SEC Rule Proposal – Enhanced Disclosures by Certain Investment Advisers and Investment Companies about Environmental, Social, and Governance Investment Practices
Investor interest in environmental, social, and governance (“ESG”) strategies has rapidly increased in recent years with significant inflows of capital to ESG-related services and investment products. Asset managers have responded to this demand by creating and marketing funds and strategies that consider ESG factors in their selection process. Unfortunately, there has been a lack of consistent, comparable, and reliable information among investment products and advisers that claim to consider one or more ESG factors. This lack of information can create a risk that a fund or adviser’s actual consideration of ESG does not match investor expectations. The lack of specific disclosure requirements tailored to ESG investing creates the risk that funds and advisers marketing such strategies may exaggerate their ESG practices. With respect to environmental and sustainability factors, this practice often is referred to as “greenwashing.”
Additionally, the absence of a common disclosure framework also makes it difficult for investors to find the disclosures and to determine whether a fund’s or adviser’s ESG marketing statements translate into concrete and specific measures taken to address ESG goals and portfolio allocation. It also makes it difficult for investors to understand how effectively the strategy is implemented over time, and can frustrate investors’ attempts to compare different ESG strategies across funds or advisers. The SEC is therefore proposing to amend rules and forms under both the Investment Advisers Act of 1940 and the Investment Company Act of 1940 to require registered investment advisers, exempt reporting advisers, registered investment companies, and business development companies, to provide additional information regarding their ESG investment practices.
Proposed Rules – Investment Advisers
The SEC is proposing to require ESG-related disclosures from registered investment advisers that utilize ESG factors as part of their advisory business. Requiring advisers to disclose with specificity their ESG investing approach would help clients understand the investing approach the adviser uses, as well as compare the variety of emerging approaches, such as employment of an inclusionary or exclusionary screen, focus on a specific impact, or engagement with issuers to achieve ESG goals.
The SEC is proposing to add a new sub-Item 8.D to ADV Part 2A, which would require an adviser to provide a description of the ESG factor or factors it considers for each significant investment strategy or method of analysis for which the adviser considers any ESG factors. The SEC does not define “ESG” or similar terms, instead, proposing to require advisers to provide a description of the ESG factor or factors they consider, and disclose to clients how they incorporate these factors when providing investment advice, as well as when they recommend or select other investment advisers.
The SEC is also proposing an amendment to Item 10.C of Part 2A to require an adviser to describe any relationship or arrangement, which is material to the adviser’s advisory business or to its clients, that the adviser or any of its management persons have with any related person that is an ESG consultant or other ESG service provider (for purposes of this release, a “related person ESG provider”). Related person ESG providers may include, for example, ESG index providers and ESG scoring providers.
The SEC is also proposing to amend Item 17.A of Part 2A to require advisers that have specific voting policies or procedures that include one or more ESG considerations when voting client securities to include in their brochures a description of which ESG factors they consider and how they consider them.
Wrap Fee Programs
Advisers sponsoring wrap fee programs would be required to describe in Item 4 of their wrap fee brochures the services, including the types of portfolio management services, provided under each ESG program that they sponsor.
ADV Part 1A & Form N-CEN
The SEC is proposing to collect census-type information about advisers’ and funds’ uses of ESG factors, including their uses of ESG providers. This information would be reported in Form ADV Part 1A and Form N-CEN and would apply to registered advisers (both registered investment advisers and exempt reporting advisers), and registered funds, respectively. The SEC is also proposing additions to Item 5 of Part 1A, separately managed account reporting, to provide information about the advisory businesses with respect to SMA clients and proposed additions to Items 6 and 7 (other business activities and private fund reporting) to both advisers and exempt reporting advisers about their uses of ESG factors in managing their reported private funds. Additionally, the SEC is proposing to require advisers to disclose whether they conduct other business activities as ESG providers or have related persons that are ESG providers by amending Items 6 and 7 of Part 1A and Sections 6.A. and 7.A. of Schedule D.
Related to registered (‘40 Act) funds, the SEC has proposed to require additional specific disclosure requirements regarding ESG strategies to investors in fund registration statements and the management discussion of fund performance in fund annual report. To address exaggerated claims about ESG strategies, the SEC is proposing minimum disclosure requirements for any fund that markets itself as an ESG-Focused Fund, and requiring streamlined disclosure for Integration Funds that consider ESG factors as one of many factors in investment selections.
Specifically, the proposed rules would require that an Impact Fund summarize its progress on achieving its specific impact(s) in both qualitative and quantitative terms, and the key factors that materially affected the fund’s ability to achieve the impact(s), on an annual basis.
There are also amendments to fund annual reports to require a fund for which proxy voting or other engagement with issuers is a significant means of implementing its strategy to disclose information regarding how it voted proxies relating to portfolio securities on particular ESG-related voting matters and information regarding its ESG engagement meetings.
Finally, the SEC is proposing a requirement for ESG-Focused Funds that consider environmental factors. Specifically, the proposal would require disclosure of two greenhouse gas (“GHG”) emissions metrics for the portfolio in such funds’ annual reports. In addition to the ESG-specific disclosure, the Commission is proposing an amendment to Form N-CEN that would require all index funds, regardless of whether the fund tracks an ESG-related index, to report identifying information about the index. In addition the SEC is proposing to require UITs to provide investors with clear information about how portfolios are selected based on ESG factors. The proposed amendment would require any UIT with portfolio securities selected based on one or more ESG factors to explain how those factors were used to select the portfolio securities.
Advertising & Marketing
Current regulations seek to prevent false or misleading advertisements by advisers, including greenwashing, by prohibiting material misstatements and fraud. Advisers are prohibited from making false or misleading statements to existing or prospective investors in pooled investment vehicles (e.g., investors in a registered investment company or private fund). It generally would be materially misleading for an adviser to overstate in an advertisement the extent to which it utilizes or considers ESG factors in managing client portfolios. To address any concerns, the SEC proposal is reaffirming existing obligations under the compliance rules when advisers and funds incorporate ESG factors and compliance policies, and procedures should address the accuracy of ESG-disclosures made to clients, investors and regulators.
Compliance Policies & Procedures
Compliance policies and procedures should address the accuracy of ESG-disclosures and they should also address portfolio management processes to help ensure portfolios are managed consistently with the ESG-related investment objectives. If an adviser discloses to investors that it considers certain ESG factors as part of an integration strategy, the adviser’s compliance policies and procedures should be reasonably designed to ensure the adviser manages the portfolios consistently with how the strategy was described to investors, actually considering the ESG factors in the way it says it considers them. If a registered fund discloses to investors that it adheres to a particular global ESG framework, its policies and procedures should include controls that help to ensure client portfolios are managed in accordance with that framework.
The compliance date of the proposals would be one year following the effective date, which would be sixty days after the date of publication in the Federal Register: (i) the proposed disclosure requirements in prospectuses on Forms N-1A and N-2, (ii) the proposed disclosure requirements for UITs on Form N-8B2; (iii) the proposed regulatory reporting on Form N-CEN, and (iv) the proposed disclosure requirements and regulatory reporting on Form ADV Parts 1 and 2.
The compliance date of any adoption of the proposed disclosures in the report to shareholders and filed on Form N-CSR would be 18 months following the effective date, which would be sixty days after the date of publication in the Federal Register.
Comments are due on or before August 16, 2022 – Use the Commission’s internet comment form (https://www.sec.gov/rules/submitcomments.htm).