SEC Proposes New ESG Disclosures for Investment Advisers and Funds

The Proposal would amend various disclosure forms, including a registered investment company’s summary prospectus, statutory prospectus, annual report on Form N-CSR, and Form N-CEN, as well as Form 10-K (for BDCs) and Form ADV Part 1A (for both registered and exempt reporting advisers), Part 2A (for registered investment advisers), and advisers’ wrap fee program brochure (Part 2A Appendix 1). The new required disclosures would vary based on the extent to which an ESG strategy is followed (an integration strategy, ESG-focused strategy, or impact strategy), how the ESG strategy is pursued (e.g., indexes, screens, proxy voting, or other engagement), and the status of the fund or adviser (i.e., registered fund, BDC, adviser to private funds, adviser to separately managed accounts (SMAs)).

The Proposal suggests a compliance date one year after the effective date, which would in turn be 60 days after publication of the final rule in the Federal Register, except for the compliance date for the N-CSR requirements, which would be 18 months following the effective date.

Our Take

The Proposal represents a significant departure from the Commission’s existing disclosure framework for the use of any particular investment strategy or approach because it prescribes specific disclosures relating to ESG. Various approaches to ESG investing have been part of the investment landscape for some time, with some viewing ESG as a strategy or focus, and others viewing E, S, and/or G as factors to consider in many investment decisions. The Commission recognized that there is an active state of innovation and evolution in ESG and noted that the Commission staff sought draft rules to “promote consistent, comparable, and reliable information for investors concerning funds’ and advisers’ incorporation of ESG factors.” However, the proposed rules, by being very prescriptive and detailed in their requirements, could hamper efforts by investment companies and advisers and their investors to adjust in response to the active innovation and evolution in ESG investing. Commissioner Hester Peirce’s critical dissent from the new rules observes that “markets are dynamic and equipped in ways we can never duplicate when it comes to the efficient dissemination of information. This proposal would displace the market’s efficient signaling mechanisms with value-laden regulatory nudges.” Her point is, in part, that the level of prescriptive disclosure here almost ensures ill-fitting application from the start and rapidly dated look and feel for the future. 

The absence of a definition for E, S, and G in the context of detailed requirements creates ambiguity and a significant risk of subjective judgments and hindsight, although we agree that definitions would not be feasible or appropriate. Funds and advisers will face significant compliance challenges in addressing the detailed requirements, whereas regulatory tools to prevent “greenwashing” and to ensure compliance with ESG policies identified or promoted by funds and advisers already exist. We encourage clients to pay particular attention to the compliance suggestions throughout the release (and outlined below), which are not implemented by the proposed rules but reflect the Commission’s expectations of registrants and will likely be a focus in examinations and enforcement matters, including by the SEC’s Climate and ESG Task Force, which has begun bringing actions relating to ESG.

In perhaps the clearest example of the detailed and prescriptive nature of the proposed rules, registered investment companies can be expected to encounter difficulties compiling and reporting data on greenhouse gas emissions (GHG). Not all companies in which registered investment companies invest report GHG emission numbers. In light of the Commission’s stated goal of promoting reliable information for investors to better understand ESG investment criteria, rather than require funds to make potentially subjective judgments, it would appear that this type of requirement should be reserved until GHG emission numbers are more widely reported globally by public and private issuers.

Comments on the Proposal are due 60 days after the date of publication in the Federal Register, and clients are encouraged to submit public comments to address some of the practical challenges and unintended effects in the Proposal as drafted as well as alternative metrics.

Proposed Rules and Disclosure Amendments for Investment Companies

Key Definitions

The Proposal prescribes different disclosure requirements for “Integration Funds,” “ESG-Focused Funds,” and “Impact Funds” in the context of both registered investment companies and BDCs. These categories are also relevant to the new ESG disclosure requirements applicable to investment advisers. The Proposal provides the following definitions and descriptions of these ESG fund types.

