SEC rule proposal would order investment firms to back up ESG claims

The proposed rule would allow investors to “drill down to see what’s under the hood” of a fund’s ESG strategies, said SEC Chair Gary Gensler in a press release Wednesday.

“The proposed amendments seek to 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.

Approved by a 3-1 margin, the rule will be open for public comment for 60 days after publication in the Federal Register. Gensler was joined by Commissioners Allison Herren Lee and Caroline Crenshaw in approving the proposal; Commissioner Hester Peirce voted no. There is one vacancy on the Commission.

In addition, the SEC approved another rule proposal Wednesday that would punish firms that name funds “that are likely to mislead investors about a fund’s investments and risks.”

In his statement supporting the ESG disclosures proposal, Gensler said the SEC has watched as an increasing number of funds market themselves as “green,” “sustainable,” and “low-carbon.” An estimate by the U.S. Forum for Sustainable and Responsible Investment pegged the value of the “U.S. sustainable investment universe” at $17.1 trillion, Gensler noted.

Gensler said funds that say they consider ESG factors would have to disclose to investors the ESG factors they consider, 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 ESG disclosures 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.

ESG-focused and impact funds that consider GHG emissions “would be required to disclose additional information about how the fund considers GHG emissions, including the methodology and data sources the fund may use as part of its consideration of GHG emissions,” the fact sheet said.

Funds that disclose they do not consider GHG emissions as part of their ESG strategy would not be required to report this information.

Lance Dial, partner at Morgan Lewis, said if the rules pass as written, investment advisers and investment companies will have to put many more policies and procedures in place to generate disclosures that satisfy the requirements. Firms will have to use data analysis to calculate certain measurements required under the rules, like the GHG emissions of the investments in a particular fund. That may require hiring outside consultants as well, he said.

“I don’t see these rules as pushing anyone out of the ESG space, but investment advisers will have a lot more work to do,” he said.

Dial said he’s also interested to hear feedback from portfolio managers who manage ESG funds about how they would incorporate these new rules into their firm’s disclosure framework.

Larry Godin, KPMG’s principal and national practice lead for asset and wealth management, regulatory risk and compliance, said the two rule proposals “reflect significant steps taken by the Commission to bring investors enhanced transparency surrounding fund strategies.”

“In the absence of a universally accepted definition of ESG, the SEC is seeking to combat greenwashing by placing increased accountability on investment advisers to disclose, in sufficient detail, the investment process used to arrive at decisions made within a portfolio,” Godin said. “The goal is to ensure investment decisions are consistent with the name of a fund and investors’ expectations.”

Steven Rothstein, managing director of the Ceres Accelerator for Sustainable Capital Markets at nonprofit organization Ceres, said the new rules will combat greenwashing in the ESG investment fund industry.

“The tremendous growth in the number and variety of ESG funds available shows that analysis of ESG risks and opportunities is a mainstream strategy to create long-term value for investors,” he said. “But better, more consistent disclosures are sorely needed to help investors take advantage of this dynamic and growing market.”

Many in the investment adviser community took note of the $1.5 million fine the SEC announced Monday against BNY Mellon for “misstatements and omissions” on ESG mutual funds it managed over three years.

BNY Mellon told investors via mutual fund prospectuses, and in written responses to requests for proposals, the mutual funds it managed had received “proprietary ESG quality reviews” as part of the investment research process, according to the SEC. The agency determined while such reviews had been conducted for some of the managed mutual funds in question, they were not conducted for all of them, specifically overlay funds.

Peirce, the lone commissioner who voted no on the proposal, said the BNY Mellon enforcement action is proof the SEC should simply enforce the rules and laws that already apply.

“A new rule to address greenwashing … should not be a high priority,” she said in a dissenting statement.

She also argued the definition of what constitutes ESG factors in an investment strategy is not nearly clear enough.

“How precisely do we envision determining whether a fund has incorporated ‘ESG factors’ into its investment selection process when we have not defined just what those factors are?” Peirce said. “‘I’ll know it when I see it’ is not a practice currently recognized in administrative law.”

The latest proposed rules by the SEC are the most recent prongs in the agency’s ESG disclosure regime, joining a proposal ordering climate-related disclosures by public companies issued in March. The comment period on that proposal was recently extended to June 17.

The climate-related disclosure rule is a sweeping potential mandate that, if passed, would force all public companies to quantify, measure, and disclose their effect on the environment. The rule would order public companies to include disclosures about how climate-related risks affect their strategy, business model, and outlook; how the company’s board and management oversee climate-related issues; and any plans for transition to a lower carbon footprint.

Passage of the climate-related disclosure rule “will go a long way toward closing the gaps for investor funds,” Dial said.