SEC Proposals on ESG Disclosures and Fund Names Take Shape

Two SEC proposals impacting investment advisers and funds are expected to be finalized in Q323.

The first enhances investment funds’ ESG disclosures. The second expands the scope of the “Names Rule” to additional ESG terminology like “green” or “sustainable” in fund names, among other amendments.

Together, these proposals are designed to provide consistent ESG standards, allowing investors to make more informed decisions. The rapid rise of ESG-related investment products coupled with divergent data and investment criteria used in ESG strategies have prompted both regulator and consumer interest in greater standardization, transparency, and measurement of ESG investments.

Overview

The proposals were originally released in May 2022 and apply to:

• Registered investment companies.
• Business development companies (together with registered investment companies, “funds”).
• Registered investment advisers.
• Certain unregistered advisers (together with registered investment advisers, “advisers”).

These new proposals followed the previous SEC proposal announced on March 21, 2022, requiring registrants to include climate-related disclosures in annual reports and/or registration statements. These efforts align with the market’s increasing expectations for more scrutiny of ESG compliance and reporting. While still in the proposal phase, the issues in question are already relevant as illustrated by the SEC’s active enforcement of existing regulations in the ESG funds space. The regulator has fined two well-known financial institutions in the last year, with the last fine doubling the previous one.  

Proposal 1: Enhanced ESG Disclosures for Investment Advisers and Funds 

The SEC proposes requiring funds and advisers that consider ESG factors in their investment process to disclose additional information regarding their strategy, such as including greenhouse gas (GHG) emissions metrics, having a tabular strategy overview in statements, and submitting statements and reports in a structured machine-readable data language.  

The amendments would enhance disclosure by:  

• Requiring additional specific disclosures regarding ESG strategies in fund prospectuses, annual reports, and adviser brochures.  
• Implementing a layered, tabular disclosure approach for ESG funds to allow investors to compare ESG funds more consistently. 
• Requiring ESG-focused funds that consider environmental factors in their investment strategies to disclose additional information regarding the GHG emissions associated with their investments. 

Additionally, the amount of required disclosure under the proposed rule depends on the degree to which ESG factors are core to a fund’s strategy. The proposal identifies the following three types of ESG funds:  

1. 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. 
2. ESG-focused funds: Funds for which ESG factors are a significant or main consideration would be required to provide detailed disclosures, including a standardized ESG strategy overview table.  
3. Impact funds: A subset of ESG-Focused funds that seek to achieve a particular ESG impact would be required to disclose how they measure progress on their objective.  

Proposal 2: Amendments to the Fund ‘Names Rule’ 

The Names Rule requires funds with certain names to adopt a policy to invest at least 80% of their assets in the investments suggested by that name. The SEC is proposing expanding that rule to apply to any fund names with particular characteristics, such as ESG characteristics. For example, fund names with terms like “growth,” “value,” “sustainable,” “green,” etc. will fall under this new proposal.  

In addition, the proposal would: 

• Require a fund to use a derivatives instrument’s notional amount, rather than its market value, to determine the fund’s compliance with its 80% investment policy. 
• Not permit “integration funds” to use ESG terms in their names since ESG factors are generally no more significant than other factors in the investment selection process.  
• Specify the particular circumstances under which a fund can depart from the 80% requirement, including time frames for returning to it.  
• Prohibit a registered closed-end fund or business development company whose shares are not listed on a national securities exchange from changing its 80% investment policy without a shareholder vote. This prohibition would ensure investors could vote on a change in investment policy given their limited options to exit their investments if the change were made. 
• Require fund prospectus disclosure that defines the terms used in a fund’s name. The proposal also includes amendments to Form N-PORT to require greater transparency on how the fund’s investments match the fund’s investment focus. The proposal would, furthermore, require funds to keep certain records regarding how they comply with the rule or why they think they are not subject to it. 
• Retain the current rule’s requirement that, unless the 80% investment policy is a fundamental policy of the fund, notice must be provided to fund shareholders of any change in the fund’s 80% investment policy. The proposal would update the rule’s notice requirement to expressly address funds that use electronic delivery methods to provide information to their shareholders. 

Clarity in ESG Details

Currently, the way ESG is defined in the market, even between different funds and advisers, can vary widely. There are differences in the data, criteria, and strategies used as part of an ESG-focused fund. The lack of disclosure requirements and a common framework tailored to ESG investing make it harder for investors to understand which investments or investment policies are associated with a particular ESG strategy. 

In the absence of informative disclosures, a fund’s or adviser’s disclosure could exaggerate its actual consideration of ESG factors. The proposed rule would help make ESG disclosures more consistent, measurable, and reliable, thus allowing investors to make informed decisions when comparing ESG investments.  

In addition, having a robust disclosure and reporting framework that investment managers would be mandated to provide on the criteria and data they use to achieve their investment goals, as well as details about their strategies, would help expand the governance of the SEC over ESG-related funds and advisers. 

The name of a fund is an important marketing tool and should reveal much about the fund and its portfolio. Fund names can be misleading or deceptive if they include words like “green” or “sustainable,” and they truly are not. This may entice or draw investors to these funds based on the name, even if they’re not reflective of their portfolio. To ensure funds are properly descriptive of their portfolio, the amendments to the Names Rule would require that a fund’s name accurately reflect the fund’s investment strategy.  

Next Steps 

The comment period closed August 2022. The proposals are expected to be finalized in the fall of 2023 following the SEC’s review of public comments. 

Funds and advisers should consider acting now by reviewing their policies and procedures around ESG factors. Reporting and disclosures should also be updated to meet compliance with these enhanced requirements. It’s important to assess underlying ESG data and determine whether there’s a need for enhanced compliance and governance.  

Asset managers needing ESG reporting and disclosure support can contact CrossCountry Consulting today.