On May 25, 2022, the Securities and Exchange Commission (“SEC”) proposed new rules and amendments (collectively, the “Proposed Rules”) that would enhance the disclosure requirements for certain investment advisers and investment companies related to environmental, social and governance (“ESG”) investment practices. The full text of the Proposed Rules can be viewed here.

Background

Investor interest in ESG strategies has grown dramatically in recent years. Markets have seen significant inflows of capital to ESG-related investment products and advisory services. In response, fund and asset managers have increasingly created and marketed ESG-specific products to their clients to meet this growing demand.

The SEC has concluded that this rapidly developing area lacks the uniformity and consistency in disclosure guidance and practice necessary to adequately inform and protect investors. For example, funds and advisers define ESG in disparate ways, and there can be significant differences in the data, criteria, and strategies used as part of any given ESG strategy. The absence of clear, uniform and informative disclosures makes it difficult for investors who seek to understand which investments or investment policies are associated with a particular ESG strategy and leaves open the possibility of exaggeration or even fraudulent marketing with respect to a fund’s or adviser’s ESG practices or the extent to which their investment products or services take into account ESG factors (known as “greenwashing”).

The Proposed Rules are designed to provide consistent standards for ESG disclosures, to assist investors in making more informed decisions as they compare various ESG investments. The Proposed Rules’ framework for ESG-related strategy disclosure is designed to enable investors to determine whether a fund’s or adviser’s ESG marketing statements translate into concrete and specific measures that address ESG goals and portfolio allocation.

ESG Strategy Disclosures: Registered Funds

The Proposed Rules would require a registered fund engaging in ESG investing to provide additional information about the implementation of ESG factors in the fund’s principal investment strategies. The level of detail required by this enhanced disclosure would depend on the extent to which a fund considers ESG factors in its investment process, as evaluated under a new classification system of “Integration Fund” or “ESG-Focused Fund” (including a subcategory known as “Impact Funds”).

• Integration Fund means a registered fund that considers one or more ESG factors along with other, non-ESG factors in investment decisions, but for which 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.
• ESG-Focused Fund means a registered 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, including but not limited to any registered fund that markets itself (in name or in promotional materials) as having an ESG focus.
• Impact Fund means an ESG-Focused Fund that seeks to achieve a specific ESG impact or impacts.

The additional disclosures would appear in either a registered fund’s prospectus or its annual reporting.

Prospectus Requirements

Integration Funds

An Integration Fund would be required to summarize in a few sentences how it incorporates ESG factors into its investment selection process, including what ESG factors it considers. This additional disclosure is meant to be in addition to the information that registered funds are currently required to provide about their investments, risks, and performance.

ESG-Focused Funds

An ESG-Focused Fund would be required to provide specific disclosure about how the fund focuses on ESG factors in its investment process. Such information would be provided in a tabular format – an ESG Strategy Overview table – and would include the following information: 

• Overview of the fund’s ESG strategy. A fund would (i) provide a concise description in a few sentences of the factor or factors that are the focus of the fund’s strategy and (ii) include a list of common ESG strategies as indicated in the form of ESG Strategy Overview table and, in a “check the box” style, indicate all strategies in that list that apply.
• How the fund incorporates ESG factors in its investment. A fund would summarize how it incorporates ESG factors into its process for evaluating, selecting, or excluding investments, including a requirement to provide specific information, in a disaggregated manner, with respect to each of the common ESG strategies applicable to the fund as identified by the above “check the box” disclosure.
• How the fund votes proxies and/or engages with companies about ESG issues. Funds that check either proxy voting or engagement boxes in the “check the box” disclosure would be required to provide a brief narrative overview in the last row of the ESG Strategy Overview table of how the fund engages with portfolio companies on ESG issues, including whether the fund has specific or supplemental proxy voting policies and procedures that include one or more ESG considerations for companies in its investment portfolio (and, if so, state which ESG considerations those policies and procedures address) and an overview of the objectives it seeks to achieve with its engagement strategy.

The concise disclosure provided by a fund in the ESG Strategy Overview table would be complemented by additional information in an open-end fund’s statutory prospectus and later in a closed-end fund’s prospectus, which would provide investors with complete information to evaluate a fund’s engagement, while not overwhelming investors with information at the front of the prospectus.

Impact Funds

An Impact Fund would be required to provide the disclosures proposed for all ESG-Focused Funds. Additionally, an Impact Fund would need to disclose, on its ESG Strategy Overview table, an overview of the impact(s) the fund is seeking to achieve, and how the fund is seeking to achieve the impact(s). The overview must include (i) how the fund measures progress toward the specific impact, including the key performance indicators the fund analyzes, (ii) the time horizon the fund uses to analyze progress, and (iii) the relationship between the impact the fund is seeking to achieve and financial return(s).

Annual Report Requirements

The Proposed Rules do not contemplate any specific annual report requirements for Integration Funds. For ESG-Focused and Impact Funds, however, the Proposed Rules would include new reporting categories which could comprise significant additional reporting requirements.

Impact Funds

Impact Funds would be required to summarize briefly their progress on achieving specific impact(s) in both qualitative and quantitative terms during the reporting period, and the key factors that materially affected their ability to achieve the specific impact(s), on an annual basis in their annual report.

