The U.S. Securities & Exchange Commission (“SEC”) recently found that an investment adviser mischaracterized its integration of Environmental, Social, and Governance (“ESG”) factors into research and investment recommendations for certain products. These miscommunications included the extent to which advisory personnel used a proprietary ESG ratings engine to assign an A to F rating to issuers to help guide investment decisions.
The adviser’s integration of ESG factors into its research and investment recommendations appears to have started with good intentions. The SEC found, however, that implementation and supervision of the robust program was inconsistent. Firm leadership, business teams, and compliance personnel also seem to have had communication breakdowns along the way. The adviser neither admitted nor denied the SEC’s findings. It also noted that the settlement order found no misstatements in its financial disclosures or any fund prospectuses.
Financial services providers can glean many insights from the detailed SEC settlement, including the points below. These insights should be useful as the industry prepares to grapple with substantial new ESG regulatory and reporting requirements from the SEC as early as this year.
- Robust Education. Investment professionals and management should be fully educated on new products or processes to help ensure consistent implementation across large organizations.
- Monitor, Ensure & Document Compliance. Senior management should have a means to monitor, ensure, and document compliance with any new ESG policies. For example, where a proprietary ESG ratings engine is implemented, controls should be in place to ensure that investment professionals use it consistently across the organization.
- Holistic Quality Checks. Supervisors should receive clear instructions on when and how to monitor new ESG policies and products. Quality checks should be widespread, formalized, and documented.
- Red Flags. Senior leadership and managers should be sensitive to red flags, including pushback from managers or business personnel to incorporating new ESG policies or products due to resource constraints or other concerns.
- Prompt Remedial Action. Where red flags are identified, prompt remedial action should be taken.
- Closely Monitor External Communications. As part of any remediation exercise, companies should examine all prior and future public communications about an ESG policy or product to ensure its accuracy. Companies should also consult with ESG compliance teams prior to making any public statements about an ESG policy or program.
The adviser also took the steps below to improve its practices according to the SEC order. Companies designing or implementing new ESG policies or programs may find them helpful too:
- Requiring research analysts and investment professionals to complete specific fields in template forms confirming the consideration of ESG factors and summarizing their analyses.
- Enacting written policies to clarify which supervisors are responsible for ESG policy implementation. Additionally, these policies should highlight what to focus on during reviews, including the identification of key ESG issues.
- Conducting regular ESG training sessions for both business and supervisory personnel.
- Forming internal corporate governance bodies focused on continuous improvement of ESG capabilities.
- Establishing systems to regularly review the ESG quality of portfolios even after investment decisions are made.
[The adviser] lacked policies and procedures to ensure its ESG Integration Policy was consistently followed by its investment professionals, and to confirm whether investment professionals consulted the ESG Engine, documented ESG factors in research notes, and incorporated ESG issues in valuation models and investment recommendations for the ESG Integrated Products.