In his first month as chairman of the Securities and Exchange Commission (the “Commission” or “SEC”), Gary Gensler has repeatedly emphasized the SEC’s focus on initiatives related to climate and other environmental, social and governance (“ESG”) matters. Most recently, on May 13, 2021, in opening remarks delivered at the Conference on Financial Market Regulation, Chair Gensler identified a regulatory framework centered on disclosure of climate investing risks and human capital disclosures as an “early focus” of his tenure.
His statements build on several months of SEC statements and releases indicating movement towards studying and formulating potential disclosure frameworks. Chair Gensler pointed to investor interest in such information, stating that a clearer set of disclosure rules would also serve to benefit issuers and help them deliver exactly the information their investors want. Chair Gensler and those at the SEC who share his focus are already facing criticism on whether a new disclosure framework is needed, with Commissioner Hester Peirce objecting that an entirely new disclosure framework is unnecessary. Instead, Commissioner Peirce stated her belief that the objective “materiality” standard for investor disclosure, coupled with the SEC’s 2010 climate guidance, already provides a clear-cut framework, and that proponents of a new ESG framework are overlooking the difficulty in implementing a “prescriptive” ESG framework.
Gensler’s identification of a new framework for climate risks and other ESG disclosures as a top priority of his early tenure should come as no surprise to anyone who has been following the SEC’s recent climate- and ESG-related initiatives. While no timetable has been set for when the SEC will present concrete proposals for a new framework, the SEC has already solicited market feedback on what such a framework might look like and has begun to articulate more precisely what it perceives as deficiencies in issuer disclosure practices and processes under the existing regulatory framework. Shortly before Gensler’s appointment, on April 9, 2021, the Division of Examinations (the “Division”) published a risk alert (the “Risk Alert”) outlining observations from recent exams of investment advisers, registered investment companies, and private funds offering ESG products and services (collectively, “firms”). The Risk Alert highlighted what the Division identified as common deficiencies and contrasted them with examples of effective ESG disclosure practices. The Division noted that its staff will continue to examine firms’ ESG practices, specifically highlighting portfolio management and the processes in place to identify and select ESG investments, the accuracy of ESG-related statements in regulatory filings and marketing materials, and internal compliance programs as areas of examination focus. In its observations, the Division identified flaws such as misleading disclosures, ineffective internal control processes, and inconsistent investment practices, while praising what it considered to be clear and accurate disclosure materials, the use of well-designed and targeted internal policies and processes, and the use of knowledgeable compliance personnel. The Division’s observations of these perceived deficiencies are, in part, meant to frame the discussion as to why a new regulatory framework is needed and what deficiencies a new regulatory framework will be meant to address.
The Division’s Risk Alert focused on how the absence of a universal ESG investment framework combined with the rapid growth of ESG-related investment products and marketing material targeted to meet increased investor demand has resulted in wide variations among firms in approaches, processes, and disclosures, presenting additional risks to investors. In its examinations of firms offering ESG investment options, the Division identified specific instances of mismanagement and misleading activities, including the following:
- Portfolio management actions that were inconsistent with firms’ regulatory disclosures and statements to clients, such as holding investments in issuers that did not meet stated ESG benchmarks advertised to investors.
- Ineffective or vague internal control programs meant to monitor and update clients’ investment guidelines and mandates, specifically in cases where investor portfolios contained securities prohibited by those investors’ ESG requirements.
- Inconsistent and misleading statements concerning proxy voting on ESG-related issues when compared to internal policy.
- Misleading claims regarding firm ESG investment approaches and results, such as using inflated return metrics or embellishing the firm’s participation in developing specific investment products.
- Ineffective internal control programs meant to ensure compliance and oversight for adherence to stated ESG investment processes or decisions and a lack of knowledgeable personnel in such programs.
Effective Firm Practices
In contrast, the Division also identified examples of effective firm practices, such as accurate disclosure and client marketing material and effective internal compliance and maintenance processes, as follows:
- Accurate and clear disclosures that specifically identified the analysis and decision-making processes for ESG investments, including an explanation of how various ESG factors are weighed in accordance with several global ESG frameworks.
- Well-designed and maintained internal policies surrounding ESG investing, often including detailed documentation at numerous stages of the investment process.
