The Securities and Exchange Commission (SEC) has proposed a new rule requiring registered investment advisers, investment companies, and business development companies to provide enhanced disclosures about funds that claim to be driven by environmental, social, and governance (ESG) strategies.
According to SEC Chair Gary Gensler, the proposed rule would allow investors to "drill down to see what is under the hood" of a fund's ESG strategies.
"The proposed amendments seek to categorize certain types of ESG strategies broadly and require funds and advisers to provide more specific disclosures in fund prospectuses, annual reports, and adviser brochures based on the ESG strategies they pursue," according to the SEC.
The rule, which was approved by a 3-1 margin, will be open for public comment for 60 days after it is published in the Federal Register. Commissioners Allison Herren Lee and Caroline Crenshaw joined Gensler in voting yes; Commissioner Hester Peirce voted no. The Commission currently has one vacancy.
In addition, on Wednesday, the SEC approved a rule proposal that would penalize companies that name funds "that are likely to mislead investors about a fund’s investments and risks."
The SEC has watched as an increasing number of funds market themselves as "green," "sustainable," and "low-carbon," according to Gensler's statement supporting the ESG disclosures proposal. According to Gensler, the value of the "US sustainable investment universe" was estimated to be $17.1 trillion by the United States Forum for Sustainable and Responsible Investment.
According to Gensler, funds that claim to consider ESG factors must disclose the ESG factors they consider, as well as the strategies they employ, to investors. This could include whether the fund follows an index, includes or excludes certain assets from its investment mix, uses proxy voting or engagement to achieve specific goals, or aims to have a specific impact. According to an agency fact sheet that accompanied the ESG disclosures proposal, these are integration funds, which "integrate ESG factors alongside non-ESG factors in investment decisions."
The SEC defines ESG-focused funds as funds in which environmental, social, and governance factors are a significant or primary consideration. "Including a standardized ESG strategy overview table," ESG-focused funds would be required to provide detailed disclosures that describe the specific impact they seek to achieve and summarize their progress toward achieving those impacts.
Impact funds, a subset of ESG-focused funds, would be required to disclose how they track progress toward their goal. Environmental funds, for example, would be required to disclose their "carbon footprint and the weighted average carbon intensity of their portfolio," which would include greenhouse gas (GHG) emissions, according to the SEC.
GHG emissions are taken into account by integration funds. The fact sheet stated that the fund "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."
Funds that state that GHG emissions are not a part of their ESG strategy are exempt from reporting this information.
If the rules are passed as written, investment advisers and investment companies will have to put in place a lot more policies and procedures to generate disclosures that meet the requirements, according to Lance Dial, a partner at Morgan Lewis. Firms will be required to use data analysis to calculate certain measurements required by the rules, such as the GHG emissions of a fund's investments. He added that this may necessitate the hiring of outside consultants.
"I don’t see these rules as pushing anyone out of the ESG space," he said. "But investment advisers will have a lot more work to do"
Dial said he would like to hear from portfolio managers who manage ESG funds about how they would implement the new rules into their company's disclosure framework.
The two rule proposals "reflect significant steps taken by the Commission to bring investors enhanced transparency surrounding fund strategies," according to Larry Godin, principal and national practice lead for asset and wealth management, regulatory risk and compliance at KPMG.
"IIn the absence of a universally accepted definition of ESG, the SEC is seeking to combat greenwashing by placing increased accountability on investment advisers to disclose, in sufficient detail, the investment process used to arrive at decisions made within a portfolio," Godin explained. "The goal is to ensure investment decisions are consistent with the name of a fund and investors’ expectations."
The new rules, according to Steven Rothstein, managing director of Ceres' Accelerator for Sustainable Capital Markets, will combat greenwashing in the ESG investment fund industry.
"The tremendous growth in the number and variety of ESG funds available shows that analysis of ESG risks and opportunities is a mainstream strategy to create long-term value for investors," he said. "But better, more consistent disclosures are sorely needed to help investors take advantage of this dynamic and growing market."
The SEC fined BNY Mellon $1.5 million on Monday for "misstatements and omissions" on ESG mutual funds it managed over three years, which drew the attention of many in the investment adviser community.
According to the SEC, BNY Mellon informed investors via mutual fund prospectuses and written responses to RFPs that the mutual funds it managed had undergone "proprietary ESG quality reviews" as part of the investment research process. While such reviews were carried out for some of the managed mutual funds in question, they were not carried out for all of them, particularly overlay funds, according to the agency.
The SEC enforcement action against BNY Mellon, according to Peirce, the lone commissioner who voted no on the proposal, is proof that the SEC should simply enforce the rules and laws that already apply.
In a dissenting statement, she stated, "A new rule to address greenwashing... should not be a high priority."
She also claimed that the definition of ESG factors in an investment strategy is not precise enough.
"How precisely do we envision determining whether a fund has incorporated ‘ESG factors’ into its investment selection process when we have not defined just what those factors are?" According to Peirce, "‘I’ll know it when I see it’ is not a practice currently recognized in administrative law."
The SEC's latest proposed rules are the most recent prongs in the agency's ESG disclosure regime, joining a proposal requiring public companies to disclose climate-related information issued in March. The deadline for submitting comments on that proposal was recently extended to June 17.
The climate-related disclosure rule is a potentially broad mandate that, if passed, would require all publicly traded companies to quantify, measure, and disclose their environmental impact. The rule would require public companies to disclose how climate-related risks affect their strategy, business model, and outlook, as well as how their board and management handle climate-related issues and any plans for a lower carbon footprint transition.
The climate-related disclosure rule, according to Dial, "will go a long way toward closing the gaps for investor funds."
By fLEXI tEAM