Yesterday, the SEC voted 3-1 to put forward a pair of proposals aimed at reducing “greenwashing” in the investment industry. Commissioner Peirce cast the sole “nay” vote on both proposals.
Enhancing Disclosure About ESG Investment Practices
If adopted, the first proposal – which weighs in at 362 pages and poses 199 questions – will require investment companies, business development companies and investment advisers that say they consider ESG factors in their investment process to provide consistent, comparable ESG disclosures. According to the fact sheet, that means:
– Requiring additional specific disclosure requirements regarding ESG strategies in fund prospectuses, annual reports, and adviser brochures;
– Implementing a layered, tabular disclosure approach for ESG funds to allow investors to compare ESG funds at a glance; and
– Generally requiring certain environmentally focused funds to disclose the greenhouse gas (GHG) emissions associated with their portfolio investments.
The extent of disclosure that would be required in a fund’s prospectus under the proposed rules depends on how central ESG factors are to a fund’s strategy and follows a “layered” framework. The proposal identifies three types of ESG funds:
- Integration Funds. Funds that integrate ESG factors alongside non-ESG factors in investment decisions would be required to describe how ESG factors are incorporated into their investment process.
- ESG-Focused Funds. Funds for which ESG factors are a significant or main consideration would be required to provide detailed disclosure, including a standardized ESG strategy overview table.
- Impact Funds. A subset of ESG-Focused Funds that seek to achieve a particular ESG impact would be required to disclose how it measures progress on its objective.
The proposal also contemplates additional disclosure about:
Impacts, Proxy Voting or Engagements: Certain ESG-Focused Funds would be required to provide additional information about their strategies, including information about the impacts they seek to achieve and key metrics to assess their progress. The proposal would require funds that use proxy voting or engagement with issuers as a significant means of implementing their ESG strategy to provide additional information about their proxy voting or ESG engagements, as applicable.
GHG Emissions Reporting: ESG-Focused Funds that consider environmental factors in their investment strategies would have to disclose additional information regarding the GHG emissions associated with their investments. These funds would be required to disclose the carbon footprint and the weighted average carbon intensity of their portfolio. The requirements are designed to meet demand from investors seeking environmentally focused fund investments for consistent and comparable quantitative information regarding the GHG emissions associated with their portfolios and to allow investors to make decisions in line with their own ESG goals and expectations. Funds that disclose that they do not consider GHG emissions as part of their ESG strategy would not be required to report this information. Integration funds that consider GHG emissions would be required to disclose additional information about how the fund considers GHG emissions, including the methodology and data sources the fund may use as part of its consideration of GHG emissions.
Preventing Misleading Fund Names
The SEC not only wants to enhance disclosure by ESG funds, it also wants to make sure that funds deserve the “ESG” label in the first place. In a separate 209-page release, the Commission proposes rules that would expand the current requirement for certain funds to adopt a policy to invest at least 80% of their assets in accordance with the investment focus the fund’s name suggests, as well as enhance disclosure, reporting and record-keeping requirements. The fact sheet explains:
The Names Rule currently requires funds with certain names to adopt a policy to invest 80 percent of their assets in the investments suggested by that name. The proposal would expand this requirement to apply to any fund name with terms suggesting that the fund focuses in investments that have, or investments whose issuers have, particular characteristics. This would include, for example, fund names with terms such as “growth” or “value” and those indicating that the fund’s investment decisions incorporate one or more environmental, social, or governance (“ESG”) factors.
The proposal would include a number of amendments to provide enhanced information to investors and the Commission about how fund names track their investments. The proposal would require fund prospectus disclosure that defines the terms used in a fund’s name. The proposal also includes amendments to Form N-PORT to require greater transparency on how the fund’s investments match the fund’s investment focus. The proposal would, furthermore, require funds to keep certain records regarding how they comply with the rule or why they think they are not subject to it.
Under the proposal, a fund that considers ESG factors alongside but not more centrally than other, non-ESG factors in its investment decisions would not be permitted to use ESG or similar terminology in its name. Doing so would be defined to be materially deceptive or misleading. For such “integration funds,” the ESG factors are generally no more significant than other factors in the investment selection process, such that ESG factors may not be determinative in deciding to include or exclude any particular investment in the portfolio.
As is often the case, the Commissioners each issued supporting and dissenting statements to provide their thoughts and more context on the proposals. Those statements are available on the SEC’s “speeches & statements” page – and, for SEC Chair Gary Gensler, on the press release pages for the respective proposals.
What This Means
Investment fund compliance can get very complex, very fast – so I’m not going to get into the weeds here. For companies that might be included in fund portfolios, these rules are yet another sign that the SEC is cracking down on perceived “greenwashing” in an industry that reached $2.78 trillion in assets during the first quarter of this year, up from less than $1 trillion only two years ago, according to this WSJ article and Morningstar data. These proposals follow an enforcement action against an ESG investment fund earlier this week.
With institutional investors under pressure to prove their ESG credentials and provide enhanced disclosure, they’ll in turn be passing more information requirements along to portfolio companies. That means it’s more important than ever to be in regular conversation with your investors, so that you aren’t caught flat-footed by information requests – and to stay in line with peers and emerging best practices (because demands can accelerate quickly).
It also means there’s an opportunity for ESG-focused companies that are seeking capital. There may be a big rush to ESG assets if funds are faced with the choice between compliance or a name change. The ESG investment fund space may also shrink, which is what happened in the EU when regulators realized that so-called ESG funds were not actually performing screens. As I noted in my book, Killing Sustainability (available to PracticalESG.com members on our “Guidebooks” page):
The EU Commission passed the Sustainable Finance Disclosure Regulation (SFDR), which became effective March 2021. in anticipation of the effective date, however, ESG-tagged investments in Europe shrank by $2 trillion from $14 trillion in 2018 as funds deleted references to ESG, responsible or green in their names/descriptions.
Comments for both of the proposals are due 60 days after the date the proposal is published in the Federal Register. It is interesting that this proposal was given a 60-day comment period initially, in contrast to the climate disclosure rule.