In a 3-1 vote on May 25, 2022, the US Securities and Exchange Commission (SEC) approved a proposed environmental, social, and governance (ESG) rulemaking for investment advisers and funds. The proposed rule and form amendments are intended to achieve more standardized and comparable disclosures and reporting of ESG information to both investors and the SEC. Importantly, the proposed amendments would establish a new ESG disclosure framework for prospectuses, annual reports, and adviser brochures, incorporating both qualitative and quantitative information regarding ESG investment practices.
Enhanced Disclosures by Certain Investment Advisers and Investment Companies about Environmental, Social, and Governance Investment Practices (the Proposal) is part of the SEC’s continued focus on funds’ and advisers’ ESG investment practices. The Proposal follows on the heels of the SEC’s proposed rule on enhanced climate-related disclosures for issuers, for which comments are due on June 17, 2022. Additionally, on the same day the Proposal was released, the SEC proposed amendments to Rule 35d-1 under the Investment Company Act of 1940 (the Names Rule) that, among other proposed changes, addresses funds that include ESG terms in their names.
The public comment period for the Proposal will end 60 days after it is published in the Federal Register. Please refer to our ESG and Sustainability Working Group page for further information and updates.
In support of the Proposal, the SEC cites the rapid growth of ESG investing—due in part to the increase in investor demand for ESG products—and the need to provide investors with consistent, comparable, and reliable information regarding ESG investment strategies and related information.
While the SEC acknowledges how expansive and varied ESG investment strategies are and the challenges this presents, the Proposal falls short of defining ESG or related terms such as “sustainable” or “socially responsible investing,” leaving it up to funds and advisers to determine the applicability of the proposed requirements.
The Proposal would establish an ESG investment strategy categorization scheme, broadly defining three types of ESG strategies. The disclosure requirements for registered funds (and business development companies) and advisers vary depending on which of the following three ESG strategies best describes their investment approach:
In addition to proposed amendments to fund registration statement forms, the Proposal includes amendments to the information required to be disclosed in fund annual reports and adviser brochures on Form ADV, as well as the information reported in Form N-CEN and Form ADV Part 1A. All ESG-related information in prospectuses and annual reports is proposed to be disclosed in iXBRL format.
Note: The Proposal makes clear that the SEC seeks to level the playing field by requiring funds and advisers to provide investors with comparable and “decision useful” information about their ESG strategies and practices. The proposed requirements, discussed below, include some flexibility with respect to qualitative disclosures, but also include more prescriptive requirements to disclose information regarding proxy voting and engagement with portfolio companies, as well as greenhouse gas (GHG) emissions reporting.
Proposed amendments to fund registration statement forms would apply to open-end funds (including exchange-traded funds) and closed-end funds (including business development companies) that meet the proposed definitions of ESG Integration, ESG-Focused, or ESG Impact. The Proposal calls for a “layered” disclosure approach in which certain information would be included earlier in a fund’s prospectus (e.g., item 4 disclosures for open-end funds), and more detailed information would be included later in the prospectus (e.g., item 9 disclosures for open-end funds).
Under the Proposal, an ESG Integration fund would include a short narrative summarizing how the fund integrates ESG factors into its investment strategy. This information could include a description of what ESG factors a fund considers and a statement that ESG factors are considered alongside other factors in evaluating a potential investment. This information would be included in the summary prospectus for an open-end fund, while a closed-end fund would include this disclosure in its prospectus’s general description of the fund.
An ESG Integration fund would also be required to include a more detailed description of how ESG factors are incorporated into the fund’s investment strategy; this would appear in the non-summary section of an open-end fund’s statutory prospectus (e.g., item 9) and later in a closed-end fund’s prospectus. Additionally, if an ESG Integration fund considered GHG emissions of its portfolio holdings, this additional detail would describe how GHG emissions are considered and describe any relevant methodologies surrounding GHG emissions.
Note: In the Proposal, the SEC expresses concern surrounding greenwashing, or when an ESG Integration fund might overstate or overemphasize the ESG aspects of its strategy. However, the proposed disclosure requirements for ESG Integration funds may ultimately have this effect as they would require a fund to include substantive and detailed disclosure regarding the ESG aspects of its strategy—necessarily drawing investors’ attention to those aspects and potentially obscuring other important aspects of that fund’s strategy.
ESG-Focused funds would be subject to enhanced disclosure requirements.
The Proposal introduces an “ESG Strategy Overview” table that would require an ESG-Focused fund to disclose certain information that the SEC views as key to investors’ investment decision-making. This table would be located before the principal investment strategies discussion in an open-end fund’s risk/return summary and at the beginning of the discussion of a closed-end fund’s organization and operation. More detailed information would then be included later in a fund’s prospectus, with hyperlinks in the table that link directly to such information.
