SEC Proposes Two Rules as Cairns to Prevent Misleading ESG Claims
On October 7, 2022, the U.S. Securities and Exchange Commission reopened the public comment periods, for 14 days from the day the notice is published in the Federal Register, for 11 of its rulemaking releases, some of them viewed as controversial including the rules discussed in this blog post, due to a technical glitch that led to a number of comment letters being lost.
The Securities and Exchange Commission published in the Federal Register last Friday, June 17, 2022, proposed rules for new naming requirements and disclosures for investment funds making ESG claims.
It would be a mistake for the broader business community to ignore these two rules interpreting them narrowly as only regulating asset managers at investment industry firms. These SEC proposals are cairns with the Commission providing clear trail markers both for its future federal public policy on ESG, when most of its priorities will be reduced to future SEC regulations by this Administration when ESG matters do not have enough votes to not pass Congress; and, for the SEC’s contemplated future enforcement actions over ESG greenwashing and misleading claims.
The first proposed rule amends the Investment Company Act of 1940 (the “Names Rule”) to address changes in the mutual fund industry and compliance practices that have developed in the approximately 20 years since the current rule was adopted. A fund’s name is an important marketing tool and can have a significant impact on investors’ decisions when selecting investments, and the Names Rule addresses fund names that are likely to mislead investors about a fund’s investments and risks.
“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,” said SEC Chair Gary Gensler in a virtual news conference on the day of the rules release. “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.”
The Names Rule currently requires registered investment companies whose names suggest a focus in a particular type of investment (among other areas) to adopt a policy to invest at least 80 percent of the value of their assets in those investments (an “80 percent investment policy”). The proposed amendments would enhance the rule’s protections by requiring more funds to adopt an 80 percent investment policy. Specifically, the proposed amendments would extend the requirement to any fund name with terms suggesting that the fund focuses in investments that have (or whose issuers have) particular characteristics. 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 environmental, social, or governance factors.
The amendments also would limit temporary departures from the 80 percent investment requirement and clarify the rule’s treatment of derivative investments.
The second proposal is significantly more problematic when it amends rules and reporting forms “to promote consistent, comparable, and reliable information for investors” concerning funds’ and advisers’ incorporation of ESG factors. The proposed changes are wide-ranging, applying to certain registered investment advisers, advisers exempt from registration, registered investment companies, and business development companies; a huge expansion beyond those currently regulated.
“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,” said Gensler.
The proposed amendments seek to categorize what is ESG extremely broadly, but artificially without defining the terms or offering any substantive guidance (.. as if a market driven definition of the hugely overarching umbrella of ‘environmental social governance’ leaves anything unsaid?) and require funds and advisers to provide more specific disclosures in fund prospectuses, annual reports, and adviser brochures based on the ESG strategies they claim to pursue.
The proposal would require ESG focused funds that consider environmental factors in their investment strategies to disclose additional information regarding the GHG emissions associated with their investments. These funds would be required to disclose the carbon footprint and the weighted average carbon intensity of their portfolio. The requirements are transparently designed to meet demand from investors seeking environmentally focused fund investments for consistent and comparable quantitative information, but this rule goes too far. The GHG emissions data and weighting process is simply information not available today and what may exist is almost universally not public information and largely not scientifically sound. Funds that disclose that they do not consider GHG emissions as part of their ESG strategy would not be required to report this information. Integration funds that consider GHG emissions would be required to disclose additional information about how the fund considers GHG emissions, including the method.
Additionally, funds claiming to achieve a specific ESG impact would be required to describe the specific impact they seek to achieve and summarize their progress on achieving those impacts. 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 particular ESG related voting matters and information concerning their ESG engagement.
Finally, to complement the proposed ESG disclosures in fund prospectuses, annual reports, and adviser brochures, the proposal would require significant new ESG reporting to the SEC. All of which combines to make compliance with these rules expensive.
While admittedly these two rules are not as far reaching as the pending SEC proposed ESG rule, again, it would be a mistake to ignore these interpreting them narrowly as only regulating investment industry firms. These proposed rules are cairns with the SEC providing clear trail markers both for its future federal public policy on ESG, when most of its priorities will be reduced to future SEC regulations at a time when ESG matters cannot muster enough votes to not pass Congress; and, also significantly for the SEC’s contemplated future enforcement actions over ESG greenwashing and misleading claims or deceptive claims.
The proposed rules were published in the Federal Register on June 17, 2022 and comments should be received on or before August 16, 2022.