By Chintan Panchal & Marie Cita
RPCK Rastegar Panchal LLP is an international boutique law firm that regularly advises on multiple bottom-line transactions and has helped deploy over $1 billion in impact capital around the world since the firm’s founding in 2010. This article is base on remarks given by Chintan Panchal at the Insight Exchange Network ESG Due Diligence and Analytics Summit in New York, NY.
At RPCK, we are deeply committed to the successful growth and evolution of the impact investment, ESG and socially responsible investment sectors (for convenience, we refer to these sectors of the financial industry, collectively, as the “ESG” industry, although there is much to say about the distinctions between each of these investment approaches). We view ESG investing as one significant tool among many that must be used effectively if we as a society are to ensure a socially just and environmentally sustainable future.
We view ESG investing as one significant tool among many that must be used effectively if we as a society are to ensure a socially just and environmentally sustainable future.
RPCK is not alone in its view that the investment and financial sectors should embrace, and even ultimately transition to, a multiple bottom-line approach to investing. As reported by the Wall Street Journal, between January and November 2019 alone, over $17.67 billion flowed into ESG funds. By comparison, in 2018, approximately $5.48 billion of new money flowed into ESG funds. The uptick in new ESG fund investments in 2019 shows the market’s growing enthusiasm for ESG investment and the new vision it presents for a market economy.
As a result of the notable rise of ESG investing, the U.S. Securities and Exchange Commission (the “SEC”) has increased its scrutiny of the industry. In December 2019, pursuant to its examination authority under the Investment Advisers Act of 1940, the SEC sent examination letters to numerous investment and wealth management firms that offer ESG products, platforms and services. The examination letters requested substantial information from those firms surrounding ESG, including about the advisers’ respective definitions of ESG and related criteria; proprietary or third-party ESG scoring systems and investment models; written policies and procedures on the application of ESG criteria to investment decisions; written policies and procedures on proxy voting; and the results of internal audits of the respective advisers’ compliance with its policies and procedures.
From these letters, it is apparent that the SEC is gathering information about the ESG investment advisory industry. However, these letters also indicate a distinct possibility that the SEC will use information gathered during this examination process to bring enforcement actions against registered investment advisers the SEC views as failing to adhere to acceptable fiduciary, anti-fraud and other applicable legal standards as they relate to ESG. Furthermore, statements from certain commissioners of the SEC indicate that some at the agency are skeptical of the burgeoning industry, raising concerns that the SEC may ultimately use it examination and enforcement powers to hinder the growth and evolution of the industry.
For example, SEC Commissioner Hester Peirce gave remarks to the American Enterprise Institute (the “AEI”) on June 18, 2019, where she raised a number of concerns, including about (1) the lack of transparency and authenticity of certain actors in the ESG market; (2) investment advisers’ ability to fulfill their fiduciary duty while incorporating ESG factors into their investment models; and (3) the role proxy advisors play in ESG-related corporate decisions of public companies. We discuss these concerns in turn.
Commissioner Pierce … raised a number of concerns…
1. Inauthenticity in the ESG Market
Commissioner Peirce spoke at length, often in surprisingly moralistic terms, about the disservice inauthenticity and a lack of transparency can do to financial markets. She begins by asserting that the absence of uniform ESG definitions, criteria and standards have led to arbitrary ESG labeling and rating. She claims, “ESG is broad enough to mean just about anything to anyone.”
What is more, given the lack of uniform standards and criteria, the information companies report to ESG raters and scorecard producers and the information investment advisers consider varies widely, making it difficult for investors to understand the true ESG ratings of their investments. From Commissioner Peirce’s perspective, the nebulous definitions, criteria and standards enable investment advisers, and the ESG rating and scorecard agencies they rely on, to make misinformed claims about companies’ ESG performance. This misinformation, she fears, unfairly skews the market, as investors, believing the merit of ESG labels – whether or not deserved – may mis-value companies, investments and products based on unsubstantiated ESG reporting or an arbitrary lack thereof.
In Commissioner Peirce’s own moralistic terms, “incomplete information” surrounding ESG may lead to nothing more than “public shaming, and shunning wrapped in moral rhetoric preached with cold-hearted, self-righteous oblivion to the consequences,” resulting in an ESG industry that “pin[s] scarlet letters on allegedly offending corporations without bothering much about facts and circumstances.” She worries that “peddlers of ESG products and philosophies” are merely inauthentic salespeople engaged in widespread “greenwashing.”
