On November 4, the U.S. Securities and Exchange Commission issued a Risk Alert, warning fund managers of recurring issues the SEC is seeing in audits. While focused on other areas, the alert included a note that showed environmental, social, and governance has remained as an area of focus for the SEC, despite a winding down of major ESG initiatives. This is reflective of an overall shift in sustainability reporting from a new marketing tool to part of everyday business.
ESG is a form of investing that considers factors beyond strictly financial. While similar forms of investing have existed for decades, ESG saw a spike in 2020 and 2021 following a global push by fund managers and activists. As the name implies, ESG is divided into three categories: environmental, social, and governance. Globally, ESG is primarily focused on the environmental component with a direct link to the goal of the Paris Agreement to reduce greenhouse gas emissions by net zero by 2050.
In most jurisdictions, the social category is focused on basic human rights standards. In the U.S., companies focused on other social issues, including the Black Lives Matter movement and LGBTQ issues. This made ESG overly controversial as conservative lawmakers pushed back on the “woke” agenda. As ESG becomes more regulated, U.S. companies and funds are shifting towards a climate focus, with the majority of regulations requiring reporting of GHG emissions of the company and its energy provides.
While a lot of the focus of ESG has been on reporting standards for business, including sustainability reporting and climate related risk reporting, the actions of fund managers in the ESG realm have also seen increased regulation. The SEC enacted a series of rule changes aimed at fund managers to prevent a misrepresentation of the content of the fund and have subsequently penalized funds for violating those rules.
In April 2021, the SEC Division of Examinations issued a Risk Alert relating to ESG. The Division conducts exams, their terminology for reviews of SEC filings of publicly traded companies and investment funds for compliance with regulations.
Examinations are, in essence, narrow audits of the investment industry that include “analysis of an entity’s history, operations, services, products offered, and other risk factors.” The SEC began releasing examination priorities in 2011 as a guide for where the Division would focus for the upcoming fiscal year. They also issue periodic Risk Alerts updating companies of areas of focus and concern.
The April 2021 alert showed a new focus on ESG and stayed an annual priority until 2023, when it was quietly omitted. When the 2024 examinations priorities were released in October 2023, ESG was notably absent.
This absence aligns with a September 2023 amendment of the Investment Company Act, known as the “Names Rule”, to take into consideration ESG. The SEC has identified that most investors get their first impression of a fund from the name. Therefore, the name needs to reflect the investment strategy of the fund and is regulated under the Names Rule.
Under the 2023 amendment, funds with phrases related to environmental, social, or governance factors, including climate and sustainability, are forced to align 80% of the investment with those names. This is most likely the reason why ESG was removed from priorities in 2023 and is now reemerging, as it gave funds time to adjust to the new rule. ESG returned in a November 4 Risk Alert that addressed ESG claims made by funds.
In listing “examples of deficiencies or weaknesses observed by the staff related to funds’ disclosure issues”, the SEC stated:
“Sales literature, including websites, appeared to contain untrue statements or omissions of material fact. For example, funds described as “no-load” charged such fees. Funds also mischaracterized the use of environmental, social, and governance factors in their investment decision-making processes compared to their actual practices.”
While this signals a written shift in priorities, it aligns with the enforcement action of the SEC. On October 21, the SEC announced a penalty against WisdomTree Asset Management for misleading investors relating to ESG funds.
In a press release, the SEC stated, “According to the SEC’s order, from March 2020 until November 2022, WisdomTree represented in prospectuses for three ESG-marketed exchange-traded funds, and to the board of trustees overseeing the funds, that the funds would not invest in companies involved in certain products or activities, including fossil fuels and tobacco. However, the SEC’s order finds that the ESG-marketed funds invested in companies that were involved in fossil fuels and tobacco, including in coal mining and transportation, natural gas extraction and distribution, and retail sales of tobacco products.”
The SEC Division of Examinations found that action violated the Names Act and the Investment Advisers Act. “Without admitting or denying the SEC’s findings, WisdomTree agreed to a cease-and-desist order and censure and to pay a $4 million civil penalty.”
The return of ESG in an SEC Risk Alert is notable, but not a surprise. In a short time, ESG has established itself in the marketplace. Even with the Trump Administration’s promise to undo regulatory actions relating to ESG and climate change, expect some to remain in place within the SEC.
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