Increased investor demand for financial products and services that offer features and benefits variously described as green, ethical, integrated, sustainable, climate-friendly, no-or-low-carbon, environmental/social/governance (ESG) and so forth (in this article generally described as “ESG-related”) has led to a plethora of investment options available on the supply side.

As the amount of investor funds allocated to these options has increased substantially in recent times, financial regulators have become more concerned about the ESG-related risks and harms posed both to investors directly involved and maintenance of wider public confidence in markets. At the heart of this concern is a question about the integrity of the contract between securities issuers (e.g., for managed investment schemes (MIS) and debt securities such as bonds) and their investors:

• Are these investors actually getting what they have been led to believe they will receive by including non-financial ESG-related criteria in their investment decision-making that the securities issuers purport to be able to satisfy?
• The corollary question is, what happens when these ESG-related criteria are not being met by the securities issuers, including what role should financial regulators play within that context?

Policing ESG-related representations a top US regulatory priority

The US Securities and Exchange Commission (SEC) ranks as one of the world’s foremost law enforcement agencies, purposely designed and constantly upgraded to match the vast and complex financial markets it polices. The United States of America is the world’s leading, largest and most innovative marketplace for financial products and services. It is also the most enticing and lucrative ground for ever-more sophisticated forms of misleading or dishonest dealings with investors. As the sheriff of this bailiwick, the SEC needs to keep ahead of such shenanigans at every twist and turn.

A burgeoning greenfield for financial misconduct has emerged in exploiting climate change and ESG themes to part investors from their money. The nub of the problem, at least in relation to managed funds, was succinctly characterised by SEC Chairman Gary Gensler in his July 2021 presentation to the Principles for Responsible Investment’s “Climate and Global Financial Markets” webinar. Therein he stated:

We’ve seen a growing number of funds market themselves as “green,” “sustainable,” “low-carbon,” and so on.

What information stands behind those claims? The basic idea is truth in advertising.

How to undertake effective enforcement of marketing and advertising truthfulness in respect of climate and ESG-related claims made to sell financial products and services is a contemporary and increasingly acute question for regulators worldwide, including in New Zealand. In March 2021, the SEC unveiled its answer by formally announcing that it had created a specialized Climate and ESG Task Force (Task Force) within the Division of Enforcement. In the media release, the mission statement of the new Task Force was set out as follows:

Consistent with increasing investor focus and reliance on climate and ESG-related disclosure and investment, the Climate and ESG Task Force will develop initiatives to proactively identify ESG-related misconduct.  The task force will also coordinate the effective use of Division resources, including through the use of sophisticated data analysis to mine and assess information across registrants, to identify potential violations.

The initial focus will be to identify any material gaps or misstatements in issuers’ disclosure of climate risks under existing rules.  The task force will also analyze disclosure and compliance issues relating to investment advisers’ and funds’ ESG strategies.

Since inception, the Task Force has not been idle, according to a list of enforcement actions published by the SEC. We will examine two of the published cases that the Task Force was involved with during 2022, both concerning fund managers that did not comply with their own representations concerning ESG-related standards applicable to funds that they managed. There are similarities in both cases that should serve as a warning lesson to issuers of securities in New Zealand who rely on ESG-related claims to market and advertise their products to investors and intermediaries.

Case study 1 (published May 2022)

The SEC found that BNY Mellon Investment Adviser had managed some funds between July 2018 to September 2021 for which it variously claimed or implied in statements that that all the investments included in the funds had undergone an ESG quality review. However, many of these investments did not have an ESG quality review score assigned as of the time of investment. The fund manager agreed to pay a $US1.5 million penalty.

In this case, the SEC’s Adam S. Aderton, Co-Chief of the SEC Enforcement Division’s Asset Management Unit and a member of the Task Force, stated, “As this action illustrates, the Commission will hold investment advisers accountable when they do not accurately describe their incorporation of ESG factors into their investment selection process.”

Case study 2 (published November 2022)

The SEC found that Goldman Sachs Asset Management had marketed as ESG investments two mutual funds and one separately managed account strategy that were subject to failures in applying ESG research policies and procedures by the investment teams responsible for selecting and monitoring their securities. The problems arose between April 2017 until February 2020. For example, from April 2017 until June 2018, one product did not have any written ESG research policies and procedures, and when policies and procedures were established, they were not followed consistently up until February 2020. Despite these policies and procedures being shared with third parties such as intermediaries and the funds’ board of trustees, non-compliance often occurred, such as completing ESG questionnaires subsequent to selection of securities for inclusion or relying on previous ESG research which was not conducted in the manner required. The fund manager agreed to pay a $US4 million penalty.

In this case, Sanjay Wadhwa, Deputy Director of the SEC’s Division of Enforcement and head of its Climate and ESG Task Force was quoted as saying, “When [fund managers brand and market their funds and strategies as ‘ESG’], they must establish reasonable policies and procedures governing how the ESG factors will be evaluated as part of the investment process, and then follow those policies and procedures, to avoid providing investors with information about these products that differs from their practices.”

The SEC’s reported actions have wider ramifications beyond just the US financial markets in that they reveal the kinds of ESG-related misconduct by fund managers and other securities issuers that regulators in other jurisdictions will look for, go after, and seek to penalise. In this sense, the two case studies constitute a “health check” for securities issuers in general to measure themselves by.

