SEC Proposes ESG Disclosure Rules for Investment Advisers and Investment Companies

On May 25, 2022, the U.S. Securities and Exchange Commission (the “SEC”) proposed a package of new rules to address and enhance investor disclosure practices, and related policies and procedures, regarding Environmental, Social and Governance (“ESG”) investment considerations and objectives (the “Proposed ESG Disclosure Rules”) by investment advisers to registered investment companies and private funds and other clients. The Proposed ESG Disclosure Rules are intended to provide investors with clear and comparable information about how advisers consider ESG factors. On the same day, the SEC proposed amendments to Rule 35d-1 under the Investment Company Act of 1940 (the “Names Rule”) (the “Proposed Names Rule Amendments”) that would, among other things, significantly expand the scope of the terms used in the names of registered funds that would subject the fund to the requirements of the Names Rule, including terms indicating that the fund’s investment decisions incorporate one or more ESG factors. We have briefly summarized both sets of proposed rules below and will have additional detail forthcoming.

Categories of ESG Strategies and Required Disclosures

Under the Proposed ESG Disclosure Rules, registered investment companies and registered investment advisers that employ ESG strategies in their investment processes would be required to make ESG disclosures either in the fund prospectus for a registered investment company or in the Brochure (Form ADV Part 2A) for a registered investment adviser. The proposed disclosure obligations would vary based on the following three categories of ESG investment strategies:

• Integration Strategies. Funds and accounts where ESG factors may be considered as part of the investment selection process but are generally not dispositive compared to other factors in investment decision-making. The adviser to such a fund or account would need to disclose how ESG factors influence its investment selection process, including the specific ESG factors considered in investment decision-making and how ESG factors weigh against non-ESG factors.
  
  
• ESG-Focused Strategies. Funds and accounts for which ESG factors are a significant or main consideration in their investment strategy. An adviser to such a fund or account would need to disclose: (1) whether and how the fund’s or account’s ESG strategies track an index; (2) whether the fund or account has inclusionary or exclusionary screens of portfolio investment characteristics; (3) the ESG impact(s) that the fund or account seeks to achieve (including specific metrics to assess progress); (4) how ESG strategies are part of investment decision-making for the fund or account; and (5) whether and how the adviser uses proxy voting and/or engagement with portfolio companies to advance the fund or account’s ESG strategies.
  
  
• Impact Strategies. Funds or accounts that primarily seek to achieve one or more specific ESG impacts. An adviser to such a fund or account would be required to make all of the same disclosures as with an ESG-Focused Strategy but would also need to disclose: (1) how ESG progress of the fund or account is measured, including the performance indicators that the adviser analyzes; (2) the time horizon of the fund’s or account’s ESG strategy; and (3) the relationship between the impact(s) that the fund or account seeks to achieve and financial returns.

The Proposed ESG Disclosure Rules would also require registered investment advisers to funds or accounts with ESG strategies that consider environmental factors to disclose detailed information about the greenhouse gas impacts associated with their portfolio investments, including the carbon footprint and the weighted average carbon intensity of portfolio investments.

In addition, the Proposed ESG Disclosure Rules would also require registered investment advisers to funds and accounts to provide disclosure on which ESG factors they consider in proxy voting and any material relationship or arrangement between it or its management personnel with any related person that is an ESG consultant or other ESG service provider.

Finally, the Proposed ESG Disclosure Rules also would require census-like regulatory disclosures on ESG matters on Form N-CEN (for registered investment companies) and Form ADV Part 1A (for both registered investment advisers and exempt reporting advisers).

Proposed Names Rule Amendments

The SEC adopted the Names Rule in 2001 to address certain fund names that are likely to mislead an investor about a fund’s investments and risks. The Names Rule currently requires registered funds and business development companies (but not private funds) whose names suggest a focus in a particular type of investment, industry, country or geographical region to adopt a policy to invest at least 80% of the value of their net assets in holdings aligned with the fund’s name. Among other changes, the Proposed Names Rule Amendments would:

• Expand the Names Rule 80% investment policy requirement beyond its current scope to apply to any fund name with terms suggesting that the fund focuses in investments that have, or investments whose issuers have, particular characteristics, which would include funds with names indicating that the fund’s investment decisions incorporate one or more ESG factors. This expansive approach would capture terms such as “growth” and “value” that historically have been considered by the SEC to be investment strategy terminology (as opposed to types of investments) that fall outside of the scope of the Names Rule.
  
  
• Prohibit funds from using ESG or similar terminology in their names where the identified ESG factors do not play a central role in the fund’s strategy. This would mean that funds considering ESG factors alongside, but not more centrally than, other non-ESG factors (so-called “integration funds”) would be prohibited from using ESG or similar terminology in their names.
  
  
• Specify the particular the circumstances under which a fund may depart from its 80% investment policy, including specific time frames for coming back into compliance with the 80% investment policy (as soon as reasonably practicable but in any event within 30 consecutive days, subject to certain specified exceptions).
  
  
• Require that the notional value of derivatives, rather than market value, be used in determining a fund’s compliance with the 80% investment policy, as well as address what types of derivatives can be included in a fund’s 80% basket.
  
  
• Require all unlisted registered closed-end investment companies (such as interval funds) and business development companies that have an 80% investment policy to make such policy “fundamental” so they may not be changed without a shareholder vote.
  
  
• Update the notice requirements under the Names Rule for providing notice to shareholders when a fund makes any change to its 80% investment policy by specifying the form and requirements for electronic as well as written notices.
  
  
• Enhance funds’ prospectus disclosure to require a fund to define the terms used in its name, including the criteria the fund uses to select the investments that the term describes. Terms used in a fund’s name that suggest an investment focus (e.g., an ESG focus) would need to be consistent with those terms’ plain English meaning or established industry use.
  
  
• Impose recordkeeping requirements that are designed to give SEC staff and fund compliance staff the ability to evaluate the fund’s compliance with the Names Rule. Funds that do not adopt an 80% investment policy would be required to maintain a written record of their analysis that such a policy is not required under the Names Rule.

Compliance Policies and Procedures

The releases for the Proposed ESG Disclosure Rules and the Proposed Names Rule Amendments also set forth the compliance policies and procedures the SEC would expect with respect to ESG strategies and fund names, including policies and procedures that address the accuracy of ESG-disclosures and portfolio management processes to seek to ensure consistent management in accordance with ESG disclosures.

The SEC also suggested specific examples of ESG-related policies and procedures regarding (i) advisers pursuing an integration strategy, (ii) adherence to a particular ESG framework, (iii) the use of ESG-related positive and/or negative screens, (iv) compliance with a client’s ESG-related investing guidelines, mandates, or restrictions, and (v) evaluation of ESG-related proxy proposals.