The Securities and Exchange Commission (the “SEC”) has regularly emphasized its focus on environmental, social, and governance (“ESG”)-related investing and the importance of registrants having accurate disclosures on ESG matters, so it is not surprising that the SEC recently issued its first order sanctioning a registrant for misleading ESG-related disclosures and failing to enforce disclosed ESG-policies.[i] In the recent administrative order (the “Order”), the SEC charged a registered investment adviser (the “Adviser”) with failing to perform the ESG quality review that it disclosed as part of its investment selection process for certain mutual funds it advised.[ii] The Order stands as the first major settled SEC enforcement action in this growing ESG-investment space, and likely serves as a sign of future SEC actions to come.[iii]

We note that the SEC announced two proposed rules today (May 25, 2022) related to ESG fund names and ESG specific disclosure obligations.[iv] One of the proposed rules would, if adopted as proposed, update the rules governing the names of registered funds that would, among other things deem the use of “ESG” or similar terminology in a fund’s name misleading where the identified ESG factors do not play a central role in the fund’s strategy.[v] The other proposed rule would, if adopted as proposed, significantly enhance disclosure requirements for registered investment advisers and investment companies about their ESG practices.[vi] Blog posts on these proposed rules are forthcoming.

As noted in our recent legal alert, SEC’s Division of Examinations Releases 2022 Examination Priorities, the SEC has communicated a continued and enhanced focus on ESG-related investments, specifically noting the heightened risk for materially false and misleading statements in the ESG-related investment space and the lack of standardization in ESG investment terminology and the variety of ESG strategies. In particular, the SEC is seeking to ensure that registrants are actually implementing the ESG investment policies they disclose and advertise to investors. This Order demonstrates that the SEC will take action to enforce its priorities related to ESG-related advisory services and products, and provides an example of the conduct and disclosures the SEC will view as misleading with respect to ESG investments.

A summary of the Order and some key takeaways are set forth below.

Case Summary

On May 23, 2022, the SEC released the Order, finding that the Adviser made various misleading statements (e.g., in mutual fund prospectuses, in requests for proposals (“RFPs”), and during mutual fund board meetings) suggesting that ESG quality reviews would be prepared for investment decisions made for certain mutual funds that the Adviser or its affiliated sub-adviser advised (the “Overlay Funds”), when in fact the ESG quality reviews were not required to be, and often were not, prepared.[vii] Notably, the Order states that the Adviser and its affiliated sub-adviser did require and in fact carry out ESG quality reviews for investment decisions made for certain mutual funds that the Adviser considered “Sustainable Funds”; however, these same ESG quality reviews were not required and were not always performed for selecting investments for the Overlay Funds, despite, the Order states, the Adviser’s representations that investment decisions for the Overlay Funds would incorporate ESG considerations.[viii]

As part of its investment recommendation research process, the Adviser’s affiliated sub-adviser established a “Responsible Investment Team” to prepare ESG quality reviews and subsequently assign ESG quality scores.[ix] According to the Order, the Overlay Funds purported to require that an ESG quality review be performed for all equity investments prior to investment, or within 30 days after a corporate bond investment. Despite this representation, numerous investments made by certain Overlay Funds were found to have no ESG quality review score as of the time of investment.[x] Since the Overlay Funds did not require the ESG quality review (and such an ESG quality review was not always conducted), the Order states that the Adviser’s statements implying such a review was done with respect to investment decisions made for the Overlay Funds were materially misleading.

The Order illustrated several instances where the Adviser claimed that investment decisions for the Overlay Funds were subject to the ESG-quality review. For example, the Order found that the Adviser made misleading statements regarding ESG quality review practices within the Overlay Fund prospectuses filed with the SEC. The “Goal and Approach” section of the Overlay Funds’ prospectuses provided that the sub-adviser had a process that included “identifying and considering…[ESG] risks, opportunities, and issues throughout the research process . . . in an effort to ensure that any material ESG issues are considered.”[xi] However, the SEC found this was misleading because it failed to disclose that those ESG quality reviews were neither required nor prepared for all investments decisions made for the Overlay Funds.[xii] Additionally, board minutes show that the Adviser represented that “prior to making any investment” each investment would be assigned “a proprietary ESG quality review rating designed to ensure that any material ESG issued of the company are taken into consideration.”[xiii] However, because the Overlay Funds could and did include investments that were not subject to ESG-quality review, the SEC found this representation to be materially misleading.[xiv]

The Order also states that the Adviser made misleading statements in certain RFP responses to other investment firms evaluating the Overlay Funds for their own clients, where the Adviser suggested that ESG quality reviews were conducted for “every security” recommended by its affiliated sub-adviser.[xv] The SEC found these statements to be misleading because the Overlay Funds included portfolio investments that did not receive an ESG quality review score.[xvi] Similarly, the Order also highlights that the Adviser represented in an RFP response concerning its clients’ separately managed accounts that each security must have an ESG quality review, but the SEC found this to be inaccurate because the response was in reference to a strategy that tracked an Overlay Fund, which did not require the quality review before all investments.[xvii]

Finally, the Order provided that the Adviser lacked written policies and procedures reasonably designed to prevent the inaccurate, materially incomplete, or untrue statements in prospectuses, RFP responses, and board minutes, as described above. The Order states that Adviser compliance personnel were unaware before mid-March 2020 that quality reviews were not prepared for all Overlay Fund investments, and thus lacked the critical facts to determine if the relevant prospectuses and RFP responses complied with securities laws.[xviii]

Sanctions

The Adviser was ordered to cease and desist, was censured, and was ordered to pay a civil monetary penalty of $1.5 million.

Takeaways

• The SEC is clearly continuing to communicate its significant focus on ESG-related investment issues. This focus is further demonstrated by this Order (being the first notable enforcement action in the space), the numerous SEC statements and proposed rules related to ESG (including the two proposed rules released today, May 25, 2022), and the inclusion of ESG as an examination priority for the third consecutive year in the SEC Division of Examination’s Annual Priorities.
• If registered investment advisers (“RIAs”) or mutual funds apply ESG criteria and policies to only certain funds or strategies, disclosures and other communications should clearly identify which strategies or products those ESG criteria and policies apply to and which they do not. Likewise, if firms will apply ESG criteria to some but not all investment decisions, they should be particularly cautious in their descriptions of how ESG criteria are applies and be cautious to avoid indications or insinuations that the criteria are applicable to all investment decisions.
• Registrants should be aware of the need to be precise with language regarding the use of ESG criteria and processes not just in their disclosure documents, but in all communications (e.g., materials presented at board meetings, board minutes reflecting oral discussions at meetings, RFP responses, and other communications with clients).
• Registrants should ensure that funds or strategies that do not consider ESG factors in their investment processes avoid representing that they are “ESG conscious” or otherwise indicating that they consider such factors.
• RIAs and mutual funds should be cautious of advertising or describing a fund or product using the term “ESG” where the fund or strategy does not actually require ESG criteria be considered or ESG procedures be followed.
• Registrants should review their policies and procedures surrounding ESG criteria and policies, to ensure that the registration will be able to identify if ESG policies are being consistently applied as disclosed.
• Registrants should continue to monitor new ESG-related guidance and news as it becomes available, including SEC actions like the Order.