On May 25, the Securities and Exchange Commission (the SEC) introduced a proposal to amend certain rules and forms under the United States Investment Advisers Act of 1940 (the Advisers Act) and U.S. Act on Investment Companies of 1940 (the Companies Act) to provide what the SEC describes as greater transparency to investors about the environmental, social and governance (ESG) factors of certain products investment funds, particularly for investment funds that present themselves as having ESG-focused strategies.
The SEC does not currently mandate specific ESG disclosures by funds or advisors, instead applying existing anti-fraud and marketing rules and regulations that apply to all disclosures, including ESG matters. By emphasizing the particular risks for investors in ESG-focused investment products, the SEC intends that the proposed rules provide investors with consistent, comparable and reliable information about ESG funds and strategies. In particular, the SEC has expressed concern about “greenwashing,” the idea that funds or advisers may overestimate the role that ESG factors play in their investment decisions.
The SEC’s proposal imposes the heaviest new burdens on registered investment companies (such as mutual funds, exchange-traded funds, and other registered investment products), unit trust investments, and business development, not private funds.
Nevertheless, the new rules would affect private funds through proposed changes to Form ADV, with implications not only for Registered Investment Advisers (RIAs), but also, in some cases, for Exempt Reporting Advisers (ERAs). relying on the venture capital fund advisor or the private fund. advisor registration exemptions.
The ESG rules are the latest in a series of regulatory proposals from the SEC, which follow (i) proposed changes to the Advisor Act rules in January regarding Form PF reporting; (ii) proposed rules under the Companies Act and Advisers Act in February strengthening cybersecurity practices and imposing sweeping new restrictions and regulations on private funds in February; and (iii) the Companies Act rules proposed in March improving disclosures and protections relating to special purpose acquisition companies (SPACs).
A new spectrum in three parts
The proposed rules establish a common three-part framework for ESG-related investment products that would apply in the future to registered funds, private funds and investment advisers:
— “ESG integration” strategies that take into account one or more ESG factors as well as other non-ESG factors in investment decisions; in these strategies, ESG factors may be considered in the investment selection process, but are generally not decisive over other factors when selecting or excluding a particular investment.
— “ESG-focused” strategies focus on one or more ESG factors by using them as a significant or primary consideration in selecting investments or in engaging with portfolio companies; for example, these ESG-focused strategies may exclude or include certain investments based on particular ESG criteria.
— “ESG impact” strategies have the stated objective of seeking a specific ESG impact or impacts generating specific ESG-related benefits; these impact strategies generally seek to target portfolio investments that generate specific and measurable environmental, social or governance results.
Proposed Disclosures for Registered Investment Firms
The SEC is proposing to create a uniform ESG strategy disclosure system for registered funds, which would include disclosure requirements regarding the role of ESG in investment decision-making in a registered fund’s prospectus. The SEC proposed a “layered” approach, so that “ESG integration” funds would provide less information than “ESG-focused” (and “ESG-impact”) funds. In addition, some ESG-focused funds (including impact) would have a requirement to publish an annual ESG report. In addition, ESG-focused environmental funds (including impact) would have additional disclosures, including some harmonized measures of greenhouse gas (GHG) emissions.
Proposed Disclosures for Investment Advisors and Private Funds
While noting the growth of ESG-focused investment strategies in recent years with respect to mutual funds and ETFs, the SEC noted that less than 1% of private funds had names suggesting ESG investments. .1 Nevertheless, the SEC believes that ESG considerations have become increasingly important for private fund sponsors and investors.
Accordingly, RIAs would be required to disclose certain ESG practices in Form ADV Part 2A (commonly referred to as the “brochure”). In addition, RIAs and ERAs would be required to provide “census” type summary information on ESG-related issues as part of their annual Form ADV Part 1A amendments.
Form ADV Part 2A
RIAs would be required to accurately disclose their ESG investment approach to help investors understand the advisor’s ESG approach through the addition of several new elements:
— Proposed sub-item 8.D would require RIAs to describe each ESG factor or factors, if any, that it considers for each investment strategy or material analysis method, including any criteria or methodology that the adviser uses to evaluate, select or exclude investments, such as internal or third-party methodologies, inclusion or exclusion filters, or any other index and how that index has used ESG factors.
— Proposed subsection 10.C would require RIAs to describe any material relationship or arrangement that is material to the adviser’s business or to its clients, or that the adviser or any of its officers has with a ESG consultant or other ESG service provider (including ESG index providers or ESG rating providers). This requirement is designed, among other things, to allow investors to assess any conflicts of interest that may be created by an adviser’s relationships or arrangements with related persons.
— Amended subsection 17.A would require RIAs that have specific voting policies or procedures that include one or more ESG considerations when voting on client securities to include a description of the ESG factors they take into account and how they take them into account; for example, if an adviser has different voting policies and procedures for strategies that address ESG issues or for different clients or ESG strategies, the adviser should describe those differences.
Form ADV Part 1A
The SEC would also amend Items 5, 6, and 7 of Form ADV Part 1A to require disclosures on the use of ESG factors for separately managed accounts (SMA) and private funds, with the changes made to item 5 required for RIA and changes to items 6 and 7 required for RIA and ERA.
— Advisors would be required in item 5.K for ADMs and new question 29 of item 7.B(1) of Appendix D for private funds to provide standardized background information on their use of factors ESG in the management of each reported private fund, including (i) whether each private fund takes ESG factors into account; (ii) if yes, whether the fund deploys an integration, targeted or ESG impact strategy; and (iii) whether the fund takes into account, in particular, environmental factors, social factors, governance factors, or a combination of the three.
— In addition, advisers would be required to disclose whether they follow one or more third-party ESG frameworks as part of their advisory services and, if so, name the framework(s).
— Finally, in Items 6 and 7, advisers would be required to disclose whether they conduct business as ESG providers themselves or have related persons who are ESG providers, again to allow investors to better understand conflicts of interest.
Focus on existing regulations
In the proposal, the SEC reaffirmed its view that existing adviser law obligations, including the general anti-fraud provisions of Section 206, apply equally when advisers incorporate ESG factors. . In particular, the SEC noted that existing regulations currently prevent false or misleading advertising by advisers, including greenwashing, by prohibiting material misstatements and fraud. Rule 206(4)-8 prohibits all advisers, whether registered or not, from making false or misleading statements to existing or potential investors in pooled investment vehicles. Rule 206(4)-1, the newly enacted marketing rule that comes into effect November 2022 (with early adoption permitted, as advisers move from the old advertising and fundraising rules), prohibits RIAs Disseminate, directly or indirectly, advertisements containing any misrepresentation of a material fact or any omission of a material fact.
Notably, the Examinations Division has added ESG investing to its list of “important focus areas” in its 2022 examination priorities for investment advisers. The Division highlighted the risk of false and misleading statements or omissions by advisors in their publications, highlighting the potentially cumulative risks of (1) the lack of standardization in ESG investing terminology, (2) the variety of approaches to ESG investing; and (3) the inability to effectively address legal and compliance issues with new industries and products. The SEC’s proposal attempts to reduce each of these cumulative risks. In light of the SEC’s emphasis on existing requirements, and particularly in light of the impending effective date of the new Marketing Rule, RIAs may wish to review their compliance policies and procedures relating to ESG disclosures to ensure consistency with the adviser’s actual portfolio management processes.
Most ESG-related rules and amendments, including those relating to investment advisers and private funds, would come into effect one year after the effective date of the amendments. Upon publication of the proposed rules in the Federal Register, the public will have 60 days to submit comments in response to the rules.