The table would be presented as follows:
In the proposed ESG Strategy Overview table, a fund would check the applicable box(es) relevant to its strategy in the first row and provide additional information in the second and third rows. To the extent an ESG-Focused fund uses an ESG-related term, such as “sustainable,” the fund could name the table “Sustainable Strategy Overview” and label row headings accordingly.
After checking those boxes relevant to an ESG-Focused fund’s strategy, the second row would require the fund to elaborate on how the ESG strategy is implemented. The Proposal includes a discussion of the types of information the SEC envisions will be included in this second row, including how inclusionary and exclusionary screens are applied, how internal methodologies are used, how third-party data is incorporated into a strategy, and how the fund defines certain terms used in its strategy (e.g., how the fund defines “significant” in the context of evaluating whether a company derives significant revenue from a certain industry). An index fund that seeks to track an ESG-related index would summarize how the index incorporates ESG factors, with an expanded description of the index methodology required later in the prospectus. This second row would also include an overview of any ESG frameworks that the fund follows as part of its investment process, such as the United Nations Sustainable Development Goals or United Nations Principles for Responsible Investing.
The third row of the ESG Strategy Overview table calls for specific information regarding how an ESG-Focused fund uses, or does not use, proxy voting and engagement with portfolio companies as part of its investment strategy. If a fund checks either the proxy voting box or the engagement box in the first row, it would be required to provide in the third row a narrative description of how proxy voting and/or engagement are used as a significant part of its investment strategy, including identifying both formal and informal methods used to influence issuers on ESG issues. If neither box is checked in the first row of the table, the fund would include a statement that neither proxy voting nor engagement is used as a significant part of the fund’s investment strategy.
Note: The ESG Strategy Overview table seeks to establish a comparable format for ESG-Focused funds’ disclosures regarding the ESG aspects of their strategies, but this approach may raise other concerns in the process. The Proposal states that an open-end ESG-Focused fund would not be required to repeat information included in the ESG Strategy Overview table elsewhere in the fund’s summary prospectus disclosure. The tabular format would necessitate an ESG-Focused fund to restructure its strategy disclosure to accommodate this format, potentially skewing the fund’s presentation of its investment strategies. The check boxes in the first row somewhat arbitrarily highlight certain types of ESG strategies. Unchecked boxes may cause investor confusion about the relative value of a fund’s ESG strategy. The Proposal also includes specific guidance on how a fund might evaluate whether proxy voting or engagement is a significant part of its investment strategy, which the SEC admits is a facts-and-circumstances analysis and includes subjective determinations. Additionally, the requirement to state affirmatively that proxy voting and/or engagement is not a significant part of a fund’s investment strategy could disproportionately emphasize this fact for investors.
ESG Impact funds are considered a subset of ESG-Focused funds under the Proposal. As such, ESG Impact funds would be subject to the prospectus disclosure requirements summarized above. Additionally, in the ESG Strategy Overview table, an ESG Impact fund would be required to include additional specific information in the second row, including what impact(s) the fund is seeking to achieve and how the fund measures progress toward these impacts.
This additional proposed disclosure is intended to distinguish ESG Impact funds from other ESG-Focused funds in an attempt to clarify for investors that an ESG Impact fund may consider financial returns secondarily to its impact objectives. In a similar vein, the Proposal includes a requirement that an ESG Impact fund’s investment objective include the ESG impact that the fund seeks to achieve.
Unit Investment Trusts
Unit investment trusts (UITs) would also be required to incorporate additional ESG information into their registration statements. The Proposal includes a requirement that any UIT that uses ESG factors to select portfolio securities must explain how the ESG factors are used. Given how UITs are structured, the Proposal does not include a requirement to distinguish a UIT as ESG Integration or ESG-Focused, and it does not require disclosure regarding proxy voting or engagement with portfolio companies.
The Proposal includes annual report disclosure requirements specific to ESG Impact funds as well as disclosure requirements that would apply to all ESG-Focused funds regarding proxy voting, engagement, and GHG emissions information.
These disclosures would be included in the management discussion of fund performance section of an investment company’s annual report, and in the management discussion and analysis section of a business development company’s annual report on Form 10-K.
The additional annual report disclosure required for ESG Impact funds seeks to provide investors with information about an ESG Impact fund’s progress in achieving its stated impact objective during the reporting period. An ESG Impact fund would be required to cite both qualitative and quantitative information in support of its progress. The specific information provided will depend on the impact objective(s) of a given fund. The Proposal includes a number of examples of the types of disclosure the SEC envisions.
