Asset managers will be required to justify their use of ESG labels.
The US Securities and Exchange Commission (US SEC) proposed two rule changes on Wednesday to prevent misleading claims by US funds on their ESG credentials and increase product disclosure requirements.
The proposals are in response to increasing concerns raised by investors that current rules are potentially facilitating greenwashing, misleading customers over products’ underlying holdings.
The first proposal outlines amendments to the Investment Company Act’s ‘Names Rule’, expanding the requirements of the 80% rule so it covers a wider variety of funds, and also introducing enhanced disclosure requirements.
The second proposal aims to amend reporting rules concerning funds’ and advisers’ incorporation of ESG factors in their marketing material, such as prospectuses and annual reports.
Both proposals are now subject to a 60-day comment period.
“Investors increasingly recognise that their investments are exposed to the financial risks of climate change and want to invest in funds that manage those risks,” said Kirsten Spalding, Senior Programme Director of the Ceres Investor Network.
“It is critical that investors be able to understand which funds consider climate risks and opportunities for purely financial reasons, which seek to have an impact, and how funds intend to achieve those goals. The SEC must ensure that investors are armed with the information they need to select funds that meet their objectives.”
What’s in a name?
The SEC previously asked for feedback on whether the ‘Fund Names Rule’ should be updated in March 2020.
The current rule requires funds focused on a particular type of investment to invest at least 80% of its assets accordingly – for example, a large cap US equity fund needs to hold at least 80% equities. The rule has been criticised for not effectively extending to thematic funds or sustainable funds.
In the new proposal, the SEC noted that the rule would be extended to any fund name that includes terms suggesting the product either focuses on investments that have particular characteristics, such as ‘growth’ and ‘value’, or that incorporate ESG-related factors.
It does not currently require greenhouse gas (GHG) emission disclosures, but the SEC has welcomed advice on this.
“As the fund industry has developed, gaps in the current Names Rule may undermine investor protection,” said SEC Chair Gary Gensler.
“In particular, some funds have claimed that the rule does not apply to them – even though their name suggests that investments are selected based on specific criteria or characteristics.”
US-based shareholder advocacy NGO As You Sow has noted that the 80% framework is “flawed”, which offers a loophole for ESG-labelled funds to invest the remaining 20% unsustainably.
In January, As You Sow collaborated with the Rady School of Management at the University of California and assessed 90 US mutual funds and ETFs with ‘ESG’ in their names. Sixty scored a D or an F in terms of their actual degree sustainability, according to As You Sow’s Invest Your Values ESG rating platform.
“The proposed rules acknowledge the problem and are a good first step in stopping funds with ‘ESG’ in their names from continuing to hold dozens of fossil fuel companies and coal-fired utilities. However, the new rule continues to use the flawed 80/20 framework,” said As You Sow CEO Andrew Behar.
“On the plus side, fund managers will be required to define ESG in the prospectus, how they vote proxies, and use a very simple set of standardised definitions and categories. While a good first step, investors were hoping for a new structure to close loopholes and eliminate confusion and misleading marketing.”
Justifying the label
Separately, the ‘Enhanced Disclosures by Certain Investment Advisers and Investment Companies about Environmental, Social, and Governance Investment Practices’ proposal seeks to promote “consistent, comparable, and reliable information for investors concerning funds’ and advisers’ incorporation of ESG factors”, the SEC said.
The SEC aims to categorise certain types of ESG strategies, then requiring funds and advisers to provide more specific ESG-related disclosures in prospectuses, annual reports and adviser brochures. For example, a fund focused on environmental factors would be expected to disclose the GHG emissions associated with its investments.
The proposal identifies three types of ESG funds: integration funds, which integrate ESG factors alongside non-ESG factors; ESG-focused funds, for which ESG factors are a significant or main consideration; and impact funds, a subset of ESG-focused funds that seeks to achieve a particular ESG impact.
ESG reporting would also be expected on Forms N-CEN and ADV Part 1A. These are forms typically used to collate “census-type data” from funds and advisers that then informs the SEC’s regulatory, enforcement and policymaking roles, the SEC said.
US SEC Commissioner Allison Herren Lee said: “Those offering investments must fully and fairly disclose what they are selling, and act consistently with those disclosures. In others words: say what you mean and mean what you say.”
The changes will apply to certain registered investment advisers, advisers exempt from registration, registered investment companies, and business development companies.
Earlier this week, the SEC fined BNY Mellon Investment Adviser US$1.5 million for allegedly misstating and omitting information about ESG investment considerations for managed funds.
“While we have just begun reviewing these proposed rules, the actions taken by the SEC would address concerns about greenwashing, and result in greater investor confidence that sustainable funds are what they say they are,” said Steven Rothstein, Managing Director of the Ceres Accelerator for Sustainable Capital Markets at US investor network Ceres.
“The tremendous growth in the number and variety of ESG funds available shows that analysis of ESG risks and opportunities is a mainstream strategy to create long-term value for investors. But better, more consistent disclosures are sorely needed to help investors take advantage of this dynamic and growing market.”