When the SEC released its fiscal 2024 exam priorities, regulators made almost as much news for what they didn’t say. For the first time in three years, examiners didn’t mention ESG.
“I think a big question a lot of folks have is why ESG wasn’t called out specifically in the exam priorities this year,” says Carlo di Florio, global advisory leader for compliance consulting firm ACA Group. “My view is that you shouldn’t read too much into that.”
When di Florio ran the SEC’s exams program from 2010 until 2013, he started the now annual tradition of releasing the division’s priorities. They’re meant to be a kind of study guide for the industry. Di Florio doesn’t think anyone should confuse examiners’ silence on ESG for disinterest. If anything, he says, people should hear the opposite message, given how much attention the Commission has given to ESG across its exams, enforcement and rulemaking divisions.
“The SEC has already clearly communicated that ESG is a priority in prior letters, risk alerts, speeches, conferences and enforcement actions,” he says. “Firms have the benefit of all these communications to understand regulatory expectations and align their compliance programs. The ESG risk alert in particular clearly sets forth the types of deficiencies and effective practices the Exams Division sees during their exams of ESG.”
‘Get your house in order’
In di Florio’s view, ESG is becoming foundational to private fund compliance. Consider the agency’s enforcement division, he says. In 2021, the Commission announced that it had formed its own climate and ESG enforcement task force. It’s already taken credit for bringing nearly a score of cases, including a 2022 settlement with Goldman Sachs’ asset management division and, in late September, a $19 million settlement with Deutsche Bank’s investment adviser.
Meanwhile, under its chairman, Gary Gensler, the SEC has adopted or proposed three sweeping rules packages designed to help bring uniformity to ESG disclosures, di Florio says. The first, a new names rules under the Investment Company Act, is aimed squarely at so-called “greenwashing.” It was adopted by a divided commission in late September. The other two—one that would require public companies to disclose their climate-related risks and carbon emissions, and the other that would require registered investment advisers to make a series of new disclosures about how ESG factors into their investment decisions—are still pending.
“Whenever you see the SEC taking action across rulemaking, exams and enforcement,” di Florio says, “it should be seen as a clear signal that this is a big focus for them, and you need to get your house in order.”
‘Highest common denominator’
That regulatory pressure might be a lot for any industry to take. Private funds, broadly, are open to some kind of universal grammar for ESG—and not just as a product line. A growing number of limited partners, private fund managers and industry advocates see ESG as an enterprise-wide valuation/risk/opportunity question. Reading financial statements only tells you part of the story, such people say. It’s time, they argue, to account for other “externalities”—such as biodiversity loss, water stress or land degradation. If you’re asking LPs to invest in a portfolio company that focuses on beer sales, you ought to be able to tell them how water scarcity affects its returns. As the Biden administration put it recently, it’s time to “put nature on the balance sheet.”
The problem is that in the US, ESG is still a divisive political question. Some see it as a marketing gimmick that helps fund managers hide their high fees. Others see it as an “ideological joy ride” that distracts fiduciaries from their obligations to clients.
Fund managers are caught in the middle, along several axes. Conservative-led states such as Florida, Oklahoma and Texas have all passed laws or adopted rules aimed at curbing “woke” excesses in public pension or investment funds. California—the US’s largest economy—has passed a new carbon disclosure law that goes even further than anything the SEC has contemplated. New York is considering similar legislation, and New York City has already adopted Local Law 97, which imposes strict new limits on carbon emissions in real estate.
“Assuming you’re an adviser that wants to sell to investors in all 50 states, you have to comply with the highest common denominator,” says Chris Robertson, a partner at Seyfarth Shaw. “What are my most onerous metrics for me to go sell in wherever, especially if you’re marketing online? The interesting question is, if we’ve done everything we have to do to comply with state law, will that be enough for whatever rules the SEC finally adopts?”
Indeed, some of the initial pressure on regulators to adopt federal ESG standards came from fund managers worried they might be tangled in the emerging patchwork of rules and regulations. In 2021, shortly after the SEC asked for public comment on whether it should impose new ESG disclosure rules, BlackRock, the world’s largest private equity manager, with more than $7.5 trillion of assets under management, urged the Commission to apply any new rules to the private funds market, too.
Too much, too quickly
Since the SEC formally proposed its adviser ESG rules last year, industry’s response has been relatively muted. Few managers or their advocates have condemned the proposals outright, but most industry advocates say that the proposals are asking too much, too quickly.