Commissioner Peirce’s rhetoric is troubling as it forecasts potential SEC hostility toward the burgeoning market. However, despite the seeming hostility and charged rhetoric, we agree that many of Commissioner Peirce’s concerns do have merit; but it is our expectation that the SEC will not use its examination and enforcement powers to hinder the ESG market, but rather to make the market more transparent, robust and authentic by fostering the transparency and accountability, that over time will support efficient market decision-making and a coalescing around leading ESG definitions, criteria and standards.
…make the market more transparent, robust and authentic by fostering transparency and accountability…
Certainly, investment advisers and other ESG service providers – such as ratings agencies and scorecard producers– should not be able to get by without providing clear and transparent information on ESG definitions, criteria and standards, as well as on their specific policies and procedures for evaluating investments against those standards. As such, the SEC should use its examination authority – and where necessary, enforcement authority – to ensure investment advisers:
- (1) have clear ESG definitions and criteria that they communicate to investors in a transparent manner;
- (2) maintain written policies and procedures to ensure ESG investments are suitable for their clients and that their clients give informed consent to the applicable investment strategy;
- (3) maintain written policies and procedures to ensure adherence to the selected criteria and standards;
- (4) maintain an adequate audit function for testing compliance with those policies and procedures; and
- (5) require ESG service providers, including proxy advisors as discussed further below, to do the same as a condition to contracting with the investment adviser.
In addition, there is merit to Commissioner Peirce’s concerns that the variety of ESG metrics and criteria make it difficult for investors to distinguish between different products, strategies and advisers. However, with improved disclosure of, and informed consent to, relevant criteria and decision-making processes, investors will better understand how each adviser or service provider incorporates ESG into investment decisions or ratings. While the differences in approaches to ESG will result in some inefficiency at first, over time, the market should coalesce around a smaller number of more successful approaches to ESG, as determined by the market. Relatedly, over time, issuer ESG reporting expectations should become more standardized and far easier to fulfill.
In short, the role of the SEC should be to ensure a transparent market, not to condemn the market or to determine for investors whether or not it is worthwhile to consider ESG factors. If investors view certain ESG ratings, metrics and standards as “material” to investment-making decisions, the SEC should work to ensure those investors are armed with the information necessary to make those choices on an informed basis.
…the role of the SEC should be to ensure a transparent market, not to condemn the market or to determine for investors whether or not it is worthwhile to consider ESG factors.
2. ESG and Fiduciary Duties
Second, Commissioner Peirce’s remarks could be understood as questioning whether fiduciary duties investment advisers owe to clients allow the investment advisers to consider ESG metrics independent of financial return when advising clients. She remarks, “most investment advisers, in light of their fiduciary duty, want to focus primarily on maximizing the value of their investors’ portfolios,” suggesting and investment advisers’ fiduciary duty precludes them from considering ESG metrics that are not “financially” relevant. There is a more academic discussion to be had as to whether an investment adviser could recommend investment decisions within a particular investment thesis that have strong ESG outcomes if those decisions significantly undermine the likelihood of a solid financial return. However, in our view, this question is not of practical concern.
For one, as a number of studies indicate, an increased focus on ESG risks improves returns. In other words, when done effectively, an ESG focus is beneficial, not only socially, but also financially. Commissioner Peirce, although skeptical, acknowledges such studies. In short, an investment adviser that honestly considers ESG metrics – i.e., does more than label itself as an ESG adviser – does not run afoul of fiduciary duties simply by incorporating ESG into an investment model. In fact, if studies continue to show that incorporating ESG risk-assessment into investment models leads to better financial returns, one might one day question whether an investment adviser can fulfill its fiduciary duties if it does not do so in order to ensure its clients’ financial objectives are met.
Second, even without strong studies indicating that an ESG focus can boost returns, ESG need not be viewed as categorically different from other investment strategies, theses or approaches. For example, investment advisers’ fiduciary duties are not implicated where clients want to invest in exclusively tech, as long as the investor is well advised and informed of the nature of investment, regardless of the broader market view on relative returns in that industry.
Commissioner Peirce expressed concern that ESG metrics are being used to justify poor financial performance. While it is likely that some use ESG to excuse weak returns, similar excuses are made across industries. The SEC’s approach should not be to unilaterally exclude ESG metrics from the realm of factors investment advisers can consider as a fiduciary. Investment advisers should be able to factor ESG, like any other investment criteria, into investment models. The role of the SEC here again should be to ensure clients are advised on, and give informed consent to, the investment approach.