Note: These qualitative and quantitative disclosure requirements may require funds and/or advisers to acquire and evaluate new data, or even develop new metrics for assessing the impact of their funds or strategies. Different funds may also use different metrics for the same impact goals, making it difficult for investors to compare similar funds. This process will be even more complex for funds with multiple impact themes. Notably, the Proposal stops short of requiring all ESG-Focused funds to include disclosure regarding the effectiveness of their ESG strategies. The Proposal does, however, request public comment on a series of questions regarding this approach.
ESG Proxy Voting Disclosure
All ESG-Focused funds that include proxy voting as a significant component of their ESG strategies would be required to disclose information about how they voted ESG-related proxies. The disclosure would include the percentage of ESG-related voting matters that the fund voted in furtherance of during the reporting period. The disclosure would include a cross-reference to the fund’s full voting record on Form N-PX, as well as a hyperlink in the electronic version of the annual report to the fund’s most recently filed Form N-PX.
ESG Engagement Disclosure
All ESG-Focused funds that include engagement as a significant component of their ESG strategies would be required to disclose prescriptive information about progress on key performance indicators of the fund’s engagement. The Proposal calls for quantitative information about the number and percentage of issuers a fund engaged with on ESG issues and the total number of ESG engagement meetings.
The Proposal also includes a discussion about what would qualify as an “ESG engagement meeting” for the purposes of this reporting requirement. For example, a meeting where ESG is discussed would not necessarily be considered an ESG engagement meeting if ESG were not the focus of the meeting. The Proposal recommends that funds include procedures in their compliance policies to monitor this metric.
Note: The SEC states in the Proposal that requiring funds to provide information about engagement will reduce “the potential for exaggerated claims of engagement.” Yet the SEC also acknowledges that the determination of whether an engagement would qualify as an ESG engagement meeting is subjective. This could result in inconsistent interpretations across funds and advisers when making these determinations and reporting information in annual reports.
GHG Emissions Reporting
The Proposal includes a requirement for ESG-Focused funds that consider environmental factors as part of their investment strategies to report two different metrics relating to the GHG emissions of the portfolio companies they hold. Specifically, the requirement calls for reporting of the carbon footprint and the weighted average carbon intensity (WACI) of a fund’s portfolio. The required reporting of these metrics would be accompanied by a brief summary of how the fund calculated the metrics. More information regarding assumptions and methodologies applied when calculating the GHG emissions metrics would be required in the fund’s Form N-CSR. If an ESG-Focused fund does not consider GHG emissions in its investment strategy, it would not be required to report this information if it discloses this fact to investors in the fund’s prospectus.
Note: These calculations are complex. The Proposal includes more than 20 pages of discussion regarding how to calculate the carbon footprint and WACI of a fund’s portfolio. The SEC recognizes some of the challenges presented by requiring this information, including, for example, a requirement that funds must look through to the holdings of private funds in which they invest. Although these metrics could be useful, in theory, for investors who are seeking to invest in environmentally focused funds, the complexity of the calculations may result in less than accurate information being reported in funds’ annual reports. The proposed requirements could also serve as a disincentive for funds and advisers to consider GHG emissions at all.
The Proposal also includes amendments to Form ADV Part 2A—the adviser brochure—to require information regarding registered investment advisers’ consideration of ESG factors in their investment processes. An adviser that considers ESG factors as part of its advisory business would be required to comply with the proposed disclosure requirements.
Methods of Analysis, Investment Strategies, and Risk of Loss
The Proposal would add new Item 8.D. requiring disclosure describing the ESG factor(s) an adviser considers for each investment strategy or the method of analysis for which the adviser considers ESG factors. The additional disclosure would provide investors with more information about how advisers are incorporating ESG factors when providing investment advice, including when an adviser is recommending other investment advisers.
The SEC proposes definitions for ESG integration, focused, and impact strategies that are in line with the definitions for registered funds, as discussed above. To the extent an adviser employs an ESG impact strategy, additional disclosure would be required regarding how the adviser measures progress toward the impact objective and key performance indicators related to the objective. An adviser would also be required to describe ESG criteria and methodologies used in any inclusionary or exclusionary ESG strategies.
The Proposal includes a nonexclusive list of criteria and methodologies to address in an adviser’s disclosure, including the use of (1) internal and third-party scoring methodologies, (2) screens applied and which industries or business activities are included or excluded by the screens, and (3) information about indexes used, including how an index uses ESG factors.
Other Financial Industry Activities and Affiliations
The Proposal would amend Item 10.C. to require a description of any relationship or arrangement that is material to the adviser’s business or its clients that the adviser or management persons have with any related person that is an ESG consultant or other ESG service provider. These providers could include index providers or ESG scoring providers, among others. The Proposal would require the adviser to identify the related person ESG provider, and if the relationship or arrangement creates a material conflict of interest with clients, to describe the nature of the conflict, as well as how the adviser addresses it.
