On May 25, the Securities and Exchange Commission (SEC) proposed amendments to rules and forms under the Investment Company Act of 1940 and the Investment Advisers Act of 1940 to require registered investment companies, registered investment advisers and exempt reporting advisers to provide additional information regarding their environmental, social and governance (ESG) investment practices. The proposed rule and form amendments are designed to create a “consistent, comparable and decision-useful” regulatory framework for ESG investment companies and advisory services, with consistent standards for ESG disclosures that allow investors to make informed decisions as they compare various ESG investments.

Investment Companies

The SEC is not proposing to define ESG or similar terms. Rather, it is proposing to require a fund to disclose to investors how it incorporates ESG factors into its investment selection process and investment strategy. The proposed disclosure would follow a layered approach, with a concise overview in the fund summary and more detailed disclosure in the statutory section of the prospectus.

A fund that considers ESG factors in its investment process would be required to self-identify as an Integration Fund, ESG-Focused Fund or ESG Impact Fund based on how significant ESG factors are to the fund’s strategy. The amount of disclosure required would vary depending on the type of ESG fund.

Integration Funds

These funds consider one or more ESG factors alongside other non-ESG factors in their investment decisions, but those ESG factors are generally no more significant than other factors in the investment selection process, such that ESG factors are not determinative in deciding to include or exclude any particular investment in the portfolio.

Prospectus Disclosure

ESG disclosure for Integration Funds would be more limited than for ESG-Focused Funds or ESG Impact Funds. The proposed amendments would require an Integration Fund to briefly describe in the prospectus summary section how it incorporates ESG factors into its investment selection process. The SEC is not proposing more extensive disclosure requirements in the statutory prospectus because it is concerned that doing so could overemphasize the role ESG factors play in the fund’s investment selection process. However, an Integration Fund that considers the greenhouse gas (GHG) emissions of companies in which the fund invests as one ESG factor in the fund’s investment selection process would be required to describe how the fund considers the GHG emissions of its portfolio holdings.

Summary of Proposed Disclosure

ESG-Focused Funds

This type of fund focuses on one or more ESG factors by using them as a significant or main consideration in selecting investments or in its engagement strategy with the companies in which it invests. ESG-Focused Funds include:

  • Funds that track an ESG-focused index.
  • Funds that apply a screen to include or exclude investments in particular industries based on ESG factors.
  • Funds with names that include terms indicating that investment decisions incorporate one or more ESG factors.
  • Funds whose advertisements or sales literature 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.3
  • Funds that have a policy of voting proxies and engaging with the management of portfolio companies to encourage ESG practices or outcomes.

Prospectus Disclosure

An ESG-Focused Fund (including an ESG Impact Fund) would be required to provide a proposed ESG Strategy Overview Table at the beginning of the Risk/Return section of its summary prospectus and other more detailed disclosure regarding its ESG investment practices in the statutory prospectus.4 The ESG Strategy Overview Table would require an ESG-Focused Fund to disclose the following information in a tabular format:

  • Overview of the fund’s ESG strategy. The overview would include a concise description of the ESG factor or factors that are the focus of the fund’s strategy. The fund must also include a list of common ESG strategies and “check the box” of each applicable strategy.5
  • How the fund incorporates ESG factors in its investment decisions. For each common ESG strategy marked with a check, the fund would be required to separately summarize how it incorporates ESG factors into its investment process for evaluating, selecting or excluding investments. The summary must include:
    • An overview of how the fund applies any inclusionary or exclusionary screen, including a brief explanation of the factors the screen applies, whether any exceptions apply to the inclusionary or exclusionary screen, and the percentage of the portfolio to which the screen applies.
    • An overview of how the fund uses an internal methodology, third-party data provider (such as a scoring or ratings provider) or a combination of both, if applicable.
    • The name of any index the fund tracks and a brief description of the index and how it utilizes ESG factors in determining its constituents.
    • As applicable, an overview of any third-party ESG frameworks the fund follows as part of its investment process.6
  • How the fund votes proxies and/or engages with companies about ESG issues. The fund must briefly describe how it engages or expects to engage with issuers on ESG issues, whether by voting proxies or otherwise.
    • The fund must state whether it has specific or supplemental policies and procedures that include one or more ESG considerations in voting proxies and, if so, state which considerations.
    • If the fund seeks to engage through meetings with or advocacy to management, it must provide an overview of the objectives it seeks to achieve with the engagement strategy.
    • If the fund does not engage or expect to engage with issuers on ESG issues (whether by voting proxies or otherwise), it must disclose that neither proxy voting nor engagement with issuers is a significant means of implementing its investment strategy.

The concise disclosure provided by the fund in the ESG Strategy Overview Table would be complemented by additional information in the statutory prospectus.