For issuers of securities in New Zealand, the case studies point to the need to have appropriate and effective policies and procedures in place to underpin any investments that are marketed and advertised as ESG-related.  Such policies and procedures must have checks and controls in place (including via a compliance assurance programme (CAP) and functional reporting lines through to board directors and senior management) to help ensure full compliance and that any instances of non-compliance are promptly reported and acted upon internally.

It is critical also to make certain that any external representations about these ESG-related policies and procedures made to third parties, such as investors, intermediaries and the general public, but additionally Supervisors and the FMA, by way of disclosure (including via offer documents), marketing or advertising are always correct, truthful and accurate, and not in any manner actually or potentially false, confusing, misleading or deceptive. Part and parcel of making such representations is that satisfactory evidence can be provided on demand to support them. Similar considerations will apply to climate-related disclosure (CRD) by climate reporting entities (CREs) concerning any ESG-related credentials they may claim.

Australia tightens up on ESG-related financial product promotion

In June 2022, the Australian Securities & Investments Commission (ASIC) published online an Information Sheet entitled “How to avoid greenwashing when offering or promoting sustainability-related products” (INFO 271). INFO 271 is concerned with providing information to fund managers about misrepresenting sustainability-related products, defined as “a financial product where the issuer has incorporated sustainability-related considerations – such as environmental, social and governance (ESG) matters – into its investment strategies and decision making.” The information sheet is also aimed at other sustainability-related financial product issuers such as companies listed on a securities exchange or entities issuing green bonds.

INFO 271 has a series of short chapters concerned with:

• what greenwashing is and why it is a concern
• the current regulatory setting for communications about sustainability-related products
• questions to consider when offering or promoting sustainability-related products.

Whilst INFO 271 is concerned with the application of Australian law to offering and promoting sustainability-linked products, its final chapter on questions to consider is equally applicable to fund managers and other securities issuers with ESG-related products on offer and promotion in New Zealand, including helpful examples of what could be deemed misleading. The way in which INFO 271 presents and analyses these questions could be used beneficially by any New Zealand-based securities issuers in respect of checking pre-publication the advertising and marketing of their own ESG-related products:

1. Is your product true to label?
2. Have you used vague terminology?
3. Are your headline claims potentially misleading?
4. Have you explained how sustainability-related factors are incorporated into investment decisions and stewardship activities?
5. Have you explained your investment screening criteria? Are any of the screening criteria subject to any exceptions or qualifications?
6. Do you have any influence over the benchmark index for your sustainability-related product? If you do, is your level of influence accurately described?
7. Have you explained how you use metrics related to sustainability?
8. Do you have reasonable grounds for a stated sustainability target? Have you explained how this target will be measured and achieved?
9. Is it easy for investors to locate and access relevant information?

New Zealand has not been dragging the ESG chain

The FMA has issued some important guidance and research around ESG-related advertising and marketing:

Disclosure framework for integrated financial products (December 2020)

Integrated financial products: Review of managed fund documentation (July 2022)

Ethical Investment Journey Research (July 2022)

New Zealand-based issuers of ESG-related financial products and services should seek to incorporate the principles of these FMA resources into their policies and procedures.

Conclusion

“Investment issuers who make claims for the relevancy of climate change, ESG, ethical or sustainability considerations to the desirability of their products have fallen under critical surveillance and scrutiny by financial regulators actively on the lookout for misconduct and misrepresentation,” said Matthew Band, General Manager of Corporate Trustee Services at Trustees Executors.

“Fund managers and other securities issuers in New Zealand should take heed of the lessons taught and resources available both here and overseas to keep themselves out of trouble with respect to their own ESG-related products and services.”

“The SEC’s approach, publicised in cases where it has taken action against US-based fund managers, gives insight into how a financial regulator might go through with a fine-toothed comb the ways that ESG-related investment policies and procedures are applied and adhered to in practice and represented to third parties in order to find examples of legally actionable misconduct.”

“ASIC’s straightforward guidance in INFO 271 should give pause for thought to securities issuers in New Zealand before they burst into print about their ESG-related products and services or otherwise represent them to third parties such as investors and intermediaries.”

“Particularly concerning marketing and advertising via potentially fast-and-loose avenues such as websites, social media, and investor contact events, where there might not be the same degree of prior controls imposed as on standard print media, securities issuers need to be extremely wary of the risk of committing ESG-related misconduct and have in place adequate checks and supervision to prevent breaches from occurring.”

“As a Supervisor, Trustees Executors will be monitoring its supervised clients’ representations for any ESG-related products and services they may offer.”

“It is only to be expected, given its own publications to date, that the FMA will also be vigilant in watching out for misconduct in the marketing and advertising of ESG-related financial products and services and stand ready to take enforcement action where needed.”

“In essence, under the label of greenwashing, this type of misconduct represents serious breach of contract between securities issuers and their investors.”

“Zero tolerance for such breaches should be the shared common goal of New Zealand’s financial regulator, licensed Supervisors, and securities issuers of ESG-related products and services.”

For comment or more information, or to be added to the free email subscriber list of “The Supervisor”, please contact Matt Band at [email protected].