Anti-greenwashing proposals get mixed review

The Securities and Exchange Commission continued its focus on environmental, social and governance investing coupled with heightened transparency for investors with its latest rule proposals aimed at combating greenwashing that, if implemented, would add a host of new requirements for fund managers and investment advisers.

"I think what you see is the SEC really putting a lot of regulatory and enforcement energy into ESG issues, whether it's company disclosures (or) representations related to ESG and sustainable investment products," said Christian D.H. Schultz, Washington-based partner with Arnold & Porter Kaye Scholer LLP. "And they're really trying to protect against what they're perceiving as greenwashing efforts. They're really trying to ensure that both Main Street investors and institutional investors have transparency into the products that are being presented to them and the representations that are being made to them by investment companies."

The SEC on May 25 issued two proposals on greenwashing — when a fund or company overstates its ESG offerings. One proposal would require investment advisers and fund managers to disclose additional information on ESG strategies in fund prospectuses, annual reports and adviser brochures. The other proposal would expand the “Names Rule” under the Investment Company Act of 1940, which requires funds with certain names to adopt a policy to invest 80% of their assets in the investments suggested by that name. The latter proposal would subject fund names with terms such as “growth” or “value” and those indicating that the fund’s investment decisions incorporate one or more ESG factors to the Names Rule.

Both proposals were approved in 3-1 votes with the dissent from the commission’s lone Republican, Hester M. Peirce, and have 60-day comment periods upon publication in the Federal Register, which as of press time hadn’t happened yet.

Under the ESG disclosure proposal — which aims to promote consistent, comparable and reliable information for investors concerning funds and advisers’ incorporation of ESG factors — funds that consider such ESG factors in their investment process would be required to disclose additional information regarding their strategy. The amount of required disclosure depends on how central ESG factors are to a fund’s strategy and follows a “layered” framework, according to an SEC fact sheet. The layered framework starts with “a concise overview in the prospectus supplemented by more detailed information in other sections of the prospectus or in other disclosure documents,” the fact sheet noted.

There are three types of ESG funds outlined in the proposal with varying requirements:

• Integration funds, which integrate ESG factors alongside non-ESG factors in investment decisions, would be required to describe how ESG factors are incorporated into their investment process.
• ESG-focused funds, for which ESG factors are a significant or main consideration, would be required to provide detailed disclosure, including a standardized ESG strategy overview table.
• Impact funds, a subset of ESG-focused funds that seek to achieve a particular ESG impact, would be required to disclose how they measure progress on their objectives.

J. Paul Forrester, Chicago-based partner with Mayer Brown LLP, said he is concerned that the SEC is “asking for a lot of very detailed information that I’m not sure investors want or need.”

Mr. Forrester also takes issue with the layered disclosure framework, particularly with respect to integration funds that consider both ESG and non-ESG factors. “For those funds, arguably the proposal is even more prescriptive and seems to treat at them in a way that seems disproportionate since many fund managers would say that some consideration of ESG factors is merely prudent, and I’m struggling to understand why they warrant that special treatment,” he said. “If you’re an ESG-focused fund, which maybe now everybody will want to become in order to be able to use an ESG-related name, you mostly have the same regulatory burden, which is just upside-down to me.”

Jon Hale, Chicago-based head of sustainability research at Morningstar Inc., is also curious to see how integrated funds react to the proposal.

“My experience is that a lot of otherwise conventional funds are claiming to use ESG information in their investment process, but it’s difficult for them to explain exactly how it’s used or how often it actually plays into an investment decision,” Mr. Hale said. “This offers them an opportunity to clarify things,” adding that it will be interesting to see if such funds go through with the added disclosure or just drop their ESG claims.

“We certainly don’t want strategies, funds saying they use ESG when they don’t,” Mr. Hale said. “On the other hand, we’re so early in terms the development of this field, especially in the mainstreaming of it, that I’m not sure I want to discourage conventional asset managers from using the information because they might find it increasingly useful and increase the weighting of it in their process over time.”

Investment advisers that consider ESG factors would also be required to make disclosures in their brochures with respect to their consideration of ESG factors in the significant investment strategies or methods of analysis they pursue and report certain ESG information in their annual filings with the SEC, the agency’s fact sheet said.

Karen L. Barr, president and CEO of the Washington-based Investment Adviser Association, an organization for fiduciary investment advisers, said her group supports policies that facilitate sustainable investing but is concerned with some of the information the SEC is seeking.

“We believe that investment advisers should clearly articulate their investment strategies, including sustainable investment strategies, so their clients can understand their philosophy and can make informed decisions,” Ms. Barr said. “But at a certain point, the disclosures get so granular that you’re potentially leading the investors to a certain inference.”

The SEC adopted its Names Rule in 2001 and since then the fund industry has evolved and gaps in the rule have become apparent, SEC Chairman Gary Gensler said prior to the May 25 vote. Currently, the Names Rule requires funds with a name suggesting it focuses on a particular type of investment, such as the “ABC Stock Fund” or the “XYZ Bond Fund,” to invest at least 80% of its assets in the type of investment suggested by its name. Also, names suggesting that a fund focuses its investments in a particular country or geographic region, that a fund’s distributions are exempt from income tax, and that a fund or its shares are guaranteed or approved by the U.S. government are subject to the rule, according to the SEC.

Mr. Forrester of Mayer Brown said an update to the Names Rule is needed. “I, like many, saw funds that were not performing (well) rebrand themselves as ESG in an attempt to attract more money and keep themselves alive,” he said. “I think greenwashing is probably going on and is a pretty significant risk, and I think the public needs to made aware of it and perhaps we’re going to be.”

There are more than 1,400 funds in the U.S. with “value” or “growth” in their names, according to data from Morningstar Direct. Moreover, there are more than 500 funds in the U.S. sustainable fund universe, which includes open-end funds and exchange-traded funds, that thoroughly integrate ESG factors into their investment processes, pursue sustainability-related investment themes or seek measurable sustainable impact alongside financial returns, according to Morningstar Direct.

Separately, the SEC in March 2021 announced the formation of a climate and ESG task force to proactively identify ESG-related misconduct.

Just before the SEC proposed expanding the Names Rule, BNY Mellon Investment Adviser Inc. agreed to settle SEC charges that the registered investment adviser made misstatements and omissions about ESG considerations involving investment decisions for six mutual funds that it managed, the agency announced May 23. BNY Mellon Investment Adviser, a subsidiary of Bank of New York Mellon Corp., agreed to a cease-and-desist order, a censure and a $1.5 million penalty to settle the charges, though it did not admit to or deny the SEC’s findings.

“Investors are increasingly focused on ESG considerations when making investment decisions,” said Adam S. Aderton, co-chief of the SEC enforcement division’s asset management unit and a member of its climate and ESG task force, in a news release. “As this action illustrates, the commission will hold investment advisers accountable when they do not accurately describe their incorporation of ESG factors into their investment selection process.”