Remarks at the California ‘40 Acts Group

Good afternoon. I am pleased to join you today at the first large gathering of the California ‘40 Acts Group since the start of the pandemic. This group provides an important forum for discussing matters affecting the investment management industry, and I hope that this event marks the return to normalcy. My remarks today will focus on issues related to asset managers’ use of environmental, social, and governance (ESG) investment strategies. These remarks reflect my individual views as a Commissioner at the U.S. Securities and Exchange Commission.[1]

The Growth of ESG Investing

ESG investing has taken the asset management industry by storm. According to one estimate, global ESG assets are expected to exceed $50 trillion by 2025, which would represent more than one-third of total projected global assets.[2] To put this in perspective, ESG assets only crossed the $35 trillion threshold in 2020.[3] In 2021, assets invested in ESG-themed mutual funds and exchange-traded funds rose to $2.7 trillion globally.[4]

ESG products typically charge higher fees than more “plain vanilla” products.[5] Globally, fee revenue from ESG-themed funds grew from $1.1 billion in 2020 to $1.8 billion in 2021.[6] Touting a product as being “ESG” is good for business.

The incentive for asset managers to label any product as being “ESG” makes it hard to calculate the true assets under management in ESG funds. Some ESG funds are highly correlated with broad-based indices, like the S&P 500 Index.[7] A skeptic might believe that some ESG products are merely offered in order to extract higher management fees. In 2022, one ESG rating firm stripped more than 1,200 funds of their “ESG” designations because the funds did not “integrate [ESG factors] in a determinative way in investment selection.”[8] Collectively, these funds had assets under management of more than $1 trillion.[9]

Although ESG investing is wildly popular, it is difficult to ascertain exactly what ESG means, so it is challenging to identify when an ESG investment strategy is properly labeled as such. Fortunately, the federal securities laws are designed to address situations in which an investment adviser is marketing a particular strategy to clients and potential clients.

The Fiduciary Duty of Investment Advisers

The Investment Advisers Act of 1940 (Advisers Act) requires an investment adviser to act in accordance with its fiduciary duty to its clients.[10] According to the Commission, this fiduciary duty “means the adviser must, at all times, serve the best interest of its client and not subordinate its client’s interest to its own.”[11] The Commission recognizes that an adviser and its client may shape the advisory relationship by agreement, provided that there is full and fair disclosure and informed consent.[12] This means that an adviser can only pursue an ESG investment strategy if the client expresses a desire to pursue such a strategy after receiving full and fair disclosure regarding the salient features of the strategy, including the strategy’s risk and return profile.

The regulatory issues presented by ESG investing are nothing new. Advisory clients have always been free to select investment strategies that suit their objectives – which may be non-financial in nature – and investment advisers are required to fully describe those strategies. The Commission has brought enforcement actions under Sections 206(2) and 206(4) of the Advisers Act when advisers failed to implement investment strategies in the manner described to clients.[13] These provisions have explicitly been applied in the ESG context. For example, in May 2022, the Commission brought an enforcement action against an investment adviser for misstatements and omissions about ESG considerations in making investment decisions for certain mutual funds that it managed.[14]

A straightforward regulatory approach would treat ESG investing like any other investment strategy and apply this well-established framework, rather than impose a specific ESG regulation. ESG investing is complicated by three factors. First, the inability to objectively define “ESG” or any of its components. Second, the temptation to place the regulators’ fingers on the scale in favor of specific ESG goals or objectives. And third, the desire of certain asset managers to use client assets to pursue ESG-related goals without obtaining a mandate from clients. A deep dive into these factors reveals the difficulty of establishing “ESG”-specific regulatory frameworks.

The Definition of “ESG”

Regulators, industry participants, and investors have struggled to define “ESG.” The Commission’s proposed ESG rule for investment advisers and investment companies recognizes that there are a “variety of perspectives concerning what ESG investing means, the issues or objectives it encompasses, and the ways to implement an ESG strategy.“[15] According to the Commission, “[e]ven when investors focus on the same ESG issue, such as climate change or labor practices, there are debates about how to address such issues, resulting in different, and sometimes opposing, assessments of whether a particular investment meets the investors’ goals in furthering that issue.”[16]

The Commission’s release essentially recognizes the fundamental reality that standardized ESG measures are doomed to fail. This is particularly true because ESG measures increasingly are put to use to advance social or political causes. Although certain ESG metrics could be used to assess the projected financial returns of a company, the goal of ESG investing often is something other than financial performance. Since stakeholders have different views as to what constitutes a desirable social or political outcome, success in categorizing investments as “good” or “bad” from an ESG perspective can be elusive.

