07/07/2022 - Corporate Climate Disclosures

The SEC’s Proposed ESG Rules Aim to Provide Better Information to Investors

by Sara Dewey

Boom time for ESG funds – and exaggerated claims of ESG impact 

Investment funds purporting to focus on environment, social, and governance (ESG) factors have boomed in recent years. Bloomberg projects that ESG investments may surpass $41 trillion worldwide by the end of 2022, up from $22.8 trillion in 2016. In the US alone, sustainable investments grew to $17.1 trillion in 2020, which accounts for a third of US assets under management according to the US Forum for Sustainable and Responsible Investment. 

As interest in ESG investing grows, there is considerable variation in how fund managers define ESG and how funds approach ESG investing. For example, some funds may exclude certain polluting investments like oil and gas, while other funds may include some oil and gas companies based on their stated commitment to decarbonization. There is also variation in the utility of the ESG label to investors: researchers have found high levels of misleading claims among ESG funds.  

Regulators and investors are questioning the approach and impact of many ESG funds. Given the lack of relevant reporting requirements, it’s difficult for investors to understand how a fund accounts for ESG factors in investment decisions and what impacts those investments have on the issues they claim to address. 

The SEC responds with two proposed rules  

 The high level of heterogeneity and lack of transparency in many ESG investment strategies has prompted the Securities and Exchange Commission (SEC) to crack down on false or overblown ESG claims by funds and companies. The SEC sent a spate of comment letters related to climate change disclosure starting in late 2021, requiring companies to provide more information about their climate risk. The SEC’s Climate and ESG Task Force, appointed in 2021, has begun its enforcement work, for example charging an investment firm for misleading claims related to ESG this spring. European investors have seen similar trends, with regulators investigating asset managers for misleading ESG statements. 

In ESG investment, the lack of specific disclosure requirements or a consistent disclosure framework make it difficult for investors to understand a fund’s ESG strategy, its impact and benefits, and how it compares to other funds. To help investors make informed decisions, the SEC released a pair of proposed rules in June 2022 that are designed to improve transparency related to funds’ ESG metrics. The proposed rules: (1) establish new disclosure and reporting requirements related to ESG investments and (2) refine ESG-related fund naming requirements to avoid misleading investors. These proposed rules complement the SEC’s proposed climate risk disclosure rule for companies released in March 2022. 

Proposed ESG Fund Disclosure Rule  

Registered investment companies, including ESG funds, are subject to disclosure requirements under the Investment Company Act of 1940 and other securities laws.[1] The proposed ESG fund disclosure rule, Enhanced Disclosures by Certain Investment Advisers and Investment Companies about Environmental, Social, and Governance Investment Practices, would require additional reporting from funds and advisers about their ESG approach and impact. The proposed rule, which would amend certain registration and reporting forms, applies to funds, including registered investment companies and business development companies, and advisers, including registered investment advisers and certain unregistered advisers. The proposal includes a layered approach: the more that funds incorporate ESG factors into their investment process, the more they will need to disclose. 

The proposed rule lays out three categories of ESG funds, which have different levels of disclosure based on their degree of ESG focus. 

  • Integration funds consider ESG factors but do not give them greater weight than other, non-ESG factors in investment decision making. These funds would need to describe how ESG factors are accounted for in the investment process in their prospectus. 
  • ESG-focused funds include ESG as a “significant or main consideration” when making investment selections. These funds would need to provide detailed disclosures that include a standardized ESG strategy overview table in the prospectus. The SEC is proposing to require this category to provide additional disclosures in their annual reports related to the use of proxy voting on ESG matters, engagement meetings related to ESG strategy, and in some cases, greenhouse gas emissions. Specifically, funds with a focus on environmental factors would need to disclose the greenhouse gas emissions associated with their portfolio company investments unless they disclose in the ESG strategy overview table that these emissions are not part of their investment strategy.  
  • Impact funds are a subset of ESG-focused funds that seek to achieve an ESG objective, such as combating climate change or improving labor conditions. In addition to the prospectus and annual report disclosures required for ESG-focused funds, impact funds would be required to disclose their progress toward meeting their stated aim in their annual report, including qualitative and quantitative terms and key factors that affect their ability to reach the objective.  

