United States: SEC Continues ESG Push With Proposed Investment Disclosure And Fund Name Requirements

Continuing its push to make Environmental, Social, and Governance ("ESG") issues a key agency priority, on May 25, 2022 the SEC announced two sets of proposed rule amendments taking aim at "greenwashing" in investment funds. One set of amendments would require enhanced disclosures by investment funds claiming to have an ESG focus¹ while another would require funds with names denoting certain characteristics to have at least eighty percent of its value in investments reflecting those characteristics, with the SEC's commentary making clear that the rule enforcement focus will be on funds with names reflecting an ESG-principled investment strategy, such as "green" or "socially responsible."²

Background

The SEC has of late undertaken a number of actions to prioritize ESG; for example, through the formation last year of a "Climate and ESG Task Force"³ and by issuing guidance suggesting that shareholder proposals relating to ESG issues could not be excluded from proxy materials.⁴ Indeed, this past March the SEC proposed rules regarding climate disclosures⁵ so sweeping that Republican-appointed Commissioner Hester Pierce released a statement in opposition titled "We are Not the Securities and Environment Commission - At Least Not Yet."⁶ The agency has also indicated it intends to modernize its rules relating to investment funds, such as through proposed rules designed to mitigate cybersecurity risk for investment companies.⁷ The two sets of proposed rules relating to ESG investment funds discussed below are a reflection of these trends.

The Proposed Rules

The two sets of proposed rules, both announced on the same day, seek to bring increased transparency to funds that market themselves as ESG-related.

Enhanced Disclosure Rules for ESG-related Funds

First, the SEC has proposed rules requiring enhanced disclosures by ESG-related investment advisors and funds. In his statement in support of these rules, SEC Chair Gary Gensler noted the "increasing number of funds" which "market themselves as 'green, 'sustainable,' 'low-carbon,' and so on," and stated that "investors should be able to drill down to see what's under the hood of these funds."⁸ Similarly, the commentary to the proposed rule notes that "[i]nvestors looking to participate in ESG investing face a lack of consistent, comparable, and reliable information among investment products and advisers that claim to consider one or more ESG factors," and concludes that "[t]he lack of specific disclosure requirements tailored to ESG investing creates the risk that funds and advisers marketing such strategies may exaggerate their ESG practices or the extent to which their investment products or services take into account ESG factors," in a "practice often referred to as 'greenwashing.'"⁹ The commentary further identified the risk of inconsistency in ESG reporting due to "the variety of perspectives concerning what ESG investing means, the issues or objectives it encompasses, and the ways to implement an ESG strategy."¹⁰

In an attempt to address these concerns, the proposed rule would require a suite of specific disclosures regarding ESG strategies in a variety of fund documents, such as fund registration statements, fund annual reports, and advisor brochures.¹¹ For example, an ESG-focused fund that seeks to achieve a specific ESG impact, referred to in the proposed rule as an "Impact Fund,"¹² would need to summarize in its annual report "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)."¹³ As another example, ESG-focused funds would be required to disclose two greenhouse gas emissions metrics for their portfolio in the funds' annual reports.¹⁴ Even funds that consider one or more ESG factors as part of a broader investment process that also incorporates non-ESG factors (referred to in the proposed rule as "Integration Funds") would face enhanced disclosure requirements, including a summary of "how the fund incorporates ESG factors into its investment selection process, including what ESG factors the fund consider" and additional disclosures in the fund's prospectus regarding the role of greenhouse gas emissions in the Integration Fund's ESG investment selection process.¹⁵

Additional Requirements for Fund Names

Second, the SEC has also, separately, proposed amendments to the already-extant "Names Rule," which presently requires that if a registered investment company's name suggests a focus in particular types of investments it must invest at least eighty percent of its value in assets consistent with that name.¹⁶ In his statement in support of the proposed rules, Chair Gensler explained that the proposed amendments would expand these requirements so that funds whose names suggest that their investments have particular characteristics, such as funds with ESG-related names, would be included in this eighty percent requirement, as well as additional changes including new required disclosures regarding how the fund "defines the terms in its name and selects investments in line with its name."¹⁷ Furthermore, funds that consider ESG factors "along with, but not more significantly than, other factors," i.e. Integration Funds, would not be permitted to use ESG-related terms in their names.¹⁸

The commentary to this proposed rule makes clear that a key impetus for the proposed rule is concern regarding fund-names that potentially exaggerated their ESG focus, through naming funds with terms such as "sustainable," "green," or "socially responsible."¹⁹ That said, the proposed rule is not limited to ESG, with the commentary identifying other examples of funds with an investment focus in "'thematic' areas such as cybersecurity, blockchain, and artificial intelligence."²⁰

Commissioner Pierce's Oppositions

Notably, while the SEC has taken an aggressive approach to ESG disclosures, there remains internal division within the agency as to the wisdom of these proposed rules. In particular, Commissioner Pierce issued statements in strong opposition to both of the proposed rules noting that the burden will be borne by investors.

