SEC Charges Fund Manager for ESG Misstatements: Overview and Practical Takeaways

The US Securities and Exchange Commission (SEC) announced settled charges against BNY Mellon Investment Adviser, Inc. (BNYMIA) on May 23, 2022, for misstatements and omissions regarding Environmental, Social and Governance considerations (ESG) related to investment decisions for certain of BNYMIA’s managed funds. While this is the SEC’s second ESG-focused action since the Division of Enforcement created its Climate and ESG Task Force in March 2021 (Task Force), it is more indicative of the Task Force’s priorities in the early stages of its ESG-focused mandate. As we wrote in our April 29, 2022 Advisory, although the SEC’s first ESG-related action—against the Brazilian mining company, Vale S.A. (Vale)—is based on false and misleading ESG disclosures, that action is akin to a traditional fraud case that more remotely implicated ESG disclosures. The allegations against BNYMIA, on the other hand, involve the type of “greenwashing” statements that are likely to be the focus of the Task Force going forward.

With the SEC set to consider ESG-related rule amendments for investment advisers and investment companies this week, investment advisers and companies should expect more scrutiny related to ESG statements and disclosures.

This Advisory sets forth the Commission’s findings against BNYMIA and our observations for future ESG-related actions, as well as key takeaways and best practices.

Findings Against BNYMIA

In its Order, the SEC found that, between July 2018 and September 2021, BNYMIA made representations that all investments in certain mutual funds it advised underwent a proprietary ESG quality review, conducted by its sub-adviser, as part of the investment research process in making investment selections. The ESG quality review entailed rating a company BNYMIA was considering for investment on a scale of 1-to-10, with 10 being the score for a company with “world leading” ESG practices. BNYMIA represented that it would assign the rating before making the investment selection (for equities) or within 30 days of investment (for corporate bonds). BNYMIA made these representations in mutual fund prospectuses, in responses to requests for proposals (RFP Responses) from potential investment firms, and to the mutual funds’ boards. For example, one fund’s prospectus stated that the investment process “includes identifying and considering the Environmental, Social and Governance (ESG) risks, opportunities and issues throughout the research process via [the sub-adviser’s] proprietary quality reviews, in an effort to ensure that any material ESG issues are considered.”

The SEC found that while BNYMIA represented that the sub-adviser conducted an ESG quality review and assigned a rating to “each” company under consideration prior to making investment decisions, 67 of the 185 investments made by one of the funds did not have an ESG quality rating at the time of investment (or within 30 days after purchase in the case of corporate bonds). The SEC further found that BNYMIA’s representations about the ESG quality review therefore were misleading, because a reasonable investor could mistakenly conclude that all holdings selected by the sub-advisor were subject to the ESG quality review and rating. The SEC concluded that BNYMIA failed to adopt and implement written policies and procedures that were reasonably designed to prevent the inclusion of inaccurate or misleading statements in its documents.

To settle charges brought under the Investment Advisers Act and Investment Company Act, BNYMIA agreed to pay a $1.5 million penalty, and accept a censure and cease and desist order.

Observations

The BNYMIA settlement and the pending Vale lawsuit are the first output from the SEC’s more than year-long focus on climate and ESG related disclosures that began with the creation of the Task Force. In our Advisory last month on the Vale action, we noted that the SEC will be under pressure to bring more ESG-related cases prior to the end of its fiscal year in September. As we foreshadowed, the announcement of the BNYMIA settled action followed less than a month later. The Task Force likely is under continued pressure to conclude and file other ESG-related cases currently under investigation as well as begin new investigations to show the success of the Task Force. As such, we expect to see further ESG-related cases in the future.

The BNYMIA action can be seen as a message case in the early stages of the SEC’s new enforcement initiative. The Commission’s findings are rather clear cut: the firm disclosed to investors that it was assigning an ESG quality rating to all potential investments, but it assigned a rating only to some investments. And while the $1.5 million fine is relatively small, it establishes a baseline upon which future penalties against other violators will be assessed and may become increasingly larger as more cases are brought. Future enforcement actions are also likely to involve more nuanced findings of greenwashing. In addition to investigating clear misrepresentations as found here, the SEC is likely to probe situations where, for example, investment research included an ESG review, but the ESG ratings were inflated or the ESG bona fides of the investment were overstated. The SEC will be focused on investor demand for ESG products and the corresponding incentive to exaggerate an investment’s ESG credentials.

Key Takeaways

In light of the BNYMIA case and the ever-increasing focus by the SEC on climate and ESG-related issues, investment advisors, fund managers, company executives, and other industry participants may want to consider the following best practices and key takeaways.

Increased Focus on Compliance Teams. The BNYMIA case is instructive for compliance departments that have responsibility for business units and products in the increasingly scrutinized ESG space. The SEC cited BNYMIA for lacking policies and procedures reasonably designed to prevent the allegedly inaccurate or materially incomplete statements regarding the funds’ ESG quality reviews. Specifically, the SEC alleged that BNYMIA compliance personnel were unaware that quality reviews were not conducted for all relevant investments, which left compliance personnel unable to determine whether the prospectus and representations made in RFP responses complied with federal securities laws. Ensure your compliance team is involved in developing the policies and procedures that safeguard the accuracy and consistency of disclosures. Conduct periodic checks to ensure that everyone is consistently following the policies and procedures. In particular, the focus on RFP’s by the SEC, while not unprecedented, is an area of concern since RFP responses are not typically subject to the same level of internal scrutiny as prospectuses and other filings.

Policies and Procedures Should Include Safeguards for Consistent and Accurate Communications. Firms should pay close attention to their ESG statements to ensure they are accurate and consistent across all firm communications, both written and oral. For example, prospectus disclosures should be consistent with corporate sustainability reports, which should be consistent with press releases, which should be consistent with media interviews and social media posts. For private fund managers, private placement disclosures should be consistent with the firm’s policies, procedures and practice.

Prompt Remediation is Important. Without quantifying the benefit to the settlement, the SEC favorably cited BNYMIA’s prompt remediation efforts to modify relevant disclosure processes, policies, and procedures, as well as the cooperation in advancing “the quality and efficiency” of the SEC’s investigation which helped conserve SEC resources. These statements suggest the SEC may consider a strong—or promptly remediated—ESG-related compliance program as a potential mitigating factor in assessing any penalty.

Arnold & Porter continues to monitor the rapidly evolving climate-related and other ESG developments and recommend best practices for our clients. If you are seeking advice on how to reduce ESG enforcement-related risk, or how to incorporate ESG factors into your risk management or disclosure processes, please contact any author of this Advisory or your regular Arnold & Porter contact. For prior advisories related climate and ESG related developments, see our ESG series Parts I, II, III, IV, and V.

© Arnold & Porter Kaye Scholer LLP 2022 All Rights Reserved. This Advisory is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.