ESG Investing Risks & Compliance Implications

ESG Investing Risks & Compliance Implications

02 July 2021

Main Contributor: Gretchen Sturdivan, Creative Director & Client Service Manager

Approaching Sustainability

The SEC Division of Examinations published a Risk Alert on April 9, 2021, as a result of their exam findings with firms who offer Environmental, Social, Governance (“ESG”) products and services. ESG investing has been an Examination Priority for the SEC for the past two years (2020 and 2021), so it comes as no surprise that we are now receiving exam observations and guidance to enhance compliance programs. The SEC is using ESG in its broadest sense to encompass a wide variety of factors, i.e., socially responsible investing, sustainable, green, ethical, impact, or good governance.

ESG Investing is a hot topic for investors and advisers are working quickly to meet this demand. However, in blazing this new eco-investing path, advisers are lacking a consistent approach and definition to ESG investing. Many approaches exist out there, all falling under the ESG umbrella. In some cases, advisers consider ESG factors alongside macroeconomic trends, or focus on specific companies with policies aimed at minimizing their environmental impact. Some advisers perform ESG screening, excluding issuers if they fail to meet minimum standards or have negative ESG characteristics. Other advisers focus on a range of ESG themes, including sustainability, climate, and faith-based investing or they invest with a goal of generating measurable ESG-related benefits, known as impact investing.

Where is the SEC’s Focus?

In ESG-focused examinations, SEC staff will evaluate the accuracy of disclosures around ESG investing approaches, whether the firm has adopted and implemented written policies, procedures, and practices, and whether those fall in line with the ESG-related disclosures. Examinations may focus on written policies, procedures, and their implementation, compliance oversight, marketing materials, performance advertising, and their ESG practices and disclosures.

Reducing Risk & Improving Compliance

The ESG investment approaches have expanded, and the number of product offerings has increased. Now the onus is on advisers, as fiduciaries, to ensure that they clearly and consistently articulate their ESG approaches, definitions, and disclosures when offering products to retail investors (cue Form CRS and ADV Part 2A). Once the ESG approaches are defined in disclosures and the Firm’s policies and procedures, advisers should ensure that their actual portfolio management practices are consistent with those processes in order to avoid internal control weaknesses.

In light of recent ESG-focused exams, the staff ultimately found advisers do not actually have formal processes in place for ESG investing, nor the policies to support such processes, and their documentation for ESG-related decisions is lacking or unclear. Additionally, compliance programs are not guarding against inaccurate disclosures around ESG approaches in marketing materials.

So, what practical processes can you implement to improve your Firm’s ESG compliance program?

  1. Generate Policies and Procedures “reasonably designed” to specifically address ESG-related concerns and investment approaches. Ensure that the Firm dictates how ESG investments are evaluated, and the due diligence performed, as well as the monitoring and testing in place. Not doing so imposes a risk of performing investment advisory functions that are inconsistent in practice and do not align with the Firm’s objective.
  2. Ensure portfolio management practices are consistent with disclosure documents that directly discuss ESG approaches to clients. Not doing so imposes a risk of providing potentially misleading information to clients.
    • For example, if you have documented approaches in your policies to ensure issuers with low ESG scores are excluded from clients’ holdings, ensure your processes and screening practices execute and allow for that exclusion.
  3. Ensure the controls you have in place to implement and monitor clients’ ESG-related guidelines and objectives are sufficient (i.e., to complete negative screenings, for example). Not doing so imposes a risk that prohibited investments will be included in clients’ holdings.
  4. If you claim adherence with ESG frameworks, ensure it is adequate and consistent, especially if you disclose such adherence to clients in any format. Not doing so imposes a risk of providing potentially misleading information to clients.
  5. When providing disclosures to clients, ensure they are simple, clear, precise, and tailored to the Firm’s specific approaches to ESG investing and align with the Firm’s actual practices. Not doing so imposes a risk of providing potentially misleading information to clients.
  6. Ensure you have written policies around your ability to vote separately on ESG-related proxy proposals and ensure your Firm’s actual practices align with client disclosures. Not doing so imposes a risk that proxies are not voted in accordance with client agreements.
  7. Disclose all material facts in marketing materials around ESG products and/or performance and ensure you can substantiate all claims and performance shown. Not doing so imposes a risk of providing potentially misleading information to clients.
  8. Ensure all staff are trained and knowledgeable about the Firm’s ESG-related analysis practices, disclosures, and marketing decisions. Not doing so imposes a risk of your compliance program not being followed and practices not aligning with documented disclosures.

Principles for Responsible Investment (“UNPRI”) and Sustainable Development Goals (“SDGs”)

Guidance for ESG investing feels a bit like the Wild West. Advisers are finding their best approaches as they work to meet investor demand and ensure those approaches are in the clients’ best interest; the universe is lacking consistency. As part of an ESG strategy, some advisers may choose to adhere to the ESG frameworks provided by UNPRI and SDG. These are voluntary global ESG frameworks, principles, or standards and they may also only apply to very specific investment types. The SEC has not taken a position on their merit of efficacy, but the framework is at least a starting point for ESG guidance.

UNPRI defines responsible investment as “a strategy and practice to incorporate environmental, social and governance (ESG) factors in investment decisions and active ownership.” PRI’s Mission, established in 2006, encourages the adoption of their six principles for ESG investing, in line with an adviser’s fiduciary duty, and they will collaborate on their implementation. They provide investment tools and guidance on how to best implement the five-part framework into your own Firm’s ESG investment process in line with SDGs. The five-part framework includes identifying outcomes, setting policies and targets, understanding how investors and financial systems shape outcomes, and the collaboration of global stakeholders to achieve outcomes in like with the SDGs.

Launched in 2015 by the UN, the SDGs provide the first globally agreed-upon sustainability framework for institutional investors. They encourage investors to use these goals and targets as a framework for their ESG investing efforts, providing a way to understand and measure investors’ real-work impact and a way to demonstrate their efforts to incorporate environmental issues into their investment approach and contribute to a world that their investors want to live in.

It will be important for advisers to provide clear explanations regarding how investments were evaluated, if using goals established under global ESG frameworks such as UNPRI and the SDGs. This would apply to marketing materials, investment statements, client presentations, and annual reports. It is also worth disclosing that ESG factors may be considered alongside many other factors, if applicable. Advisers want to ensure that though they may satisfy the requirements of the ESG framework, if their investment process is not solely ESG focused, this should be clearly disclosed to clients.

DOL ESG Guidance

The DOL recently released rule initiatives for ESG investments, however these are on hold at least until the end of 2021 while the DOL follows up with more guidance and clarification. The initial rules “created a perception that fiduciaries” would actually “be at risk” if they included ESG approaches in their investments, therefore they are trying to “craft rules that better recognize the important role that environmental, social and governance integration can play” in investment plans while continuing to act as a fiduciary.  Stay tuned for more information as this will impact your ERISA accounts subject to the DOL.


Thanks to the SEC’s guidance, we see it can be done; advisers can act as a fiduciary while recommending and marketing ESG investments. The key takeaway from this risk alert is to ensure your policies, marketing, disclosures, and public statements align with your ESG investment approach and actual internal practices. Try and create a consistent, defined process that can be clearly disclosed to clients and fully adhered to. If you choose to adopt the global ESG framework, do so in a consistent manner with the SEC’s guidance. Ensure that your firm puts a robust compliance oversight process in place and document all ESG investment rationale to substantiate performance and marketing claims. SCS can help develop policies around ESG investing if this is something of interest to your firm!