As more investors seek to align their portfolios with their values, asset managers and financial advisors are increasingly offering environmental, social and governance (ESG) products and strategies. While investors certainly gravitate toward ESG options, the resulting market demand has created a financial incentive for branding and investment advisors like ESG, even when categorization may be overdone.
The SEC has thus focused on the issue of false ESG claims. For example, in late November, it announced a $4 million settlement with Goldman Sachs for alleged breaches of its own ESG policies and procedures when choosing investments for two mutual funds and a separately managed account strategy.
“In response to investor demand,” the SEC explained, “[advisors]are increasingly branding and marketing their funds and strategies as ESG.” But when they do, “they must establish reasonable policies and procedures governing how ESG factors will be assessed as part of the investment process, and then follow those policies and procedures, to avoid providing investors with information about those products that differ from their practices.”
With this theme as context, and following other recent enforcement actions, SEC Commissioner Mark Uyeda made remarks on ESG concerns in late January to the California ’40 Acts Group, a nonprofit forum lucrative that facilitates discussions on issues that impact the investment management industry. The commissioner’s remarks include numerous caveats for any asset manager or advisor offering ESG options.
Mr. Uyeda explained that the demand for ESG investments has grown rapidly, with these investments yielding higher fees than traditional alternatives. “Presenting a product as ‘ESG’ is good for business,” concluded Uyeda. “Although ESG investing is extremely popular, it is difficult to determine exactly what ESG means, so it is difficult to identify when an ESG investment strategy is correctly labeled as such.”
Beyond the risk of mislabeling a strategy, Uyeda observed another compliance challenge with ESG strategies: namely, they are sometimes not fully and fairly disclosed to clients. The commissioner notes that asset managers and advisers have a fiduciary duty to their clients to provide full disclosure of strategy details. As Mr. Uyeda explained, “an advisor can only pursue an ESG investment strategy if the client expresses a desire to pursue such a strategy after having received full and fair information on the main characteristics of the strategy, including including the risk and reward profile of the strategy”.
Against this backdrop, Uyeda cautioned against implementing specific ESG regulations to govern the growing space, arguing instead that the current regulatory framework is sufficient to address ESG concerns. Under applicable federal securities laws, asset managers and advisers must ensure that their investment strategies align with clients’ objectives, including non-financial objectives, in the case of ESG, which requires full and adequate disclosure, and client approval, before implementing an ESG strategy. . Additionally, asset managers and advisors have a fiduciary duty to their clients that prohibits them from labeling or misrepresenting a strategy as ESG in order to make the strategy more attractive to the market.
Arguing that existing securities laws are adequacy, Mr. Uyeda is skeptical of the implementation of a new ESG regulatory framework for three reasons:
First, in the Commissioner’s view, we lack a uniform and objective definition of ESG and need to recognize the “fundamental reality that standardized ESG measures are doomed to failure”. Rather, each advisor engaging in an ESG strategy should clearly inform investors what that particular advisor means when they use the term ESG.
Second, Mr. Uyeda believes that regulators have “the temptation to put (their) fingers on the scales in favor of specific ESG goals or objectives,” which can compel companies to pursue politically motivated ESG programs. Although the goal is to prevent greenwashing, the potential result is that political considerations govern business decisions.
Third, Mr. Uyeda observes that asset managers have a “desire . . . pursue ESG-related goals without obtaining a mandate from clients,” thus prioritizing social and political goals over clients’ financial results. Using Mr. Uyeda’s example, when asset managers who intend to track indices use their proxy voting rights to promote non-financial ESG objectives, those advisers may not be acting in accordance with their fiduciary duty. towards clients, who are invested in an index, rather than an ESG strategy, and has never agreed to compromise financial results for political and social purposes.
While some may dispute Mr. Uyeda’s pessimistic assessment of an ESG-specific regulatory framework – indeed, the SEC has proposed several rules regarding ESG investing – the commissioner’s remarks make it clear that the SEC is focusing on full disclosure and transparency regarding ESG claims.
So where does this leave us? The SEC is closely monitoring the rapid growth of ESG strategies and investments. The commission is concerned that market demand for ESG products has created a financial incentive for asset managers to identify products as ESG, even when the definition is not entirely appropriate. The SEC is also concerned that investment advisers are implementing ESG strategies for client accounts without full disclosure and approval, potentially in violation of advisers’ fiduciary duty.
Based on these related concerns, the commission set its sights on ESG. Whether the SEC moves forward with an ESG-specific regulatory framework, despite the Commissioner’s concerns, or continues to rely on existing obligations of federal securities laws, advisers and asset managers can continue to expect enforcement action, both when alleged ESG products are mislabeled and when ESG strategies are implemented without full and proper disclosure and client approval.
Overall, asset managers and financial advisers would be well served to confirm that they have a good rationale for qualifying a strategy as ESG. Likewise, they must have a good reason for implementing ESG products or strategies for particular client accounts, namely that the client has requested such a product or strategy, or has approved it after full disclosure of their profile. of risk and return by the advisor. By taking these steps while remaining mindful of the SEC’s new ESG guidance, asset managers and advisors can stay out of the regulatory crosshairs.