August 10, 2021

A Regulatory Framework for ESG Investing is on the Horizon

The Securities and Exchange Commission’s (SEC) Division of Examinations Conducted a Review of ESG Investing

By Keith Coyle, CPA, Senior Manager, Alternative Investment Group

A Regulatory Framework for ESG Investing is on the Horizon Alternative Investments

The growth of environmental, social, and governance (ESG) investing over the last several years has prompted regulators, such as the SEC, to increase its focus on funds that promote ESG investment-related products and services.

The SEC’s Division of Examinations (the Division) exists to protect investors, ensure market integrity, and support responsible capital formation through risk-focused strategies. When the Division conducts an examination, its findings are used by the SEC to inform rule-making initiatives, identify and monitor risks, improve industry practices, and pursue misconduct.

Here, we’ll review the results of the Division’s recent examination of ESG investing with an eye toward what investors and advisors need to know when choosing to invest in and offer ESG related products and services. But first, here’s a primer on ESG investing.


ESG investing is a form of investing that considers not only the financial performance of the company but also its overall impact on the community, market, and environment. The demand for investment advisors, registered investment companies, and private funds (collectively, funds) to incorporate ESG factors into their investment portfolios has increased significantly over the last several years. According to Morningstar, in 2020, ESG-focused funds captured $51.1 billion of net new money from investors, up from roughly $21 billion in 2019 (and an annual record for the fifth consecutive year). In addition, according to Bloomberg, in 2020, ESG ETF assets surpassed $190 billion and accounted for approximately 13% of global ETF asset growth.

ESG investing offers investors a way to align investment opportunities with their values by factoring in a company’s impact on the environment, its social impact (both within the company and within the community), and how the company’s board and management demonstrate leadership and good corporate governance.

Environmental Social Governance
Energy use, greenhouse gas/carbon emissions, waste management, air and water pollution, natural resource conservation, etc. Data protection and privacy, health and safety, human rights, labor standards, community relations, etc. Management and board composition, executive and employee compensation, political contributions, etc.

Current Frameworks

Global frameworks and tools, such as the United Nations’ Principles for Responsible Investment (PRI), the Global Reporting Initiative, the Sustainability Accounting Standards Board (SASB), and the Global Impact Investing Network (GIIN), have existed for 10+ years. Each provides standards for responsible investment, as well as guidance on reporting, measurement, and improvement to impact performance.

In addition, as the importance of ESG investing has grown in the minds of shareholders and investors, third-party research companies, such as Bloomberg, JUST Capital, MSCI, and Refinitiv, have developed ways of numerically measuring a company’s ESG activities by issuing questionnaires and surveys. Researchers also review annual reports, corporate sustainability measures, resource/employee/financial management, and board structure and compensation. The higher the score, the better the company fulfills the ESG criteria.

Exam Findings and Risk Alert

In response to this demand and the increase in funds and separately managed accounts offering ESG-related investment products, on April 9, 2021, the Division issued a risk alert to highlight observations from its recent exam of funds and separately managed accounts. The overall takeaway from the review was that firms approach ESG investing in very different ways, and due to certain factors including the rapid growth in demand; the various standards and rating scales available; and the increasing number of ESG products offered, the investment industry needs clearer ESG definitions and more consistency between firms’ ESG investing practices and the investment processes that are disclosed in the offering documents.

Some firms consider ESG factors alongside many other factors like macro-economic trends, price-to-earnings ratios, market capitalization, and portfolio diversification. Other firms focus on a particular ESG factor, such as investing in companies that focus on energy conservation, animal welfare, or data protection. Still others focus on a range or subset of ESG themes.

In addition, the risk alert provides the Division’s observations of funds’ effective practices, as well as deficiencies and internal control weaknesses found during the examinations. These observations are designed to highlight risk areas and assist firms in developing and enhancing their compliance practices when it comes to investing in ESG-related products and services. Highlights are outlined below.

