What to Know About the SEC’s ESG Investing Rule Proposals

Nina Wilson is Vice President of Edelman ESG Advisory. This post is based on her Edelman memorandum. Related research from the Program on Corporate Governance includes The Illusory Promise of Stakeholder Governance (discussed on the Forum here) by Lucian A. Bebchuk and Roberto Tallarita; Does Enlightened Shareholder Value Add Value? (discussed on the Forum here) and Stakeholder Capitalism in the Time of COVID (discussed on the Forum here), both by Lucian Bebchuk, Kobi Kastiel, and Roberto Tallarita; Restoration: The Role Stakeholder Governance Must Play in Recreating a Fair and Sustainable American Economy—A Reply to Professor Rock (discussed on the Forum here) by Leo E. Strine, Jr.; and Corporate Purpose and Corporate Competition (discussed on the Forum here) by Mark J. Roe.

The May 31, 2022, law enforcement raids of the Frankfurt offices of Deutsche Bank AG and its asset management unit, DWS Group, over accusations of prospectus fraud and “greenwashing”—generally defined as the practice of making false, misleading or unsubstantiated claims about the environmental and/or social impact of an investment—have asset managers, among other stakeholders, wondering: could similar actions be on the horizon in the U.S.?

U.S. asset managers are right to be wary: the raids in Germany came just days after the U.S. Securities and Exchange Commission (SEC) proposed new disclosure and naming requirements for funds that consider environmental, social and governance (ESG) factors in their investment decisions.

The proposals are the latest in an intensified focus on transparency and fair marketing of ESG products and services by the U.S. regulator. The same week the proposed rules were released, the SEC announced that BNY Mellon Investment Adviser, Inc. agreed to pay a $1.5 million fine to the SEC to settle allegations that the firm made misleading claims about ESG funds it managed. Most recently, the Wall Street Journal reported that the SEC is also investigating Goldman Sachs over its ESG and clean-energy investment funds.

New Rules for a New Era in ESG Investing

By late 2021, ESG funds accounted for an estimated 10 percent of global fund assets. The rapid growth and mainstreaming of ESG investing—with $343 billion in assets in sustainable funds in the U.S. as of the first quarter of 2022—has led brokers, advisors and investors to demand more transparency and clarity into how ESG factors are considered in asset management and investment decision-making.

The two new proposed rules aim to provide just that.

  1. The first would require additional disclosures for three categories of registered funds that use ESG factors in investment strategies: ESG-integrated (funds that consider ESG factors, but those factors are not more significant than other non-ESG factors); ESG-focused (funds for which ESG factors are the significant or main consideration); or ESG-impact (funds that seek to achieve specific ESG impacts). The proposal would also require ESG-focused funds that claim to consider environmental factors to include greenhouse gas (GHG) emissions disclosures associated with their portfolio company investments, unless the fund discloses that it does not consider GHG emissions as part of its investment strategy.
  2. The second would expand the scope of the Investment Company Act’s “Names Rule,” a two-decades-old rule that dictates that, if a fund’s name suggests a certain focus, at least 80 percent of the value of its assets should be invested accordingly. The expanded rule would, among other things, now cover funds with names that suggest investment decisions incorporate one or more ESG factors.

A Chilling Effect for Future ESG Funds?

While some applaud the SEC proposals as much-needed transparency measures to help retail investors make more informed decisions, others worry they could deter asset managers from pursuing ESG-focused investments. For example, the GHG emissions disclosure requirement could give funds pause for thought, given the challenges of portfolio carbon measurement and reporting.

While it is unlikely that funds would abandon ESG-focused investing completely, there is a risk that the proposed rule would slow the development of new ESG-focused funds because of the due diligence and compliance costs associated with carbon accounting for their portfolio companies. That said, the SEC’s separate proposed climate disclosure rule should arguably improve the quality of GHG emissions data available in the market generally, as public company registrants would be required to report emissions with their annual filings.

What’s Next?

The proposed rules entered a 60-day public comment period, during which investors, companies and other stakeholders provided support, opposition or feedback. While these rules are not finalized and may face legal challenges, the proposals are expected to be adopted—albeit perhaps in modified form.

The U.S. results of Edelman’s fifth annual Trust Barometer Special Report: Institutional Investors found that 86 percent of U.S. investors believe that companies frequently overstate or exaggerate their ESG progress when disclosing results, and 72 percent of investors globally don’t believe companies will achieve their ESG commitments. The SEC’s proposed rules on climate disclosure and ESG funds signify that calls for greater transparency in ESG investing and corporate disclosure are finally leading to regulatory action.

As regulatory momentum builds, companies should work with their advisers to test the integrity and robustness of their ESG strategies and prepare to report in line with the proposed rules.

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