SEC “Risk Alert” A Good Step Toward Improving ESG Standards

The recent focus of the U.S. Securities and Exchange Commission (SEC) on better quality, more comprehensive reporting on environmental, social and corporate governance (ESG) standards is a welcome development, particularly as investor interest in ESG products continues to grow rapidly.

In fact, demand shows no signs of slowing. The subsequent responses from asset managers has been to launch more products, creating a crowded market environment and making it harder for investors to assess the ESG credentials of the funds as well as the managers who created them.

Visibility by the SEC to combat “greenwashing” and misleading ESG claims began in January 2021 under Acting Chair (and Trump appointee) Allison Herren Lee. It continues as Gary Gensler takes the helm, indicating broad bipartisan support. Both parties recognize that ensuring ESG policies, procedures and documentation protect investors is good public policy.

To this end, the SEC issued a Risk Alert memo on April 9, 2021 titled The Division of Examinations’ Review of ESG Investing. The SEC staff outlined broad areas of deficiencies they observed and expect to be addressed, as well as describing best practices within the industry.

We believe this was a shot across the bow, a preview of what could ultimately be a U.S. version of the European Union’s Sustainable Finance Disclosure Regulation (SFDR), which took effect in March.

SFDR requires firms managing money in the EU to state if they review the environmental and social aspects of their investments. In particular, they must state whether they are considering the adverse sustainability impacts of their investment decisions. Firms are also required to disclose information about how their financial products work to achieve sustainability outcomes.

Those of us who were early adopters of ESG integration have spent significant time and effort educating the U.S. market on what ESG is and is not. Track records for ESG funds have grown, but the biggest misperception (if less than in the past) is that ESG investing requires sacrificing returns. Hundreds of academic studies prove instead that ESG analysis often improves performance.

Some also believed ESG investing violated a firm’s fiduciary duty to investors. The overwhelming conclusion was that it does not. If anything, to not consider ESG factors could be a violation of fiduciary duty.

If the SEC is anticipating global sustainable reporting standards, it could help solve the perceived problem of subjectivity. Yet while ESG criteria can apply to companies differently, they are not necessarily subjective. Investors must have intimate fundamental knowledge of how a company operates to objectively decide which ESG criteria (if any) are material and relevant.