The Division’s Observations of Deficiencies and Internal Control Weaknesses

  • Portfolio management practices were inconsistent with disclosures about ESG approaches. Portfolio management practices differed from client disclosures in Form ADV and other advisory agreements; offering documents; and due diligence questionnaires.
  • Controls were inadequate to maintain, monitor, and update clients’ ESG-related investing guidelines, mandates, and restrictions. Advisors did not have sufficient controls in place around the implementation and monitoring of clients’ negative screens (i.e., prohibitions on investments in certain industries, such as tobacco, alcohol, or firearms), which leads to the risk of including prohibited securities in client portfolios.
  • Proxy voting may have been inconsistent with advisors’ stated approaches. Inconsistencies exist between public ESG-related proxy voting claims and internal proxy voting policies and practices. Most notably, the Division cited instances in which public claims were made about a client’s ability to vote separately on ESG-related proxy proposals; however, clients were never provided such opportunities, and no policies concerning these practices existed.
  • Unsubstantiated or otherwise potentially misleading claims regarding ESG approaches. Marketing materials that touted favorable risk, return, and correlation metrics related to ESG investing were distributed to prospective investors without disclosing material facts regarding the significant expense reimbursement received from the fund sponsor. In addition, the Division observed unsubstantiated claims by advisors about their substantial contributions to the development of specific ESG products, when in fact, their roles were very limited.
  • Inadequate controls to ensure that ESG-related disclosures and marketing are consistent with the firm’s practices. A lack of adherence to global ESG frameworks existed despite claims to the contrary. In addition, the Division observed a failure to update marketing materials in a timely fashion, which led to firms advertising ESG-related products that are no longer offered.
  • Compliance programs did not adequately address relevant ESG issues. Policies and procedures that addressed ESG investing analyses, decision-making processes, or compliance review and oversight were lacking. Mainly, firms had trouble substantiating adherence to stated investment processes, such as supporting claims made to clients that each fund investment received a high score for each separate component of ESG (i.e., environmental, social, and governance).

Not everything the Division examined fell short. Here are a few strengths noted in the findings.

The Division’s Observations of Effective Practices

  • Disclosures that were clear, precise, and tailored to firms’ specific approaches to ESG investing, and which aligned with the firms’ actual practices. The Division observed instances of clear disclosures in client-facing materials where clients were offered choices of standardized portfolios focused on particular ESG issues, or of customized, separately managed accounts designed to accommodate particular client preferences.
  • Policies and procedures that addressed ESG investing and covered key aspects of the firms’ relevant practices. Detailed investment policies and procedures that addressed ESG investing, including specific documentation to be completed at various stages of the investment process, were also noted in certain cases (i.e., research, due diligence, selection, and monitoring).
  • Compliance personnel that were knowledgeable about the firms’ specific ESG-related practices. The Division observed that, when compliance personnel were more knowledgeable about firms’ ESG approaches and practices, firms were more likely to avoid materially misleading claims in their ESG-related marketing materials and other client/investor-facing documents. The compliance personnel in these firms appeared to: provide more meaningful reviews of firms’ public disclosures and marketing materials; test the adequacy and specificity of existing ESG-related policies and procedures, if any; evaluate whether firms’ portfolio management processes aligned with their stated ESG investing approaches; and test the adequacy of documentation of ESG-related investment decisions and adherence to clients’ investment preferences.

Examinations will continue in 2021 and 2022 to evaluate whether funds and separately managed accounts are accurately disclosing their ESG investing approaches, including the adoption of policies, procedures and practices that align with these disclosures.

Examinations are expected to include, among other matters, the following:

  1. Portfolio Management
    A review of the firm’s policies, procedures, and practices related to ESG and its use of ESG-related terminology (i.e., due diligence and processes for selecting, investing, and monitoring the firm’s disclosed ESG investments and whether proxy voting decision-making processes are consistent with ESG disclosures and marketing materials).
  2. Performance Advertising and Marketing
    A review of the firm’s regulatory filings, websites, client presentations, requests for proposals, and client/investor-facing documents, including marketing materials.
  3. Compliance Programs
    A review of the firm’s written policies and procedures and their implementation, compliance oversight, and ESG investing practices and disclosures.


With ESG investing gaining traction, it’s important for regulatory bodies to ensure that firms are properly evaluating whether their disclosures, marketing claims, and other public statements are accurate and consistent with internal practices. Although there are currently no regulations in place that govern ESG investing in the United States, this risk alert is a warning that such regulations are on the horizon and funds should take the appropriate steps now to ensure that their investment approaches and disclosures align with their advertising and marketing programs, as well as their written policies and procedures. If you have questions or concerns please consult your Marcum assurance professional for further guidance.