Saying that it is seeking “consistent, comparable and reliable information,” the SEC is taking aim at the way investment advisers and registered investment companies describe and disclose their ESG investment practices, as well as how they name certain funds.
On May 25, the Commission voted to release two sets of proposed amendments. The first seeks to “enhance disclosures” by certain investment advisers and investment companies about ESG investment practices. The second seeks to modernize the Investment Company Act “Names Rule.” The Commission approved the release of both proposals in separate 3-1 votes, with Hester Peirce, the lone Republican commissioner, voting against both proposals.
ESG Disclosures
The SEC is proposing amendments that 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 lack of disclosure requirements and a common disclosure framework tailored to ESG investing make it harder for investors who seek to understand which investments or investment policies are associated with a particular ESG strategy,” the SEC explains in a factsheet. “In the absence of informative disclosures, a fund’s or adviser’s disclosure could exaggerate its actual consideration of ESG factors.”
The proposal describes three types of ESG funds and their corresponding disclosures:
- Integration Funds. Funds that integrate ESG factors alongside non-ESG factors in investment decisions would be required to describe how ESG factors are incorporated into their investment process.
- ESG-Focused Funds. Funds for which ESG factors are a significant or main consideration would be required to provide detailed disclosure, including a standardized ESG strategy overview table.
- Impact Funds. A subset of ESG-focused funds that seek to achieve a particular ESG impact would be required to describe the specific impact they seek to achieve and summarize their progress on achieving those impacts.
In addition, funds that use proxy voting or other engagement with issuers as a significant means of implementing their ESG strategy would be required to disclose information regarding their voting of proxies on ESG-related matters and information concerning their ESG engagement meetings. Moreover, funds focused on the consideration of environmental factors would be required to disclose the greenhouse gas emissions associated with their portfolio investments.
The proposal would also require certain ESG reporting on Forms N-CEN and ADV Part 1A, on which funds and advisers report census-type data that inform the Commission’s regulatory, enforcement, examination, disclosure review and policymaking roles.
“I am pleased to support this proposal because, if adopted, it would establish disclosure requirements for funds and advisers that market themselves as having an ESG focus,” SEC Chair Gary Gensler said in a statement. “I think investors should be able to drill down to see what’s under the hood of these strategies. This gets to the heart of the SEC’s mission to protect investors, allowing them to allocate their capital efficiently and meet their needs.”
A public comment period will remain open for 60 days after publication in the Federal Register.
Names Rule Update
The SEC also proposed updated guidance to “enhance and modernize” the Investment Company Act “Names Rule” to address certain broad categories of investment company names that the Commission suggests are likely to mislead investors about an investment company’s investments and risks.
Under the current rule, registered investment companies whose names suggest a focus in a particular type of investment or other area are required to adopt a policy to invest at least 80% of the value of their assets in those investments (an 80% investment policy). The proposal would enhance the rule’s protections by requiring more funds to adopt an 80% investment policy.
The proposed amendments would extend the requirement to any fund name with terms suggesting that the fund focuses on investments that have (or whose issuers have) particular characteristics. The SEC notes that this would include fund names with terms such as “growth” or “value” or terms indicating that the fund’s investment decisions incorporate one or more ESG factors.
The proposal also specifies the circumstances under which a fund may depart from its 80% investment policy, such as sudden changes in market value of underlying investments, including specific time frames for returning to 80%. Further, to address the rule’s application to derivatives investments, the proposal would require a fund to use a derivatives instrument’s notional amount, rather than its market value, for the purpose of determining the fund’s compliance with its 80% investment policy.
The Commission is also proposing enhanced prospectus disclosure requirements for terminology used in fund names and additional requirements for funds to report information on Form N-PORT regarding compliance with the proposed names-related regulatory requirements.
Use of ESG Terminology
Under the Names Rule proposal, a fund which considers ESG factors alongside but not more centrally than other, non-ESG factors in its investment decisions would not be permitted to use ESG or similar terminology in its name. Doing so, according to the SEC, would be defined to be materially deceptive or misleading.
For such “integration funds,” the 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, the SEC explains.
The proposal follows a request for comment the SEC issued to gather public feedback on potential reforms to the rule in March 2020.
“A lot has happened in our capital markets in the past two decades. As the fund industry has developed, gaps in the current Names Rule may undermine investor protection,” stated Gensler. “In particular, some funds have claimed that the rule does not apply to them—even though their name suggests that investments are selected based on specific criteria or characteristics. Today’s proposal would modernize the Names Rule for today’s markets.”
A public comment period will remain open for 60 days after the proposal is published in the Federal Register.
