On May 25, 2022, the US Securities and Exchange Commission (SEC or Commission) proposed new rules to enhance the regulatory framework for disclosures concerning investment funds and investment advisers' environmental, social and governance-related (ESG) investing strategies (the Proposed Rules). If adopted, the Proposed Rules would require SEC-registered advisers to include ESG factors and strategies for investors in fund prospectuses, annual summaries and brochures. More specifically, they would require:
- Registered investment funds to be categorized into an ESG fund-type depending on the extent that the funds advertise or utilize ESG factors in investment decision making;
- New disclosures in fund prospectuses about how funds functionally incorporate ESG factors in their investment strategies, with specific disclosure obligations corresponding to which newly defined category a fund falls into;
- Fund annual summaries to disclose additional ESG-related information, including progress on achieving stated impacts, disclosure of aggregated Green House Gas (GHG) emissions and enhanced narrative disclosure of how proxy voting or engagement with issuers is a means of implementing an ESG strategy;
- Registered advisers to disclose ESG practices in their brochures, including progress toward stated impact, key performance indicators, the time horizon the adviser uses, the relationship between ESG impacts and financial returns and any material conflicts of interest; and
- ESG disclosures to be structured in a machine-readable data language.
The SEC's Proposed Rules are now in a public comment period, which will remain open for 60 days after publication in the Federal Register. This is the SEC's second ESG-related rule proposal. On March 21, 2022, as discussed in this legal update, the SEC proposed ESG disclosure rules requiring domestic and foreign registrants to provide climate-related disclosures in their registration statements and annual reports. That comment period was extended to June 17, 2022.
These new Proposed Rules seek to standardize ESG disclosure practices to prevent funds and investment advisers from "greenwashing" their investment decisions. Greenwashing has dominated concerns for investors over the past year and SEC Chairman Gary Gensler has warned companies about it since his term began. Recently, the SEC charged BNY Melon Investment Advisor, Inc. for material misstatements and omissions about a sub-adviser's ESG quality reviews. According to Gensler, the Proposed Rules will serve to prevent greenwashing by providing "consistent and comparable disclosures about asset managers' ESG strategies" so that investors can understand what data underlies each fund's claims.
Implications and key takeaways
While the key provisions of the lengthy Proposed Rules are synthesized below, at the outset, we wanted to provide key takeaways for funds to determine, first, if the rules would apply to them and, if applicable, how they might be impacted.
Determine the applicable fund category
Whether and how the SEC's Proposed Rules will impact a fund depends primarily on what newly-defined ESG fund-type applies to the fund's investment decisions. To make this determination, funds would have to perform confidential internal reviews of how ESG metrics have been incorporated in investment strategies and how the fund presents those ESG investment strategies in marketing materials:
- Integration Fund: A fund that considers one or more ESG factors along with other, non-ESG factors in investment decisions where those ESG factors are generally no more significant than other factors in the investment selection process.
- ESG-Focused Fund: A fund that focuses on one or more ESG factors by using them as a significant or main consideration (1) in selecting investments or (2) in its engagement strategy with the companies in which it invests. The SEC will explicitly consider a fund's name and sales literature as possible indicators that the fund's investment decisions incorporate ESG factors as a significant or main consideration.
- ESG Impact Fund: A subset of ESG-Focused Funds, a fund that seeks to achieve a specific ESG impact or impacts.
If an internal review indicates that a fund is likely to be considered an ESG-Focused Fund or ESG Impact Fund under the Proposed Rules, it may be necessary to devote greater resources to handle the accompanying increased disclosure requirements.
Tailor marketing and advertisement policies to the new ESG fund-type classification system
Because disclosure obligations vary by ESG fund type, funds should consider adopting internal policies aligned with their intended ESG fund type classification. Specifically, funds should be thoughtful and deliberate about the publication of sales literature that indicates the significance of ESG factors in investment decision making, as these types of marketing materials could unintentionally lead to enhanced disclosure obligations under the framework found in the Proposed Rules.
