As featured in Sustainable Investment
The Securities and Exchange Commission (SEC) recently penalised BNY Mellon Investment Adviser, Inc. (BNY Mellon) for misstatements and omissions about Environmental, Social, and Governance (ESG) considerations in making investment decisions for certain mutual funds that it managed. As a result, BNY Mellon agreed to pay a $1.5 million penalty to settle the charges.
This ESG enforcement decision is important for at least two reasons, firstly because it is the first major enforcement action focused on ESG representations in investment prospectuses, and secondly the availability of a written decision provides valuable insights on the SEC’s approach enforcing standards in sustainability investing.
The investment industry should however take note that this is not only ESG enforcement case in progress following the formation of the SEC’s Climate and ESG Task Force in March 2021. For example, in April 2022, the SEC raised complaints against Vale, S.A. (Vale), a publicly traded Brazilian mining company, for making false and misleading claims about the safety of its dams prior to the deadly collapse of the Brumadinho dam in Minas Gerais, Brazil that buried 150 people alive, and killed 270 people in January 2019. According to the SEC press release, this disaster led to a loss of more than $4 billion in Vale’s market capitalization. In this case the SEC alleged that Vale was in violation of antifraud and reporting provision in the securities laws because it manipulated dam safety audits obtained numerous fraudulent stability declarations and misled governments, communities, and investors about the dam’s integrity.
In a further step, as reported recently in the Wall Street Journal, the SEC is investigating Goldman Sachs’ asset management division “over its funds that aim to invest based on environmental, social and governance standards” for potential misuse of words such as “ESG” or “clean energy” in their funds’ names to signal funds are focused on ESG. In particular, according to the article, regulators are becoming increasingly concerned that ESG, while lacking a defined regulatory meaning, can nevertheless make financial products appear more attractive as its apparent indication to tackle issues such as climate change, carbon emission, deforestation, diversity or working conditions.
And, on the other side of the Atlantic, European regulators are also ramping up their ESG investigations. On 1 June, German prosecutors raided asset managers DWS Asset Management as well as the headquarters of its majority owner Deutsche Bank in Frankfurt for DWS allegedly misleading investors through “greenwashing”, a practice where investments are purported “greener” and more sustainable than they actually are. This latest probe follows last year’s SEC investigation into allegations made by DWS’ former head of sustainability that the firm exaggerated how it considered “sustainable investing” criteria to manage its investments.
What happened in the BNY Mellon case?
In BNY Mellon’s case, the SEC found that nearly 25% of the investments going back to 2018 and purporting to be sustainable in certain funds did not undergo a “proprietary” ESG quality review during their investment selection process, despite BNY Mellon claiming that it did so for all investments in those funds. According to the SEC’s order, BNY Mellon’s policies did not require an ESG quality review for all investments in those funds. However, BNY Mellon represented to its prospective clients that ESG considerations were considered at every stage of the investment process and that each security being considered for investment was subjected to an ESG quality review.
The SEC also found that BNY Mellon’s policies and procedures were not adequately designed to prevent inaccurate or materially incomplete statements in the company’s representations. BNY Mellon’s compliance team were, unaware that ESG quality reviews were not being conducted for all investments in the funds in questions up until mid-March 2020 and, as such, could not provide meaningful assessments of whether BNY Mellon’s representations complied with US securities laws.
The SEC’s focus on identifying ESG-related misconduct comes at a time where investors increasingly rely on disclosures including ESG criteria when deciding where to invest their money. In response, asset managers and similar companies are offering more investment strategies that incorporate ESG considerations: a growing line of investment products require that asset management firms evaluate their current processes and understand whether they are adequately designed to minimize both exposure to regulatory scrutiny and the risk of having charges brought against them.
As the SEC gains momentum in investigating cases of this nature, it will become more difficult for companies to evade attention from the Commission. The BNY Mellon case is a clear example of how transformation in the sustainable investment industry requires swift and effective action to ensure firms are prepared to meet their compliance obligations.
Firstly, firms must conduct a compliance risk assessment, with senior management and business functions sponsoring and engaged in the process, in order to demonstrate top-level commitment, define a clear scope and prepare a targeted review of relevant policies and procedures, organizational structure, resourcing, monitoring systems, and other relevant materials. Secondly, firms must determine where in their operations risk and exposure to regulatory scrutiny exist, so that they can assess the design of existing controls and test their effectiveness. Lastly, firms must develop an action plan to mitigate each risk and ensuring that any gaps such as ineffective controls, insufficient training or inadequate monitoring are sufficiently remediated.
It is critical that counsel and compliance teams embrace and lead this transformation by leveraging existing components of a compliance program at these complex and dynamic regulatory enforcement priorities. ESG continues to be in a state of flux with international consensus on the thresholds for inclusion still to be agreed, which adds a layer to an already complex regulatory picture. In the BNY Mellon case, for example, the SEC simply focused on the failure to conduct the ESG quality reviews as promised, rather than whether the “proprietary” ESG rating system was itself fit for purpose, thus hoisting BNY Mellon by its own petard. In the future, as the regulatory environment matures, we expect to see scrutiny on the methodology, algorithms, metrics, definitions, and sources of information used in rating investment products marketed as “ESG” or “Sustainable”.
In this decision the SEC looked back to at least 2018 in calling out ESG compliance failings, a clear signal for asset managers to clean their house now and remediate any issues before getting caught up in the SEC’s industry sweep.