Just because a financial product says it is sustainable, doesn’t mean it is, the examinations staff at the Securities and Exchange Commission (SEC) has been finding out.
The regulator has issued a risk alert to make investors aware of potentially misleading statements found during recent examinations of investment companies that offer environmental, social, and governance (ESG) products and services.
The SEC said it discovered instances of potentially misleading statements regarding ESG investing processes and representations on adhering to global ESG frameworks. The regulator found “a lack of policies and procedures related to ESG investing” and “policies and procedures that did not appear to be reasonably designed to prevent violations of law,” among other issues, such as weak documentation of ESG-related investment decisions and compliance programs that weren’t properly designed to prevent inaccurate ESG-related disclosures and marketing.
The SEC’s examination staff said it also saw portfolio management practices that differed from client disclosures in required disclosure documents, as well as fund holdings predominated by issuers with low ESG scores.
“Controls were inadequate to maintain, monitor, and update clients’ ESG-related investing guidelines, mandates, and restrictions,” the SEC said in its alert. “The staff noted weaknesses in policies and procedures governing implementation and monitoring of the advisers’, clients’, or funds’ ESG-related directives.”
For example, the SEC said staff observed that advisers did not have adequate controls for implementing and monitoring clients’ negative screens, such as prohibitions on investments in certain industries, including alcohol, tobacco, or firearms. It also said advisers did not have adequate systems to consistently and reasonably track and update clients’ negative screens, “leading to the risk that prohibited securities could be included in client portfolios.”
Additionally, proxy voting may have been inconsistent with advisers’ stated approaches, the examiners found. They said they found inconsistencies between public ESG-related proxy voting claims and internal proxy voting policies and practices, as well as public claims that clients would be able to vote separately on ESG-related proxy proposals, when in reality “clients were never provided such opportunities, and no policies concerning these practices existed.”
The regulator also found instances of marketing materials for some ESG-oriented funds that touted favorable risk and return and correlation metrics related to ESG investing without disclosing material facts about the “significant expense reimbursement they received from the fund-sponsor, which inflated returns for the funds.”
The staff also noted “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.”
Additionally, the SEC said compliance programs were found to be less effective when personnel had limited ESG knowledge or oversight over ESG-related disclosures and marketing decisions. For example, it said compliance controls and oversight for reporting to sponsors of global ESG frameworks as well as responses to requests for proposals (RFPs) and due diligence questionnaires appeared to be ineffective.
Despite finding ESG compliance deficiencies and weaknesses in its examinations, the SEC said it did encounter positive examples of investment advisers and funds with disclosures that accurately conveyed material aspects of the firms’ approaches to ESG investing. It said some firms maintained policies, procedures, and practices that appeared to be “reasonably designed in view of their particular approaches to ESG investing” and said they provided good examples for advisers and funds with compliance issues.
The staff observed, for example, investment statements posted on adviser websites, client presentations, and annual reports detailing how firms approached the UN-sponsored Principles for Responsible Investment (PRI) or Sustainable Development Goals (SDGs), including quantitative information on the local impacts of investments.
The SEC said it is encouraging firms promoting ESG products to evaluate whether their disclosures, marketing claims, and other public statements related to ESG investing are accurate and consistent with internal firm practices.
“Firms should ensure that their approaches to ESG investing are implemented consistently throughout the firm where relevant and are adequately addressed in the firm’s policies and procedures,” the SEC said. “Firms should also consider taking steps to document and maintain records relating to important stages of the ESG investing process.”