Perhaps the hottest buzzword—or buzz acronym—in the world of asset management is ESG (Environmental, Social, and Governance). By any measure, the demand for and size of ESG products is rapidly increasing. For example, in the 30-month period ending June 30, 2020, “socially conscious”-registered investment products grew 6-fold and since the start of 2020, the total amount of assets invested in US-exchange traded ESG portfolios has more than doubled.
Investors’ voracious appetite for ESG products has led to demand for data regarding individual issuers’ ESG policies and practices and fund and asset managers’ ESG strategies. This, in turn, has drawn the attention of regulators, and particularly the Securities Exchange Commission.
In the first several months of this year, the SEC has issued multiple statements, reports, and risk alerts emphasizing the Commission’s focus on disclosures relating to ESG and climate-related risks.1 These pronouncements raise questions about the Commission’s examination and enforcement regime and its rule making moving forward. Here, we examine some of those questions in the context of SEC examinations and enforcement actions.
Recent SEC Statements
The SEC has commented on ESG disclosure issues in the past, but never with the frequency or focus that it has in the past few months. On February 24, 2021, Acting Chair Allison Herren Lee issued a Statement on Review of Climate-Related Disclosure2 in which she directed the Division of Corporate Finance to enhance its focus on climate-related disclosures in company filings with the intention of ultimately updating the Commission’s more than decade-old guidance regarding such disclosures.3 Approximately a week later, on March 3, 2021, the Division of Examinations identified reviewing the consistency, adequacy, and accuracy of disclosures about ESG processes and practices as one of its 2021 examinations priorities.4 The following day, the Commission announced the creation of a Climate and ESG Task Force in the Division of Enforcement,5 which was tasked with identifying material gaps or misstatements in issuers’ disclosure of climate-related risks under existing rules and analyzing disclosure and compliance issues relating to investment advisers’ and funds’ ESG strategies.
Most recently, on April 9, 2021, the Division of Examinations released a Risk Alert6 regarding its review of ESG investing, in which the Division stated that it had observed deficiencies, internal control weaknesses, and potentially misleading statements regarding ESG investing processes.
ESG Disclosure Risks Under Current Rules
This all begs the questions of whether companies face increased risks regarding ESG disclosures, what are those risks, and who bears them—asset managers and investment advisors working with ESG products or issuers more broadly? In fact, the SEC’s two republican commissioners have made several statements criticizing the SEC’s focus on ESG disclosures as nothing more than public relations spin, which leads to confusion in the investing community.
Chairman Gary Gensler’s testimony at his confirmation hearing may provide some guidance. Chairman Gensler explained that in assessing ESG and climate-related disclosures, he would apply the historical materiality standard—i.e, what a reasonable investor would consider material in making investment and voting decisions. He went on to note, however, that this analysis could be guided by the investor community, which has demonstrated support for ESG-related disclosures. Accordingly, asset managers and investment advisors are unlikely to be saved from exposure for misrepresentations regarding ESG practices and policies by arguing that the misrepresentations are immaterial since the ESG strategy itself—not only the performance implications of it—is material to many investors’ investing and voting decisions. This is consistent with the SEC Investor Advisory Committee’s observation in May 2020 that information regarding ESG strategy “is material to investors regardless of an issuer’s business line, model or geography.”7
For now, at least, it appears that the focus of the Divisions of Examinations and Enforcement will be on disclosures from investment advisors and funds regarding ESG strategies. But issuers generally will face scrutiny as well, particularly with respect to climate risk disclosures or where issuers make representations about ESG practices.
How the Commission will deal with the inherently thorny nature of ESG disclosures in a complex world involving cross border supply chains where “green” technologies often require the environmentally damaging mining of rare earths remains to be seen. But the Commission’s repeated pronouncements to start this year about its ESG focus cannot be disregarded.
- While climate disclosures can be considered under the umbrella of ESG, the SEC’s practice has been to separate climate change disclosures into its own category. The logic behind this is that some climate change disclosures relate to solely economic risk (risk to physical assets or supply chains from climate change) while only some fit under the more traditional ESG framework (decarbonization efforts).
- On March 11, 2021, John Coates, the Acting Director of the Division of Corporate Finance made remarks regarding the Division’s considerations for implementing an effective ESG disclosure system, emphasizing the need for SEC policy in this area to be adaptive and innovative. https://www.sec.gov/news/public-statement/coates-esg-disclosure-keeping-pace-031121. And on March 15, 2021, the Commission put out a request for public input on climate change-related disclosures. https://www.sec.gov/news/public-statement/lee-climate-change-disclosures