The Securities and Exchange Commission issued a risk alert last week on ESG. New Private Markets spoke to lawyers at Kirkland & Ellis and Akin Gump to find out how this affects investors and managers.
The SEC issues risk alerts to notify the market about potential areas of compliance weakness, to clarify managers’ fiduciary duties and to guide managers on how to remedy them.
The risk alert stated that the SEC’s Division of Examinations has noticed that portfolio managers’ ESG practices didn’t line up with their compliance disclosures and offered “unsubstantiated or otherwise potentially misleading claims” about their ESG programmes.
What’s the SEC doing here?
Jason Daniel, Akin Gump: The SEC staff is interpreting the rules and obligations as they currently exist to apply to those who are claiming to adhere to ESG principles in their investment decisions.
How did the risk alert come about?
Alpa Patel, Kirkland & Ellis: It emanated from the exam group and all their observations. Examiners have jurisdiction to routinely examine any registered advisor. A few years ago they noticed that lots of firms were using the moniker ESG, and it was a part of their marketing, but nobody does it the same way. Their concern is that it’s a wildly divergent practice and investors do not understand what they are signing up for.
What is the SEC saying managers or advisors should do?
JD: They’re asking you to define what ESG is and how you’re interpreting it yourself. There’s no substantive requirement beyond disclosure. If you disclose and mitigate those conflicts of interest, you are ok.
AP: They’re not actually saying anybody should do ESG affirmatively or in any particular way. The SEC’s statutory authority is to talk about disclosure to investors and then investors can decide whether something is good, bad or they don’t care about it.
And given the fact that there’s no universal idea of what ESG really means, you need to describe that to your investors, so that they understand what it is that you precisely mean.
So is transparency on ESG a fiduciary duty?
AP: The word ‘fiduciary duty’ is not in the Advisers’ Act. It’s a caselaw concept. It’s well-established now that the relationship between the advisor and the client is actually a fiduciary relationship. All material facts must be disclosed. The baseline of fiduciary duty is disclosure. You have a duty to put your client’s interests first, and you have to mitigate or disclose conflicts.
How have advisors reacted?
AP: All advisors should be reading that risk alert and thinking about what they say to their investors about ESG and to ensure their disclosure to investors matches with actual operational processes.
Alexandra Farmer, Kirkland & Ellis: We have heard from many of our clients about re-evaluating their policies and programmes to make sure they’re really capturing what is actually happening with their ESG programmes. Now we see our clients forming groups with compliance and really taking a close look to make sure they are being implemented in full and they’re being transparent, conducting appropriate record-keeping.
“I think there are certain investors who would like to see an affirmative fiduciary duty to consider ESG and climate risk.”
Kirkland & Ellis
And they’re thinking about their future ESG programme, benchmarking against their peers, planning out how they plan to expand their ESG focus in the next couple of years and doing studies to identify opportunities for ESG value creation.
Would these extra requirements induce any advisors to abandon their ESG commitments?
AF: I don’t think there’s a singular reason why certain advisors won’t move on ESG. But for those advisors that had already decided not to move on ESG, this risk alert is an additional justification [to] their LPs. But they’re in the minority. From what I see, the majority of advisors do have an ESG programme.
I don’t see advisors going backwards. It’s more about making changes to ESG programmes to clarify what they’re doing, but not pulling back their ESG policy by any means.
What’s next? Will we see regulation or enforcement action around ESG?
AP: The notion that there will eventually be an ESG enforcement action should not be news to anybody. But it would be hard to imagine a scenario where they would follow this up with specific regulation under the Advisers’ Act. I can very well see them bringing an enforcement action against an advisor that has touted ESG but then are not doing what they said. But that would still be based upon the existing concept of fiduciary duty.
What’s missing from the risk alert? Are investors satisfied?
AF: There are certain investors and certain others within the ESG community who would like to see an affirmative fiduciary duty to consider ESG and, in particular, climate risk. We see talk in the responsible investment community of duty of care or duty of prudence that would make an affirmative obligation to consider ESG. This risk alert is not doing that.
Should mandatory ESG considerations come from the SEC?
JD: They’re not going to say, ‘These are the things you must consider.’ To go the next step and adopt a rule that requires substantive ESG obligations is beyond what the SEC would normally consider. I don’t think the SEC is going to come out tomorrow and say, ‘you shall not invest in companies that are negligent when it comes to the environment’.
What the SEC has just done, I think is very appropriate and I think that’s probably about as far as they could go. The European model of ‘if you’re claiming this level of ESG, then you will do these specific substantive things,’ that’s not the US model.
Alexandra Farmer is a partner at Kirkland & Ellis and leads the firm’s ESG & Impact Practice Group.
Alpa Patel is a partner at Kirkland & Ellis and previously worked as a lead advisor in private funds regulation at the SEC.
Jason Daniel is a partner at Akin Gump Strauss Hauer & Feld and represents alternative investment funds.