SEC’s new proposed ESG disclosures for funds and advisers
On May 25th, 2022, the Securities and Exchange Commission (SEC) proposed changes to rules and reporting forms to establish disclosure requirements for funds and investment advisers to tackle the challenges raised by growing ESG investments. The aim of these amendments is to categorize ESG strategies broadly and required more specific ESG disclosures from funds and advisers in fund prospectuses, annual reports and adviser brochures. This will prevent US funds’ misleading or deceptive claims on their ESG qualifications.
These amendments proposed by the SEC occur in a context of increasing commitment of the American watchdog to develop the ESG regulation in the US. After a first holistic and landmark proposal focusing on publicly traded companies and climate-related disclosures announced in March 2022, the SEC’s new proposed amendments apply to funds and aims at tackling greenwashing. These SEC’s regulatory initiatives align with the broader environmental agenda of the Biden Administration.
These amendments split into two proposals:
- The first one creates additional disclosures for three categories of registered funds that use ESG factors in investment strategies;
- The second one is an expansion of the scope of the Investment Company Act’s “Names Rule”.
These proposing rules are under comment period until July 24th, 2022.
The number of ESG funds and the amounts invested in sustainable investments are growing steadily, ESG funds reaching about 10% of worldwide fund assets in the fourth quarter of 2021. These trends combined with the lack of and unharmonized disclosure requirements and frameworks generate major consequences for the market. First, significant risks of greenwashing may arise from the exaggeration of actual consideration of ESG factors. The greenwashing cases, i.e. concerns that funds could have misled shareholder over their ESG credentials, are indeed multiplying along with several scandals that have broken in the news (DWS, Goldman Sachs, BNY, etc.). The SEC has recently carried an enforcement action against a mutual fund adviser regarding misleader ESG disclosures and a complaint filed against an issuer for misleading investors through its ESG disclosures. Second, investors may have difficulties to understand which investment or policies are associated with a particular ESG policy.
Therefore, the need for disclosure requirements and a common disclosure framework to ESG investing is massive. Such regulations would allow investors to determine whether a fund’s or adviser’s ESG marketing statements translate into concrete and specific measures.
The scope of the SEC’s proposed rule on ESG disclosures covers:
- “Funds”: registered investment companies and business development companies; and
- “Advisers”: registered investment advisers and certain exempt reporting advisers.
The degree to which ESG factors are core to a fund’s strategy would determine the disclosures required under the proposed rule. This first proposed rule distinguishes three categories of ESG registered funds:
Funds that integrate both ESG factors and non-ESG-factors in their investment decision making
Funds for which ESG factors are the significant or main consideration in selecting investments
A subset of ESG-focused funds composed of funds that seek to achieve a specific ESG impact
For these new disclosures, the SEC proposes a “layered” framework with a concise overview of funds’ strategy in the prospectus complemented by more comprehensive information to disclose.
Funds that consider ESG factors in their investment process would be submitted to disclosure regarding their strategy.
The funds would have to provide an overview of their ESG strategy and how the funds incorporate ESG factors in their investment decisions. This integration of ESG factors could be materialized in different ways: screens, percentage in terms of net asset value to which the screen is applied, why the screen applies to less than 100% of the portfolio, reliance on internal methodology, third party data, reliance on third party frameworks such as UN SDG, index tracked by the funds, etc.
More specifically, integration funds would have to describe how ESG factors are incorporated into their investment process and guide their investment decisions to avoid overstating the role of these ESG factors. On their side, ESG-focused funds would be required to submit detail disclosures, notably an ESG strategy overview table. Impact funds would have to disclose how they measure progress on their specific objective, both in qualitative and quantitative terms, and summarize achievements towards their specific ESG goal. It includes KPIs, the time horizon the funds use to check for progress, as well as the relationship between the impact the fund is looking for achieving and financial return.
Last but not least, as investors increasingly buy baskets of stocks or indexes, index funds would be required to report identifying information about the index, regardless of whether the fund tracks an ESG-related index. Collecting data may constitute a first step towards a regulatory oversight of how an index is designed.
Similar disclosure requirements are proposed for advisers regarding both the consideration of ESG factors in their investment strategies and the methods of analysis employed for any ESG factors in their brochures (Form ADV Part 2). They would also have to disclose certain ESG information in annual SEC filings.
