Investment advisers and companies are pushing back against a recently proposed rule by the Securities and Exchange Commission (SEC) that would require enhanced disclosures about funds that claim environmental, social, and governance (ESG) strategies drive investment choices, worrying it would have “substantial impact” without providing useful information to investors.
The proposed rule would “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,” the SEC said in a press release May 25.
The amendments “would have a substantial impact on the way our clients go about their business,” said Kenneth Holston, partner at law firm K&L Gates.
First, fund managers would have to define what an ESG strategy means for them because the SEC’s proposal does not include any definitions of ESG or even of the individual parts of the term.
“What ESG means will vary from market participant to market participant and can change over time,” Holston said. “It’ll be like trying to nail jelly to the wall.”
For example, some companies whose main business is drilling for oil or manufacturing weapons might find their ESG strategies will need to be adjusted as public perception swings. These changes in perception can be caused by many factors—like Russia’s war in Ukraine, which makes oil and gas sourced in Russia verboten and weapons placed in Ukrainian hands viewed as protecting democracy. What’s perceived as a negative in terms of ESG can become a positive relatively quickly and vice versa.
Karen Barr, president and chief executive of the Investment Adviser Association, said investment advisers “should clearly articulate their investment strategies, including sustainable investment strategies, so investors understand an adviser’s philosophy and can make informed investment decisions.
At the same time, the rule should strike “the right balance between helping investors understand a potential investment and overloading investors with too much information or information that is dense and technical and ultimately not decision-useful,” she said, adding, “The Advisers Act already requires advisers to make full and fair disclosure of material information to investors, whether about ESG or anything else, so it’s not clear that a new rule that focuses on ESG disclosure is necessary.”
Barr also said the association is “concerned that the detailed nature of the disclosure may lead to advisers” revealing proprietary information that “could place them at an unfair competitive disadvantage.”
According to the proposed rule, funds claiming ESG factors would have to disclose them to investors, along with the strategies they use. This could include whether the fund tracks an index, includes or excludes certain assets from its investment mix, uses proxy voting or engagement to achieve certain objectives, or aims to have a specific impact. The SEC defines these as integration funds, which “integrate ESG factors alongside non-ESG factors in investment decisions,” according to an agency fact sheet that accompanied the proposal.
A second type of fund, called ESG-focused funds, is defined by the SEC as funds for which ESG factors are a significant or main consideration. ESG-focused funds would be required to provide detailed disclosures that describe the specific impact they seek to achieve and summarize their progress on achieving those impacts, “including a standardized ESG strategy overview table.”
A subset of ESG-focused funds, called impact funds, would be required to disclose how they measure progress on their objective. For example, funds focused on environmental factors would have to disclose the “carbon footprint and the weighted average carbon intensity of their portfolio,” which would also include greenhouse gas (GHG) emissions, the SEC said.
Fund managers seeking to comply with the new rule might also have to watch for what Holston calls “ESG creep,” where a fund classified as an integration fund, with its set of requirements, could transition during the year into another type of classification, such as an ESG-focused fund, which comes with increased disclosure requirements.
Another potential pothole in complying with the proposed rule would be for funds managing a mix of registered and private funds, Holston said. ESG strategies would have to be consistently described across product types, he said. Managers who juggle non-U.S. based funds would also have to ensure their approach complies with ESG rules and laws in regions like the European Union, he said.
The rule, if passed as written, also would require ESG impact funds to disclose the GHG emissions of their portfolios, if they make environmental claims about their investment strategy.
“The burden will be significant for firms to comply with those requirements,” Holston said. “It’s quite a bit more work than what is required now,” he said, and is “based on the expectation that GHG emission information will become available” due to a different rule that is not yet finalized and might be challenged in court. That rule is the SEC’s proposed climate-related disclosure amendments from March.
The SEC has shown a keen interest in exploring claims of “greenwashing,” in which investment funds offer exaggerated ESG claims in their disclosures to the agency. A recent example of this is the enforcement action against BNY Mellon, in which the SEC fined the bank $1.5 million for making “misstatements and omissions” on ESG mutual funds it managed over three years.
“The SEC remains vigorously engaged in review and enforcement activities in regard to greenwashing,” Holston said.