 Along with fund disclosures, investment advisors would need to disclose information about how they incorporate ESG factors and strategies into investment decisions in client brochures.  

The SEC designed these proposed changes to improve transparency and comparability of ESG-related funds. The disclosure-focused approach, which is typical of SEC regulations, does not define ESG or stipulate a particular approach, but rather requires funds and advisors to disclose information about how they define and implement ESG in their investment portfolio. Interestingly, this approach contrasts with the EU ESG scheme, the Sustainable Finance Disclosure Regulation, which does provide a detailed definition of sustainability investing. The SEC’s approach will allow a range of ESG strategies and approaches to evolve with the benefit of increased transparency for investors so that unsubstantiated claims diminish.  

Fund Names Rule  

Section 35(d) of the Investment Company Act, as amended by the National Securities Markets Improvement Act of 1996, prohibits investment companies from using names that the SEC deems “materially deceptive or misleading.” A fund’s name provides important information to investors, and for decades the SEC has required funds using a name that suggests a particular area of focus, including industry, geography, or type of investment, to invest at least 80 percent of its value in assets that are consistent with its name. The proposed fund names rule, Investment Company Names, would update this rule to improve transparency for investors. This proposed update, which would apply to all registered investment companies, would expand the rule to include funds that have names suggesting investments with certain characteristics, including ESG-related names. 

The proposed rule would require a fund to disclose how it defines terms in its name and selects investments that are consistent with that name. In its reporting, a fund would indicate which holdings count toward the 80 percent of assets invested in accordance with the fund’s name. Under the proposed rule, the 80-percent policy would be determined using the notional amount of derivatives, rather than market value. The rule would require that funds dropping below the 80 percent requirement follow certain guidelines to come back into compliance, generally within 30 days. In addition, the rule would prevent integration funds that consider ESG among other factors from using ESG-related terms in the fund name. 

In drafting the proposed rule, the commission builds on the history of the names rule and its statutory mandate to ensure that it reflects current trends in the investment sector. Ensuring that the name of a fund is more transparent and aligned with the investments in the fund is a simple step toward protecting investors. 

What is ahead for the proposed rules? 

Commissioners have consistently raised the need for more comparable disclosure standards that support investor decisions and tamp down exaggerated or unfounded claims, including in the burgeoning ESG space. The commission designed these rules to be in keeping with its disclosure-oriented framework, improve the information provided to investors, and respond to industry trends.  

Criticism of the proposal includes concerns over potential compliance costs and charges that reporting will stifle innovation in the ESG investing sector. However, the commission is not mandating a particular methodology for ESG investing, which is intended to allow funds to continue to innovate. It is asking firms to share their approach and impact to improve investor information.  

Opponents of the proposed rule may also challenge the greenhouse gas disclosure requirements in the ESG fund disclosure rule, arguing that conducting that analysis is overly burdensome to the fund managers and portfolio companies. It is important for the commission to ensure that these requirements do not have an unintended chilling effect on environment-focused funds. However, given high investor demand for green funds, this quantitative information is key for understanding the measurable impacts of these investments. 

The SEC has posed nearly 300 questions for commenters in the two proposed rules. The rules are open for comment until August 16, 2022. The SEC will use these comments to refine and strengthen the proposed rules into legally durable final rules.  

[1] Investment Advisers Act of 1940, 15 U.S.C. 80b et seq.; Investment Company Act of 1940, 15 U.S.C. 80a et seq.; the Securities Act, 15 U.S.C. 77a et seq.; and the Exchange Act, 15 U.S.C. 78b et seq.