ESG spotlight moves to investment advisers and registered funds under SEC proposals
Proposals focus on requiring investment advisers and SEC-registered investment companies to provide standardized disclosures regarding ESG strategies, as well as revising the Names Rule
Driven by concerns about greenwashing, the U.S. Securities and Exchange Commission (the “SEC”) has issued two new ESG-related proposals that would apply to investment advisers and registered investment companies. These proposals represent a significant development for investment advisers and investment companies and demonstrate the SEC’s continued focus on ESG on the back of its Climate Disclosure Proposal for public companies in March 2022.
Among other things, the proposals would:
- require advisers to make specific and standardized disclosures regarding their ESG strategies in their Form ADV, and registered investment companies to make similar disclosures in their registration statements and annual reports;
- require certain registered investment companies to disclose information regarding the greenhouse gas (“GHG”) emissions associated with their portfolio investments; and
- expand the scope of the so-called “Names Rule”, which requires certain registered investment companies to adopt a policy to invest at least 80% of their assets in accordance with the investment focus suggested by the fund’s name, to apply to fund names that suggest an investment focus with particular characteristics, such as ESG factors.
While certain proposals would not apply explicitly to private funds, the SEC emphasized in its proposing release that all advisers should have compliance policies and procedures that address their use of ESG factors. These proposals are a clear reminder of the SEC’s focus on ESG, concerns about “greenwashing,” prohibitions under the anti-fraud provisions of the Investment Advisers Act of 1940 (the “Advisers Act”), and regulations that govern investment adviser marketing and that prohibit investment advisers from making false or misleading statements to investors in pooled investment vehicles, including private funds.
ESG Strategy Proposal
In the ESG Strategy Proposal, the SEC has proposed requiring (i) investment advisers and registered investment companies to make specific and standardized disclosures regarding their ESG strategies, and (ii) certain registered investment companies to disclose information regarding the GHG emissions associated with their investments.
The proposed amendments would apply to registered investment advisers, and exempt reporting advisers (together with registered investment advisers, “advisers”), and registered investment companies.
The ESG Strategy Proposal would:
- Require advisers to make specific disclosure about ESG strategies in Form ADV – Under the proposal, advisers would have to make specific disclosures about ESG strategies in their Form ADV. The proposal would amend Form ADV Part 1A to collect information about an adviser’s use of ESG factors in its advisory business, including:
- Amendments to Item 5 of Part 1A to collect aggregated information about advisers’ use of ESG factors for their separately managed account (“SMA”) clients and their use of any third-party ESG framework(s) in connection with their advisory services;
- Amendments to Section 7.B.(1) of Schedule D to Part 1A to collect information about advisers’ use of ESG factors in managing each reported private fund; and
- Amendments to Items 6 and 7 of Part 1A (and Sections 6.A. and 7.A. of Schedule D) to require advisers to disclose whether they conduct other business activities as ESG providers or have related persons that are ESG providers.
While only registered investment advisers are required to respond to Item 5 of Part 1A, exempt reporting advisers are required to respond to Items 6 and 7 and, therefore, could be impacted by this proposal.
In addition, the proposal would amend Form ADV Part 2A (the “Brochure”) to require advisers to include in their Brochure (i) a description of the ESG factors they consider for each significant investment strategy or method of analysis for which the advisers consider any ESG factors, (ii) a description of any material relationships that the advisers or any of their management persons have with any related person that is an ESG consultant or other ESG service provider, and (iii) if advisers have specific voting policies or procedures that include one or more ESG considerations when voting client securities, a description of which ESG factors they consider and how they consider them. Only SEC-registered investment advisers are required to file a Brochure.
- Establish a taxonomy for types of ESG strategies – The ESG Strategy Proposal generally requires advisers and registered investment companies that use ESG factors in their investment strategies to categorize their strategy within, and provide disclosure relating to, three types of ESG strategies:
- “Integration” Strategies – The ESG Strategy Proposal generally describes an “integration” strategy as one that considers one or more ESG factors alongside other, non-ESG factors when investing, but such ESG factors are generally no more significant than other factors, such that ESG factors may not be determinative in an investment decision.
- “ESG-focused” Strategies – The ESG Strategy Proposal generally describes an “ESG-focused” strategy as one that focuses on one or more ESG factors by using them as a significant or main consideration in respect of investment decisions or in engagement strategies with companies in which the adviser or fund has invested.
- “Impact” Strategies – The ESG Strategy Proposal generally describes an “impact” strategy as an ESG-focused strategy that seeks to achieve a specific ESG impact or impacts.
The ESG Strategy Proposal would impose varying disclosure requirements based on the type of ESG strategy pursued by the adviser or fund.
- Require registered investment companies to make specific disclosure about ESG strategies – The proposal would require registered investment companies to make similar disclosures in their registration statements and annual reports. The proposal would impose a “layered” framework for disclosure, and the amount of required disclosure would depend on how central ESG factors are to the fund’s strategy. The proposal would also require registered investment companies that use proxy voting or ESG engagement with issuers as a significant means of implementing their ESG strategy to provide additional information about these items.
