ESG-Related Regulations on the Horizon: What the SEC Has in Store
1st June 2023
Note to US Citizens: Please note that this article is not intended to constitute legal advice to any citizen or resident of the United States of America.
In recent years, Environmental, Social, and Governance (“ESG”) factors have become a focus point for investors and advisers alike when considering investment strategies. In addition to the standards adopted by the EU, such as the ‘Sustainable Finance Disclosure Regulation’ (“SFDR”), the US Securities and Exchange Commission (“SEC”) has proposed rules addressing ESG approaches to prevent greenwashing and requiring transparency for US actors as well.
Whilst SFDR requires different levels of disclosure depending on the ESG integration adopted, one of the rules proposed by the SEC actually differentiates between three types of funds, thereby formally introducing a “labelling regime”.
The SEC has published three proposals: the first is a proposal for climate-related disclosure rules for Public Companies; the second is a proposal for ESG disclosure rules for Investment Companies and Advisers; the third is an amendment to the existing Name Rule to address misleading investment company names.
The Proposal for Climate-Related Disclosure Rules for Public Companies (the “Climate Risk Disclosure Proposal”)
The first set of rules requires public companies registered with the SEC to disclose “information about a registrant’s climate-related risks that are reasonably likely to have a material impact on its business, results of operations, or financial condition,”. The rules within this Climate Risk Disclosure Proposal would require disclosures to be made in periodic SEC reports and registration statements. The Climate Risk Disclosure Proposal requires qualitative – description of risks, impacts and opportunities – and quantitative climate-related disclosures. The quantitative metrics must be provided in accordance with XBRL and will need to be in part attested by an independent attestation service provider. These disclosures will need to be included in the publicly traded companies annual reports and, if applicable, reports throughout the year.
These rules are based on recommendations from the Task Force on Climate-Related Financial Disclosures (“TCFD”) as well as the Greenhouse Gas Protocol and are in the final state before enforcement, coming into force under a phased-in approach at the earliest by 2024.
The Proposed ESG Categorizations
The SEC is proposing three categories of funds to reflect differences of sustainability related objectives. Funds will only fall into the different categories if they consider any ESG factors at all.
i. Integrated Funds
Integrated funds are funds which integrate both ESG and non-ESG factors in investment decisions. The disclosure requirement for Integrated Funds is to explain to investors how ESG factors are included in their strategy in the prospectus. The proposed rules include amendments to the registration and periodic reporting forms themselves, as such the required disclosures must be included in the relevant forms. For example, integrated funds would need to include disclosures on the funds’ annual and periodic reports.
ii. ESG-Focused Funds
ESG-focused funds are funds which use ESG factors “as a significant or main consideration” in investment selection or engagement. These disclosures require information about the fund’s strategy, including:
• a table demonstrating ESG-related investment strategy;
• the procedure for proxy voting or engagement with issuers as part of ESG strategy;
• the portfolio’s carbon footprint;
• the fund’s use of exclusionary screening methods if applicable; and
• how the fund considers GHG emissions.
This type of funds also includes those whose name indicates the incorporation of ESG factors in the investment decision making.
iii. Impact Funds
Impact funds are a subset of ESG-focused funds mentioned above. The disclosure requirements for Impact funds are the same as those for ESG-focused funds with the addition of qualitative and quantitative measures assessing the progress made in achieving the specific ESG impact.
These rules also affect advisers who will be required to provide specific disclosures in relation to their approach to ESG investing in the Adviser Brochures.
The Proposed Amendments to the Fund Name Rule
These proposed rules seek to amend the Name Rule, which regulates the labelling of investment products under the Investment Company Act of 1940 to prevent misleading investors. The proposal would require funds to disclose additional information about their ESG investments and strategies, which includes information on the criteria used to select ESG investments, the extent to which the investments align with their ESG goals, and the methods used to evaluate the ESG performance of the investments. The proposed rules amend the scope of the 80% investment policy requirement, by extending this to funds whose names indicate particular characteristics being considered in the investment decision. These funds will be required to invest at least 80% of their assets (incl. derivatives calculated by using the notional amount rather than market value) in alignment with the ESG objective, whilst allowing potential drifts to be rectified withing 30 days. This includes references to “ESG”. In addition, affected funds will be required to disclose in the prospectus how they define the terms used in the name as well as the criteria described by the name that are used to select investments.
These rules also mean that ESG-related terms cannot be used in the name of funds which consider ESG factors along with, but not more significantly than, other factors (e.g. integration funds).
Other procedural amendments are also included in the proposed rules.
The proposed amendments are expected to be finalized by October 2023.