If they use proxy voting or engagement with issuers to implement their ESG strategy, ESG-focused funds would also have to disclose information on ESG-related voting topics and their ESG engagement meetings. The fund thus has to describe briefly how it engages with firms or votes its proxies on ESG issues. It could allow to detect “proxy washing” given recent evidence that ESG funds do not even vote in favor of ESG proposals in shareholder meeting.
In details, the funds would have to disclose several KPIs. The percentage of ESG voting matters during the reporting period is required as well as the number or percentage of issuers with which a fund has held ESG engagement meetings and the total number of ESG engagement meetings
Additional information on the GHG emissions associated with the investments would be required from ESG-focused funds with investment strategies considering environmental factors. The carbon footprint and the weighted average carbon intensity (WACI) of the funds’ portfolio are to disclose to provide consistent and comparable quantitative information regarding the GHG emissions associated with portfolios to investors. The carbon footprint and the weighted average carbon intensity to disclose include Scope 1 and Scope 2 emissions but not Scope 3 emissions. These last ones need to be disclosed separately if available or estimable in a reasonable manner. The SEC could ask funds to disclose the margin of error expected in their KPIs, notably if funds rely on third party providers’ estimates of Scope 3 emissions. This information is not required from funds that do not consider GHG emissions as part of their ESG strategy. If integration funds consider GHG emissions, they would be required to disclose the methodology and data sources used.
The second part of the proposed amendments is the expansion of the scope of the Investment Company Act (the “Names Rule”) to encompass ESG characteristics. This “Names Rule” dictates that, if a fund’s name focused on a particular class of investment, at least 80% of the value of its assets should be invested accordingly. An expansion of this requirement is proposed to apply to any fund name with terms suggesting a specific focus of the fund in investments that have specific characteristics. The expanded rule would notably now cover funds with names that suggest investment decisions incorporate one or more ESG factors. The funds would also have to use a derivatives instrument’s notional amount, rather than its market value, to determine the fund’s compliance with its 80% investment policy.
Under particular circumstances, a fund may deviate from its 80% investment policy. Sudden changes in market value of underlying investments are thus an acceptable justification. Nevertheless, time frames for returning to 80% have to be proposed.
Furthermore, the proposal aspires to address the rising materially deceptive and misleading use of ESG terminology. When a fund considers both ESG factors and other non-ESG factors in its investment decisions processes, it would not be allowed to use “ESG” or similar terms in its name. Indeed, ESG factors are generally not central in the inclusion or exclusion policies regarding the funds’ portfolios. These funds are the so-called “integration funds” defined in the first SEC’s proposed amendments regarding ESG disclosures for investment advisers and investment companies. Funds violating these rules would be considered misleading or materially deceptive.
Despite enhanced safeguards for shareholders and investors, a common definition of ESG concepts is still needed
In details, several additional amendments to the “Names Rule” are proposed. If a registered closed-end fund or business development company (BDC)’s shares are not listed on a national securities exchange, it would be prohibited to change its 80% investment policy without going through a shareholder vote. Indeed, as investors have limited options to exit their investments if some changes are made, it is relevant to allow them to vote on any change in investment policy of the fund. Additionally, a notice must also be provided to fund shareholders of any change in the fund’s 80% investment policy. This rule’s notice requirement is updated by this SEC’s proposal.
New prospectus disclosure, reporting and recordkeeping requirements are also suggested by the SEC to provide enhanced information to investors about how funds track their investments. The terms used in the funds’ names would have to be defined in the fund prospectus. Greater transparency on how the fund’s investments match the fund’s investment focus and keeping certain records regarding how the funds comply with the rule or why they think they are not subject to it are also required.
These changes are necessary as capital markets have known significant evolutions in the last decades and gaps in the current “Names Rule” may undermine investor protection. This proposal therefore constitutes a largely awaited modernization of the “Names Rule” for today’s markets. However, if the new “Names Rule” will fight misleading labeling for investors, it does not fully address greenwashing. Indeed, the proposed rule does not provide clarity on what ESG terms mean (“sustainable”, “low-carbon”, etc.).
 SEC, “Enhanced Disclosures by Certain Investment Advisers and Investment Companies about
Environmental, Social, and Governance Investment Practices”, proposed rule, May 25th, 2022, available here.