Annual Report Disclosure

In addition to the proposed amendments to fund prospectuses, the SEC is proposing several amendments to the annual reports of ESG-Focused Funds and ESG Impact Funds to provide additional ESG-related information. The proposed disclosure would be included in the management discussion of fund performance (MDFP) section of the fund’s annual shareholder report. The proposed disclosures for ESG-Focused Funds would include:

  • Information regarding how the fund voted proxies relating to ESG matters if it uses proxy voting as a significant means of implementing its ESG strategy.
  • Information about the fund’s engagement practices, including participation in engagement meetings if engagement with issuers on ESG issues through means other than proxy voting is a significant means of implementing its ESG strategy.7
  • Disclosure of the carbon footprint and the weighted average carbon intensity of a fund’s portfolio, including Scope 1, Scope 2 and, if available, Scope 3 emissions, if a fund indicates on Form N-CEN that it considers environmental factors but does not affirmatively state that it does not consider issuers’ GHG emissions as part of its investment strategy in the ESG Strategy Overview Table in the fund’s prospectus.

Summary of Proposed Disclosure

ESG Impact Funds

This type of fund seeks to achieve a specific ESG impact or impacts. ESG Impact Funds would be a subset of ESG-Focused Funds but would be distinguished from other ESG-Focused Funds by their stated goal of pursuing a specific impact(s). Examples include:

  • A fund that invests with the goal of seeking current income while also furthering the fund’s disclosed goal of financing the construction of affordable housing units.
  • A fund that invests with the goal of seeking to advance the availability of clean water by investing in industrial water treatment and conservation portfolio companies.

Prospectus Disclosure

An ESG Impact Fund would be required to provide the disclosures proposed for all ESG-Focused Funds but would also be required to provide an overview of the impact(s) the fund is seeking to achieve and how the fund is seeking to achieve the impact(s). The overview must include:

  • How the fund measures progress toward the specific impact(s), including the key performance indicators the fund analyzes.
  • The time horizon the fund uses to analyze progress.
  • The relationship between the impact(s) the fund is seeking to achieve and financial returns.

The requirement for a fund to disclose the relationship between the impact(s) it is seeking to achieve and financial returns is designed to require funds to disclose, if true, that financial returns are secondary to achieving the fund’s stated impact(s) – or conversely, that achieving the fund’s stated impact(s) is intended to enhance financial returns.

In addition to disclosure in the ESG Strategy Overview Table, the SEC proposes requiring an ESG Impact Fund to disclose in its investment objective the ESG impact(s) it seeks to generate with its investments.

The concise disclosure provided by the fund in the ESG Strategy Overview Table would be complemented by additional information in the statutory prospectus.

Annual Report Disclosure

In addition to the proposed amendments to the annual shareholder report requirements for all ESG-Focused Funds, the SEC is proposing to require an ESG Impact Fund to discuss in the MDFP section of the fund’s annual shareholder report its progress on achieving its impact(s) in both qualitative and quantitative terms. An ESG Impact Fund would also be required to discuss the key factors that materially affected the fund’s ability to achieve its impact(s).

Summary of Proposed Disclosure

Key Points

  • Many funds consider governance and social issues as part of their investment process, but don’t hold themselves out as ESG funds. Requiring those funds to separately discuss how ESG factors are incorporated into their investment decisions could mislead investors to conclude that ESG factors play a more significant role than they actually do.
  • ESG-Focused Funds are those that use ESG factors as a “significant” or “main” consideration in selecting investments or in their engagement strategy. Neither of these terms is defined in the proposed form amendment, nor do they mean the same thing. Without a more objective criteria, funds may categorize themselves differently, making it difficult for investors to make informed decisions as they compare various ESG investments.
  • An ESG Impact Fund would be required to disclose as part of its investment objectives or goals the impact(s) it seeks to generate with its investment. This requirement could result in impact objectives that are so broad as to be meaningless (e.g., alleviating poverty) or so specific that a fund cannot adapt to changing conditions.
  • To demonstrate compliance with the federal securities laws, funds claiming to engage with issuers would need to amend their compliance policies and procedures to require that employees create and preserve meeting agendas and contemporaneous notes of engagements relating to ESG issues or otherwise memorialize the discussion of ESG issues to assure accurate reporting on the number of engagements.
  • ESG-Focused Funds would be required to provide in the statutory prospectus more detailed information on how they incorporate ESG factors in their investment decisions. While more details may be useful, it remains to be seen whether investors will find extensive disclosure of the methodologies used by ESG-based indices or the rating systems used by third-party data providers to be “decision-useful” information.
  • Funds that consider environmental factors in selecting portfolio companies would be required to disclose the aggregated GHG emissions metrics of their portfolios. Gathering and calculating this information is an expense that may give larger, well-funded complexes a competitive advantage over smaller fund groups.

