SEC Rule Proposal: Enhanced Disclosures for ESG Practices
Main Contributor: Zachary Fenno, CSCP, Compliance Manager
Highlight of Proposed Changes
The SEC is proposing disclosure requirements for ESG-focused funds and advisors to create specific, standardized disclosures in order to assist investors in their decision-making process when investing in ESG products. These disclosures will promote consistent, comparable, and reliable information for investors. This new rule will apply to open-end funds, including ETFs, and closed-end funds, including BDCs that incorporate one or more ESG factor(s) into their process.
For funds that wish to use ESG investments to make an impact in certain areas, whether that be global warming or ensuring diversity on governance boards, the SEC is proposing that Impact Funds summarize their progress on achieving their specific impacts in both qualitative and quantitative terms including the key factors that materially affected the fund’s ability to achieve the impact. This impact reporting would be required on an annual basis.
If your fund uses proxy voting or other active engagement to achieve impact goals, then the SEC proposes that the fund disclose information regarding how they voted proxies on ESG matters and information regarding its ESG engagement meetings.
For funds focusing on environmental factors, they must disclose two greenhouse gas (“GHG”) emissions metrics for the portfolio in the fund’s annual reports. These disclosures are meant to prevent funds from exaggerating claims about the effectiveness of their ESG programs.
The final proposal for ESG-related disclosures required certain ESG reporting on Forms N-CEN and ADV Part 1A where funds and advisors report census-type data.
In addition to the specific information proposed, advisors will also need to provide more detailed descriptions in their disclosure documents which may include details about the methodology used when selecting ESG investments; how your fund measures progress towards meeting ESG goals; or details on impact between ESG investment goals and financial returns.
Integration Funds
An integration fund will take into consideration ESG factors when investing, while also considering other factors in the process. ESG factors do not carry any more weight than other factors in the investment process. The SEC is proposing that Integration Funds discloses how the fund incorporates ESG factors into the selection process, including the ESG factors considered. This could be in the form of a brief narrative or providing an example to demonstrate how it considers ESG factors alongside other factors.
Finally, if your fund considers GHG emissions, you must include a description specifically about the methodology used when considering GHG emissions. (E.g., only “high emitting” sectors or companies).
ESG-Focused and Impact Funds
An ESG-Focused Fund is a fund that focuses on one or more ESG factor(s) by using them as a significant or main consideration in selecting investments or in its engagement strategy with the companies in which it invests.
An Impact Fund is an ESG-Focused Fund that seeks to achieve a specific ESG impact, whether that impact is reducing GHG, or diversifying a board of directors.
ESG-Focused Funds will need to provide key information about what factors they consider for ESG investments in an ESG Strategy Overview table, which the SEC provided an example of in the Rule Proposal on page 36. More detailed disclosures will appear elsewhere in fund documents, and if the prospectus is provided electronically, it must link to the additional disclosures.
The table requires:
A concise description of the factors that are the focus of the strategy
Whether or not the fund follows an ESG index
Summary of how ESG factors into the fund’s process for evaluating, selecting, or excluding investments, including what factors determine including or excluding investments
Identify the Index used, if applicable, with an overview of the kinds of companies included in the index
Third-party ESG framework overview, if applicable
In addition, an Impact Fund will also be required to disclose the following:
How the fund measures progress toward the specific impact, including the key performance indicators the fund analyzes
Time horizon the fund uses to analyze progress
The relationship between the impact the fund is seeking to achieve and financial returns
State what the ESG impact is that the fund seeks to generate
Proxy Voting and Engagement with Companies
Firms that engage with companies or use proxy voting as a means of making an impact with regard to ESG factors will be required to disclose that fact in the Overview table. The advisor must also identify the specific methods, both formal and informal, that the fund uses to influence issues, whether that be through proxy voting or direct company engagement.
If a fund engages companies, the fund is required to disclose information on the objectives it seeks to achieve and the time horizon for achieving that goal including any key performance indicators.
ADV Part 1
Item 5.K – ESG Data for Separately Managed Account Clients and Private Funds
The Part 1 will be updated for advisors to select whether they offer ESG products, whether those products are an ESG-impact approach, and whether they incorporate one or more of E, S, and/or G factors (environmental, social, or governance). Additionally, advisors will be required to indicate whether they use a third-party ESG network. Similar requirements will be included in Section 7.B.1 of Schedule D for private fund advisors.
Items 6 and 7 – Additional Information about Other Business Activities and Financial Industry Affiliations
The SEC proposal wants advisors to disclose any additional activities or industry affiliations in regard to ESG investing. You are probably already doing this in your ADV for other related parties, and now there would be one more factor to consider when updating this section.
ADV Part 2A
Item 8 – Methods of Analysis, Investment Strategies, and Risk of Loss
The SEC is proposing adding a section to Item 8. Item 8.D would require an advisor to describe the ESG factors they considered for each strategy or method of analysis which would include whether the advisor uses:
An internal or third-party methodology
An inclusionary or exclusionary screen, including the factors the screen applies
An Index including the name of the index, a description of the index, and how that index utilizes ESG factors
Item 10 – Other Financial Industry Activities and Affiliations
The SEC proposes adding a section requiring a disclosure around any relationship that is material to the advisor’s business when determining ESG factors, such asany relationship with an ESG consultant or service provider.
Item 17 – Voting Client Securities
Advisors will need to describe their ESG considerations and how they consider them when voting client securities.
Annual Reports
The disclosures discussed above will all be present in the prospectus and other disclosure documents for funds. Similar disclosures will also be required for Annual reports, with a few nuances around the type of information provided. For example, an annual report for impact firms that engage companies will have to disclose key factors that led to not meeting their goals. The annual report disclosures will generally focus on the actual results of practices and the goals achieved, whereas the prospectus and related disclosures will provide information on how the fund plans on achieving its goals.
Policies and Procedures and Marketing
There are no proposals in place to change policies and procedures or marketing materials, however, the SEC recommends reviewing these items to ensure that all procedures align with actual practices and are designed to effectively incorporate ESG investment standards. Additionally, review your marketing materials that reference your ESG policies and ensure your disclosures accurately reflect the actual practices of your firm.
Conclusion - What to Do Now
First, hold tight. This is just a proposal and will likely have many changes coming in the near future. The comment period will end on August 16, 2022. However, if you want to get a jump start on meeting these requirements, start by evaluating the core principles of your ESG offerings and asking yourself these questions:
What factors are you considering when choosing ESG investments?
What factors do you, or your investors, care about most when it comes to ESG investing?
Do you want to make an impact in your investing, or are you providing investors a chance to invest in companies that are meeting certain ESG factors?
Then, do your disclosures clearly articulate how your incorporate ESG into your investment process and the inherent limitations?
