Kentucky AG Investigation Into ESG-Related Investment Practices Reflects Emerging Trend
On November 14, 2022, the Kentucky Attorney General’s Office announced an investigation “into alleged violations of Kentucky’s consumer protection laws related to ESG (environmental, social, governance) investment practices of The Vanguard Group, Inc. . . . and State Street Bank.” The announcement indicates that the Attorney General’s Office sent civil investigative demands (CIDs) to each institution, with a specific focus on examining their ESG investment practices and fiduciary responsibilities as members of the Glasgow Financial Alliance for Net Zero, Climate 100 +, and Net Zero Asset Managers (NZAM).
The Kentucky Attorney General’s investigation reflects an emerging trend of authorities at the state and federal levels targeting the promotion of ESG investments. Environmental, social, and governance (ESG) investments have exploded in popularity in recent years, both among institutional investors and among retail investors working with brokers and investing independently. The U.S. Securities and Exchange Commission (SEC) is emphasizing ESG investment compliance as well, taking an “all-agency approach” to combatting fraudulent practices in this emerging area.
The Kentucky Attorney General’s Investigation of The Vanguard Group and State Street Bank
In its civil investigative demands issued to The Vanguard Group and State Street Bank, the Kentucky Attorney General’s Office is seeking to gather information related to each institution’s efforts to meet their ESG-related representations to the public market. Notably, however, while the SEC is primarily focused on ensuring that investors receive accurate information about ESG investments (among others), the Kentucky Attorney General’s investigation is focused on ensuring that institutions like The Vanguard Group and State Street Bank do not place too much emphasis on environmentally-conscious efforts. The Office’s announcement quotes Attorney General Daniel Cameron as stating, “Kentucky’s Consumer Protection laws prohibit companies from placing a climate agenda ahead of the financial profitability of their client’s investments. . . . We launched this investigation to protect Kentucky consumers . . . .”
The announcement then goes on to reference The Vanguard Group’s and State Street Bank’s public statements regarding their membership in Net Zero, Climate 100 +, and NZAM. But, rather than questioning the authenticity of these statements—as is often the issue in ESG-related investigations—the Kentucky Attorney General’s Office is instead focusing on whether these institutions’ environmental commitments represent a deviation from their fiduciary duty to maximize their clients’ returns. The Office’s CIDs further illustrate its efforts to challenge The Vanguard Group’s and State Street Bank’s environmental commitments as a deviation from their fiduciary obligations. For example, the Office’s CID to The Vanguard Group asks questions such as:
- “As a fiduciary, does Vanguard act in the sole interest of its clients?”
- “Does Vanguard act in its clients’ financial interests only?”
- “[T]o what extent does Vanguard verify financial and market data reported by portfolio companies and third-party ESG ratings providers?”
It will be interesting to see where the Kentucky Attorney General’s investigation leads, and this will be an important case for financial institutions and ESG-conscious entities to follow. If other state regulators follow suit, entities engaged in the ESG investment market may need to walk a very fine line between satisfying the SEC’s disclosure expectations and not overstepping the bounds of state-level consumer financial protection.
The SEC’s Recent Approach to Ensuring Transparency in the ESG Investment Market
As noted above, the Kentucky Attorney General’s approach departs from, and is somewhat at odds with, the approach that the SEC is taking at the federal level. While the SEC is also prioritizing compliance in the ESG investment market, to date its efforts have focused more on the environmental, social, and governance side of the equation. For example, in a May 25, 2022 press release announcing a proposal to enhance investment advisors’ and investment companies’ ESG investment disclosures, the SEC wrote:
“The proposed amendments seek to . . . require funds and advisers to provide more specific disclosures in fund prospectuses, annual reports, and adviser brochures based on the ESG strategies they pursue. Funds focused on the consideration of environmental factors generally would be required to disclose the greenhouse gas emissions associated with their portfolio investments [and f]unds claiming to achieve a specific ESG impact would be required to describe the specific impact(s) they seek to achieve and summarize their progress on achieving those impacts.”
The SEC’s press release also notes that its proposal would require the reporting of, “census-type data that inform the Commission’s regulatory, enforcement, examination, disclosure review, and policymaking roles.” However, notably absent from the SEC’s press release—particularly in light of the Kentucky Attorney General’s pending investigation—is any reference to investment advisors’ or investment companies’ obligation to maximize their clients’ profitability from ESG investments as fiduciaries.
