When reports started circu- lating in January that the Securities and ExchangeCommission’s Office of ComplianceInspections and Examinations was sending inquiries to asset management firmsthat offer environmental, social and governance investment products, it came asno surprise to those familiar with regulatory reactions to investment trends.
The SEC has a long history of bringing enforcement actions against assetmanagers alleging a mismatch betweenwhat investors are told their funds areinvested in and what investors’ fundsactually are invested in. For example, ifyour fund’s prospectus says that it willemploy a covered-call strategy but thefund instead employs individual nakedindex puts or short variance swap positions, the SEC may take issue.
So it stands to reason that if investment managers are touting ESGinvestments, the SEC will take aninterest in verifying the accuracy ofthose representations.
However, what, precisely, it means toemploy an ESG investment strategy can bedifficult to determine with any certainty.
The environmental category caninclude, for example, water usage, carbon footprint, emissions, what industrythe company is in, and the quantity ofpacking materials the company uses.The social category can include howwell a company treats its workers, whata company’s diversity policy looks like,its customer privacy practices, whetherthere is community opposition to anyof 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
done, it is difficult to figure out how to
measure success or failure.
The lack of clarity around ESG definitions combined with booming interestin ESG investments has resulted in various calls for the SEC to impose uniformdefinitions and disclosure requirements.In March, for example, the SEC requested comments regarding whether Rule35D- 1 under the Investment CompanyAct of 1940, or the “Names Rule,” shouldapply to funds that include terms such as“ESG” and “sustainable” in their name.
Then in late May, the SEC’s InvestorAdvisory Committee recommendedthat the regulator mandate disclosuresconcerning ESG for registered issuersof securities.
One aspect of ESG disclosures theSEC would do well to shy away from iscompelling certain ESG disclosures toencourage or discourage certain underlying ESG conduct.
Compelled ESG disclosure for the
purpose of pursuing ESG goals, rath-
er than for the purpose of ensuring
accurate and complete disclosures, may
infringe on First Amendment rights.
That was the finding of a federal appel-
late court that struck down a portion
of the conflict minerals provision of
Dodd-Frank because it violated “the
First Amendment to the extent the stat-
ute and rule required regulated entities
to report to the Commission and to state
on their website that any of their prod-
ucts have ‘not been found to be DRC-
And it may be unnecessary for the
SEC to compel any particular ESG dis-
closures in light of already existing
legal requirements. The antifraud pro-
visions of the federal securities laws
already prohibit investment advisors
(and others) from making false or mis-
leading 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
Those antifraud and disclosurerequirements apply to advisor representations about ESG investments in thesame way that they apply to every othertype of investment.
For public companies at least, the SEChas so far declined to go beyond thesebasic disclosure principles and dictatewhich particular ESG disclosures mightbe material to specific companies (andthus require disclosure).
Whether the SEC will show similarrestraint in requiring specific, affirmative disclosures by investment advisorsremains to be seen.
In the meantime, expect to see someSEC enforcement actions in the coming months against investment advisorsalleging misrepresentations around ESGtopics. The SEC doesn’t need any newlaws to bring those cases.
Nicolas Morgan is a partner at the globaldefense firm Paul Hastings.
By Nicolas Morgan
SEC: If a Strategy Claims It’s ESG, It Better Be
The regulator has begun to investigate the accuracy of sustainable
disclosures in fund documents.