SEC Proposes New Disclosure Requirements for ESG Funds

What Happened 

On May 25, 2022, the SEC voted 3–1 to propose amendments to: (i) the "Names Rule" (Rule 35d-1) under the Investment Company Act of 1940 ("1940 Act") and (ii) rules and forms under both the Investment Advisers Act of 1940 ("Advisers Act") and the 1940 Act. The amendments require registered investment advisers, exempt reporting advisers, registered investment companies, and publicly traded business development companies to provide additional information regarding their environmental, social, and governance ("ESG") investment practices, including disclosures relating to their consideration of ESG factors in making investment decisions. 

The Proposed Amendments 

First, the proposed amendments to the "Names Rule" seek to enhance and modernize the rule to address the ways in which registered funds and the asset management industry have evolved since its adoption approximately two decades ago. Traditionally, under the Names Rule, investment companies must invest at least 80% of their assets in the type of investments suggested by their names. The proposal would expand the Names Rule to address names that imply certain investment characteristics (e.g.,"growth" or "value") and those indicating that investment decisions incorporate ESG factors. Funds that consider ESG factors, but do not elevate those considerations above other investment factors, may not use ESG or ESG-related terminology in their names. Funds—including ESG funds—that comply with the 80&% requirement, but invest their remaining capital in instruments that are antithetical to the fund name, may also be found to be acting deceptively.  

The proposed changes would also provide guidance regarding valuing derivatives, in order to ensure that a fund's exposure to a particular investment is not overstated (or understated) for purposes of calculating compliance with the 80% threshold. Finally, the rule enumerates the circumstances under which a fund may depart from the 80% requirement (e.g., sudden changes in portfolio market value) and provides time frames for returning to 80%. 

Second, the proposed amendments regarding ESG disclosure aim to provide disclosures in annual reports, fund prospectuses, and adviser brochures that will assist investors in making more informed ESG-related investment decisions. In particular, the proposed amendments separate funds that consider ESG factors in their investment process into three categories: (1) Integration Funds, where ESG is one consideration, but there are other considerations as well; (2) ESG-Focused Funds, in which ESG is "a significant or main consideration"; and (3) Impact Funds, which aim to achieve a specific ESG-based goal. The level of disclosure varies depending on the category into which the fund falls, requiring more of an ESG-Focused and Impact Fund than of an Integration Fund. The proposed amendments would require certain funds to disclose the ESG factors considered in proxy voting, and an ESG-Focused Fund to report greenhouse gas emissions (both the weighted average carbon intensity and the carbon footprint) for its portfolio if the fund considers environmental factors in its investment strategy.  

Points to Consider 

The proposed rules reflect the SEC's increasing emphasis on ESG disclosure and enforcement. In April 2021, the Division of Examinations released a Risk Alert identifying a series of factors that investment advisers and funds should consider in implementing policies and procedures that accord with their ESG-related disclosures.  

In March of this year, the SEC released its proposed rule on climate risk disclosure. If adopted, the rule would require registrants to disclose information concerning emissions, oversight of climate-related risks, and their processes for identifying and managing these risks.  

Most recently, the SEC's Climate and ESG Task Force filed an enforcement action relating to false and misleading statements concerning toxic waste produced in mining operations. In addition, in late May, the Task Force announced that it had settled charges with an investment adviser for misstatements and omissions concerning ESG considerations in making investment decisions for certain mutual funds that it managed.  

Public comment on each of the proposed rules is expected to run for 60 days (after publication in the Federal Register), after which the SEC will review the proposed rules and make any relevant updates before convening a final vote.