This point is illustrated by comparing the correlations between ESG ratings and credit ratings issued by various providers. According to one study, the two largest credit rating agencies issue the same letter category rating 78% of the time when evaluating investment-grade issuers, and ratings differ by more than one letter grade less than 1% of the time.[17] In contrast, the same study showed that two large ESG rating firms agreed on their ESG ratings only 18% of the time.[18] The low correlation among ESG rating agencies can be attributable to various factors, including differences as to: (1) scope – meaning what the relevant categories of ESG performance are, (2) weight - meaning how important the categories are relative to one another, and (3) measurement – meaning how well a company performs within a given category.[19] To the extent investment advisers use ESG ratings to make portfolio management decisions, subjective ESG ratings will play an increasing role in how asset managers allocate capital.

The impracticality of a universal “ESG” definition creates the potential for abuses that can drive assets to particular companies based on social or political agendas. To the extent regulators have concerns about “greenwashing,” the federal securities laws already have standards in place. If an adviser uses third-party ESG ratings as inputs for its ESG strategy, the identity of the rating firm and its methodology would need to be disclosed to investors if material. While the use of the term “ESG” – without more – says very little about an investment strategy, an adviser is required to provide full and fair disclosure about what it means when it uses that term. Given this existing framework, it is not clear why additional rulemaking is needed in this area.

Attempts by Regulators to Favor ESG Investing

Recognizing the lack of any consistent framework for issuing ESG ratings, the International Organization of Securities Commissions recently issued a “call for action” that encourages voluntary standard setting bodies and industry associations to “promote good practices among their members.”[20] IOSCO’s primary concern appears to be the “risk of greenwashing related to asset managers and ESG rating and data providers.”[21] The call for action follows an IOSCO report that issued recommendations for ESG rating firms, investors who use ESG ratings, and companies that receive ESG ratings.[22]

I have significant concerns that the goal of establishing ESG rating standards goes far beyond preventing “greenwashing.” Rather, these standards may be intended as a means for asset managers to engage with company management in a broader effort to drive companies to satisfy the criteria of a specific ESG rating service. Because ESG ratings may be divorced from matters of financial materiality, they can reflect a particular political or social agenda. The result – and perhaps the point – is that companies will be forced to further the agenda of the ESG rating firm in order to obtain capital. The emerging system has more in common with a George Orwell novel than what anyone would consider an accepted financial analysis tool.

In the United States, regulatory efforts tend to target asset managers and other fiduciaries rather than ESG rating firms. But in the limited efforts to date, regulators have found tackling ESG to be quite difficult. For instance, the U.S. Department of Labor (DOL) adopted a rule in 2020 that set forth clear standards for ERISA fiduciaries in selecting and monitoring investments for employee sponsored benefit plans.[23] The rule codified the fundamental principle that “an ERISA fiduciary’s evaluation of plan investments must be focused solely on economic considerations that have a material effect on the risk and return of an investment based on appropriate investment horizons, consistent with the plan’s funding policy and investment policy objectives.”[24] The preamble to the rule appropriately recognized that “there are instances where one or more [ESG] factors will present an economic business risk or opportunity that [may appropriately be treated] as material economic considerations under generally accepted investment theories.”[25]

But in 2021, the DOL attempted to move away from this clear principle and place its finger on the scale of ESG investing. For example, the 2021 proposal specified that an ERISA fiduciary’s consideration of the projected return of a portfolio relative to the funding objectives of the plan “may often require an evaluation of the economic effects of climate change and other [ESG] factors.”[26] That language was not included in the final rule. Instead, the final rule retains the requirement of the 2020 rule that an ERISA fiduciary’s investment decision must be based on factors that the fiduciary reasonably determines are relevant to a risk and return analysis.[27]

While the new rule states that “[r]isk and return factors may include the economic effects of climate change and other ESG factors,” this permissive language added to the body of the rule seems merely to create confusion as to why ESG factors – and not any other type of investment factor – are singled out as being permissible for consideration. The DOL’s 2021 proposal also would have codified examples of ESG factors that might be material to a risk-return analysis. Those examples were deleted in the final rule text.

So what exactly is the DOL accomplishing with this rule change? Under the Supreme Court’s ruling in the Dudenhoeffer case, it is unlikely that a rule permitting the consideration of non-financial factors would be lawful. In its opinion, the Supreme Court interpreted ERISA’s prudent person standard for fiduciaries making investment decisions and held that fiduciaries (1) are required to manage retirement plan investments solely for the purposes of providing retirement income to participants, and (2) are prohibited from considering nonpecuniary factors.[28]

But that is not what the DOL said. The DOL trumpeted in a press release that the new rule “remove[s] barriers to considering [ESG] factors in plan investments.”[29] According to the press release, the prior rule adopted in 2020 “unnecessarily restrained plan fiduciaries’ ability to weigh [ESG] factors when choosing investments, even when those factors would benefit plan participants financially.”[30] A quote from the Secretary of Labor states that the new rule “clarifies that retirement plan fiduciaries can take into account the potential financial benefits of investing in companies committed to positive [ESG] actions as they help plan participants make the most of their retirement benefits.”[31]

