The SEC is not trying to force funds to invest in ESG, but instead is seeking to make sure disclosures are consistent and reliable so that investors have the information they need, an SEC branch chief told delegates at the 2022 NAPA DC Fly-In Forum.
In “The Environment for ESG—an SEC Perspective,” moderator Bonnie Treichel, Chief Solutions Officer at Endeavor Retirement, spoke with Zeena Abdul-Rahman, Branch Chief of the Investment Company Rulemaking Office within the Division of Investment Management at the SEC, about the parameters of the proposed SEC rules and shared insights on the rulemaking process.
The Backdrop
Adbul-Rahman kicked off the session by providing a high-level overview of the current state of affairs with environmental, social and governance (ESG) investing, noting that it has become popular with investors over the last few years. In response, a lot of mutual funds and advisors have created funds that they market as funds that consider ESG factors as part of their investment selection process. By the SEC’s estimates, the Commission believes there are about 800 ESG funds right now with more than $3 trillion in assets under management, so it’s a large and growing area of interest to investors, she emphasized.
Abdul-Rahman explained that a lot of ESG funds’ marketing materials have images of rolling green hills and ocean and wind farms—things that investors think they like and understand—but the reality in actually implementing ESG factors is much more complicated.
Investors have become more savvy, at least to the extent they are demanding more disclosures; in response, ESG funds have tried to beef up their disclosures. However, she noted, because there is not currently a regulatory framework that establishes minimum disclosure requirements for funds, there are funds that are competing with other funds and trying to ramp up their disclosures.
“What happens is that what a fund is disclosing they are doing doesn’t necessarily match up with what they’re actually doing, and that mismatch is what we call greenwashing—essentially, that you are over-exaggerating,” Adbul-Rahman explained.
The SEC staff has tried to address these discrepancies, first issuing an investor bulletin in 2021 explaining the different types of ESG funds and strategies and how they get implemented. The Commission then issued a Request for Information asking for input about ESG related disclosures, followed by the Exams office finding problems, the most significant of which was the greenwashing issue.
The Proposal(s)
Consequently, the SEC issued two sets of proposed amendments. The first seeks to “enhance disclosures” by certain investment advisers and investment companies about ESG investment practices, and the second seeks to modernize the Investment Company Act “Names Rule.”
The SEC’s ESG rule is not intended to “save the world” through disclosure rulemaking, Adbul-Rahman emphasized. “We are not trying to force funds to invest in ESG. This is largely focused on funds and advisors making claims about their ESG related investment strategies, making sure that their disclosures are consistent, reliable and useful for investors as they’re making investment decisions,” she said.
The SEC branch chief added that the proposal does not attempt to define ESG, because for example, good governance is not the same for one person as it is for another, so rather than focusing on what funds are doing, the SEC is focused on how funds are doing it. As such, the Commission has proposed a categorization system that focuses on how ESG-related strategies or factors are being incorporated. And the level of disclosure that funds have to provide depends on their categorization, basically to the extent to which they incorporate ESG, she explained.
The proposal describes three types of ESG funds—integration funds, ESG-focused funds and impact funds—and their corresponding disclosures. Adbul-Rahman noted that probably the most significant and controversial portion of the rulemaking was for ESG-focused funds that consider environmental factors and how those funds would have to disclose the scope of greenhouse gas emissions of the portfolio companies in which they invest; that is, unless they specifically say that they don't consider emissions as part of their investment strategy.
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In explaining the differences between the different funds and their related categorizations, Adbul-Rahman emphasized that the proposal is intended to be a self-identifying regime, such that they are creating the framework, but leaving it to the funds to decide for themselves what kinds of funds they are. “And then investors get enough information to say, ‘Hey, you call yourself an ESG focus fund, but it doesn’t really sound like that from your disclosure,’” Adbul-Rahman observed.
She was not able to provide a timeline for the rulemaking, but noted that the comment period for this proposal ends on Aug. 16. Note also that there’s a second SEC proposal from the Corporate Finance Division that would apply to all corporate issuers, requiring them to make certain climate-related risk disclosures.
SEC vs. DOL on Materiality
Separately, the Department of Labor has issued its own proposal on the use of ESG factors in selecting plan investments and fiduciary duties regarding proxy voting that explicitly allows a consideration of those factors.
When asked whether there are differences between the SEC and the DOL on materiality, Adbul-Rahman explained that the SEC’s proposal does not raise the issue of materiality, but instead tailors the amount of disclosure to the extent to which a fund is considering ESG. “So, if it’s more material, then you’re going to get more information; if it’s less, you’re going to get less information, but we don’t actually invoke the materiality standard in the ESG proposal,” she explained.
Treichel noted that, in contrast, if you look at the current DOL proposal, it talks about materiality and even mentions that the DOL has embraced the concept of materiality going back to 2015. “I think that’s where you have to really understand that the SEC and the DOL are two different regimes, and so, you have to understand both and you’re going to have to keep track of both,” Treichel emphasized.
When asked why the SEC and DOL don’t coordinate on this issue, noting that it might be more efficient to have uniform nomenclature and meanings, and that it might be better for participants, Adbul-Rahman observed that whenever an agency is engaged in rulemaking, you always want to make sure the U.S. government is speaking with one voice and that it makes sense and is consistent, but added that the two are not otherwise coordinating.