With respect to the enhanced ESG disclosure rule, Commissioner Pierce argues that "[i]nvestors will pick up the tab for our latest ESG exploits without seeing much benefit."²¹ Her reasoning: "E, S, and G cannot be adequately defined," noting in a tongue-in-cheek tone that the "cool kids" are now referring to "'EESG—Employees, Environmental, Social, and Governance," and "[w]e better amend that proposal before it goes out the door lest a fund or adviser that prioritizes human capital issues despairs of being able legally to offer an ESG fund."²² She further argues that this lack of a coherent definition of ESG means that the proposals are "incapable of enforcement on a practical level," and asks "[w]hy do we feel compelled to propose such sweeping and prescriptive new rules when we can and do use existing rules to hold funds and advisers to account?" suggesting that the answer lies in "a troubling trend of not-so-subtle coercion through disclosure mandates."

Commissioner Pierce's opposition to the proposed amendments to the Names Rule, is based on a similar critique that ESG, and other characteristics that would be impacted such as "growth" and "value" are not defined and rely on "subjective judgments."²³ She further argues that the proposed rule would encourage "more generic names so that managers can preserve flexibility in their portfolio management," noting that these generic names will in fact be "less informative for investors."²⁴ She argues that the prevention of use of ESG-terms in names of Integration Funds will not incentivize the use of ESG factors in investment funds, as funds "would be unable to use their name to signal to investors that they are integrating ESG," which may, alongside the heightened disclosure requirements, cause investment advisors to "try to run from ESG to avoid the heightened disclosure requirements."²⁵

Next Steps and Takeaways

Neither of the proposed rules are yet in force. Rather, as next steps both will be subject to a period of public comment until sixty days after the proposed rules' publication in the federal register.²⁶ In light of the SEC's recent, strong, ESG-focus, however, it is reasonably likely to expect these rules to be adopted in some form notwithstanding Commissioner Pierce's strong opposition. Investment companies should therefore be prepared, and analyze the proposed rules carefully to discern what additional disclosures they may need to make, as well as whether they have funds which will require a name-change.

If you have questions or would like to discuss, please reach out to your Seyfarth ESG, Corporate Citizenship & Human Rights attorney.

Footnotes

1. See Proposed Rule, "Enhanced Disclosures by Certain Investment Advisers and Investment Companies about Environmental, Social, and Governance Investment Practices," https://www.sec.gov/rules/proposed/2022/ia-6034.pdf; see also Press Release, "SEC Proposes to Enhance Disclosures by Certain Investment Advisers and Investment Companies About ESG Investment Practices," (May 25, 2022), https://www.sec.gov/news/press-release/2022-92.

2. See Proposed Rule, "Investment Company Names," https://www.sec.gov/rules/proposed/2022/ic-34593.pdf; see also Press Release, "SEC Proposes Rule Changes to Prevent Misleading or Deceptive Fund Names," https://www.sec.gov/news/press-release/2022-91.

3. Press Release, SEC Announces Enforcement Task Force Focused on Climate and ESG Issues (March 4, 2021), https://www.sec.gov/news/press-release/2021-42.

4. See Between A Rock and A Hard Place... ESG Investments in 401(k) Plan Line-Ups (May 20, 2022), Seyfarth Shaw LLP, https://www.seyfarth.com/news-insights/between-a-rock-and-a-hard-place-esg-investments-in-401k-plan-line-ups.html.

5. See It's Here - The Move from Voluntary to Mandatory ESG Disclosures Begins with Climate, Seyfarth Shaw LLP (March 23, 2022), https://www.seyfarth.com/news-insights/its-here-the-move-from-voluntary-to-mandatory-esg-disclosures-begins-with-climate.html#:~:text=The%20Proposed%20Rule%20requires%20that,the%20last%20completed%20fiscal%20year.

6. Pierce, Hester, We are Not the Securities and Environment Commission - At Least Not Yet (March 21, 2022), https://www.sec.gov/news/statement/peirce-climate-disclosure-20220321.

7. See Ferrillo, Paul, Davis, Tracee, and Morduchowitz, Daphne, How Fund Industry Can Prepare For SEC's Cyber Proposal, Law360 (March 4, 2020), https://www.seyfarth.com/dir_docs/publications/Law360-How-Fund-Industry-Can-Prepare-For-SECs-Cyber-Proposal.pdf.

8. Gensler, Gary, Statement on ESG Disclosures Proposal (May 25, 2022), https://www.sec.gov/news/statement/gensler-statement-esg-disclosures-proposal-052522.

9. Supra n. 1 at 7-8.

10. Id. at 18.

11. Id. at 20.

12. Id. at 35.

13. Id. at 21.

14. Id. at 21-22.

15. Id. at 207-208.

16. See supra n. 2.

17. See Gensler, Gary, Statement on Proposed Updates to Names Rule (May 25, 2022), https://www.sec.gov/news/statement/gensler-statement-proposed-updates-names-rule-052522.

18. Id.

19. See supra n.2 at 14.

20. See supra n. 2 at 13.

21. Pierce, Hester, Statement on Environmental, Social, and Governance Disclosures for Investment Advisers and Investment Companies (May 25, 2022), https://www.sec.gov/news/statement/peirce-statement-esg-052522.

22. Id. (emphasis in original).

23. Pierce, Hester, Statement on Investment Company Names (May 25, 2022), https://www.sec.gov/news/statement/peirce-fund-names-statement-052522.

24. Id.

25. Id.

26. See Press Releases, supra ns. 1 and 2.

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