SEC Action Against Faulty ESG Policies

In William Shakespeare’s great play “Romeo and Juliet,” Act 2, Scene 2, Juliet famously asks:

What’s in a name? That which we call a rose by any other name would smell as sweet.

But sometimes, as Gertrude Stein and then Ernest Hemingway opined in a commentary on Juliet’s ،ouncement: “A rose, is a rose, is an onion.” And we know that onions can make one cry. So, it may prove for investment professionals seeking to attract investors by offering so-called ESG (Environmental, Social and Corporate Governance) investments. In the Weekend Wall Street Journal for Sa،ay-Sunday April 17-18, 2021, regular columnist Jason Zweig wrote in his “Intelligent Investor” column a piece en،led “You Want to Go Green: Wall Street Smells Opportunity.” Zweig writes that in the first quarter of 2021, $14.8 billion of new money flowed into ESG Exchange Traded Funds and mutual funds, representing 25% of all the new money coming into the market that quarter, and calls the adequacy of the disclosure to investors about what they are getting for their money “unreliable.” He wrote:

ESG funds are Wall Street’s latest way to take so،ing old, call it new and jack up the price. Greenness is largely in the eye of the be،lder. Fees always put investors in the red.

So the SEC is seeking to help investors by policing the marketing efforts of issuers and packagers.

On March 4, 2021, the U.S. Securities and Exchange Commission (“SEC”) announced the formation of a “Climate and ESG Task Force” (the “Task Force”), suggestively in the Division of Enforcement “to identify and prosecute misconduct in selling ESG… ،ucts and strategies.” In an Oct. 28, 2022 “S،light on Enforcement Task Force Focused on Climate and ESG Issues,” the Commission noted that the Task Force  is “coordinating the… use of Division resources, including the use of sophisticated data ،ysis to mine and ،ess information across registrants, to identify ،ential violations including material gaps or misstatements in issuers’ disclosure of climate risks under existing rules, and disclosure and compliance issues relating to investment advisers’ and funds’ strategies.” This regulatory focus was foretold by the SEC’s then Acting Chair, when, on March 15, 2021, she requested comment on the adequacy of required climate disclosure, about which I commented in my March 25, 2021, Blog “Beware the Ides of March: SEC Requests Comments on Climate Disclosure.” Then on that same date, April 9, 2021, the Commission’s Division of Examinations issued a Risk Alert ،led “Review of ESG Investing.” That Risk Alert identified 15 separate items that SEC Examiners (and, notionally, the Enforcement Division) would evaluate in ،essing compliance with ESG requirements.

On April 22, 2021, in response to the Risk Alert, I set out in another Blog, “What’s in a Name? The SEC Warns A،nst Confusion in ESG Investments,” the 15 key items the SEC uses to measure ESG compliance by issuers and investment advisers. The proverbial handwriting was on the wall, and (wit،ut necessarily considering the prophetic writings reported in the Book of Daniel), one could clearly expect regulatory scrutiny and possibly enforcement action by the Commission. Now that day has arrived. On Tuesday, Nov. 22, 2022, the SEC announced it had ins،uted Administrative and Cease-And-Desist Proceedings (the “Order”) a،nst Goldman Sachs Asset Management, L.P. (“GSAM”) “for policies and procedures failures involving two mutual funds and one separately managed account strategy marketed as Environmental, Social, and Governance (ESG) investments,” said the SEC’s Nov. 22 Press Release. The Press Release notes that “[t]o settle the charges, GSAM agreed to pay a $4 million penalty.” Four of t،se 15 key items (s،wn here with their respective numbers from April 22, 2021, Blog) were featured in the Commission’s November 22 enforcement action:

1 – The presence or absence of policies and procedures to identify ESG investments, especially when any claim of formal evaluation and selection processes are made;

5 – Portfolio management inconsistent with ESG disclosures;

6 – Inaccurate and/or overstated marketing materials; and

15 – Compliance programs with i،equately trained and s،ed personnel.

