Why Should Compliance Officers Consider ESG Principles?

Environmental, Social, and Governance (ESG); impact investing, and sustainability are terms you may believe are outside the remit of your compliance and ethics program.

This article will illustrate the applicability of ESG and impact investing to general compliance programs as well as risk management and prudent business judgment. The heart of a compliance officer’s job is to help ensure claims to investors or consumers are accurate. ESG principles can help a compliance officer deliver on that responsibility. For example, understanding what is meant by ESG claims, or borrowing ESG principles to identify and manage risk, can help compliance officers not just protect their companies and end customers, but also add important commercial value by helping the business make prudent business decisions.

Recent policy changes support the move to an ESG framework; in May, the European Commission released an ESG proposal advocating enhanced transparency and duties for institutions. These principles are already incorporated in the investment mandates of US pensions such as CalSTRS and the New York Common Fund. Additionally, there are global investment standards such as the UN Principles of Responsible Investing (PRI) with over 1,500 signatures and the UN Sustainable Development Goals pointing the private sector toward those issues that require the most attention and investment.

Even if you put aside these evolving standards and new products, such as impact private funds or ETFs or mutual funds using a socially responsible index such as the Calvert US Large-Cap Core Responsible Index or the MSCI KLD 400 Social Index as a performance benchmark. Compliance officers can look at ESG investing concepts for sales practices, compliance, and managing risks.

When businesses consider a new investment, product, or service provider, they often rely on others’ claims to forecast their own returns or profits. What happens if those claims are inaccurate and then forecasts are inflated? Faulty due diligence can lead to unmanaged risks and liability. However, by leveraging ESG principles, companies can minimize these blind spots and avoid the predictable surprises that come along with unsubstantiated claims.

Public companies have a duty to deliver a return on investment (ROI) to shareholders. Technology companies and those that manage personal information have a duty to protect said information. Investment advisers and brokers have a range of duties under the Department of Labor (DOL) Fiduciary Rule, the SEC proposed Regulation Best Interest, as well as investment advisor regulation. Likewise, compliance officers and business leaders should consider ESG principles as meeting a necessary enterprise risk management (ERM) duty. ERM is the process of identifying and rating material risks to decrease the probability a company will be harmed by an unexpected risk. ERM helps avoid predictable and unpredictable risks and errors – such as a reliance on inflated performance or underestimated the importance of controls to protect against a data breach or systems hack.

Leveraging ESG as an ERM duty teaches us to think big – to prioritize and strategically work on systematic risks. It teaches us to manage risks as projects, to set deadlines, and to require a backup for process solutions to help avoid repeat deficiencies. It also teaches us to continuously broaden risk factors – staying on top of technology and global regulatory developments. As the business world becomes more complex and global, so to should our approach to managing compliance, governance, and operational risks. In Turning Corporate Compliance into a Competitive Advantage, Bird and Park describe the benefits of using an efficient investment-risk (EIR) model to build and manage an effective compliance program. The model similarly focuses on the benefits of tailored and strategic planning to address the most impactful enterprise issues by finding the compliance “sweet spot” on what amounts to a compliance efficient frontier. It also acknowledges the mistakes legal and compliance professionals can make if they do not adopt an ERM approach (choosing instead to focus on process over results and/or undue emphasis on fear of personal liability or sanctions).

Not considering ESG principles is like not considering cybersecurity to run an online business. Considering these principles as an ERM duty helps a company and its gatekeepers strategically focused on identifying and mitigating material risks – which can mean knowingly accepting reasonable risks while eliminating blind spots that can cost a company money and reputational damage.

A perfect illustration is a company that has experienced multiple enforcement cases resulting in fines, lost share value, and brand tarnish that arguably creates an adverse impact on investors. For example, an allocator considering a new investment in Wells Fargo can more accurately forecast returns after considering risks such as the sustainability of its historical sales success; the efficiencies and costs to fix recurring systemic operational processes; and the impact of a tainted brand on growth projections. If an allocator does not consider systemic “social” and “governance” attributes; for example, by studying the effectiveness of Wells Fargo’s whistleblower program, its regulatory enforcement cases, and its incentive compensation programs, the allocator may not meet its legal duties such as best interests, suitability, and even a fiduciary standard during the sales process.

How ESG Impacts Your Compliance Program?

ESG principles and this ERM duty can also surface when a compliance officer tests investment governance; supports the development of new ESG or impact investing products and services; conducts or responds to due diligence requests, or reviews sales and marketing campaigns. Compliance officers should keep the following in mind as they work:

• Sales and Marketing: Make sure promotional statements don’t misrepresent products or services to customers, particularly retail customers. Regulators, such as the SEC, have recently focused on performance reporting and sales practices related to retirement investments. The same concepts apply in the ESG area when it comes to impact reporting. If an investment purports to be in line with ESG or impact investing mandates, ask for the quantitative and qualitative evidence to support any statements. When reviewing ESG claims, compliance officers should understand the claims by asking how impact performance is measured.
• Due Diligence: Whether conducting due diligence on a service provider, providing certifications to clients or testing your firm’s adherence with impact investing or sustainability claims, consider asking targeted due diligence questions. For example, if a real estate development firm asserts it meets LEED or WELL Building Standards because it uses technology and research to build a sustainable, clean working environment, and a company relies on those claims to build its offices without further due diligence, it takes on liability if the claims are exaggerated or inaccurate. In this scenario, if the health research is faulty, or the new sensors missed toxins in the building’s air, the company is open to legal and compliance risks that the building is not safe. In extreme cases, sick employees may file a class action lawsuit. On the other hand, if the company asked questions about the supporting science, operations, and technology behind the sensors, the company can avoid such liability because it prudently assessed the validity of the claims and risk associated with the new technology. A few questions to consider as compliance officers test claims, review marketing materials, or consider new investments:
  • Does any ESG claim include a guaranteed impact? If so, what is the basis and are there any exclusions? If not, why not?
  • Is there an extra layer of costs either through a fund of fund structure or sales intermediary? If so, consider the costs when analyzing returns.
  • Is the provider publicly committed and aligned with any impact-related marketing statements? How does it run its own business; is it sustainable or is it a signatory to PRI?
  • Has a trusted third-party affirmed its ESG or impact statement so you know it isn’t limited to a branding exercise?
  • How can you test environmental claims? Can you see a demonstration rather than rely on market demand or excitement for a new offering?
  • What is the desired time horizon? Is the timing for positive impact, positive returns, and any liquidity risks well documented?

 Additionally, compliance officers can bring value-add by helping the business ask the tough questions and adhere to this ERM duty. For more information.

How are ESG Principles Applied to Compliance Officers’ Performance?

 From a compliance program perspective, a more holistic approach can also enhance the performance within a compliance team. Compliance officers can approach each facet of the compliance program by building a sustainable governance approach that also avoids predictable surprises of repeat compliance deficiencies.

In the same way ESG is innovating the way we look at financial investments and environmental impact, sustainable governance innovates the way we look at compliance and compliance officers as gatekeepers. Responsibility and accountability for results is broadened for each. For investing, it’s delivering financial and corporate responsibility; for Compliance, it’s delivering protection from legal and regulatory liability but it’s also making an impact as a trusted business leader.

Let’s look at some ESG-related compliance issues to illustrate the difference in the approach.

Imagine a compliance officer for a global investment firm has finished the annual compliance review and is eagerly planning next year’s training program when a call from the head of the London office interrupts her early morning calm. He sternly explains that a client at a large pension fund requires a complete report on the firm’s promised ESG investment strategy. The client is seeking a certification that its funds have been tracking ESG guidelines from the time of the initial investment.

Tactical Response

“Why are you calling Compliance? I don’t make the investment decisions. Talk to the investment team, please,” the compliance officer reflexively says.

Sustainable Governance Response

Sustainable Governance entails thinking of, and helping avoid, systemic risks and repeat deficiencies. In other words, helping the business with its ERM duty. What if the investment team doesn’t have written guidelines and hasn’t been investing in the manner the pension fund expected? Compliance officers should not “own” compliance with ESG investment instructions, but they should help confirm investments are aligned with investment guidelines.

In this scenario, a better response would have been to offer to be a liaison between the Office Head and the investment team. The compliance officer could help prevent the investment team’s submission of a certification that isn’t accurate, comprehensive, and transparent. She could get details from the London office about when the client came on board and what promises were made. If there were any compliance gaps in reporting or adherence with investment guidelines, she could help the investment team respond and remedy any gaps.

In conclusion, compliance officers can maintain independence and avoid involvement in ESG investment decisions while still helping uncover and address governance gaps. Common compliance and governance gaps to look for include:

• Requests for Proposals: The investment team could over-sell the client about ESG capabilities. Compliance officers should review RFPs and sales materials to make sure representations are supported by process and documentation.
• Documentation to Support Certifications: There may be inconsistency between investment holdings and client instructions or investment guidelines because of a lack of written protocols. ESG investments entail specialized investment strategies and typically require additional investment instructions that may relate to higher standards for corporate accountability for investable assets. For example, with regard to the use of resources, labor practices, supply chain management or management of conflicts, internal controls, and board diversity. These instructions must be documented and followed as the client expects. Clients may be required to adhere to standards, regulations, or laws such as PRI and/or specific pension fund mandates. Clients often ask for certifications to ensure they are followed. Compliance officers should help, or at least test, to make sure the certifications are handled appropriately.
• Accountability and Collaboration: ESG investments may be consistent with the client’s expectations, but the documentation may be inadequate or just not filed/vetted as needed because of a lack of coordination. Without the engagement of all stakeholders, the business can make mistakes and compliance can be bureaucratic. Engagement is a key benefit of sustainable governance. Compliance officers help the business using project management skills as much as their technical knowledge. Compliance will bring value-add, increasing rapport with the business and engagement in the compliance program if it establishes a disclosure committee or process to ensure accountability for each part of the ESG certification process. The business will appreciate an engaged compliance officer who helps the business with ESG obligations as proposed above in the sustainable governance approach.

In a sustainable governance world, compliance officers can add value by improving controls because they are supported by an engaged network of business colleagues who they have also helped meet an ERM duty and avoid predictable surprises.

Beth Haddock, CEO and founder of Warburton Advisers, is the author of Triple Bottom-Line Compliance: How to Deliver Protection, Productivity and Impact. She has more than 20 years of experience as a compliance and business executive. Her consulting firm provides sustainable governance and compliance solutions to leading international corporations, technology companies, and nonprofits.