Voting Client Securities
The Proposal also would amend Item 17 to require disclosure surrounding an adviser’s ESG considerations when voting client securities. An adviser’s brochure would include a description of ESG factors considered, how such factors are considered when voting client securities, and a description of the difference, if any, between different clients or different ESG-related strategies.
Wrap Fee Brochure
The Proposal includes proposed disclosure requirements specific to appendix 1 of the adviser brochure—the wrap fee program brochure—which is used by advisers that sponsor wrap fee programs. The proposed disclosure requirements are similar to the disclosure proposed for the adviser brochure but tailored for this structure. Advisers would be required to include in Item 4 of the wrap fee program brochure a description of any ESG factors they consider and how those factors are incorporated into each program.
The Proposal would also amend Item 6 to require a description of any ESG factors used when selecting, reviewing, or recommending portfolio managers within the wrap fee programs that an adviser sponsors. Also proposed are disclosure requirements surrounding how an adviser evaluates portfolio managers’ application of ESG factors. Lastly, for an adviser that also acts as a portfolio manager in its wrap fee program, the Proposal would require the adviser to provide the information required by proposed new Item 8.D., discussed above.
Note: The proposed disclosure requirements for investment advisers align with, but are less extensive than, the related proposed disclosure requirements for funds. The detailed nature of these disclosures, however, especially with respect to internal and third-party scoring or screening methodologies, may cause concerns regarding proprietary information about the adviser’s processes. The SEC specifically requested comment as to whether the proposed disclosures could reveal “non-public information regarding an adviser’s SMA strategy and/or a private fund’s trading strategies, analytical or research methodologies, trading data, and/or computer hardware or software containing intellectual property.”
Also included in the Proposal is new Item C.3(j) of Form N-CEN, which would require funds to answer certain tailored ESG questions. A fund would be required to report whether it employs an ESG strategy and whether it qualifies as an ESG Integration, Focused, or Impact strategy, as well as what ESG factors it considers and what method(s) it uses to implement its ESG strategy. A fund would also be required to report its use of ESG-related information provided by third parties in implementing its strategy and whether the fund follows any third-party ESG frameworks.
Additionally, any index fund, regardless of whether it employs an ESG strategy, would be required to report the name and legal entity identifier (LEI), if any, of the index the fund seeks to track.
Form ADV Part 1A
The Proposal includes proposed amendments to Form ADV Part 1A that would collect ESG information about an adviser’s advisory services provided to separately managed accounts (SMAs) and reported private funds. The information proposed to be collected from private fund advisers would be applicable to each private fund individually and would be similar to the information proposed to be collected on Form N-CEN, including information about whether an adviser considers ESG factors and disclosure of the types of strategies it employs in SMA strategies.
Advisers would also be required to report whether they follow any third-party ESG frameworks in connection with advisory services provided. Lastly, the Proposal includes a requirement for advisers to disclose whether they, or any related persons, conduct business as ESG providers, and associated information.
The Proposal does not impose a new requirement related to compliance policies and procedures, but it does include guidance reminding funds and advisers that they must have policies and procedures in place that address the accuracy of disclosures made to investors and the accuracy of portfolio management processes, including their consistency with stated investment objectives and related disclosures.
In a cautionary note, the SEC stated that the Division of Examinations staff have observed compliance practices that are not effective in addressing how advisers incorporate ESG factors into their advisory services. The SEC also stated that each category of ESG fund (Integration, Focused, and Impact) necessitates varying levels and types of compliance policies and procedures.
The Proposal provides several examples of how funds and advisers might approach components of ESG investing in their compliance policies and procedures, including controls related to disclosures, third-party frameworks, implementation of screens, proxy voting, and marketing.
Most components of the Proposal would have a compliance period of one year from the effective date of a final rule. Annual report and Form N-CSR amendments would have an 18-month compliance period following the effective date of a final rule.
Note: In the Proposal, the SEC seeks feedback from commenters on a number of elements of the proposed amendments. The SEC asks whether the Proposal appropriately characterizes funds engaging in ESG investing, and whether the required disclosures would be tailored to the risks presented by each type of fund. It also asks whether the information it requests is too granular or challenging to obtain, and whether the challenges presented by the required GHG emissions data might discourage funds and advisers from considering this data.
Although the requirements in the Proposal are subject to change following the comment period, it could be helpful for advisers and funds to consider their existing and pipelined strategies in light of the Proposal and to evaluate relevant aspects of their compliance programs, including policies, procedures, and adequacy of disclosures.
If you would like assistance in reviewing your current or proposed ESG strategies or compliance program, or if you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:
Elizabeth L. Belanger
Susan D. Resley
 References to “fund” and “funds” in this LawFlash refer to registered funds (including open-end funds and closed-end funds), unit investment trusts, and business development companies; they do not refer to private funds.