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“Green” Sweep? The SEC turns its attention to Environmental, Social and Governance (ESG) and Asset Managers

ESG and Sustainability|Financial, Executive and Professional Risks (FINEX)

By Anthony Rapa | February 19, 2020

It seems investors aren’t the only ones taking an interest in ESG.

Late in 2019, news broke that the SEC’s Los Angeles office sent examination letters1 to investment advisers concerning their involvement in ESG funds. As of this writing, it is unknown exactly how many firms received letters, but the initiative is believed to be part of a broad information gathering industry sweep. According to sources familiar with the letter, the Office of Compliance Inspections and Examinations (OCIE) is seeking information on a wide range of topics, including:

  • the number of ESG investments actually made or recommended;
  • any proxy votes made by the adviser on ESG issues and the process used to arrive at that decision;
  • the methodology and source of information used by the adviser to score an investment’s ESG credentials; and
  • service providers utilized by the adviser on ESG-related topics.

Not long thereafter, the OCIE included in its 2020 examination priorities2 a “… particular interest in the accuracy and adequacy of disclosures provided by [advisers] offering clients new types or emerging investment strategies, such as strategies focused on sustainable and responsible investing, which incorporate ESG criteria.”

What are the regulators looking for?

What should advisers make of this one-two combination from the SEC? First and foremost, that the sky is not falling.

What should advisers make of this one-two combination from the SEC? First and foremost, that the sky is not falling. Sweeps originate from the SEC’s examination division, not enforcement, and do not necessarily suggest that widespread enforcement actions are on the horizon. Rather, industry sweeps serve an important information gathering function that allows the SEC to better understand a new or evolving practice in the industry and better understand the attendant risks.

Moreover, SEC examinations can yield information that is extremely useful in an organization’s risk management function. SEC Risk Alerts, which are often informed by the results of initiatives like the SEC’s cyber security industry sweeps, play a useful part3 in identifying and mitigating one’s own risk. So too do the practices, procedures, and behaviors which are the subject of an exam or sweep. By gaining a better understanding of what the SEC is taking a closer look at, firms can better understand what areas of their operations might give rise to regulatory scrutiny down the road.

It’s not surprising then, given the lack of standardization4 in ESG data and disclosures, that the SEC would opt to take an industry-wide look at how advisers are evaluating, making, and managing ESG investments. Being able to quantify exactly how an investment matches with an ESG investment’s objectives will be critical for avoiding management, professional, and fiduciary liability risks. Although the current US political environment makes a legislative solution to this problem highly unlikely, it seems that advisers are hungry for structure and clarity. Indeed, advisers have been asking5 for the SEC to take action in this area and provide some of the structure and clarity that exists or is developing6 in other markets. That the SEC’s letter specifically asks for information on advisers’ adherence or utilization of the United Nation's Sustainable Development Goals7 and the Principles for Responsible Investing (PRI)8 is also interesting as the SEC tries to gauge the extent to which US-based advisers are adhering to these important internationally-recognized standards.

The SEC’s apparent interest in proxy voting is also noteworthy. As evidenced by SEC No-Action Letters issued in 20199, investors are increasingly looking to the proxy process to effect ESG-specific change within public companies. Although the SEC recently issued guidance10 to advisers on proxy voting, including on ESG issues, this action may create more questions than answers. In essence then, the SEC is apparently taking interest as to whether or not ESG funds can actually walk the walk11 by meeting sustainable mandates both through investment and corporate stewardship. It will be interesting to see where the Commission’s attention turns next and, ultimately, whether it is able to issuance any guidance on this topic.

What about insurance: 3 points to consider

Nevertheless, now isn’t the time for complacency, either. Although informative and potentially useful, the SEC’s letter and exam priorities should also serve as a reminder that ESG is a major risk for asset managers. This is a topic which our team has been following for quite some time, and whose continued evolution risk and legal professionals should monitor closely.

With regulatory scrutiny around ESG likely to pick up, the SEC’s letter also serves as a great opportunity to consider your firm’s insurance coverages. Management, professional, and fiduciary liability coverages should all be considered and tested together in concert, as claims seldom stay in their lanes any longer. With respect to inquiries like the SEC’s sweep letter, considerations should include:

  1. Coverage for regulatory matters differs greatly in the marketplace. Whether or not the SEC’s letter triggers coverage (and therefore notice obligations) is a fact-sensitive inquiry that must be carefully considered in a timely fashion. Even if your firm hasn’t been caught up in the sweep, now is a good time to tabletop how your policy might respond. In addition, even if your policy would not provide coverage for the SEC’s letter, firms should review their policy’s so-called notice of circumstance (NOC) provision, which provides for optional (as opposed to mandatory) reporting of matters which seem reasonably likely to give rise to a reportable claim in the future. Again, policy language in the marketplace is far from standard in this regard and careful consideration should be given before placing an NOC, lest a rejected notice create additional coverage issues if the underlying matter ultimately becomes an actual claim in the future.
  2. The availability or purchase of pre-claim coverage should also be considered. Routine examination or not, advisers may nevertheless incur significant legal costs responding to the SEC’s inquiries. Although these costs will go uninsured so long as the matter remains an uncovered examination, pre-claim coverage may allow an adviser to go back and seek reimbursement retroactively in the event the SEC subsequently issues a deficiency letter or opens an enforcement action. Although it is sometimes possible to argue for coverage on the theory that money spent properly responding to an examination lessened the risks and associated costs of follow-on regulatory action, pre-claim coverage can help provide a level of comfort that an adviser won’t be punished financially by their insurers for doing the right thing.
  3. Finally, advisers should reflect upon the availability of cost of corrections (CoC) coverage, which can be extremely useful in situations such as this. It may be that the SEC finds some sort of error in the mix of investments held by an ESG fund. Or, in responding to the SEC’s inquiries, an adviser discovers that some portion of an ESG-friendly investment’s holdings are out of line with the stated, sustainable investment objectives. CoC coverage may allow an adviser to obtain insurance coverage for the costs associated with divesting from those non-conforming investments under the principle that it helps avoid a larger customer lawsuit or regulatory action down the road. As with regulatory coverage, policy language surrounding CoC is not standardized, and often provides for tricky notice obligations that may limit or preclude coverage if not strictly complied with.

While it remains to be seen what comes from the SEC’s sweep, it is clear that ESG will serve as a source of regulatory, reputational, and litigation risk for asset managers. Advisers should therefore take this opportunity to conduct some spring cleaning and revisit risk management and insurance considerations now, before a regulator shows up with something a little less benign in hand.














Anthony Rapa is a member of the Willis Towers Watson FINEX Global Financial Institutions Claims Advocacy team.

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