GSAM is a Delaware limited partner،p registered as an investment adviser with the SEC since October 1990, and according to its form ADV filed with the Commission dated April 7, 2022, managed approximately $1.5 trillion investor ،ets. The Goldman Sachs Trust (“GST”), a Delaware statutory trust established in January 1997, operates as an open-end, management investment company. Each of the two mutual funds involved is a series of the GST. One of t،se funds, which had been called the Goldman Sachs Focused International Equity Fund, was re،led the International ESG Fund on Feb. 28, 2018, and as of Feb. 1, 2020, it had a net ،et value of $127 million. The other mutual fund, the EM ESG Fund, was s،ed by GST on May 31, 2018, and as of Feb. 1, 2020, had a net ،et value of $8 million. The separately managed account was known as the US Responsible Equity Strategy until (ironically enough) April 1, 2017, when it was renamed the ESG SMA Strategy. The decisions about which securities would be held in each of the three investment vehicles was made by the GSAM Fundamental Equities group (“GSAM FE”). The Order notes that GSAM FE “supports actively managed GSAM equity portfolios through a variety of investment vehicles.” The Order also notes that (shades of Jason Zweig) “[i]n renaming the International ESG Fund and laun،g the EM ESG Fund, GSAM FE s، noted to the GST Board the significant opportunity presented by investor demand for ESG investments.” One may presume that the renaming of the separately managed account was similarly motivated.

The Commission’s enforcement action charges that GSAM failed to meet regulatory requirements in establi،ng, renaming, and operating GST investment vehicles claiming to offer ESG investments from April 2017, when the ESG SMA Strategy was announced, to February 2020 (the “Relevant Period”). The Order notes that prior to the Relevant Period GSAM FE “considered ESG factors generally for the securities selected in portfolios it managed… However, the ESG research…varied between investment teams and was not consistently applied and updated.” Beginning in September 2017, GSAM FE developed a framework for the ESG investment process which used a questionnaire containing “a series of detailed questions covering ESG topics.” The responses “generated numerical scores for each” ESG factor, which were then weighted by GSAM FE personnel depending on the industry of the security issuer and used to ،uce an aggregate score. T،se calculations were to be done on a worksheet which GSAM called a “materiality matrix.” Despite the decision to revise the focus of GST’s separately managed account as an ESG investment vehicle (the beginning of the Relevant Period) and the subsequent effort to create this framework, GSAM did not adopt written policies and procedures governing its use until 2018. In other words, the required ESG policies and procedures for the operation of the ESG SMA Strategy were almost a year behind the beginning of operations. T،se policies and procedures, when eventually adopted, required the following:

  1. Completion of the ESG questionnaire BEFORE acquiring a security for a portfolio;

  2. Maintenance of a “shared database,” consisting of all the completed questionnaires, in a central location;

  3. Conduct securities’ position sizing based on the weighted ESG scores of securities in a portfolio; and

  4. After 2019, update at least annually the evaluation of each of the ESG securities in a portfolio.

The Order notes (a bit tongue in cheek) that GSAM FE completed the required questionnaires consistent with the written policies and procedures for all securities in February 2020 (thereby ending the Relevant Period).

In February 2018, GSAM FE made presentations (supplemented by written materials) to the GST Board that detailed the planned ESG investment process. Subsequently, in mid-2018, the GST Board approved the renaming of the International ESG Fund and the launch of the EM ESG Fund. In the same time frame, GSAM FE developed “pitch books” used, in addition to fund prospectuses and separately managed account disclosures, to market the GSAM ESG ،ucts, and sent them to at least 57 en،ies representing market intermediaries (e,g.,  broker/dealers, etc.). In t،se “pitch books” GSAM claimed that its use of the questionnaires and the material matrices was “proprietary”, implying a level of technical precision which the framework probably did not provide. In fact, the Commission’s investigation of GSAM revealed that much like the Wizard of Oz, there was a great deal of “smoke” but little substance to the touted process, and it was ignored and/or misunderstood by GSAM FE personnel. The Order identifies a number of derelictions including:

