When reports started circulating in January that the Securities and Exchange Commission’s Office of Compliance Inspections and Examinations was sending inquiries to asset management firms that offer environmental, social and governance (ESG) investment products, that came as no surprise to those familiar with regulatory reactions to investment trends.
The SEC has a long history of bringing enforcement actions against asset managers alleging a mismatch between what investors are told their funds are invested in and what investors’ funds are actually invested in. For example, if your fund’s prospectus says that it will employ a covered-call strategy but the fund instead employs individual naked index puts or short variance swap positions, the SEC may take issue.
So it stands to reason that if investment managers are touting ESG investments, the SEC will take an interest in verifying the accuracy of those representations.
However, what, precisely, it means to employ an ESG investment strategy can be difficult to determine with any certainty. In a memorable speech in June of last year, SEC Commissioner Hester Peirce noted: “E, S, and G tend to travel in a pack these days, which makes it hard to establish reliable metrics for affixing scarlet letters. Governance at least offers some concrete markers, such as whether there are different share classes with different voting rights, the ease of proxy access, or whether the CEO and Chairman of the Board roles are held by two people.”
Even with these examples, however, people do not agree on which way they cut, and they may not cut the same way at every company. In comparison to governance, the environmental and social categories tend to be much more nebulous.
The environmental category can include, for example, water usage, carbon footprint, emissions, what industry the company is in, and the quantity of packing materials the company uses. The social category can include how well a company treats its workers, what a company’s diversity policy looks like, its customer privacy practices, whether there is community opposition to any of its operations, and whether the company sells guns or tobacco.
Not only is it difficult to define what should be included in ESG, but, once you do, it is difficult to figure out how to measure success or failure.
The lack of clarity around ESG definitions combined with booming interest in ESG investments has resulted in various calls for the SEC to impose uniform definitions and disclosure requirements. In March, for example, the SEC requested comments regarding whether Rule 35D-1 under the Investment Company Act of 1940 (the “Names Rule”) should apply to funds that include terms such as ESG and sustainable in their name.
One aspect of ESG disclosures the SEC would do well to shy away from is compelling certain ESG disclosures in order to encourage or discourage certain underlying ESG conduct.
Compelled ESG disclosure for the purpose of pursuing ESG goals, rather than for the purpose of ensuring accurate and complete disclosures, may infringe on First Amendment rights. That was the finding of a federal appellate court that struck down a portion of the conflict minerals provision of Dodd-Frank because it violated “the First Amendment to the extent the statute and rule required regulated entities to report to the Commission and to state on their website that any of their products have ‘not been found be DRC conflict free.’”
And it may be unnecessary for the SEC to compel any particular ESG disclosures in light of already existing legal requirements. The antifraud provisions of the federal securities laws already prohibit investment advisors (and others) from making false or misleading material representations to investors on any subject, and, indeed the SEC has long taken the position that advisors have an affirmative duty to disclose all material information to their investors.
Those antifraud and disclosure requirements apply to advisor representations about ESG investments in the same way that they apply to every other type of investment.
For public companies at least, the SEC has so far declined to go beyond these basic disclosure principles and dictate which particular ESG disclosures might be material to specific companies (and thus require disclosure).
Whether the SEC will show similar restraint in requiring specific, affirmative disclosures by investment advisors remains to be seen.
In the meantime, expect to see some SEC enforcement actions in the coming months against investment advisors alleging misrepresentations around ESG topics. The SEC doesn’t need any new laws to bring those cases.