A Private Fund’s Guide to ESG Compliance

Ranah Esmaili, Stephen L. Cohen, and Nader Salehi are partners at Sidley Austin LLP. This post is based on their Sidley memorandum. Related research from the Program on Corporate Governance includes The Illusory Promise of Stakeholder Governance by Lucian A. Bebchuk and Roberto Tallarita (discussed on the Forum here); For Whom Corporate Leaders Bargain by Lucian A. Bebchuk, Kobi Kastiel, and Roberto Tallarita (discussed on the Forum here); Socially Responsible Firms by Alan Ferrell, Hao Liang, and Luc Renneboog (discussed on the Forum here); and Restoration: The Role Stakeholder Governance Must Play in Recreating a Fair and Sustainable American Economy—A Reply to Professor Rock by Leo E. Strine, Jr. (discussed on the Forum here).

The U.S. Securities and Exchange Commission (SEC) has recently turned its attention to private fund managers that consider Environmental, Social and Governance (ESG) factors as part of their process for selecting portfolio investments. The SEC’s primary focus is on “greenwashing,” the practice of conveying a false image to investors that a product is ESG-friendly. The SEC’s Division of Examinations (EXAMS) has been examining private fund managers on ESG investment selection and portfolio management processes, use of proprietary and third-party scoring systems, marketing materials, proxy voting procedures, and policies and procedures relating to ESG.

In this post, we discuss the SEC’s recent focus on ESG, including the compliance risks associated with ESG investing, and identify concrete steps fund managers can take to ensure compliance. Those steps include conducting an internal review of ESG-related disclosures against practices, controls, and policies and procedures, and preparing for a possible SEC examination concerning ESG investing.

SEC’s ESG Developments

The SEC’s focus on ESG disclosure, which began under Acting Chair Allison Lee, continues to be a priority under Chair Gary Gensler, who was sworn into office on April 17, 2021.

On February 1, 2021, as one of her first significant public actions, Lee appointed the first-ever Senior Policy Advisor for Climate and ESG. The following month, Lee announced an Enforcement Task Force focused on climate and ESG issues and requested public input on climate change disclosures. While nearly all of the 15 questions posed in Lee’s request for public comment focused on public issuer disclosure, one item asked how the Commission’s rules should address “its oversight of certain investment advisers and funds.”

The SEC’s attention to private funds’ ESG investments became evident with the 2021 Examination Priorities, published on March 3, 2021, which identified ESG disclosures by investment advisers and funds as an examination priority. On April 9, 2021, EXAMS issued a risk alert highlighting observations from recent exams of investment advisers, registered investment companies, and private funds offering ESG products and services.

After being sworn into office in April, Chair Gensler appointed a policy director who was previously the Head of U.S. Policy at the Principles for Responsible Investment, where she supported policies promoting the integration of ESG factors into investment decision-making. Gensler testified before the House of Representatives Financial Services Committee that he expects to propose new disclosure rules on climate risk and human capital in the second half of 2021. On June 14, 2021, the SEC announced its annual regulatory agenda, which included recommending proposed requirements for investment companies and investment advisers related to ESG factors, including ESG claims and related disclosures.

Areas of Focus for Private Funds

The 2021 Examination Priorities and risk alert together help identify traps for the unwary. In their examinations of registrants, EXAMS can be expected to:

  • review the consistency and adequacy of disclosures on ESG strategies
  • determine whether the firms’ processes and practices match their disclosures
  • review marketing materials (including due diligence questionnaires) for false or misleading statements
  • review proxy voting policies and procedures and votes to assess whether they align with the strategies

Deficiencies identified by EXAMS and described in the Risk Alert include circumstances where:

  • portfolio management practices were inconsistent with disclosures about ESG approaches
  • controls were inadequate to maintain, monitor, and update clients’ ESG-related investing guidelines, mandates, and restrictions
  • proxy voting may have been inconsistent with advisers’ stated approaches
  • advisers made unsubstantiated or otherwise potentially misleading claims regarding ESG approaches
  • controls were inadequate to ensure that ESG-related disclosures and marketing were consistent with the firm’s practices
  • compliance programs did not adequately address relevant ESG issues

What This Means for You

The SEC’s focus on ESG issues is here to stay. While there will be ESG rulemaking down the road, private fund managers will continue to be subject to the general disclosure framework under the Investment Advisers Act of 1940. Private fund managers will be expected to speak with complete accuracy when describing their investment process and stewardship, despite the challenges resulting from variability of industry ESG definitions and the lack of consistency in ESG disclosures by issuers. With increased demand from institutional investors for ESG investments as an asset class, private fund managers will need to balance carefully the pressure to address ESG issues against the regulatory scrutiny of ESG investing. Moreover, private fund managers that are required, or wish, to comply with the European Union Sustainable Finance Disclosure Regulation will need to consider how to make required disclosures in a manner that also passes U.S. regulatory scrutiny.

Here are key questions you should be asking about your ESG program:

  • Is your fund labeled as an ESG-related fund or do your disclosures state that your investment professionals consider ESG factors in making investment decisions? If so, do you have documented policies and procedures regarding how ESG factors are defined and measured as well as how they are considered and weighted against other investment objectives?
  • Do your disclosures state that you conduct ongoing due diligence on portfolio investments for ESG factors? If so, do you have disclosure of any limitations on such due diligence as well as procedures in place to ensure that this due diligence is occurring as disclosed?
  • Do your disclosures make claims about ESG goals, metrics, or performance results? If so, do you have controls and documentation in place to support those claims?
  • Do your disclosures make claims about your stewardship activity, including proxy voting? If so, do you have written procedures in place to ensure that this stewardship is occurring?
  • Do you document your ESG investment and/or due diligence processes so that you can substantiate adherence to disclosed processes to your examiners?
  • Do your compliance professionals have sufficient insight into and oversight over the investment and/or due diligence procedures to be effective?

What Should You Do?

There are concrete steps you can take to ensure you are prepared for the increasing regulatory scrutiny in this area. You will want to be informed and prepared in the following areas:

  • conducting an internal review of your ESG-related disclosures against practices, controls, and policies and procedures
  • preparing for an examination given EXAMS’ announced focus on ESG investing by private fund advisers
  • consulting with experienced counsel in connection with examination or enforcement inquiries to get the benefit of broad experience in similar circumstances
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