The market for investment products and services is very competitive. Consumers now look to their advisers to not only provide return on their investment but to do so in a way that is consistent with their personal ethos. To meet this demand, many investment advisers have turned to incorporating environmental, social, and governance (“ESG”) factors into their investment strategies. Arguably there is no hotter topic at present in the broader investment community than ESG, or, as it is sometimes called, socially responsible investing. But before your firm begins to include ESG in its investment approach, you should first consider the SEC’s increased scrutiny and subsequent guidance on the subject.

As Marc previously discussed, the SEC recently published its Division of Examinations’ priorities for 2021. Prevalent among these priorities was an enhanced focus on ESG. Moreover, the SEC also published an Investor Bulletin in February 2021 discussing ESG investing and an April 2021 Risk Alert highlighting areas of concern noted from SEC examinations of investment advisers pertaining to ESG investing.

So, what should you take from all of this SEC guidance? For one, if your firm provides ESG investment strategies, you should expect that to be a focus of any SEC examination of your firm. But more broadly, you might read the SEC’s guidance to state that ESG investing should be more than a marketing tool to attract clients (meaning you need to think about how incorporating ESG investing affects clients and what you need to tell them). To that end, below are the key points your firm should focus on when developing and maintaining your ESG program:

• Portfolio management practices must be consistent with ESG disclosures – This is not a unique concept to ESG. The way your firm manages a client’s account must be consistent with the client’s expectations and your firm’s disclosures. For example, if your website indicates that your algorithm will exclude investments in certain industries (e.g., tobacco or alcohol), you must ensure that the client’s portfolio has been filtered in accordance with this disclosure. You should also review your Form ADV and any marketing materials to ensure that consistent disclosure related to ESG investing is used.
• Accurate ESG Disclosure – As with all investment strategies, ESG investing contains risks. The SEC will expect your ESG related disclosures to be free from unsubstantiated or misleading statements. Statements such as “our strategy will only invest in companies with high employee satisfaction” must be substantiated by evidence. If your ESG investment process involves screening out certain investments, your disclosure should indicate that such process may result in lower returns due to the potential for higher performing securities to be screened out.
• Your compliance program must include adequate policies and procedures to monitor and address ESG issues – Adding an ESG component to your firm’s investment offerings means additional compliance responsibilities. The SEC will expect your compliance program to adequately address how your firm will monitor and test for ESG. This should include policies and procedures to periodically review client portfolios to ensure adherence to client stated preferences. For example, if your client intake process allows a client to indicate preferences, such as the exclusion of companies engaged in weapons manufacturing, your compliance program should include a procedure to test for the client’s intended screen. The SEC would also expect policies/procedures around making sure your algorithm is working as expected (i.e., ESG screens being applied appropriately).

While the above bullets are the key highlights from the SEC’s guidance on ESG, you should review the entirety of the guidance at the above links and consult with a legal or compliance professional before implementing your ESG program.

Thank you, as always, for your continued readership. Please check back next time when Marc will continue our series discussing the SEC’s 2021 examination priorities.