Environmental, Social and Governance Funds: SEC-Proposed Disclosure Reform

Environmental, Social and Governance Funds: SEC-Proposed Disclosure Reform

October 12, 2022
Environmental, Social and Governance Funds: SEC-Proposed
Disclosure Reform
On May 25, 2022, citing concerns over lack of consistent,
frameworks, among other issues. In March 2021, the
comparable, and reliable investor disclosures regarding
agency announced the creation of an ESG Task Force
environmental, social, and governance (ESG) fund and
within the Division of Enforcement to analyze disclosure
ESG investment adviser strategies, the Securities and
and compliance issues relating to ESG strategies. In May
Exchange Commission (SEC) voted 3-1 to issue
2022, the SEC also charged and settled with BNY Mellon
amendments to regulations implementing the Investment
Investment Adviser over alleged misstatements and
Advisers Act of 1940 (P.L. 76-768) and the Investment
omissions concerning various ESG considerations
Company Act of 1940 (P.L. 76-768) aimed at addressing
regarding mutual funds that it managed. The case was the
such perceived inadequacies. The proposal is broadly
aforementioned ESG Task Force’s first enforcement action.
portrayed as seeking to address “greenwashing”—when a
The same month, the SEC voted in favor of a proposal to
fund overstates the ESG attributes of its investments. This
modernize its fund naming convention under the
In Focus provides background on the issues prompting the
Investment Company Act, including ESG-focused funds.
rulemaking, a description of the new rules, and positions of
proponents and opponents of the rules.
May 2022 ESG Fund and Investment Adviser
Disclosure Proposals
Background
The May 2022 proposal would mandate various disclosures
ESG funds are portfolios of equities and/or bonds, typically
for open-end mutual funds, closed-end mutual funds,
in the form of mutual funds, for which ESG considerations
business development companies (closed-end funds that
have been integrated into the investment process. For
invest in small, medium-sized, and distressed firms), and
example, the fund may invest only in companies with low
investment advisers to institutional and retail investors who
carbon emissions or that promise to pay workers a living
strategically incorporate ESG considerations into their
wage. Investor interest in such funds has grown
investment selection processes. The proposals do not define
significantly in recent years. According to one industry
ESG or related terms but, instead, would direct funds and
estimate, domestic ESG funds had $357 billion in assets
investment advisors who incorporate one or more ESG
under management at the end of 2021, more than four times
factors to disclose how (1) ESG factors play a role in their
the amount of three years earlier.
portfolio investment selection procedures and (2) ESG
factors are integrated into their investment strategies.
The SEC regulates funds and investment advisers primarily
through its Division of Investment Management and the
Funds Under the Proposal
Division of Enforcement. The agency does not have rules
As part of this, the proposal identifies several types of ESG
that specifically govern the use of ESG principles or their
funds that dictate various ESG disclosure obligations.
disclosures that are relevant to specific factors such as
climate change, for example. Applying instead are general
Integration funds would incorporate a combination of
rules requiring public disclosure of factors that affect
ESG factors and non-ESG factors in their investment
financial returns and are considered “material” for
strategies, and the weight they give to ESG factors would
investors.
not exceed that for non-ESG factors. The funds would be
required to disclose how ESG factors help steer their
According to an SEC 2021 statement: “The ways that
investment processes. Funds that consider greenhouse gas
different funds and advisers define ESG can vary widely.
(GHG) emissions in their strategies would have to provide
Similarly, there are significant differences in the data,
detailed information on how they consider such emissions
criteria, and strategies used as part of ESG strategies [that]
of their portfolio companies and the methodologies they use
make it harder for investors who seek to understand which
as part of those emissions considerations.
investments or investment policies are associated with a
particular ESG strategy. In the absence of informative
ESG-focused funds (ESG-FFs) would be significantly
disclosures, a fund’s or adviser’s disclosure could
focused on ESG factors and would be required to submit
exaggerate its actual consideration of ESG factors.”
various new ESG-related disclosures, including a tabular
ESG strategy overview that would include whether they
The May 2022 fund disclosure reform proposal covered
track a particular securities index, pursue a particular ESG
below is one part of a series of related recent SEC
impact, or apply inclusionary or exclusionary ESG screens.
developments. In April 2020, the SEC’s Division of
ESG-FFs that use proxy voting or engagement with issuers
Examinations warned that its review of ESG funds had
to implement their ESG strategies would be required to
found a number of misleading statements regarding ESG
disclose how they voted their proxies and engaged their
investing processes and adherence to global ESG
underlying portfolio securities firms on ESG-related
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Environmental, Social and Governance Funds: SEC-Proposed Disclosure Reform
matters. In addition, ESG-FFs with an environmental
argument derives from the notion that a number of
investment focus would be required to disclose information
conventional funds claim to use ESG information in their
on the GHG emissions linked to their investments,
