Marketing rule opens door to ESG enforcement

The SEC’s proposed ESG disclosure rules have sat on the shelf for more than a year, but regulators are using the marketing rule to crack down on greenwashing and private fund advisers have every reason to worry, experts say.

The new investment advisers marketing rule took effect last November. Among other things, it requires advisers to substantiate any claims that might entice an investor to put money into their funds. As written, the rules open the possibility that an adviser can be sanctioned even if a claim turns out to be true, so long as the adviser doesn’t have the receipts to back a claim up.

Greenwashing may well be a target-rich environment for regulators: after the EU adopted strict new ESG disclosure standards, about 70 percent of self-described impact funds shucked their titles.

Commission regulators are already using the marketing rule’s substantiation requirements to ask probing questions about private funds’ valuations, affiliate title Regulatory Compliance Watch reports. They have also been asking advisers about their ESG claims.

RCW has obtained an SEC document request to a fund adviser. It asks the firm to provide its definition of ESG/socially responsible investing, the criteria they are using for those claims, whether the adviser uses any industry standards (such as the UN Principles for Responsible Investment) “and if so, please provide written documentation of such registrant’s consideration of the standard(s) in its investment selection, portfolio management processes and proxy voting/issuer engagement practices.”

‘Trying to figure out’

Some compliance experts have been worried that private funds were due for a confrontation with the marketing rule, with ESG as a likely battle ground. Global assets in private ESG funds reached more than $4 trillion last year.

“One thing I don’t think enough people are talking about is the impact of the marketing rule on ESG,” said Jana Nawrocki, CCO at private equity real estate adviser GID. “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 websites.”

Regulators were already following the ESG money – the Commission’s Exams Division issued a risk alert on ESG funds in early 2021 – but under chairman Gary Gensler, the hunt has intensified. Critics of ESG investing sometimes say it’s a fig leaf that hides funds’ high fees. Gensler is a proponent of ESG standards who more-or-less shares that view: a consistent theme of his is that private funds fees are too high.

Gensler inherited the marketing rule. He’s made clear that he means to use it to crack down on private funds. In November, just a few weeks after the new marketing rule took effect, the SEC announced a $4 million settlement with Goldman Sachs, over allegations that it mislead mutual fund investors about Goldman’s ESG portfolios. No one thinks that will be the end of things.

These kids today

It’s not all private fund advisers’ fault they are vulnerable to ESG cases, said Jonny Frank, a partner at compliance consulting firm StoneTurn. They are working against some structural problems, he said.

One problem is that there is no uniform standard for ESG/impact investment, Frank said. That fuzziness makes it easier for cheaters to think they can get away with cheating and for honest people to make honest mistakes. “Many of the big schemes are now non-financial reporting, as the banks call it,” he told RCW. “It’s obvious they’re going to occur, because you have to an incentive to say, ‘My firm is investing in green products.’ You can rationalize it for any number of reasons, and there are not a lot of internal controls to monitor this kind of thing. Think about what happened with Volkswagen when they were caught cheating on emissions tests.”

The other problem is that for the rising generation – that is, your firm’s front-line workers – ESG “is really, really important to them,” Frank says. There are already all sorts of incentives for whistleblowers to come forward, Frank said. “When you combine that with the ‘See Something, Say Something’ culture and the SEC ratcheting up enforcement, this is the kind of misconduct that people will report.”

Practice tips

Greg Larkin, a partner with Goodwin Procter, said he and his colleagues have been “preaching caution on ESG disclosure both due to the marketing rule requirements but also because of the general focus on ESG from the SEC examination and enforcement staff.”

“The marketing rule implications include not just the substantiation requirements but also the balance of benefits and risks and occasionally third-party ratings and awards,” he told RCW. “Private fund advisers need to be clear as to how ESG factors play into the investment process, including on the point of if or when ESG factors or criteria are not determinative and when investment decisions are made – even if ESG criteria are not met.

“In addition, private fund advisers should be clear about how ESG plays into the ongoing decision-making with respect to a portfolio investment (for example, ESG initiatives at portfolio companies), including disclosure on where the private fund adviser may be constrained in their ability to control those decisions. Private fund advisers should also include disclosure on benefits and risks associated with balancing ESG factors with other considerations. Finally, private fund advisers should also make sure references to third-party ratings and awards include the appropriate disclosure.”