Integration Funds consider one or more ESG factors along with non-ESG factors in their investment decisions, but 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.¹

ESG-Focused Funds focus on one or more ESG factors by using them as a significant or main consideration in selecting investments or in their engagement strategy with the companies in which they invest. ESG-focused funds include funds (i) with a name including terms that indicate that the fund’s investment decisions incorporate one or more ESG factors and (ii) whose advertisements or sales literature indicate that the fund’s investment decisions incorporate one or more ESG factors by using them as a significant or main consideration in selecting investments. They also include funds that (a) track an ESG-focused index; (b) apply a screen to include or exclude investments or particular industries based on ESG factors; and (c) have a policy of voting their proxies and engaging with the management of their portfolio companies to encourage ESG practices or outcomes.

Impact Funds are a subset of ESG-focused funds that seek to achieve a specific ESG impact or impacts. Examples include (i) funds that invest with the goal of seeking current income while furthering the fund’s disclosed goal of financing the construction of affordable housing units and (ii) funds that invest with the goal of seeking to advance the availability of clean water by investing in industrial water treatment and conservation portfolio companies.

Prospectus and Summary Prospectus Disclosure Requirements

The Proposal will require disclosure of the information in a registered fund’s prospectus and summary prospectus, using a layered approach with varying detail in different locations depending on whether a fund is open- or closed-ended. The Proposal also will require ESG-focused funds to include a  prescribed  ESG Strategy Overview Table, using a combination of summary descriptions of various categories of information and a “check the box” approach to identify use of common ESG strategies, including tracking an ESG index, application of screens, proxy voting, and other engagement with issuers.

Disclosure requirements for the prospectus and summary prospectus will be driven by the type of ESG fund.

Annual Report Disclosure Requirements

The Proposal requires various ESG disclosures in registered funds’ and BDCs’ annual reports.²  Impact funds will be required to disclose their progress toward achieving the impact objective of the fund in both qualitative and quantitative terms during the reporting period and key factors that materially affected the fund’s ability to achieve its impact.  For an ESG-focused fund where proxy voting is a significant means of implementing its strategy, the fund will be required to disclose certain information regarding how the fund voted proxies relating to portfolio securities with respect to ESG issues. For an ESG fund where engagement other than proxy voting is a significant means of evaluating and advancing elements of an ESG strategy for an investment, the fund will be required to disclose certain information about its engagement practices.

The proposed disclosure for registered funds will be included in management’s discussion of fund performance section of the annual shareholder report, and for BDCs in the management discussion and analysis, in the fund’s annual report on Form 10-K.

The specific details and disclosure requirements for engagement will again be driven by the type of ESG fund.

For ESG-focused funds that consider environmental factors, the Proposal prescribes the methodology for calculating carbon footprint and WACI and describes prohibited offsets to those calculations, including purchased or generated carbon offsets or short sale positions. The Proposal also identifies appropriate sources of information to use for calculating enterprise value, net asset value, and a company’s GHG. For calculating a portfolio company’s GHG (including exposure to a portfolio company through derivatives), the Proposal describes a hierarchy of sources and, if none, allows good faith estimates of a portfolio company’s Scope 1 and 2 emissions along with an explanation of the methodology for generating estimates in the annual report with granular information in the Form N-CRS. BDCs would need to provide this data in addition to the GHG disclosures required under the Climate Disclosure Reporting Proposal, although the Commission asks whether this is appropriate. Finally, environmentally focused funds will be required to disclose the Scope 3 emissions (disclosed separately by industry) of its portfolio companies to the extent that Scope 3 emissions data is reported by the fund’s portfolio companies.