This may be, at least in part, due to the fact that the crux of ESG investing is not maximization of returns—at least not for many environmentally and socially conscious investors. In fact, by definition, ESG investing involves taking into consideration factors other than bottom-line financial performance. Explaining the concept of ESG investing, the CFA Institute writes that, “it can be difficult to assign [ESG factors] a monetary value,” and further notes that, “ESG metrics are not commonly part of mandatory financial reporting, though companies are increasingly making disclosures in their annual report or in a standalone sustainability report.”
Again, this seems to be more closely aligned with the SEC’s current enforcement focus. While ESG factors can impact companies’ profitability, and while this undoubtedly remains the driver behind many retail investors’ investment decisions, the SEC is prioritizing full disclosure over necessarily maximizing investor returns. In doing so, the SEC is seeking to allow investors to make their own informed investment decisions while simultaneously allowing firms and companies to target ESG initiatives—as long as they provide adequate disclosures along the way.
What Does All of This Mean for Firms and Companies with ESG Priorities?
In a presentation given in London on October 17, 2022, SEC Commissioner Jaime Lizarraga highlighted the Commission’s ESG-related priorities going forward. Here are some of the key lines from the presentation:
- “Last year, for the first time, the U.S. Financial Stability Oversight Council identified climate change as an ’emerging and increasing threat to U.S. financial stability’. . . . It is thus not surprising that there’s been strong investor demand for climate-related disclosures.”
- “These SEC rules [are] designed to provide investors with decision-useful qualitative and quantitative information on how a fund takes into account ESG factors in its decision-making.”
- “As ESG investment continues to grow, there is greater need for accurate and reliable data to support ESG-related claims and assertions.”
- “[Investment firms’ and companies’] challenge and responsibility is to ensure that claims made to investors are supported by verifiable information so as not to make disclosures misleading.”
Notably, Commissioner Lizarraga also recognized that, “[s]everal states are making headlines for their push against ESG investing, while other states are proactive in their ESG investments.”
As you can see from the SEC’s focus and Commissioner Lizarraga’s comments, the push at the federal level is much more on the pro-ESG side. But, this does not eliminate concerns about state-level enforcement. To the contrary, as the Kentucky Attorney General’s CIDs issued to The Vanguard Group and State Street Bank show, institutions and companies will need to carefully balance their efforts to avoid facing investigations from multiple angles—and with competing enforcement goals.
Given these competing concerns, when it comes to ESG-related risk management, it is imperative that financial institutions, investment advisory firms, and companies that engage in ESG practices prioritize compliance. They must work with their counsel to carefully craft policies and procedures that are capable of withstanding scrutiny from state-level authorities while also satisfying the SEC’s disclosure requirements. ESG-conscious entities may also want to consider generating and keeping on hand documentation that illustrates the financial utility of their ESG efforts—as this documentation could prove essential for carrying out ESG initiatives without the risk of state-level investigations and enforcement actions leading to substantial penalties.
Focusing on long-term profitability in public disclosures and internal documentation may prove to be a viable strategy as well. Even if a focus on ESG-related priorities may limit short-term profitability, there is arguably little argument against the long-term utility—if not necessity—of prioritizing environmental and social considerations from both the global and financial perspectives. But, even here, entities will need to be careful. In its CID to The Vanguard Group, the Kentucky Attorney General’s Office asks, “[D]oes Vanguard act in clients’ long-term interests only, and if so, how long is that term?” This certainly seems to give a negative connotation to the long-term focus—which would be in line with anti-ESG authorities’ broader efforts to restrict corporate decision-making that is not purely financial in nature.
Contact the Securities Law Compliance Attorneys at Oberheiden P.C.
Oberheiden P.C. is a securities law compliance and defense law firm that represents financial institutions, investment advisors and companies across the United States. If you have questions about ESG-related compliance or have received a civil investigative demand (CID) related to your firm’s or company’s ESG efforts, we invite you to call 888-680-1745 or contact us online to arrange a complimentary initial consultation.
Dr. Nick Oberheiden, founder of Oberheiden P.C., focuses his litigation practice on white-collar criminal defense, government investigations, SEC & FCPA enforcement, and commercial litigation.