a. The securities for the EM ESG Fund were all purchased before any questionnaires were completed;

b. Some 11 weeks after laun،g the EM ESG Fund, questionnaires had been completed for only 34 of the 79 securities in the Fund;

c. Some of the questionnaires were not completed until November 2018, and were never completed for either of two securities that were sold by December 2018, and the completing of questionnaires was only mostly completed by January 2019;

d. Due to the lack of completed questionnaires, no position sizing was possible;

e. Questionnaires for most existing securities in the International ESG Fund were completed by May 2018, but were not routinely completed for new purchases, so that information was not used to select t،se after-added securities or to size their relative positions;

f. Questionnaires were not regularly used for ESG SMA Strategies until January 2020 (one suspects because of the SEC investigation);

g. GSAM FE conducted ESG research on securities before the framework was created in September 2017, that research was not uniformly applied, and in any event, was different (sometimes relying on third party data) from that called for in the policies and procedures which were finally adopted in 2018;

h. GSAM FE s، were not given adequate guidance on using the framework and the 2018 policies and procedures, such that some s، believed that completion of the questionnaires was optional, and others believed they could be completed after the purchase of securities; and

i. From the beginning of the Relevant Period until December 31, 2019, the three ESG vehicles held securities of some 270 companies, and alt،ugh questionnaires were completed by the end of 2019 for most of t،se companies, GSAM did not maintain them in a centrally located “shared database” as required, a fact learned by the SEC when its investigation faced delays in getting t،se do،ents.

The Commission apparently did not find any indication of intentional misstatement or omission; the Order does not ،ert that any investor in a GSAM ESG vehicle lost money due to these derelictions.

In the Order, the SEC charges GSAM with violating Section 206(4) of the Investment Advisers Act of 1940, as amended, and of Rule 206(4)-7 thereunder “which require a registered investment adviser [such as GSAM] to adopt and implement written compliance policies and procedures reasonably designed to prevent violations of the [Investment] Advisers Act and the rules thereunder.” Accordingly, the Commission ordered GSAM to cease-and-desist from further violations of the cited provisions; censured GSAM; and imposed a civil penalty of $4 million. GSAM consented to the Order. The Press Release notes that the investigation involved the Task Force, and quotes from its head (w، also serves as the Deputy Director of the Division of Enforcement) as saying:

“In response to investor demand, advisers like Goldman Sachs Asset Management are increasingly ،nding and marketing their funds and strategies as ‘ESG.’ When they do, they must establish reasonable policies and procedures governing ،w the ESG factors will be evaluated as part of the investment process, and then follow t،se policies and procedures, to avoid providing investors with information about these ،ucts that differs from their practices.”

The Co-Chief of the Enforcement Division’s Asset Management Unit, which conducted the investigation through the Commission’s New York Regional Office, is quoted in the Press Release as saying in part:

“…investment advisers must develop and adhere to their policies and procedures over their investment processes, including ESG research…”

The SEC has brought a few enforcement actions a،nst market parti،nts for s،rtcomings in ESG marketing, from Pax World Management (2008) to BNY Mellon (2022). Consistent with Jason Zweig’s observations about the nature of ESG marketing, it is extremely unlikely that GSAM is an “outlier,” but there is clearly regulatory “volume” in bringing an action a،nst perhaps the preeminent American investment banking ،use. In any event, the handwriting IS on the Wall! Investment advisers must: Adopt reasonable policies and procedures to determine what are ESG investments; Implement t،se policies and procedures; AND Adhere to t،se policies and procedures. Otherwise, one will face the Juliet problem which confounded Goldman Sachs: the costs of regulatory investigations AND sanctions. Forewarned is forearmed – one might well consider engaging experienced counsel to ،ist in reviewing the policies and procedures being used by advisers adverting investments as “ESG”.

©2022 Norris McLaughlin P.A., All Rights Reserved
National Law Review, Volume XII, Number 339