- Knowledgeable compliance personnel that effectively reviewed disclosure, marketing materials, and existing internal policies and procedures and evaluated the alignment of a firm’s ESG investment approaches with investor expectations.
Any proposed new regulatory framework for climate risks and other ESG disclosures can be expected to address the perceived deficiencies identified by the Division and encourage firms to adopt practices and procedures that are deemed to be effective.
Conflicting Voices on a new ESG Regulatory Framework
Not all voices within the SEC are supportive of a new climate risk- and ESG-focused regulatory framework. In her response to the Risk Alert, on April 12, 2021, SEC Commissioner Hester M. Peirce asserted that, while she agreed that there should be accountability for the deficiencies and concerns identified in the Risk Alert, she disagreed that ESG products, offerings and disclosure pose problems that require a new ESG regulatory framework. Commissioner Peirce instead asserted that the existing general principles under which the SEC operates are sufficient and that, in matters of climate risk and other ESG matters, the SEC should continue to demand accuracy and cohesiveness between advisers’ claims and practices, not to “assess whether any particular strategy is a good one, but to ensure that investors know what they are getting.” Commissioner Peirce expressed skepticism on whether investors are best served by requiring firms to adhere to a special set of policies and procedures for ESG matters, as opposed to existing general principles requiring that the internal policies of a firm be appropriately tailored to that firm’s particular investment strategy, whatever that strategy may be.
Building on her earlier comments, in an interview on April 30, 2021, Commissioner Peirce contended that the market is already sufficiently protected by the current “principles-based disclosure framework that is rooted in materiality and intended to be flexible so it can be used by issuers across industries.” She observed that the Supreme Court has also already provided an objective test over what disclosures about ESG matters are material, namely whether “there is a substantial likelihood that a reasonable investor would consider the information important in making a financial decision about the company.” In contrast, she pointed to the difficulties involved in creating objective standards for the potential issues and concerns at play in ESG and climate disclosures and questioned the ability of the SEC to formulate a successful, objective framework. Commissioner Peirce stated that the job of an asset manager is to “tell investors what you’re doing and how you’re doing it” and took issue with the idea that the SEC could potentially take on the role of finding non-material information for investors simply because there was demand for it.
Most recently, on May 24, 2021, in her keynote remarks at the 2021 ESG Disclosure Priorities Event, Commissioner Allison Herren Lee pushed back on Commissioner Pierce’s comments and what Commissioner Lee considers to be myths about the sufficiency of the current disclosure framework and whether it provides investors with sufficient disclosures regarding climate risks and other ESG matters. Because current disclosure requirements do not contain “explicit” climate- or ESG-related provisions, Commissioner Lee sees this type of information as often only disclosed haphazardly and only when related to another piece of information already being disclosed. Commissioner Lee also argued that the materiality disclosure requirement has limitations, as not all information that is material is required to be disclosed, and, when judging whether information is material or not, there is ample evidence from recent history that shows how executives, attorneys, and accountants can make incorrect determinations on the issue of materiality.
Given prior public statements and releases from the SEC, Chair Gensler’s unequivocal statements that a new regulatory framework for climate risks and other ESG disclosures will be a top priority of his early tenure should dispel any arguments that the SEC will seek to compromise its push to make climate risk and ESG disclosure a key focus in 2021. However, as is demonstrated by the Risk Alert and Commissioner Peirce’s objections over what sort of meaningful climate risk- and ESG-specific disclosure and other regulatory requirements can be adopted, much work needs to be done. There are real challenges to be dealt with when attempting to formulate a specific framework for the dynamic concerns related to ESG and climate risk. Although some of the specific concerns identified in the Risk Alert seem to be exclusive to ESG issues, such as the recommendations for dedicated investment review and compliance personnel, the Division does frame these as issues only when presented with cases of inaccurate disclosure and representations to investors concerning investment approach and results. Nonetheless, issuers should not ignore the SEC’s continued focus on climate- and other ESG-related investment and disclosure risks, as its stated commitment to developing a universal and effective regulatory ESG framework, the specific deficiencies identified in the Risk Alert, and growing investor interest portend greater scrutiny of these areas.