On May 25, 2022, the U.S. Securities and Exchange Commission, by a vote of three-to-one, proposed for public comment a long-anticipated framework requiring certain funds and certain U.S. investment advisers to disclose their environmental, social and governance (ESG) investment practices (the Proposal).1 The Proposal, which is a companion to a separate release issued the same day proposing changes to Rule 35d-1 under the Investment Company Act of 1940, would amend rules and forms under both the Investment Advisers Act of 1940 and the Investment Company Act.
The Proposal is intended to promote the provision of “consistent, comparable, and reliable” information to investors to facilitate informed decision-making related to ESG investment product and strategy offerings. In particular, the Proposal would seek to change existing disclosure practices by (among other provisions): expressly requiring ESG-related disclosures in fund prospectuses and annual reports and investment adviser regulatory filings (where funds use and strategies use ESG investment techniques); implementing a standardized approach for certain types of ESG funds to disclosure their ESG investing processes; and for the first time, requiring disclosure of the use of greenhouse gas (GHG) emissions data in certain circumstances.2 The Proposal comes in the wake of substantial scrutiny of disclosure practices involving ESG investment practices by the SEC and its Staff.
Although not related specifically to ESG investing, the Proposal also would amend Form N-CEN to require index funds to provide certain identifying information about the index tracked.3
Overview of Required Fund Disclosures
Overview of Required Adviser Disclosures (Form ADV Brochures)
The SEC also proposed to amend Form ADV Part 2A to require registered investment advisers that consider ESG factors as part of their advisory business to disclose information similar to that required in fund registration statements and annual reports. Specifically, the Proposal would require registered advisers to provide: a description of the ESG factors considered in providing advisory services and how they are incorporated and, if ESG factors are considered when selecting, reviewing or recommending portfolio managers, a description of the factors considered and how they are incorporated.
Regulatory Reporting on Form N-CEN and Form ADV Part 1A
The Proposal also includes proposed amendments to Forms N-CEN and Form ADV Part 1A for funds and advisers.
The Proposal would add new Items C.3(b) and (j) to Form N-CEN. Specifically, these items would require:
- Item C.3(b): Disclosure of the index tracked by an index fund, including provision of an identifying number (such as a legal entity identifier code (LEI)).
- Item C.3(j): Information related to ESG funds’ investment strategies and processes, including: whether ESG-related summary prospectus disclosure is provided under Forms N-1A or N-2; the fund’s ESG classification (i.e., integration, ESG-focused, impact); whether E, S and/or G factors are considered; whether affiliated or third-party ESG data sources or consultants are used (including names and LEIs of data sources); and whether the fund follows any third-party frameworks.
Form ADV Part 1A
The Proposal would amend Form ADV Part 1A to provide additional information about the advisory services provided to separately managed account clients and reported private fund clients. Unlike many aspects of the Proposal, certain aspects of the Part 1A amendments would be inapplicable to exempt reporting advisers. This information would generally parallel certain of the information required to be reported with respect to funds on Form N-CEN.
Impacts to Other SEC Forms
The Proposal would also modify Form N-CSR by adding proposed Item 7, which would require granular information about the process used for calculating and estimating the GHG emissions of a fund’s portfolio.9
Guidance on Compliance Policies and Procedures; Marketing
The Release also contains guidance related to fund and adviser compliance policies, as well as marketing materials, in the ESG context.
Addressing compliance policies and procedures, the Release highlights the Commission’s current expectation that policies and procedures address the “accuracy of disclosures made to clients, investors and regulators, as well as portfolio management processes, including consistency of portfolios with investment objectives and disclosures by the adviser and/or fund.” It then translates this obligation to the context of ESG, noting that “ESG strategies, including integration, ESG-focused and impact strategies, will necessarily require different levels and types of compliance policies and procedures.” With this in mind, the SEC explained 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 fund.” The Release provides specific examples of what the SEC deems to be “effective” ESG-related disclosure, policies, procedures, and practices.
The ESG Release also explains the SEC’s views on the application of current advertising requirements to the ESG context by) indicating that “greenwashing” may represent a form of false or misleading statement and affirmatively stating that, in the SEC’s view, “it generally would be materially misleading for an adviser materially to overstate in an advertisement the extent to which it utilizes or considers ESG factors in managing client portfolios.”
Key Dates and Timing
The SEC proposed a one-year transition period for: the proposed disclosure requirements in prospectuses under Forms N-1A and N-2; the proposed disclosure requirements for UITs under Form N-8B-2; the proposed regulatory reporting under Form N-CEN; and the proposed disclosure requirements and regulatory reporting under Form ADV Parts 1 and 2.
The SEC proposed an 18-month transition period for the proposed disclosures in shareholder reports and those filed under Form N-CSR.
Comments on the SEC’s proposal are due 30 days after the Proposal is published in the Federal Register.
An upcoming Dechert OnPoint will provide further analysis of this proposal.
1) See Enhanced Disclosures by Certain Investment Advisers and Investment Companies about Environmental, Social, and Governance Investment Practices, Rel. Nos. IA-6034 & IC-34594 (May 25, 2022) (ESG Release). Unless otherwise specified, the term “fund” as used in this Dechert OnPoint refers to registered investment companies (i.e., open-end funds, closed-end funds, and unit investment trusts (UITs)) and business development companies (BDCs), and the term “investment adviser” refers to any investment adviser registered under the Advisers Act and exempt reporting advisers under Sections 203(l) and 203(m) of the Advisers Act. At times, this NewsFlash tracks the ESG Release without the use of quotation marks. Terms not defined in this NewsFlash have the meaning assigned to them in the ESG Release.
2) In addition, the amendments would require tagging of certain of their ESG disclosures using the Inline Extensible Business Reporting Language (“Inline XBRL”) structured data language. This would apply to funds that file registration statements on Forms N-1A, N-2, or S-6 and annual shareholder reports on Form N-CSR and annual reports on Form 10-K.
3) For purposes of Form N-CEN, the term “index fund” is defined as “an investment company, including an Exchange-Traded Fund, that seeks to track the performance of a specified index.”
4) The proposed amendments in this section would apply to open-end funds (including ETFs) and closed-end funds (including BDCs) – but not UITs – that incorporate ESG factors into their investment process. The Proposal would also amend Form N-8B-2 to require a UIT to, if one or more ESG factors are used to select portfolio securities, briefly describe how the factors are incorporated (including which factors are used). UITs would not be subject to the proposed annual report requirements because a UIT is not required to provide a management’s discussion of fund performance section of its annual reports.
5) This would include: any fund that has a name including terms indicating that the fund’s investment decisions incorporate one or more ESG factors and any fund whose sales literature or advertisements 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. The ESG Release indicates that it would also capture funds that track an ESG-focused index and funds that apply inclusionary or exclusionary screen based on ESG factors.
6) Specific requirements apply with respect to Impact Funds.
7) As a general matter, disclosure would be required if proxy voting or engagement is a “significant means” of implementing its ESG strategy. The Release provides guidance on circumstances where proxy voting or engagement activities could be considered “significant”.
8) Both methodologies would require Scope 1 and Scope 2 emissions be included in the emissions calculation but would not require Scope 3 emissions. The GHG emissions requirements would leverage information newly-available information under the SEC’s proposal in March 2022 related to rules for the enhancement and standardization of climate-related disclosures. For additional information, see the Dechert OnPoint titled “SEC Proposes Comprehensive Climate-Related Disclosure Rules”.
9) A proposed new Instruction 10 to Item 24 of Form N-2 would impose parallel disclosure requirements for BDCs on Form 10-K.