RIA Compliance and Practice Management Blog

How RIAs can address the top ESG compliance concerns

Posted by RIA in a Box

Sep 13, 2022 2:29:42 PM

ESG compliance for RIAs (1)

ESG (environmental, social and governance) investment strategies have increasingly become a focus for sustainability conscious investors. Annual cash flow into sustainable funds more than doubled from 2019 to 2020 – and ESG funds hit a record high in 2021, with more than $120 billion invested. 

 For registered investment advisers (RIA), offering ESG strategies and investment products is almost non-negotiable, particularly for firms interested in serving younger generations.  

As ESG investing continues to grow, it’s important for advisers to understand how to navigate the Securities and Exchange Commission's (SEC) related compliance concerns. 

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The SEC recently released its 2022 exam priorities, listing ESG-related advisory services and investment products as a primary focus. This includes mutual funds, exchange-traded funds and private fund offerings.  

The SEC’s primary concerns focus on whether RIAs and registered funds properly and accurately disclose ESG investing approaches and policies, and whether they have adopted and implemented policies, procedures and practices to prevent federal violations connected to ESG-related disclosures.  

SEC examinations will also look for misrepresentations of ESG factors considered or incorporated into portfolios, as well as whether the voting of client securities aligns with ESG disclosures and mandates. 

The SEC’s primary ESG compliance concerns 

Firms using ESG investing, or considering adding offerings to their services, should pay close attention to these three areas: 

  • Portfolio management. 
  • Performance advertising and marketing. 
  • Compliance programs. 

Let’s dive deeper into some potential compliance stumbling blocks for advisory firms leveraging ESG investing, as well as how to avoid them. 

  1. Portfolio management practices differ from ESG disclosures

Information in required disclosure documents, such as Form ADV Part 2A, as well as client-facing documents, including due diligence questionnaires, advisory agreements and RFP responses, doesn’t match actual portfolio management practices. This can include a lack of adherence to global ESG frameworks or maintaining fund holdings with low ESG scores. 

  1. Not enforcing ESG guidelines

Weaknesses in policies and procedures put in place to guide the implementation and continued observation of ESG directives. This can include a lack of process or control around the implementation and ongoing monitoring of clients’ negative screens, such as aversions to investing in the alcohol, tobacco or firearms industries. This also applies to an inability to include clients’ positive screens consistently and effectively, despite claiming to do so. 

  1. Inconsistencies between proxy voting claims and internal voting

This occurs when public claims don’t match internal ESG policies, such as making public statements about a firm’s consistent evaluation of ESG proposals without implementing adequate processes and guidelines internally to enable such evaluations. This also occurs when claiming clients can vote on ESG proposals without actually giving them the opportunity to do so. 

  1. Misleading claims about ESG investing

When firms make unsubstantiated or disingenuous statements about their ESG services and/or approach. This can include inflating ESG returns by marketing favorable risk, return and correlation metrics, but failing to provide critical information about fund sponsor expense reimbursement. Advisors should also take caution not to overinflate their contributions to the development of ESG products. 

  1. Inconsistencies between ESG disclosures, marketing materials and firm practices

When proper controls aren’t put in place, firms can be at risk of not ensuring disclosures and marketing materials align with what a firm is actually doing. This can include claiming to adhere to global ESG frameworks without actually doing so, making unsubstantiated investment claims, allowing ESG marketing materials to become outdated, and failing to document ESG investing decisions. 

  1. Inadequate ESG compliance programs

When firms leveraging ESG investment strategies fail to put oversight policies and procedures in place. Advisors should ensure their compliance programs adhere to relevant global ESG frameworks and stated investment processes, as well as monitor ESG-focused sub-advisors.  

  1. Not giving compliance personnel access to ESG information

When compliance teams aren’t given adequate opportunities to review ESG-related investment analyses, disclosures and marketing materials. Compliance personnel should be able to maintain oversight into reporting to sponsors of ESG frameworks, RFP responses and due diligence questionnaire answers, as well as performance metrics included in marketing collateral. 

Tips for maintaining compliance 

Whether your firm has offered ESG strategies for years, or is just getting started, you should follow these guidelines to ensure your practices align with the SEC’s compliance regulations.  

Your disclosures should plainly and thoroughly detail your firm’s approach to ESG investing. Use simple language to explain:  

  • Your firm relies on unaffiliated advisors to conduct underlying ESG analysis for separately managed client accounts. 
  • Disclosures about investments are incongruous with ESG investing strategies. 
  • How investments were evaluated in accordance with global ESG frameworks. 

Create detailed policies and procedures, which cover your approach to ESG investing, including specifics related to research, due diligence, selection and ongoing monitoring. Make sure this documentation also clearly notes the ESG factors considered in specific investment decisions, as well as how your firm navigates using multiple ESG investment approaches simultaneously. 

Make sure your compliance personnel are kept up to date on all ESG-related practices at your firm, so they can:   

  • Help avoid misleading claims. 
  • Ensure your disclosures are adequate. 
  • Pressure-test policies and procedures. 
  • Determine if your portfolio management process is consistent with your actual practices. 
  • Make sure you continue adhering to client investment preferences. 

Keeping up with ESG compliance regulations is complicated, but don’t let it stop you from introducing ESG strategies at your firm. RIA in a Box can help you stay on top of the latest SEC examination priorities.

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Topics: RIA Operations, RIA Compliance, RIA Technology

RIA in a Box LLC is not a law firm, investment advisory firm, or CPA firm. RIA in a Box LLC does not provide legal advice or opinions to any party or client. You should always consult your relevant regulatory authorities or legal counsel if applicable.

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