The role of the SEC … should be to ensure clients are advised on, and give informed consent to, the [ESG focused] investment approach.
3. Proxy Voting
Finally, Commissioner Peirce laments the role proxy advisers play in the ESG space. As Commissioner Peirce notes, the proxy advisory industry has grown significantly since the U.S. Department of Labor (the “DOL”) and the SEC took the position that pension managers and fund advisers must vote their clients’ proxies in their clients’ best interests in order to fulfill their fiduciary duties. More specifically, in 1988, the DOL issued interpretive guidance known as the “Avon Letter” asserting that plan managers must vote the proxies associated with corporate shares comprising plan assets. The SEC came to a similar conclusion for registered investment advisers with voting authority more broadly in a 2003 rulemaking; and in two 2004 no-action letters, the SEC went on to say that investment advisers could outsource this obligation to independent third parties.
At the same time, shareholder activism increased resulting in a larger number of shareholder proposals. A substantial number of these proposals relate to ESG. Since investment advisers and plan managers can end up at any time managing investments in hundreds if not thousands of issuers, it is often infeasible for asset managers to cast an informed vote on each proposal. In light of asset managers’ requirement to vote on these proposals and the increasing number of proposals, asset managers with voting authority increasingly rely on outsourced proxy advisors to guide, if not determine, how to vote on shareholder proposals.
In her remarks to the AEI, Commissioner Peirce decries both phenomena, i.e., the proxy advisory industry’s entry into ESG advising – as proxy advisors are now increasingly engaged to advise on these ESG-related shareholder proposals – and increasing shareholder activism. With respect to the latter, Commissioner Peirce remarks that “a small number of very active shareholders” submit an outsized proportion of shareholder proposals, some of which, from Commissioner Peirce’s view are ESG-related and ill-informed.
With respect to the former, in retrospect, Commissioner Peirce concludes that allowing investment advisors to fulfill fiduciary duties with respect to proxy voting simply by outsourcing that duty helped give rise to an ill-equipped proxy industry. She highlights that at present: proxy advisors’ recommendations, including on ESG matters, are sometimes based on incomplete and inaccurate information that companies don’t have the opportunity to correct; and proxy advisors sometimes have undisclosed conflicts of interest, such as being engaged to advise on proxy proposals relating to companies for which they provide proxy consulting services. Nonetheless, the recommendations of these proxy advisors often have substantial impact on public company votes.
Once again, Commissioner Peirce’s apparent hostility toward increased shareholder activism and proxy advisor engagement on ESG issues may cloud a valid underlying criticism. Proxy advisors, like asset managers, should be held to the same robust standards to which they are held in other areas even though some may fall short. However, Commissioner Peirce unfairly focuses weaknesses in the proxy advisory industry on ESG-related proxy voting. In other words, the issue here, is not ESG. The question is: Are proxy advisors’ decision-making processes sufficiently transparent and robust across the board and are investment advisers holding them to a high enough standard?
Are proxy advisors’ decision-making processes sufficiently transparent and robust across the board and are investment advisers holding them to a high enough standard?
As indicated in recent guidance from the SEC, investment advisers should conduct reasonable due diligence of proxy advisory firms and identify potential conflicts of interests and gaps in the proxy advisory firms’ policies and procedures before contracting with those firms. With respect to ESG-related engagements, investment advisors should ensure the proxy adviser (1) has clear, transparent criteria and standards regarding the assessment of ESG-related issues and shareholder proposals; (2) reasonable policies on collecting and assessing related information and formulating recommendations; and (3) an audit and/or quality control function to ensure the proxy advisor is complying with its own standards and policies. Once again, the direction should be toward a more robust framework for ESG investing.
At the end of the day, the ESG market is growing quickly. The SEC should use its authority to ensure that it grows toward transparency and authenticity. Investment advisers should maintain written policies and procedures to ensure they adhere to the ESG criteria and standards communicated to investors, as well as an audit function to test that adherence. Investors should take care to understand the services and products they are purchasing as this space continues to develop. Many actors in the space already haven taken these steps, but if all participants commit to authenticity and meaningful standards in this burgeoning industry, the industry will continue to grow more robust and efficient.
 In September 2018, the SEC withdrew these no action letters.
 Although, it is beyond the scope of this newsletter, we note that the SEC has proposed rulemaking to impose more stringent thresholds on shareholders of public companies eligible to make proposals. At present, shareholders with $2000 worth, or 1%, of equity in an issuer for at least a year are eligible to make shareholder proposals.