Create consistent internal policies regarding the use of ESG metrics
Consistency of disclosures in fund prospectuses, annual reports and brochures are a key focus of the Proposed Rules. Therefore, funds and advisers should consider adopting internal frameworks for the use of ESG factors to mitigate the risk of inconsistent use or messaging on this potentially key issue.
Revise disclosure frameworks relying on existing reporting frameworks
Funds will need to take a second look at their existing disclosure processes. While many funds that advertise and expressly incorporate ESG factors in investment decision making have relied on existing reporting frameworks, such as the ones promulgated by the Climate Disclosure Standards Board, in issuing their prior disclosures, the Proposed Rules contain marked differences in qualitative and quantitative metrics. For example, the SEC's Proposed Rules would require ESG-Focused Funds that consider environmental factors to disclose the fund portfolio's carbon footprint and weighted average carbon intensity in their annual reports, which is not required by any existing frameworks.
Ensure that data is formatted correctly
The SEC's Proposed Rules also state that ESG-related disclosures should be structured correctly and seek to require the use of XBRL Data Tagging in funds' ESG-related registration statements and annual reports.
Summary of Proposed Rules
Who would be subject to the Proposed Rules?
The Proposed Rules would apply to registered open-end funds, registered closed-end funds, Business Development Companies (BDCs) and Registered Advisers. The Proposed Rules also include a question to commenters, however, about whether the disclosure requirements should also apply to insurance companies' separate accounts registered as management investment companies.
What would funds and registered advisers be required to disclose?
The SEC's Proposed Rules implement a "layered disclosure" regime depending on the type of fund at-issue. For example, open-end funds would have to provide an overview of their ESG strategy in the summary section of their prospectuses and provide more details about their ESG investment strategy in the statutory prospectus.
The specific level of detail required by the enhanced disclosure measures depends on the extent to which a fund considers ESG factors in its investment processes. To that end, the SEC has defined two broad categories and one sub-category of ESG Funds: (1) Integration Funds, (2) ESG-Focused Funds and (3) ESG Impact Funds. Notably, the Proposed Rules stop short of defining "ESG" and instead focus on a holistic approach to disclosures, leaving open the possibility that the final rules may provide a non-exhaustive list of ESG factors.
What are these new ESG fund types?
The Proposed Rules define an "Integration Fund" as a Fund that considers one or more ESG factors alongside other non-ESG factors in its investment decisions, but where those ESG factors are generally no more significant than other factors in the investment selection process. For these funds, the ESG factors are not determinative in including or excluding any particular investment portfolio.
- The SEC has indicated that it intends to require "streamlined disclosure" for Integration Funds. In form, the SEC's Proposed Rules will require a summary of how the Integration Fund incorporates ESG factors into its investment selection process in the beginning of a prospectus. A more detailed description of the incorporation of ESG factors in the investment selection process should be included in an open-end fund's statutory prospectus or in a closed-end fund's prospectus.
- The SEC has stated that it does not intend to force Integration Funds to overemphasize the role that ESG factors play in the fund's investment selection process.
- If an Integration Fund considers GHG emissions as an ESG factor, the Proposed Rules will also require more detailed information on that factor, including a description of the methodology that the fund uses in its consideration of GHG emissions.
The Proposed Rules define an "ESG-Focused Fund" as one which focuses on one or more ESG factors as a significant consideration in selecting investments or in its engagement strategy with the companies in which it invests. Within the ESG-Focused Funds category, the Proposed Rules also designate certain funds as "ESG Impact Funds." These are funds that seek to achieve a specific ESG impact or impacts.
- Unlike Integration Funds, the Proposed Rules would require ESG Impact Funds to provide detailed disclosures through an "ESG Strategy Overview" table in their prospectuses.
- ESG-Focused Funds that are not Impact Funds will be required to provide only a highlevel overview of how the fund incorporates ESG factors in their investment strategies in the proposed table.
- For ESG-Focused Funds that rely on proxy voting or engagement with issuers as a significant means of implementing an ESG strategy, the Proposed Rules will require additional disclosures about their proxy and engagement efforts.
