The recent exponential asset growth of environmental, social, and governance (“ESG”) based investment funds reflects a major shift in the decision-making process of many investors. According to Morningstar, a Chicago-based independent investment research firm, approximately $51 billion was invested into ESG funds in 2020. This was more than double the total for 2019 and nearly 10 times more than in 2018. The global trend toward social and environmental impact investing accelerated in the first quarter of 2021, with ESG fund investments outpacing the last four consecutive quarters, cresting at $2 trillion.
This remarkable shift in investor sentiment has been fueled by snowballing concerns about such issues as climate change, racial justice, and gender equality. Investors have responded with increased intentionality when it comes to the deployment of capital. This rapid societal change, however, has created a wave of confusion and prompted the U.S. Securities and Exchange Commission (SEC) to take new steps to protect investors.
A recent survey conducted by the CFA Institute shows that 33% of professional investors surveyed feel they have insufficient knowledge for considering ESG issues. Marketers have been pushing new funds at a breakneck pace without clear, consistent industry standards for ESG investing. The SEC has responded by prioritizing its enforcement of ESG-related issues in 2021.
The Securities Act of 1933 and the Securities Exchange Act of 1934 require that publicly traded companies make appropriate ESG disclosures in places such as Form 10-Ks where other financial and performance related disclosures are made. Several bills also have been introduced in Congress that would necessitate companies issue additional ESG disclosure above that which is already required.
Companies disclosing more and more about their environmental footprint, how they treat their employees, and how their leadership operates is becoming the status-quo. Unfortunately, not all of the disclosures have been accurate, and certain material items have been omitted. In some instances, companies distort disclosures in an attempt to “greenwash” investments, products and/or operations. Greenwashing is generally defined as conveying a false impression or providing misleading information about how a company’s products are environmentally sound. Consider, for example, electric-car maker Tesla Inc., which is generally regarded as an ESG-friendly company, but only two of its three debt offerings qualified as green. Also, consider the May 2021 class-action lawsuit filed against the company that owns and produces Hefty trash bags. This lawsuit alleges that Hefty claimed on product packaging that the bags are designed to handle all types of recyclables, when in actuality, the product actually contaminates the would-be recyclable waste (the lawsuit is still pending as of this RMT).
In March, the SEC created a Climate and ESG Task Force to focus on reviewing the filings made by publicly traded companies and funds in order to identify and red flag any examples of greenwashing.  Although substantial work is yet to be done by the SEC to craft a comprehensive ESG disclosure framework, the Task Force will make note of any misrepresentations, omissions, overstatements, or obscurifications related to ESG investing and refer matters to enforcement, as necessary.
What steps should your firm take to bolster ESG compliance and avoid a potential SEC deficiency letter? Here are 10 suggestions:
- When it comes to the ‘E’ or environmental requirement of ESG, make certain your firm is in compliance with all relevant environmental, sustainability, climate, pollution, and air quality laws and clearly disclose any situation in which an environmental agency has cited or fined your firm for any shortcomings.
- The ‘S’ or social aspect of ESG deals with such things as consumer protection, animal welfare, and human-rights issues and the health and safety of employees. For instance, if a company is relying on child labor in overseas factories, there are certain disclosures that must be made. The level of diversity and inclusion in a company’s recruitment and management policies is important to many investors as well as regulators. Disclosure of the use of animal testing for a company’s products is important.
- The ‘G’ or governance aspect of ESG is concerned with the way your company is run. This includes its management structure, employee relations, board diversity, business ethics, anti-competitive practices, executive compensation and employee compensation. Investigating a company’s management and its rights and responsibilities helps assess the corporate responsibility and in many ways, values.
- Your firm’s senior management team should engage with internal and external stakeholders to define and assess the material ESG issues specific to your organization. Only then can there be a useful dialogue among senior management, the board of directors, legal counsel, and compliance to develop appropriate policies and procedures to ensure accuracy and consistency of all ESG-related disclosures.
- Conduct a peer analysis to benchmark the practices of other companies within your industry and determine how they are addressing ESG disclosure issues.
- Conduct internal risk assessments – including a review of all advertising and public-facing materials, websites, client presentations, and due diligence questionnaires – to evaluate legal risk and potential reputational harm.
- Make certain proxy voting decision-making processes, such as executive compensation, are consistent with ESG disclosures and marketing
- Address any gaps identified by the risk assessments to review, reassess, and revise polices, processes, and procedures, as needed.
- Consider taking steps to document and maintain records relating to important stages of the ESG investing process.
- Integrate compliance personnel into your firm’s ESG-related processes, approaches, and practices, to avoid materially misleading claims in ESG-related marketing efforts.
Overall, stakeholders, including investors believe that non-financial performance related disclosure, such as ESG, provides critical insights into how a company’s management team navigates regulatory, social, global, and political risks and opportunities. Following this roadmap should provide assurance that disclosures are complete, robust, and to the satisfaction of the SEC, but will also help stakeholders see the big picture while strengthening the company’s brand and reputation.
JLG works extensively with investment ESG advisers, broker-dealers, investment companies, private equity and hedge funds, banks and corporate clients on securities and corporate counsel matters. For more information, please visit https://www.jackolg.com/.
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 See https://www.sec.gov/sec-response-climate-and-esg-risks-and-opportunities
 CFA Institute (Dec. 2020)
 See https://www.sec.gov/news/press-release/2021-39