SEC Issues Risk Alert on ESG Investing


Traditional investing is continuously transforming since the early days of the stock market. Rather than simply putting money into traditional blue-chip dividend stocks like GE, Johnson & Johnson, AT&T, and others, many investors are approaching investments in a number of new ways.

One of these new methods of investing is called ESG investing, which stands for “environmental, social and corporate governance.” ESG investing focuses on socially-responsible companies that prioritize these three factors within their organizations.

This investing method has caught on with many investors, particularly young investors. Many studies have been completed showing that ESG companies outperform traditional companies, which often leads investors to choose these investments over traditional ones.

Although the idea of investing in responsible companies seems attractive (and possibly lucrative), be careful before investing in any ESG-related fund.

SEC Risk Alert

The Securities and Exchange Commission (SEC) recently issued a Risk Alert from the Division of Examinations on recent ESG-related findings. The SEC reviewed ESG-related practices of a number of firms within the financial services industry and published some common factors that are seen within the industry. Some of these practices were concerning to the SEC, which found that there are “various ways” in which firms approach ESG investing.

ESG Definitions and Standards

One issue that the SEC found regarding ESG investing involves firms’ definitions and standards of ESG investments. For instance, firms do not adhere to uniform ESG standards because the ESG approach varies based on a particular firm’s strategy.

This mismatch throughout the industry causes confusion for investors, especially if investors assume that a particular firm is adhering to the same standards as their competitors. The SEC found that the “variability and imprecision of industry ESG definitions and terms can create confusion among investors” when firms “have not clearly and consistently articulated how they define ESG and how they use ESG-related terms.”

Portfolio Guidelines, Restrictions, and Allocations

While traditional portfolio managers and clients establish factors such as guidelines, restrictions, and specific asset allocations within their portfolios, ESG funds must do the same.

Our firm has litigated many cases where investment advisors and professionals fail to adhere to these guidelines and restrictions that their clients established for them. This is a common problem within the financial services industry. For example, a client may only approve the investment advisor to allocate 20% of the portfolio to real estate. Some advisors fail to adhere to this restriction and allocate an unapproved amount of money (i.e., 50%), which violates the agreement that was established between the client and the advisor. Additionally, advisors may be limited to the amount of trades they are allowed to execute, but they fail to abide by such restrictions. This also violates the agreement made between the advisor and the client.

Portfolio Management Practices

Similarly, the SEC has found instances where portfolio management practices “differed from client disclosures in required disclosure documents,” which includes offering materials, due diligence documents, and other important items required before making an investment with an advisor. Additionally, the SEC found “weaknesses in policies and procedures governing implementation and monitoring of the advisers’ clients’ or funds’ ESG-related directives.” For example, if a client tells an advisor that he or she does not wish to invest in a particular industry that violated his or her personal ESG standards, advisors did not have “adequate controls or systems” to monitor these client concerns.

Potentially Misleading Claims

Another crucial finding in the recent SEC Risk Alert involved “potentially misleading claims regarding ESG approaches.” While this sounds similar to the previous points mentioned above, there are some important distinguishing characteristics. The SEC found examples of ESG funds that distributed marketing materials to clients “without disclosing material facts regarding the significant expense reimbursement they received from the fund-sponsor, which inflated returns for those ESG-oriented funds.” Essentially, this means that advisors have pitched investment products to clients without disclosing potential conflicts of interest in selling the products.

Often times, we have seen many financial advisors and investment professional pitch products to clients because they received substantial sales commissions from the investment sponsors (i.e., the company/individual running the investment). This is a conflict of interest that may certainly stand in the way of fiduciary duties that advisors owe to their clients.

Good Practices

As part of the recent Risk Alert, the SEC also noted good business practices of firms creating and offering ESG investment products. For example, firms should provide disclosures that are “clear, precise, and tailored to firms’ specific approaches to ESG investing, and which aligned with the firms’ actual practices.” This includes complete information on the offering, proper ESG definitions and factors, and full explanations of investment evaluations and assessments.

The SEC also noted that firms offering ESG investment products should establish policies and procedures that reflect the goals and practices of the investment firm. This includes “research, due diligence, selection, and monitoring” of stocks that conform to particular ESG investments.

Thus, if you are deciding to look into ESG investing as a new investment approach, make sure to be aware of the potential risks of this fast-moving approach. When new opportunities start to become popular in the marketplace, there is no shortage of scam artists and incompetent companies looking to take advantage of unsuspecting clients.

Call our firm today at (239) 319-4434 for a confidential, no-cost consultation if you suspect investment fraud in your portfolio. Vernon Litigation Group represents clients across the nation in a full range of financial litigation matters, including securities litigation, investor representation, business litigation, real estate litigation, and more.