The 2020 rule permitted an ERISA fiduciary to consider any factors – including ESG factors – that were financially material to an investment decision. This is why the DOL’s messaging regarding the new rule is so confusing. On the one hand, to the extent the language of the new rule is read solely in a vacuum – a comparison of the final rule text to the proposed rule text might lead one to believe that the new rule represents an endorsement and re-affirmation of the Trump Administration’s position. On the other hand, if one reads the contemporaneous statements of DOL leadership, the rule represents a significant change that permits a greater degree of consideration of ESG factors, which would potentially conflict with the law. Which is it? Regulators speaking with a forked tongue ought to be the hallmark of acting in an arbitrary and capricious manner.

At the Commission, three proposed rules attempt to address ESG issues: one targeting corporate issuers,[32] one targeting investment advisers and investment companies,[33] and one targeting investment companies’ use of “ESG” in a fund name.[34] These proposals are on top of existing requirements under the federal securities laws to disclose accurate information about how client assets are invested. Are these unique, highly-prescriptive disclosure requirements specifically targeted at ESG investment strategies needed? The current rules provide the Commission with sufficient authority to bring enforcement actions against advisers and funds that engage in “greenwashing.” Additionally, some of the proposed disclosure requirements for investment advisers and funds would be tied to yet-to-be-adopted proposed disclosures from corporate issuers. One would think that the proper sequencing of these rules will be of significant importance.

The proposed ESG rule targeting issuers presents numerous potential issues. First, the rule could implicate the major questions doctrine in the manner set forth in West Virginia vs. EPA.[35] Beyond the question of whether the Commission would exceed its Constitutional authority by adopting the rule, I am concerned that the proposal would cast aside the Commission’s time-honored approach to securities regulation, which requires issuers to disclose information that is material to an investment decision from an economic standpoint. The Commission should tread very carefully before departing from this approach.

Activism by Asset Managers

Finally, some asset managers have been walking a fine line between hewing to their fiduciary duties to their clients and furthering social and political goals that may be unrelated to the interests of their clients. A 2022 report from the minority staff of the U.S. Senate Banking Committee notes that the three largest asset managers collectively cast about one-quarter of all shareholder votes for S&P 500 Index companies.[36] The report details these firms’ “investment stewardship” initiatives designed to vote shares of portfolio companies in a manner that is consistent with their conception of “ESG.”[37] The client assets that convey such outsized voting power to these firms are predominately invested in passive index funds, rather than funds with stated ESG objectives.

The adopting release for Rule 206(4)-6 under the Advisers Act – commonly known as the “proxy voting rule” – states that “[u]nder the Advisers Act…an adviser is a fiduciary that owes each of its clients duties of care and loyalty with respect to all services undertaken on the client's behalf, including proxy voting.”[38] Even if an adviser’s proxy voting policies and procedures are disclosed to clients, it is unclear whether an adviser to a fund that seeks to track the performance of an index is acting in accordance with its fiduciary duties when it uses fund assets to pursue non-financial goals.

Additionally, under Commission rules, asset managers have “beneficial ownership” of companies’ voting securities because they have the power to vote, or to direct the voting of, such securities.[39] It is unclear why asset managers that engage in “investment stewardship” have been filing beneficial ownership reports on Schedule 13G, which can only be used if the manager does not hold securities with the purpose or effect of changing or influencing the control of the issuer of the securities.[40] These asset managers may indeed have a control purpose when engaging in investment stewardship campaigns that seek to remove board members or impose operational changes. In that case, perhaps they should be reporting on Schedule 13D, which requires more detailed disclosure on a more prompt and frequent basis.[41]

From a business perspective, when asset managers start pursuing particular political or social agendas that do not appear to be readily connected to financial returns to clients, public pushback from dissenting parties is a natural result.[42] Pursuing a particular ESG strategy can involve choosing social and political causes. There is a reason that changes affecting broad swaths of society are best left to elected officials, accountable to the voters, and not unelected persons like regulators or asset managers. That’s called representative democracy. From that perspective, it is not surprising that an asset manager that advances certain ESG causes using client assets may receive the types of criticisms that are typically reserved for politicians.

Conclusion

Despite the fanfare around ESG investing, there are many questions on what it encompasses. Because “ESG” can mean different things, complying with the federal securities laws requires that asset managers describe precisely what they mean when they offer an ESG fund or product. In that regard, the existing regulatory framework is well suited to guide the conduct of investment advisers. Any emerging regulations should be careful not to tip the scale in favor of any particular political or social cause, and adherence to the established framework of focusing on financial materiality will continue to serve investors well.

Thank you.