ESG Proxy Voting and Engagement Disclosure

ESG-Focused Funds for which proxy voting is a significant means of implementing its ESG strategy would be required to disclose certain information regarding how they voted proxies relating to portfolio securities on particular ESG-related voting matters. Specifically, the Proposed Rules would require any such fund to disclose, in management’s discussion of financial performance (“MDFP”) or management’s discussion and analysis (“MD&A”) section of the annual report, as applicable, the percentage of ESG-related voting matters during the reporting period for which the fund voted in furtherance of the initiative. Such funds would also be required to refer investors to the fund’s full voting record filed on Form N-PX by providing a cross reference in its annual report (by hyperlink for electronic versions) to the fund’s most recent complete proxy voting record filed on Form N-PX.

ESG-Focused Funds for which engagement with issuers through means other than proxy voting is a significant means of implementing their ESG strategy would be required to disclose progress on any key performance indicators of such engagement, as well as the number or percentage of issuers with whom the fund held ESG engagement meetings during the reporting period related to one or more ESG issues and total number of ESG engagement meetings.

Funds Incorporating Environmental Considerations

The Proposed Rules would also require an ESG-Focused Fund that considers environmental factors as part of its investment strategy to disclose in the MDFP or MD&A section of the fund’s annual report, as applicable, the carbon footprint and the weighted average carbon intensity (“WACI”) of the fund’s portfolio, calculated using specific formulas and accompanying instructions and assumptions set forth in the Proposed Rules. Such funds would further be required to disclose any additional assumptions, methodologies, and/or any limitations associated with these calculations on Form N-CSR.

A fund would not be required to disclose such metrics if it affirmatively states that it does not consider issuers’ greenhouse gas emissions as part of its investment strategy.

Unit Investment Trusts

Under the Proposed Rules, any Unit Investment Trusts with portfolio securities selected based on one or more ESG factors would be required to explain how those factors were used to select such portfolio companies.

ESG Strategy Disclosures: Adviser Brochures

The Proposed Rules contemplate a similar framework of disclosure for investment advisers to those set forth above for registered funds.

Under the Proposed Rules, if a registered investment adviser considers ESG factors in connection with any significant investment strategy or method of analysis, it would be required to add the following disclosures to its ADV Part 2A brochure:

• a description of the ESG factor(s) considered and how they are incorporated into the adviser’s investment advice, including when recommending or selecting other investment advisers;
• an explanation of whether and how the adviser employs ESG Integration, ESG-Focused, or ESG Impact strategies;
• a description of any significant ESG strategy, criteria or methodology used to evaluate, select or exclude investments;
• a description of any material relationship or arrangement that the adviser or any of its management persons have with any related person that is an ESG consultant or ESG service provider;
• for advisers with specific voting policies or procedures that include one or more ESG considerations, a description of such ESG factors and how they are considered; and
• for advisers sponsoring wrap fee programs, a disclosure of whether and how they review portfolio managers’ application of ESG factors, or a statement that they do not review and a description of any resulting limitations on calculation or presentation of ESG factors.

Regulatory Reporting: Form N-CEN and ADV Part 1A

Form N-CEN Requirements

The Proposed Rules contemplate addition of a new Item C.3(j) to Form N-CEN that asks questions tailored to ESG processes and strategy. A fund that indicates that it incorporates ESG factors would be required to report, among other things:

• the type of ESG strategy employed (i.e. integration, focused or impact);
• the ESG factor(s) considered; and
• the method(s) used to implement its ESG strategy.

The new Item would also collect information regarding (i) whether a fund considers ESG-related information or scores provided by ESG providers in implementing its investment strategy, and if so, the identify of each such ESG provider, and (ii) whether a fund follows any third-party ESG frameworks in its investment strategies and, if so, the full name of such frameworks.

Form ADV Part 1A Reporting

The Proposed Rules also expand the scope of information collected from advisers on Form ADV Part 1A to include the following ESG-related disclosures:

• whether advisers consider ESG factors as part of one or more significant strategies, and if so, the type of ESG approach employed;
• whether advisers follow any third-party ESG framework(s) in connection with providing their advisory services; and
• whether advisers conduct other business activities as ESG providers or have any related persons that are ESG advisers (an expansion of current Items 6 and 7).

Compliance Timeline

In an effort to give funds and advisers sufficient time to comply with the ESG disclosure requirements and other obligations under the Proposed Rules, the SEC has proposed a compliance date of one year following the effective date of any adopted final rule (with certain reporting requirements not becoming effective until 18 months following the effective date, as set forth more specifically in the Proposed Rules).

Commissioner Peirce’s Objection

Commissioner Helen Peirce published a lengthy objection to the Proposed Rules. Among her key arguments were the following:

• The Proposed Rules would muddy, rather than clarify, the waters by failing to define “E,” “S,” or “G” but still requiring “hyper-specific” ESG-related disclosures.
• The 1-year implementation window is overly ambitious and unworkable.
• The Proposed Rules overstate the actual threat of “greenwashing” investment products or companies and fail to acknowledge the SEC’s ability to effectively police such behavior within its current regulatory framework.

The full text of her objection can be found here.

The SEC’s proposing release include approximately 300 specific requests for comment on the Proposed Rules. Comments, whether made in response to these specific requests or otherwise, are due 60 days after publication in the Federal Register.

For additional information related to the Proposed Rules, please contact one of the authors listed above, or any member of our Securities Law Practice Group.