SEC Division of Examinations Issues ESG Risk Alert

APR 21, 2021 | PRACTUS LLP

SEC Division of Examinations Issues ESG Risk Alert

Authored by Richard Pasquier

Introduction and Overview

On April 9, 2021, the Division of Examinations (DEX) of the Securities and Exchange Commission (SEC) issued a Risk Alert reflecting its review of environmental, social and governance (ESG) investing (ESG Risk Alert).  The ESG Risk Alert highlights observations from recent DEX examinations of registered investment companies, private funds (collectively, funds) and investment advisers offering ESG products and services.

The ESG Risk Alert is one of a series of recent SEC and staff initiatives in the ESG space.  Other initiatives include:

  • a request for public input from investors, registrants, and other market participants on climate change disclosure;
  • a direction to the SEC’s Division of Corporation Finance to to enhance its focus on climate-related disclosure in public company filings;
  • the creation of a climate and ESG Task Force in the SEC’s Division of Enforcement; and
  • the issuance of an ESG Funds Investor Bulletin.


The ESG Risk Alert first notes that ESG investing encompasses a variety of investment techniques, including:

  • integration (considering ESG factors alongside many other factors, such as macroeconomic trends or company-specific factors like a price-to-earnings ratio);
  • exclusionary screening/divestment (screens out);
  • positive screening (screens in/best in class);
  • impact investing (investment made with intention to measurable E, S or G-related benefits);
  • engaging with companies to encourage them to improve specific E, S, and/or G practices; and
  • sustainable investing (investment in themes/assets specifically related to sustainability; which can include S and G as well as E).

The ESG Risk Alert notes that the variability and imprecision of industry ESG definitions and terms can create confusion among investors if investment advisers and funds have not clearly and consistently articulated how they define ESG and how they use ESG-related terms, especially when offering products or services to retail investors.

1. Examinations of Investment Advisers and Funds:

DEX staff will continue to examine firms to evaluate whether they are accurately disclosing their ESG investing approaches and have adopted and implemented policies, procedures, and practices that conform with their ESG-related disclosures.  Particular areas of focus will include:

  • Portfolio management.  Examinations will include a review of the firm’s policies, procedures, and practices related to ESG and its use of ESG-related terminology; due diligence and other processes for selecting, investing in, and monitoring investments in view of the firm’s disclosed ESG investing approaches; and whether proxy voting decision-making processes conform to ESG disclosures and marketing materials;
  • Performance advertising and marketing Examinations will include a review of the firm’s regulatory filings; websites; reports to sponsors of global ESG frameworks (e.g., Principles for Responsible Investment (PRI)), to the extent the firm has advised clients and potential clients that it will follow such frameworks; client presentations; and responses to due diligence questionnaires, requests for proposals, and client/investor-facing documents, including marketing materials; and
  • Compliance programs.  Examinations will include a review of the firm’s written policies and procedures and their implementation, compliance oversight, and review of ESG investing practices and disclosures.

2. DEX Staff Observations

The ESG Risk Alert notes that the DEX staff observed instances of potentially misleading statements regarding ESG investing processes and representations regarding adherence to global ESG frameworks.  The DEX staff noted, despite claims to have formal processes in place for ESG investing, certain firms lacked policies and procedures related to ESG investing; policies and procedures that did not appear to be reasonably designed to prevent violations of law, or that were not implemented; weak or unclear documentation of ESG-related investment decisions; and compliance programs that did not appear to be reasonably designed to prevent inaccurate ESG-related disclosures and marketing materials.  Specific findings included:

