ESG compliance tips emerge from outreach

The SEC Enforcement Division works with DOE examiners to look for 'misconduct' and using sophisticated data analysis 'to identify potential violations'

What ESG means may be in the eyes of the beholder, but an adviser would be better off being clear what it means for the firm’s investing.Young activist holding sign protesting against climate change

Take an adviser that wishes to exclude fossil fuel companies from client portfolios. “What does that mean?” asked Andy Sohrn, an exam manager with the SEC’s Division of Examination based in Los Angeles. The question grows more vexing because there’s no agreed upon definition of ESG.

“Does that exclusion apply to oil and gas drilling companies only or does that exclusion apply to companies that are not primarily in the fossil fuel industry?” he continued, in speaking Nov. 15th at the DOE compliance outreach meeting in Washington, DC.

“These are actual issues and questions that we’ve seen in actual examinations,” continued Sohrn.

A hot commodity

Largely driven by investor interest and advisers detecting a hot commodity, ESG now rages in more than 800 funds with assets topping $3 trillion, said Cindy Eson, associate regional director of the DOE office in Los Angeles.

Firms face “higher compliance risks” when they seek to rebrand a fund or a strategy for ESG, said Sohrn. Be sure to think long and hard about whether the change and its related disclosures are accurate, he counseled.

A question popped up whether advisers engaging in ESG would need to have separate, written ESG P&Ps. Sohrn responded that “the more that ESG is integral to an adviser’s business,” the more likely it should have P&Ps.

John Boese, CCO, Impax Asset Management ($8.5 billion in AUM) in Portsmouth, New Hampshire, the resident CCO on the SEC panel, recommended advisers maintain ESG P&Ps. “Absolutely,” he said. “Then compliance needs to test that to ensure that it’s being done.”

Boese revealed his firm had endured “a routine exam on steroids,” which also served to help educate the SEC on ESG. “They were really seeking industry input.”

The upshot of the exam: “Are you doing what you say you’re doing,” Boese noted.

Kimberly Frederick, assistant director based in Denver in the SEC Enforcement Division’s Asset Management Unit, sounded a similar tone in summing up the session’s advice: “Say what you mean and mean what you say.”

This concept would prove crucial should the SEC’s proposed ESG rule become final. It would hold advisers to make extensive disclosures about what type of ESG firm they are.

Avoid compliance traps

Boese shared the best advice he’s ever received. “Don’t create compliance traps in your prospectus,” he said. A compliance trap is “something that you say you’re doing but you’re not going to be able to do.”

Endeavor to keep your ESG disclosures consistent throughout your website, marketing materials and Form ADV, he continued. “The way you do that is to have compliance” serve as an ad hoc member of every committee at your firm, he counseled.

He recommended that disclosures should focus on how an adviser uses ESG scores “and other inputs” in creating portfolios.

The SEC will be watching

The SEC Enforcement staff’s ESG task force, formed in 2021, counts some 24 members with experience in financial reporting, disclosures and IA matters, said Frederick. They’re working with examiners and looking for “misconduct” and using sophisticated data analysis “to identify potential violations.” Frederick also listed recent ESG enforcement actions.

The SEC’s Eson drew the audience’s attention to the DOE ESG risk alert released earlier this year.

Proxy voting

A potential exam deficiency could sprout from an ESG adviser casting its proxy votes without consideration for client’s portfolios, said Sohrn. Clients expect ESG advisers to vote proxies in line with their investment strategy, Boese added.

Sohrn recommended firms describe what it means to engage with issuers in efforts to further their clients’ ESG objectives.

“We vote against all board slates … that don’t include women,” Boese said by way of illustration. The adviser then follows up by writing to the issuer to explain its vote. “Issuers now will answer your letters,” he said. “This is something that has evolved very quickly,” and demonstrates the power of advisory firms’ ESG proxy voting.