ESG: Issues Faced by an Elusive Definition

March 2017

Herrick lawyers recently participated in a webinar on environmental, social and governance investment due diligence (ESG) that was hosted by the Investment Management Due Diligence Association. Below is the first in a series of articles that will further explore this important topic.


Threshold Diligence Issues Confronting ESG Investments

Investors with allocations in the environmental, social and governance asset class (ESG) face numerous due diligence issues regarding the construction and management of their investment portfolio. One threshold issue that must be addressed by the investor and investment manager is the scope or definition of ESG, including the amount of non-ESG asset contamination that is permitted in any portfolio or investment for it to still qualify for the investor’s ESG strategy. Investment opportunities typically offer a mix of ESG and non-ESG components. Without a clear understanding among the investor and investment manager, the ESG objectives may not be obtained and the investment manager may held liable.

Determining if a company qualifies for inclusion in an ESG portfolio illustrates this issue. Assume that the investment manager proposes an ESG-focused portfolio that will include purchasing the common stock of a New York Stock Exchange (NYSE)-listed company that is one of the largest global retailers, which has more than 10,000 stores in 28 countries, is part of the neighborhood fabric throughout the U.S. and embraces many ESG goals, including:

• A stated commitment to provide opportunities for its staff and value to its customers and communities;

• A demonstrated commitment to promoting managers from its employee base, an extensive investment in employment education; and

• Provides low-cost products to millions of low-income and middle-class consumers.

One may take the position that this company should properly be included in an ESG portfolio. Assume further, however, that this company has repeatedly taken actions to defeat any labor organizing efforts, reportedly has (or had) harsh working conditions, is subject to a U.S. investigation for allegedly bribing Mexican officials in violation of the Foreign Corrupt Practices Act, and has refused to be part of Accord on Fire and Building Safety (a pact by 190 clothing brands as well as trade unions to inspect factories for fire, electrical and structural safety). Assume further that its stores often are located in “big box” retail locations that in many cases adversely impact the environment by advancing suburban retail sprawl. The fact that reasonable and intelligent investment professionals may in good faith debate whether this investment may be properly included in an ESG investment creates numerous issues and could lead to liability for an investment adviser that allocates any material amount to its common stock.

ESG is a multi-trillion dollar asset class (some estimates are more than $8.7 Trillion - see SRI Basics and Advisor Perspectives - The Future of Investing in ESG Portfolios). However, there is no irrefutable universally adopted definition of this asset class.

The Securities and Exchange Commission (SEC) has issued its Concept Release to review and modernize ESG and other disclosure issues.1 The SEC can provide meaningful guidance and clarity to ESG reporting and disclosures. Until any such regulatory guidance is finalized, it will likely be the institutional investors and sophisticated investment managers that lead the discussion and provide a framework for the array of ESG diligence issues (including establishing factors that define ESG), by adding to the regulatory evaluation what is used and accepted in the industry.

The SEC’s Concept Release asks several important questions, including:

• Are there specific sustainability or public policy issues that are important to inform voting and investment decisions?

• Would line item disclosures be meaningful or would such disclosures obscure important information?

• Should public companies be required to provide ESG information in SEC reports or is disclosure through websites sufficient?

• Should any of the existing ESG reporting frameworks be used by the SEC in developing additional disclosure requirements?

• What additional challenges are presented in preparing additional line-item ESG disclosures?

Each of these points raised by the SEC would add to the mix of information that may enable investors to make intelligent decisions regarding ESG portfolios and investments.

The lack of an irrefutable universally adopted definition of ESG inhibits investment professionals from truly integrating ESG in their respective organizations and investment strategies, and engaging with ESG- focused investors in a meaningful process. One result is that many investment professionals describe their ESG strategies in promotional material and investment relations documentation with ambiguous terms such as “commitment,” “seeks,” “promotes” or having a “focus” on ESG factors. Investment professionals employ such ambiguities to avoid potential liability for breach of the investment contract, or facing regulatory scrutiny for false and misleading solicitation material in violation of Section 206 of the Investment Adviser Act or Section 11 of the Securities Act. The example provided above demonstrates the ability of an investor to take action against any investment professional that makes any such “flat” statement.

Investment professionals are well positioned to develop and refine factors that evaluate ESG-related investment decisions and ESG investment performance against a well-defined peer group. Private funds offer the greatest opportunity for meaningful impact because investment sponsors typically have greater influence and control over the ESG data that is reported and the integrity of the reporting process. Investors can leverage this influence and control by specifying factors in the investment adviser agreement or through a side letter in a private fund. Each agreement can provide additional clarity to ESG factors and define the appropriate weight for each factor to better construct and manage an ESG focused portfolio.

For advice on managing and understanding ESG investments, including diligence and related Investment Adviser Act implications, contact Richard M. Morris at [email protected] or (212) 592-1432.


1 SEC Concept Release BUSINESS AND FINANCIAL DISCLOSURE REQUIRED BY REGULATION S-K (Release No. 33-10064; 34-77599)