Form N-CEN

Under the proposed rules, a registered fund that indicates it incorporates ESG factors would be required to report, among other things, the type of ESG strategy it employs; the ESG factors it considers; and the method it uses to implement its strategy. A registered fund would also be required to report whether it considers ESG-related information or scores provided by ESG providers in implementing its investment strategy, including the name of such ESG provider. The SEC, in its efforts to better assess the trends in this market, would also require registered funds to disclose whether they follow any third-party ESG frameworks and include the names of such frameworks.

Investment Advisers and Form ADV

The proposed form amendments also would require investment advisers that consider ESG factors in their investment analysis to include certain additional information as part of their Form ADV. A registered investment adviser required to deliver a firm brochure and one or more brochure supplements would be required to make ESG-related disclosures in its Form ADV Part 2A. The proposed amendments would also require both registered and exempt reporting advisers to make ESG disclosures in Form ADV Part 1A and applicable schedules.

Form ADV Part 2A

Rule 204-3, the “Brochure Rule,” requires registered investment advisers to provide clients and potential clients with a brochure and one or more brochure supplements that reflect the adviser’s entire business, which may include multiple advisory services, investment strategies and methods of analysis.

Under the proposed rules, a registered investment adviser would be required to add the following ESG disclosure to its brochure and brochure supplements if the adviser considers ESG factors as part of its advisory business:

  • A description of the ESG factors it considers for each significant investment strategy and disclosure of how such factors are incorporated into its investment advice, including recommending and selecting other investment advisers.
  • An explanation of whether and how the adviser also employs integration and/or ESG-focused strategies, and if ESG-focused, whether and how the adviser also employs ESG impact strategies.
  • A description of any relationship or arrangement that is material to the adviser’s business or clients that the adviser or any of its management persons have with any related person who is an ESG consultant or other ESG service provider.
  • A description of which ESG factors an adviser considers and how it considers them, and if the adviser has specific voting policies or procedures that include one or more ESG considerations.

Form ADV Part 1A

Both registered and exempt reporting advisers would be required to expand the information disclosed in Form ADV Part 1A related to the advisory services provided to separately managed accounts (SMAs) and certain private funds. The following ESG disclosures would be required under the proposed amendments:

  • For SMA clients, an adviser would be required to disclose:
    • Whether it considers ESG factors as part of one or more significant strategies for its SMA clients, including in its selection of other investment advisers and/or part of their advisory services when requested by SMA clients.
    • Whether it follows any third-party ESG frameworks in connection with its advisory services, including the name of such frameworks.
    • Whether it employs an integration or ESG-focused approach, and if ESG-focused, whether it also employs an ESG impact approach. An adviser must select all three approaches if it offers all three.
  • For private fund clients, an adviser would be required to disclose:
    • Whether it conducts other business activities as an ESG provider or has related persons that are ESG providers.
    • The use of ESG factors in managing each reported private fund, including the type of ESG strategy and ESG factors considered.

Wrap Fee Programs

Additionally, advisers that sponsor wrap fee programs will be required to provide a description of what ESG factors they consider and how they incorporate the factors under each program. Advisers would be required to describe any criteria used to assess a portfolio manager’s application of the ESG factors. If an adviser evaluates a portfolio manager’s application of ESG factors, it would be required to provide an explanation of whether it reviews, or whether a third party reviews, and the nature of such review. If no such evaluation is completed, the adviser would be required to make an affirmative statement that no such evaluation is completed and/or that the portfolio manager’s application of the relevant ESG factors may not be calculated, compiled, assessed or presented on a uniform and consistent basis. If the adviser serves as a portfolio manager to a wrap fee program, it would be required to include the disclosures in Item 8 (discussed above) as well.

Key Points

  • If an investment adviser employs many significant investment strategies and methods of analysis that are substantially different, the proposed ESG disclosure requirements may necessitate the production of separate brochures.
  • An advisory firm is currently required to update its brochure promptly if any information becomes materially inaccurate. Changes to an investment adviser’s consideration of ESG factors in strategy implementation could trigger the need for frequent other-than-annual amendments, including redelivery of materials to clients and potential clients.
  • As noted by the SEC, the enhanced Form ADV disclosure requirements are primarily designed to assist the SEC and the public in understanding the trends in this evolving space by providing consistent, comparable and reliable information and risk mitigation. These enhanced public disclosures will potentially increase public awareness of an adviser’s investment strategies and open them to greater SEC scrutiny.
  • An adviser considering ESG as part of its investment strategy should assess how it would implement the necessary disclosures and how it would manage the associated compliance costs.