- The Proposed Rules treat UITs (Unit Investment Trust) differently than investment management companies because of the unmanaged nature of UITs. UITs will not be required to differentiate disclosure based on the Integration vs. ESG-Focused difference. The Proposed Rules will only apply to a UIT with portfolio securities selected based on one or more ESG factors and the UIT merely needs to explain how the ESG factors were used to select the portfolio securities.
What changes are made to annual disclosures?
The Proposed Rules impose additional changes to annual disclosures by funds. For registered management investment companies, the corresponding additional disclosures would be included in the management's discussion of fund performance (MDFP). For Business Development Companies, the enhanced disclosures would be included in the management discussion and analysis (MD&A).
- As currently proposed, Integration Funds are not required to provide MDFP or MD&A disclosures regarding their ESG disclosures or GHG metrics. However, the Proposed Rules include a request for comments on whether requiring disclosure by Integration Funds would be feasible and whether such disclosures would be valuable to investors.
- For an ESG-Focused Fund, the Proposed Rules would require disclosure of aggregated GHG emissions and the weighted average carbon intensity of the fund's portfolio if the ESG-Focused Fund considers environmental factors in its investment decisions. The Proposed Rules metrics are aligned with recommendations from the Task Force on Climate-Related Financial Disclosures and the Partnership for Carbon Accounting Financials. The Proposed Rules, as with the SEC's March 21st proposed set of ESG disclosure rules, uses the Scope 1, Scope 2 and Scope 3 emissions framework.
- If an ESG-Focused Fund uses proxy voting as a significant means of implementing an ESG strategy, then the Proposed Rules would require disclosure of how the fund voted on proxies relating to portfolio securities on particular ESG-related voting matters.
- ESG-Focused Funds that engage with issuers through means other than proxy voting will be required to disclose information on key performance indicators of their engagement practices. This includes disclosure of the number or percentage of issuers with whom the fund has held "ESG Engagement Meetings."
- ESG Impact Funds will also face additional annual disclosure requirements. Under the Proposed Rules, an Impact Fund will be required to briefly summarize fund progress on achieving specific impacts in both quantitative and qualitative terms and to identify the key factors that affect the fund's ability to achieve the specific impact on an annual basis.
What additional disclosures are required for advisers?
The Proposed Rules would require registered investment advisers to provide Adviser Brochures to prospective clients with details regarding their approach to ESG investing. The Proposed Rules would require such brochures to include:
- Disclosures regarding the adviser's investment strategies, methods of analysis and risk of loss.
- Details about how the adviser will measure progress toward any stated ESG impact, including the key performance indicators of that progress and the time horizon the adviser intends to use to analyze progress.
- Disclosure of material conflicts of interest presented by the adviser's relationships or arrangements with any related person that is an ESG consultant or other ESG service provider.
In addition to enhanced disclosures regarding ESG strategies, impacts and timelines, the Proposed Rules contain amendments that would require disclosures by advisers regarding their voting policies and procedures, including whether such proxy voting procedures consider ESG factors.
For advisers with a wrap fee program, the Proposed Rules would require preparation of a specialized brochure.
- Advisers who consider ESG factors in their wrap fee programs must provide a description of the ESG factors they consider as well as how those factors are incorporated under each program.
- The Proposed Rules would also require that advisers describe the criteria by which they assess their portfolio managers' application of the relevant ESG factors, as well as if and how they review their portfolio managers.
Are there additional proposed changes to disclosure requirements?
The Proposed Rules also include the collection of "census-type" information about funds' and advisers' use of ESG factors, including their use of ESG providers. Specifically, the Proposed Rules would amend forms N-CEN and ADV part 1A to collect information from registered funds and advisers for use by the public and investors.
If adopted, the Proposed Rules would be the first time that the SEC has required disclosure of a specific aspect of the investment process by private fund sponsors. A failure to comply with these rules could easily put a fund in the SEC's crosshairs if there is any significant investment strategy that was not properly disclosed even if it was not material to the investment strategy. Given the SEC's overall focus on ESG disclosures and recent enforcement activity and regardless of whether the Proposed Rules are adopted in their current form, fund advisors should begin to review their compliance programs regarding investor disclosures. They should also review their ESG practices and policies to make sure that they are consistent with their disclosures and representations.