and weaknesses of examinations of ESG investment advisers and funds through staff observations. It identifies four key risks and issues that existed in the registered investment companies and private funds, or for investment advisers conducting the ESG investment, including 1) a lack of ESG investing policies and procedures, 2) a lack of implementation of the violation of law, 3) a weak or unclear ESG investing decisions documentation, and 4) a lack of compliant personnel to oversee and disclose ESG-related issues. To maintain its mission to protect all investors, the U.S. Securities and Exchange Commission should utilize strategies that are summarized from the observed effective practices to mandate a template for guiding those investment firms to disclose ESG-related investment decisions.
About the SEC
Currently led by Gary Gensler, the U.S. Securities and Exchange Commission (SEC) is a federal government agency created to “protect investors; maintain fair, orderly, and efficient market; and facilitate capital formation.” It oversees the federal securities laws to protect investors by requiring market participants, such as public companies, asset managers, and investment professionals, to disclose their financial information accurately, completely, and timely to avoid the risk of scams so that investors can make informed decisions on their investments. The SEC manages the process with EDGAR, an electronic database for gathering all corporate filings that are publicly accessible. In addition, because the SEC can bring only civil actions, it counts on the whistle program that encourages information sharing by awarding the disclosers to enforce violations.
About ESG Investing
ESG stands for Environmental, Social, and Governance factors, which are considered when measuring sustainability. Such factors determine to what extent the current actions will meet the present needs and not compromise the future needs. ESG investing then refers to the investment approach when considering all these ESG factors. At the corporation level, environmental factors include how a firm adopts corporate policies that may address community health and climate change issues; social factors include how diverse and inclusive its workplace is; governance factors include how independent the Board is and how transparent the firm is. In the investment environment, these ESG approaches extend to broader criteria, including ESG integration, active ownership, best-in-class, and thematic selection. It needs not only integration of ESG factors into the firms’ operation, but also selection of the best-in-class with a certain theme in which the investors have a voice in the issue regulation. According to the SEC, although ESG investing has become more popular recently, its definition is still vague and complicated. To hold a general fact, ESG investing is to select investments that have integrated ESG factors and that are consistent with one fund’s goals. Due to the ambiguity, the SEC published its observations on the current ESG investing market to inform investors and other market participants about the lack of policies and procedures on ESG investing which lacks structure and definition.
Key Risk Alert and Issues Assessment
A lack of ESG investing policies and procedures. Although it is common to receive public claims that investment decisions are made with a formal process in place, the loose definition of ESG investing made it for the parties involved difficult to obtain policies and procedures related to ESG investing. As a result, the practices and disclosures about the ESG approach become inconsistent along with no control over maintaining and monitoring the ESG-related investing guidelines. In this scenario, asset owners determine objectives and regulatory rules for the asset managers, but asset managers are the ones who compose the portfolios. Since there are no mandated policies or procedures, asset managers have the freedom to eliminate some factors that seem to be against clients’ objectives in the disclosure process. The use of service providers who have their models of collecting ESG data is subject to asset managers. As a result, the lack of adherence to ESG frameworks is born when asset managers choose a service provider that reports scores in its favor.
In addition, the lack of ESG expertise from the asset owners creates trouble for the asset managers to perform their duties. Deciding the general objective of an investment portfolio, asset owners are far away from the evaluation process, leaving asset managers to determine and define ESG for them. On top of asset owners confusing ESG with impact investing, the negative screens prevent asset managers from obtaining full control of the funds as they have to behave according to asset owners’ guidelines. Such inefficiencies in control and monitoring reveal that some products that may be included in the portfolios are eliminated, possibly hurting the overall financial returns and breaking asset managers’ fiduciary responsibilities.
A lack of implementation of the violation of the law. Since there are no policies and procedures regarding ESG investing, it is a natural outcome of not having any implementation on the violation of the law. If there is no rule, there is no such thing as penalties. From the SEC’s observation, asset owners usually do not have the opportunity to vote separately on the proxy proposals as stated in the claims, and unsubstantiated claims are widely used in the marketing materials that “touted favorable risk, return, and correction metrics related to ESG investing”. Because no policies exist to regulate misconduct and violation, the price for not following the claims or the framework comes to zero, thus making the ESG investing a fraud if the clients’ initiative is to generate any social returns on top of financial returns. In this scenario, even when asset managers choose a fair service provider for ESG scoring, asset owners may still lose goods in the investment when they do not obtain the claimed right and correct information.
