Many investment funds, advisors, and companies have been working to incorporate environmental, social, and governance (ESG) factors into their investment practices, but the US Securities and Exchange Commission (SEC) has proposed new disclosure and reporting requirements that will mandate a common disclosure framework for demonstrating “concrete and specific measures taken to address ESG goals and portfolio allocation.”

Many investment funds, advisors, and companies have been working to incorporate environmental, social, and governance (ESG) factors into their investment practices, but the US Securities and Exchange Commission (SEC) has proposed new disclosure and reporting requirements that will mandate a common disclosure framework for demonstrating “concrete and specific measures taken to address ESG goals and portfolio allocation.”^[1] The SEC seems to be taking steps not only to tamp down on the practice of “greenwashing,” but also to ensure companies provide investors with consistent, comparable, and reliable information. The proposed requirements would apply to registered investment advisers, registered investment companies, business development companies, and certain advisers that are exempt from registration but still use ESG factors in their investment strategies.

In addition to the proposed reporting requirements, another proposed rule would expand the scope of the names rule, requiring funds with names suggesting an ESG focus, or “growth” and “value” focus, to invest at least 80 percent of the value of its assets in line with the focus suggested by its name.^[2] Investment entities have an opportunity to demonstrate their comparative methodological advantages in this growing and influential investment space by providing investors with consistent, comparable, and reliable information.

These proposed rules are not the SEC’s first efforts to prioritize ESG. The SEC created a Climate and ESG Task Force, seeking to “identify any material gaps or misstatements in issuers’ disclosure of climate risks” as well as “disclosure and compliance issues relating to investment advisers’ and funds’ ESG strategies.”^[3] In early 2022, the Task Force initiated an ESG-related enforcement action for “misstatements and omissions” about ESG, which was settled for $1.5 million. The proposed rules may give the SEC additional tools to promote transparency and truthfulness in ESG-focused investing.

The SEC hopes to thread the needle of providing investors with complete disclosures in predictable locations without overwhelming or misleading investors by requiring extensive information too early in documents like prospectuses. According to the SEC, the proposed rules contemplate a “layered disclosure” framework that could promote disclosure that is “inviting and usable to a broad spectrum of investors.” For example, the SEC explained that a fund would disclose that it considers greenhouse gas (GHG) emissions as one of several ESG factors in its summary prospectus, with the exact methodology of how it considers GHG emissions detailed later on in the statutory prospectus. The SEC hopes the “current lack of consistent, comparable and decision-useful data” concerning GHG-related claims will be corrected by these new rules.

Private sector efforts, such as the ESG Data Convergence Project formed to standardize ESG disclosures, can bring clarity to the SEC’s approach.^[4] The SEC does not seek to define ESG or related terms in the proposed Investment Disclosures and Investment Company Names rules, potentially subjecting the proposals to criticism for vagueness.

According to the SEC, disclosures may allow investors to more easily identify and compare ESG-focused funds. The proposed rules require funds to adhere to specific ESG disclosure requirements to investors in fund registration statements, fund annual reports, and adviser brochures.^[5] The level of detail required depends on “the extent to which a fund considers ESG factors in its investment process.”^[6] The rules contemplate three main categories of ESG investment approaches:^[7] (1) Integration Funds,^[8] (2) ESG-Focused Funds,^[9] and (3) Impact Funds.^[10]

• If finalized, the proposed rule requires Integration Funds to briefly summarize how a fund incorporates ESG factors into its investment selection process, including what ESG factors the fund considers. Integration Funds would also need to be mindful that fund names including terms indicating its investment decisions “incorporate one or more ESG factors” could be considered “materially deceptive or misleading” under the proposed names rule.

• ESG-Focused Funds, such as a fund applying an exclusionary screen, would have to disclose, in tabular and machine-readable data form, an overview of the fund’s strategy, how the fund incorporates ESG factors into its investment decisions, and how the fund votes proxies and/or engages with companies about ESG issues.

• Finally, Impact Funds would have to summarize “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), on an annual basis.”

Though the rules are not yet finalized, the proposed requirements appear consistent with the SEC’s climate-related disclosures rule, and accordingly, registered funds may have to substantially enhance and increase their ESG-related disclosures.

The SEC has invited public comment on the proposed rules for a sixty-day period after the effective date, which is when the rules are published in the Federal Register. Compliance for the vast majority of the proposed disclosure and regulatory reporting requirements would be required one year after the effective date, whereas shareholder report disclosures would be required 18 months after the effective date. The investment company name requirements would have a one-year compliance period, running from the effective date.

Additional research and writing from Kevin Cassato, a 2022 summer associate in ArentFox Schiff's Chicago office and a law student at the University of Illinois College of Law.

ENDNOTES

[1] See Enhanced Disclosures by Certain Investment Advisers and Investment Companies about Environmental, Social, and Governance Investment Practices, Advisers Act Release No. 6,034; Investment Company Act Release No. 34,594 (proposed May 25, 2022) (to be codified at 17 C.F.R. pt. 200, 230, 232, 239, 249, 274, and 279) (“Enhanced Disclosures”).

[2] See Investment Company Names, Investment Company Act Release No. 34,593 (proposed May 25, 2022) (to be codified at 17 C.F.R. pt. 232, 270, and 274) (“Investment Company Names”).

[3] Press Release, Sec. & Exch. Comm’n, SEC Announces Enforcement Task Force Focused on Climate and ESG Issues (Mar. 4, 2021).

[4] Private Equity Industry’s First-Ever ESG Data Convergence Project Announces Milestone Commitment of Over 100 LPs and GPs, Carlyle (Jan. 28, 2022).

[5] Specifically, Forms N-1A, N-2, N-CSR, N-8B-2, S-6, N-CEN, and ADV Part 2A will be amended. Id. at 20, n. 37.

[6] Id. at 23.

[7] Unit Investment Trusts (UIT) are also subject to some limited requirements, namely to explain how ESG factors were used to select portfolio securities if such factors were considered. See id. at 67.

[8] An Integration Fund is a “fund that considers one or more ESG factors along with other, non-ESG factors in its investment decisions, but those ESG factors are generally no more significant than other factors in the investment selection process, such that ESG factors may not be determinative in deciding to include or exclude any particular investment in the portfolio.” Id. at 26.

[9] An ESG-Focused Fund is a “fund that focuses on one or more ESG factors by using them as a significant or main consideration (1) in selecting investments or (2) in its engagement strategy with the companies in which it invests.” Id. at 33.

[10] An Impact Fund is an ESG-Focused Fund that “seeks to achieve a specific ESG impact or impacts,” such as a fund with a “disclosed goal of financing the construction of affordable housing units. . . .” Id. at 35.