investment processes but are hard pressed to explain the
including Scope 1, 2, and 3 emissions; the carbon footprint;
nature of its use as investment criteria or the frequency of
and the weighted average carbon intensity. Scope 1 are
that use. To address this, the proposal is said to provide a
direct GHG emissions that occur from sources owned or
mechanism for such funds to clarify those issues. Another
controlled by the company, such as emissions from
argument is that the proposed emissions reporting by
company-owned or -controlled machinery or vehicles;
Integration funds will especially benefit investors, including
Scope 2 are indirect emissions that result primarily from the
those with various environmental commitments. Another
generation of electricity purchased and consumed by the
argument is that the emissions reporting will provide
company; and Scope 3 are all other indirect emissions not
investors in environmentally focused funds with a
accounted for in Scope 2. The proposal noted that not all
comprehensive view of emissions associated with a fund’s
portfolio companies that environmentally focused ESG-FFs
financed GHG footprint. An attendant defense is that the
are invested in publicly provide the necessary GHG
emissions reporting will provide quantitative metrics related
emission data. In this case, funds would be required to
to climate for investors focused on climate risk while also
provide “good faith estimates” of Scope 1 and Scope 2
providing verifiable data from which to evaluate
portfolio company emissions.
environmental claims, which should help counter
exaggerated fund “greenwashed” environmental claims. In
Impact funds would be a subset of ESG-FFs that pursue a
support of the enhanced investment adviser brochure is the
specific ESG impact (such as underwriting the construction
notion that it will help investors to better understand
of affordable housing or helping to make clean water more
advisers’ approaches to investing and comparing the scope
available). In addition to the aforementioned ESG-FF
of their emerging investment approaches, including the use
disclosures, Impact funds would be required to disclose
of inclusionary and exclusionary screens and their
how they qualitatively and quantitatively measure progress
engagement with issuers to achieve their ESG objectives.
toward their impact goals and to describe the status of their
progress toward the goals.
Some Critical Perspectives
The proposals have garnered criticism from various
Investment Advisers under the Proposal
business advocacy groups, including the U.S. Chamber of
Under the proposals, investment advisers who strategically
Commerce, the National Federation of Independent
incorporate ESG factors and advise institutional and retail
Businesses, the Investment Advisers Association, and a
investors would be required to disclose in their brochures
major fund trade group, the Investment Company Institute.
(known as Form ADV Part 2) whether and how they
employ Integration-based strategies and/or ESG-focused
A central argument is that the current SEC rules are
strategies. If the strategies are identified as ESG-focused,
effective as is, sufficiently requiring fund disclosure of
advisers would have to disclose whether and how they also
investment objectives, principal investment strategies, and
employ ESG impact strategies. If an adviser considers
principal investment risks. A corollary assertion is that the
different ESG factors for distinct strategies, separate
volume of prescriptive and standardized disclosure required
disclosures would be required for each unique strategy.
by the proposal would not give investors useful information
Advisers would also have to disclose the criteria or
for decisionmaking. An additional issue is that the
methodology used to evaluate, select, or screen out
proposal’s more prescriptive character could expose funds
investments in their consideration of ESG factors. Also, if
to various liability risks. Another concern is that the
an adviser has specific proxy voting policies involving at
“Integration fund” category would confusingly capture
least one ESG factor when he or she votes a client’s
other fund types, including non-ESG-focused ones. A
securities, a description in the brochure of which ESG
related assertion is that the proposed definition of ESG-
factors are being considered and how they are being
focused funds would include a fund’s engagement with its
considered would be required. Advisers would also have to
portfolio companies in areas such as board composition,
describe material relationships that they have with related
which could apply to various non-ESG funds as well.
persons who act as ESG consultants or service providers.
Related CRS Products
Some Supportive Perspectives
CRS In Focus IF11716, Introduction to Financial Services:
The proposal has been generally embraced by financial
Environmental, Social, and Governance (ESG) Issues, by
reform advocates, including the Americans for Financial
Raj Gnanarajah and Gary Shorter.
Reform, and environmental and sustainable investing
groups such as the Sierra Club, Ceres, and US SIF.
CRS In Focus IF12108, Overview of the SEC Climate Risk
Disclosure Proposed Rule, by Gary Shorter and Rena S.
Proponents cite a number of arguments. On the issue of the
Miller.
SEC’s authority to promulgate them (which opponents have
raised), they argue that Congress gave the SEC authority to
Gary Shorter, Specialist in Financial Economics
mandate disclosures aimed at protecting investors or to
serve the overall public interest via the Securities and
IF12228
Exchange Act of 1934 (P.L. 73-291). An additional

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Environmental, Social and Governance Funds: SEC-Proposed Disclosure Reform

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