N-CEN Disclosure Requirements

The Proposal will amend Form N-CEN designed to collect census-type information regarding funds and the ESG-related service providers they use in structured data language. In particular, a new Item C.3(j) will ask questions of registered funds tailored to ESG funds’ strategies and processes, as follows:

Proposed Form ADV Disclosure Requirements for Investment Advisers

Form ADV Part 1A Disclosure Requirements

The Proposal will amend Form ADV Part 1A to collect information about an adviser’s use of ESG factors in its advisory business, similar to the requirements for N-CEN reporting. The Proposal will expand the information collected about the advisory services provided by advisers to SMAs and reported private funds in Items 5, 6, and 7. The proposed Item 5 amendment applies only to registered investment advisers, whereas the proposed Items 6 and 7 amendments apply both to registered investment advisers and exempt reporting advisers. The proposed amendments are as follows:

Form ADV Part 2A Disclosure Requirements

The Proposal sets forth separate Form ADV disclosures for registered investment advisers that consider ESG factors as part of their advisory services. The disclosure for integration, ESG-focused, and ESG-impact strategies follows the stratification outlined for disclosures by investment companies. The proposed Part 2A disclosure requirements for registered investment advisers include the following:

Advisers to wrap fee programs will be required to disclose the following in their ADV Part 2A, Appendix 1:

Form CRS (ADV Part 3)

The Proposal does not include amendments to Form CRS (Form ADV Part 3). However, as advisers review and consider the disclosure requirements under the Proposal, they should consider the potential impacts to the adviser’s disclosures describing its advisory services included in Item 2 of Form CRS.

Compliance Policies and Procedures

The Commission’s Proposal release describes factors funds and advisers can consider in connection with ESG compliance policies and procedures. It states that policies and procedures should address the accuracy of ESG-disclosures made to clients, investors and regulators and portfolio management processes to help ensure portfolios are managed consistently with the ESG-related investment objectives disclosed by the adviser and/or funds. Examples:

• For integration strategies, have policies and procedures reasonably designed to ensure that  the adviser manages the portfolios consistently with how the strategy was described to investors.
• For funds disclosing adherence to an ESG framework, include controls to help ensure that client portfolios are managed in accordance with that framework.
• For advisers that use screens, have controls to maintain, monitor, implement, and update those screens.
• For advisers that have agreed to implement client’s ESG-related investing guidelines, mandates, or restrictions, policies and procedures should be designed to ensure that those guidelines/mandates/restrictions are followed.
• For funds that use and disclose ESG engagement meetings, policies and procedures for employees to memorialize the discussion of ESG issues in the meetings.
• For advisers that disclose that proxy proposals will be independently evaluated on a case-by-case basis, policies and procedures for such evaluation, and if they state that clients will have an opportunity to votes separately on ESG-related proposals, provide those opportunities and maintain policies and procedures accordingly.

The Proposal outlines disclosures the Commission suggests would “promote consistent, comparable, and reliable information for investors concerning funds’ and advisers’ incorporation of ESG factors.” However, any disclosures would need to reflect the adviser’s reasonably designed policies and procedures to (a) develop metrics or other protocols addressing the adequacy and accuracy of the disclosures, (b) implement supervision and monitor of those protocols, and (c) test those protocols. While the Proposal would change disclosure requirements related to the incorporation of ESG factors in an adviser’s investment strategy, the SEC Division of Examinations (EXAMS) has already identified ESG practices as an examination priority and shared common examination deficienciesobserved by the EXAMS staff. Advisers should anticipate a similar focus on policies and procedures by the EXAMS staff related to the disclosures in the Proposal.

¹The proposed Names Rule prohibits and deems it materially misleading for Integration Funds to use ESG-related terminology in their fund name. Please see this Sidley Update.

²All open-ended funds and registered closed-ended funds and BDCs subject to Inline XBRL structured data requirements will be required to tag their ESG disclosures using Inline XBRL.

³The Proposal defines “ESG engagement meetings” as a substantive discussion with management of an issuer advocating for one or more specific ESG goals to be accomplished over a given time period, where progress that is made toward meeting such goal is measurable, that is part of an ongoing dialogue with management regarding this goal.