“Another example is the Commission’s proposed extensive ESG disclosures for funds, advisers and public companies without analyzing interdependencies or whether its regulatory objectives could have been otherwise accomplished,” American Investment Council general counsel Rebekah Goshorn wrote the Commission in August. “The [investment adviser] ESG proposal is dependent on public company disclosures in the climate disclosure proposal. The ESG proposal also overlaps with requirements under the proposed amendments to the names rule and the outsourcing proposal.”
The fears over the cumulative impact of complex, interlocking rules have become a refrain for fund managers and their allies.
“We believe the sheer number and complexity of the proposals, when considered in their totality, if adopted, would impose staggering aggregate costs, as well as unprecedented operational and other practical challenges, neither of which have been considered by the Commission in its proposals to date and neither of which are warranted by such proposals’ limited benefits,” Managed Funds Association executive vice-president Jennifer Han said in a July letter. “Instead, we believe the aggregate effect of the proposals would be to decrease the efficiency of the markets and, ultimately, to negatively impact the very investors that the Commission is attempting to protect.”
The marketing rule
The thing is, the SEC doesn’t need new rules to shape ESG policy.
“Even though the SEC hasn’t actually implemented a rule, they can still sort of quietly bring these things up in the exam process. And they’ve done it,” Seyfarth’s Robertson says.
Under the anti-fraud provisions of the Investment Advisers Act, and under the SEC’s marketing rules, registered fund managers are not only liable for materially misleading disclosures, they may also be punished for not having the evidence to back up a true claim. Under Gensler, examiners have already used the marketing rule’s substantiation requirements to probe private fund managers about their valuations, their use of artificial intelligence and their ESG claims.
“One thing I don’t think enough people are talking about is the impact of the marketing rule on ESG,” Jana Nawrocki, the CCO at private equity real estate adviser GID, told affiliate title Regulatory Compliance Watch earlier this year. “Substantiation of your ESG claims could be quite difficult. We’re spending a lot of time trying to figure out what backup is adequate to substantiate the claims on our web sites.”
David Blass, a partner at Simpson Thacher & Bartlett, agrees that ESG has become a fundamental part of private funds’ compliance obligations, regardless of what the exam priorities say.
“My sense is that the SEC saw ESG as an emerging risk a few years ago, but it isn’t much of an emerging risk anymore,” he says. “That doesn’t mean they’re not going to look at ESG. They don’t talk much about the custody rule in this year’s exam priorities. But I can almost guarantee you that they’re going to ask about custody in an exam.”
‘No one’s stopping this train’
The SEC is likely to adopt new ESG rules anyway.
“No one’s stopping this train,” Seyfarth’s Robertson says. “I think the SEC is making the effort right now to adopt a rule that will survive a court challenge. It may be scaled back from the proposal. But there is going to be an ESG mandate. There is going to be some kind of reporting required. So I think folks need to prepare for that. There are going to be additional requirements and managers need to really think these things through.”
The good news is, fund managers don’t have to wait for final rules to begin at least sketching an outline of a good ESG disclosure program, says Debbie Franzese, a partner at Seward & Kissel.
“One of the things that managers are really going to have to consider—assuming the final rules have the same type of structure as the proposal, where they’ll make advisers categorize their funds as either reviewing ESG in some way or not and if reviewing ESG then further as an ESG integration fund, ESG impact fund or ESG focused fund—if someone’s communicating to investors that they do consider ESG factors in an investment, I think there’s going to need to be a kind of a review,” she says.
“Are we comfortable with this ESG integration that the SEC has laid out? If you’re talking about a growth investment as opposed to a control investment, managers that have a variety of products are going to have to be very careful about how they categorize different funds and different strategies.”
The other good news is, fund compliance teams may be able to rely on their experience with the marketing rules to prepare for new ESG disclosure rules, Franzese says.
“If you were just making a few statements in a marketing presentation, you presumably had enough support to back those statements up,” she says. “Here, when they’re actually categorizing themselves into an ESG category, there’s going to be more of a push from the SEC that says, ‘Show us how you do this. Show us the memo.’ If you’re saying you’re reaching out to portcos to ask them for information, the SEC will likely say, ‘Show us the e-mails. Show us the ESG reports that you’ve requested and received. Show us your engagement in proxy votes that are going to focus on ESG.’”
Editor’s Note: Worried about how your firm will manage ESG regulation? Regulatory Compliance Watch and Private Funds CFO are pleased and proud to offer a free CLE/CPE webinar on Dec. 5 at 2 pm Eastern. Join host Bill Myers and expert guests Carlo DiFlorio of the ACA Group and Meredith Jones of EY for an hourlong discussion on the state of regulatory play, and ways you can help your organization manage the enterprise-wide risks/opportunities that ESG can represent. The webinar is free but you must register. Click here for more.