  • Portfolio management practices were inconsistent with disclosures about ESG approaches. DEX staff observed portfolio management practices that differed from client disclosures in required disclosure documents (e.g., Form ADV Part 2A) and other client/investor-facing documents (e.g., advisory agreements, offering materials, responses to requests for proposals, and due diligence questionnaires). For example, DEX staff noted that firms that claimed to adhere to global ESG frameworks failed to do so, and also observed issuers with low ESG scores – as measured, for example, by a sub-adviser’s proprietary internal scoring system – predominating in a fund portfolio in instances where the firms’ stated approaches would not imply that these issuers would predominate. 
  • Controls were inadequate to maintain, monitor, and update clients’ ESG-related investing guidelines, mandates, and restrictions DEX staff noted weaknesses in policies and procedures governing implementation and monitoring of the advisers’ clients’ or funds’ ESG-related directives.  For example, DEX staff observed that advisers failed to put in place adequate controls around implementation and monitoring of clients’ negative screens (e.g., prohibitions on investments in certain industries), especially if the directives were ill-defined, vague, or inconsistent.  Advisers also failed to implement adequate systems to consistently and reasonably track and update clients’ negative screens, which could result in prohibited securities being included in client portfolios.  DEX staff also noted that many advisers that marketed their ability to implement clients’ positive screens were unable in practice to effectively implement or monitor those screens. 
  • Proxy voting may have been inconsistent with advisers’ stated approaches.  DEX staff observed inconsistencies between advisers’ public ESG-related proxy voting claims and their internal proxy voting policies and practices.  For example, DEX staff observed public statements that ESG-related proxy proposals would be independently evaluated internally on a case-by-case basis to maximize value, while internal guidelines generally did not provide for such case-by-case analysis.  DEX staff also noted certain advisers publicly claimed clients could vote separately on ESG-related proxy proposals, but clients were never permitted to do so. 
  • Unsubstantiated or otherwise potentially misleading claims regarding ESG approaches. DEX staff observed unsubstantiated or otherwise potentially misleading claims regarding ESG investing in various contexts. For instance, DEX staff reviewed marketing materials for some ESG-oriented funds that touted favorable risk, return, and correlation metrics related to ESG investing without disclosing material facts regarding the significant expense reimbursement they received from the fund-sponsor, which inflated returns for those ESG-oriented funds.  DEX staff also found certain advisers made unsubstantiated claims regarding their substantial contributions to the development of specific ESG products, when, in fact, their roles were very limited or inconsequential. 
  • Inadequate controls to ensure that ESG-related disclosures and marketing are consistent with the firm’s practices. DEX staff observed inconsistencies between actual firm practices and ESG-related disclosures and marketing materials due to deficiencies in controls over public disclosures and client/investor-facing statements. For example, DEX staff observed firms that failed to conform to global ESG frameworks despite claims to the contrary, unsubstantiated claims regarding investment practices (e.g., only investing in companies with “high employee satisfaction”), and a lack of documentation of ESG investing decisions and issuer engagement efforts. In addition, the DEX staff observed failures to update marketing materials timely (e.g., an adviser continuing to advertise an ESG investment product or service it no longer offered). 
  • Compliance programs did not adequately address relevant ESG issues. DEX staff observed that certain investment advisers substantially engaged in ESG investing lacked policies and procedures addressing their ESG investing analyses, decision-making processes, or compliance review and oversight. For instance, DEX staff identified compliance programs that did not address adherence to global ESG frameworks to which the firms claimed to be adhering. DEX staff also noted a lack of policies and procedures to ensure firms obtained reasonable support for ESG-related marketing claims, and observed inadequate policies and procedures regarding oversight of ESG-focused sub-advisers. Firms also had difficulties in substantiating adherence to stated investment processes (e.g., supporting claims made to clients that each fund investment had received a high score for each separate component of ESG (i.e., environmental, social, and governance), when relying instead on composite ESG scores provided by a sub-adviser. 
  • DEX staff also observed that compliance programs were less effective when compliance personnel had limited knowledge of relevant ESG-investment analyses or oversight over ESG-related disclosures and marketing decisions. For example, compliance controls and oversight for reporting to sponsors of global ESG frameworks and responses to requests for proposals and due diligence questionnaires appeared to be ineffective. In addition, DEX staff noted weaknesses in compliance controls regarding performance metrics included in marketing materials (such as risk, returns, and correlation metrics), and a lack of compliance review of the data underlying those measures. 

3. Staff Observations of Effective Practices 

DEX staff also noted that certain investment advisers and funds successfully crafted disclosures that accurately conveyed material aspects of the firms’ approaches to ESG investing.  DEX staff also noted advisers and funds with policies, procedures and practices that appeared to DEX to be reasonably designed in light of their particular approaches to ESG investing.  These practices include:

  • Disclosures that were clear, precise and tailored to firms’ specific approaches to ESG investing, and which aligned with the firms’ actual practices In particular, DEX staff observed:
    • Simple and clear disclosures regarding the firms’ approaches to ESG investing, such as where advisers prominently stated, among other communications, that for separately managed client accounts, their ESG investing approach involved relying on unaffiliated advisers to conduct the underlying ESG analysis and allocating client assets among ESG-oriented mutual funds managed by those unaffiliated advisers. 
    • ESG factors that could be considered alongside many other factors. For example, the DEX staff observed that firms could still satisfy the requirements of certain global ESG frameworks while making investments that appeared to be inconsistent with ESG investing. Clear and prominent disclosures regarding such practices served to notify clients and investors that adherence to certain global ESG frameworks did not necessarily mean that all investments would be “ESG-friendly.
    • Explanations regarding how investments were evaluated using goals established under global ESG frameworks. The DEX staff observed, for example, investment statements posted on adviser websites, client presentations, and annual reports detailing how firms approached PRI.
  • Policies and procedures that addressed ESG investing and covered key aspects of the firms’ relevant practices. In particular, DEX staff noted detailed investment policies and procedures that addressed ESG investing, including specific documentation to be completed at various stages of the investment process (e.g., research, due diligence, selection, and monitoring). DEX staff observed that these types of detailed, comprehensive investment policies and procedures resulted in contemporaneous documentation of the ESG factors considered in specific investment decisions. Furthermore, where multiple ESG investing approaches were employed at the same time, specific written procedures, due diligence documentation, and separate specialized personnel provided additional rigor to the portfolio management process. 
  • Compliance personnel that are knowledgeable about the firms’ specific ESG-related practices. DEX staff noted that, where compliance personnel were integrated into firms’ ESG-related processes and more knowledgeable about firms’ ESG approaches and practices, firms were more likely to avoid materially misleading claims in their ESG-related marketing materials and other client/investor-facing documents. 


ESG means different things to different people.  Moreover, ESG scores historically have been poorly correlated with each other.1  Consequently, different products that claim to be ESG friendly may have wildly divergent strategies, screens and holdings.  Moreover, the range of funds and accounts that can be categorized as having an ESG strategy make comparisons fiendishly difficult.  However, the lack of standardization does not provide funds and advisers with carte blanche to do and say anything.  Instead, funds and advisers must clearly disclose which type of ESG strategy they intend to follow, implement policies and procedures reasonably designed to ensure that they do in fact follow the stated strategy, monitor to ensure that policies and procedures are being followed, and ensure that the marketing materials align with the actual management practices of the adviser.  

The Authors
Richard Pasquier
Read Full Bio

Practus, LLP provides this information as a service to clients and others for educational purposes only. It should not be construed or relied on as legal advice or to create an attorney-client relationship. Readers should not act upon this information without seeking advice from professional advisers.


 Poor scores:  Climate change has made ESG a force in investing, but the figures behind ESG rating systems are dismal (Economist, Dec. 7, 2019) ( (subscription required).

Search Icon