A weak or unclear ESG investing decisions documentation. As there is no penalty for the violation of the procedures, the controls over the firms’ actual practices and ESG-related disclosure and marketing materials are weak. As no mandate was proposed on documenting the actual investment evaluation process along with the integration of ESG factors, not only service providers but also asset managers become the leaders in packaging the investment products. They do not have the intention to follow up on the ESG products or services once the portfolio is created and done with composition. What they do thus becomes inconsistent with what they choose to disclose and market. This indicates a need for transparency in corporate governance related to ESG practices for both the public and service providers who help asset owners to choose their asset managers.
A lack of compliant personnel to oversee and disclose ESG-related issues. According to the observation by the SEC, the phenomenon that firms have difficulties in stay adherence to the proposed ESG investment process is because of the inefficient compliance programs and limited compliance personnel who have knowledge of ESG-related issues, either in regards to investment or disclosures and marketing decisions. In addition, no data is supporting the compliance review. Although ESG investing grows in its popularity, its growth has not yet allowed growth in numbers for ESG professionals, making firms’ internal compliance programs inefficient in overseeing the ESG issues as well as the investment analysis. Moreover, since ESG data are highly accounted for transparency, time, and accessibility, the sole reliance on external ESG scoring providers makes the firms’ compliancy worse. In consequence, if the asset managers do not perform accordingly to what they stay in ESG disclosures, their products and services will face challenges in trust. More importantly, they will not have the expertise and firm knowledge when convincing and educating asset owners who enjoy the privilege of setting goals and procedures with ESG investing. The lack of compliance personnel leaves the interpretation of ESG scoring to the service providers’ side who may perform such services in their own interests. By not being completely exposed to one firm’s environment and conditions, the reported score remains invalid.
Recommendations
During the examination process, the SEC has noticed several effective practices in some firms’ ESG approaches that are helpful to confront the risks mentioned above. One characteristic of the effective practices is that the disclosures are precise on firms’ ESG investing processes aligned with the actual practices. In the disclosures, it is clear how factors in the disclosures align with the global ESG framework and why those factors will help to achieve the goals. Some firms offer different choices of products for clients to choose from - either products focusing on certain issues, or products allowing customization based on preferences - to guide clients’ decisions. Also, a comprehensive document on policies and procedures is necessary to make the investment decision as well as operate the firm internally. Lastly, the involvement of compliance personnel who have expertise in ESG-related issues benefits the external disclosure of marketing materials and the internal audits of policies and procedures for gaining a non-bias and accurate result of the firms’ ESG approaches.
Adopting these three elements and considering its mission, the SEC should consider 1) mandating all disclosures to include the liaison between a factor with its outcomes - both social and financial, 2) creating a template for creating internal policies and procedures to disclose firms’ approaches and internal operation, and 3) mandating an approval record from compliance personnel who are required to earn up-to-date training on ESG-related issues public reporting.
Four key risks identified are associated with the lack of knowledge in ESG investing due to ambiguity when asset owners confused themselves with impact investing and other similar investing, and asset managers, too, rely solely on external scoring providers. This trend reveals a gap in understanding the scoring as simply using factors from the service providers that they consider to make sense. Therefore, if the liaisons between required factors and outcomes are required to report, both parties may gain more knowledge in the field. For example, for a client who wants to invest in gender equity efforts, it will be the firm’s duty to tie a required percentage of female members on board with how it contributes to the gender equity effort. By knowing how and explaining how the firms may gain back a little control over the investment selections. This process may also contribute to addressing the risk of unclear investing decisions documentations when firms are required to include the rationales in the disclosures, thus making the ESG approaches more effective.
Because the definition of ESG investing is so vague, it would be difficult for the SEC to come up with standardized policies and procedures to oversee one’s ESG investing efforts. Thus, creating a template for creating internal policies and procedures to disclose firms’ approaches and internal operations to follow can be more actionable, especially when the public can use the template as a starting point to evaluate and watch firms’ efforts in the disclosures. The provided guideline would help address the risk created by the lack of ESG investing policies and procedures and the lack of implementation of violations. If a firm does not follow the proposed template by eliminating factors from the template, it indeed will not bear any punishment. However, the public or other stakeholders may request a reason for this under coverage, thus leaving invisible pressure on firms’ actual practices.
Lastly, by requesting approval from authorized personnel who have expertise in ESG-related issues before publishing any public reports, firms will pay more attention to hiring employees to train for such roles. It ultimately addresses the risk generated by the inefficiency of internal compliance programs as well as monitoring the ESG investment analysis process and marketing materials. The personnel should also receive up-to-date training on ESG-related materials by participating in the SEC holding events on ESG investing education. In this way, materials that are used for marketing and disclosures gain more expertise and credibility when they come to the public and the clients, thus demonstrating the firm’s commitment to the promised ESG approaches.