- Require ESG-focused registered investment companies that consider environmental factors to disclose GHG emissions associated with their portfolio investments – These registered investment companies would be required to disclose the carbon footprint and the weighted average carbon intensity of their portfolio, unless. they disclose that they do not consider GHG emissions as part of their ESG strategy. Integration funds that consider GHG emissions would be required to disclose additional information, including methodology and data sources, about how the fund considers GHG emissions.
- Require registered investments advisers to implement ESG policies – The SEC reaffirmed existing obligations under the Advisers Act Compliance Rule when advisers incorporate ESG factors, stating that advisers’ compliance policies and procedures should address the accuracy of ESG disclosures made to clients, investors and regulators, and also address portfolio management processes to help ensure portfolios are managed consistently with the ESG-related investment objectives disclosed by the adviser.
- Require registered investment advisers to revisit marketing/advertising policies in light of ESG – The proposal also reiterated the core precepts of the Advisers Act Marketing Rule, re-emphasizing an adviser’s duty to avoid material misrepresentations or omissions when describing the extent to which it considers ESG factors in managing client portfolios, and its duty to apply negative screens to certain investments when it claims to do so.
The SEC’s proposal would require advisers to comply with proposed Form ADV disclosure requirements and investment companies to comply with the prospectus disclosure requirements within one year after the final rule’s effective date (60 days after Federal Register publication). Investment companies would have to comply with the proposed shareholder annual report disclosure requirements within 18 months after the effective date.
The Names Proposal applies to registered investment companies. It would amend Rule 35d-1 under the U.S. Investment Company Act of 1940 (the “Names Rule”). The Names Rule generally targets what the SEC considers to be misleading fund names. Under the Names Rule currently, a registered investment company can only use a name suggesting investment in certain investments or industries if, among other requirements, it has adopted a policy to invest, under “normal circumstances,” at least 80% of the value of its assets in the particular type of investments or industry suggested by the fund’s name.
The Names Proposal would:
- Expand the types of registered investment companies covered by the Names Rule – Currently, the Names Rule only applies to names suggesting that the registered investment company focuses its investments in a particular type of investment or investments, in investments in a particular industry or group of industries, or investments with a particular geographic focus. The Names Proposal would add to that list names that suggest the registered investment company focuses on investments that have, or whose issuers have, particular characteristics (e.g., a name with terms such as “growth,” “value,” or “sustainable”). This is intended to capture fund names that contain the term “ESG” or similar terminology (such as “sustainable,” “green,” or “socially responsible”).
- Not allow an “integration fund” to use ESG terms in its name – Under the Names Proposal, a registered investment company pursuing an “integration” strategy (described above) would not be allowed to use ESG or similar terminology in its name. Doing so would be defined to be materially deceptive or misleading. While the Names Rule does not explicitly apply to private funds, this aspect of the proposal could signal the SEC’s general view on what constitutes misleading practices in respect of funds, including private funds, that are marketing as ESG products when the funds are managed using an integration strategy.
The Names Proposal also includes several proposed amendments that, among other things, would affect the calculation of the 80% threshold. The Names Proposal would give funds one year to comply with the amendments, beginning from the date that the final amendments are published in the Federal Register.
Comparison to EU/UK Requirements
Similar to the EU Sustainable Finance Disclosure Regulation (“SFDR”) and upcoming UK Sustainability Disclosure Requirements (“SDR”) rules, ultimately advisers and registered investment companies have a choice regarding the extent to which they will be impacted by the SEC’s proposals, if they are adopted as proposed. In other words, a registered investment company that does not use ESG terms in its name and does not make ESG claims in its offering or marketing materials will not be in scope of the SEC’s proposed rules from an ESG perspective. However, this will then have significant strategic and commercial implications for a registered investment company, because it cannot then be presented as an ESG product.
The proposals appear to be broadly similar to the UK Financial Conduct Authority’s previous guidance for UK authorised funds and the upcoming proposed SDR rules, both in terms of the product naming and disclosure / reporting approach. The proposals also emulate many of the principles used by France in its local ESG doctrine. They also largely match the policy aims and disclosure principles of the EU SFDR regime, but as proposed, they do not go as far (i.e., there are no principal adverse impact or double materiality-related proposals). It is also worth noting that the scope of the Names Rule is much broader than the EU/UK rule set, as it is not just focused on the use of ESG terms, but also other terms used in names such as emerging markets fund, high yield bond fund or growth fund.
Stay tuned for our upcoming webinar, where we will explore how the U.S. ESG Strategy Proposal compares to the existing ESG standards in the UK and Europe.
The SEC has provided a 60-day comment period (rather than the 30-day period it has provided it many recent rulemaking proposals). Given the SEC’s current rulemaking agenda – which includes finalizing ambitious proposals relating to climate change disclosure, private funds, SPACs and cybersecurity – it is difficult to say for certain when it will finalize these rules, and what form the rules will take.