The Securities and Exchange Commission (SEC) has proposed to amend rules under the Investment Advisers Act of 1940 and the Investment Company Act of 1940 to require certain investment advisers, investment companies, and business development companies to provide additional information regarding their environmental, social and governance (ESG) investment practices (the "Proposed Rule"). According to the SEC, the changes are "designed to help investors...make more informed choices regarding ESG investing[.]" The changes seek to create a more standardized framework for ESG reporting, as the SEC has stated that investors assessing ESG practices "face a lack of consistent, comparable, and reliable information" and that there is currently a risk of funds exaggerating their ESG practices, also known as "greenwashing." These issues could mislead investors about a fund's sustainability and cause them to pay higher fees than they otherwise would.
To address these issues, the SEC has proposed minimum disclosure requirements for funds (both open-end and closed-end) that "incorporate one or more ESG factors into their investment selection process." Funds that use one or more ESG factors as "a significant or main consideration (1) in selecting investments or (2) in [their] engagement strategy with the companies in which [they] invest" would be deemed "ESG-Focused Funds" and would be subject to robust disclosure requirements. A fund that excludes or includes investments in particular industries for ESG-related reasons would be an ESG-Focused Fund under this definition, as would any fund that has a name indicating that ESG factors are incorporated into its investments and any fund whose marketing materials indicate that ESG factors are a significant or main consideration for the fund. The required disclosure for an ESG-Focused Fund must be presented in a standardized tabular format and must (i) give an overview of the fund's ESG strategy, (ii) select from a list of options (including, e.g. "tracks an index," "applies an inclusionary screen," etc.) how the fund implements its ESG strategy, (iii) describe how the fund incorporates ESG factors in its investment decisions, and (iv) describe how the fund votes proxies and/or engages with companies about ESG issues. Open-end funds would provide these disclosures in the "risk/return summary" section of their prospectuses, while closed-end funds would provide them at the beginning of the discussion of the fund's organization and operation.
So called "Integration Funds" would have more streamlined disclosure requirements. A fund would qualify as an Integration Fund if it considers ESG factors alongside non-ESG factors in its investment decisions, but only if such ESG factors "are generally no more significant than other factors in the investment selection process, such that ESG factors may not be determinative" in selecting an investment. Integration Funds would have to summarize in a few sentences "how the fund incorporates ESG factors into its investment selection process, including what ESG factors the fund considers." This could be accomplished with a brief narrative and/or an example illustrating how the factors are considered in practice. In the case of open-end funds, these disclosures would be made in the summary section of the fund's prospectus. Closed-end funds would include the disclosures in the prospectus's general description of the fund. Integration Funds that consider greenhouse gas emissions will also need to make specific disclosures describing how such consideration is incorporated into selecting investments for their portfolios.
Finally, the SEC proposed that funds tag ESG disclosures using a structured data language known as Inline XBRL to make their ESG data machine-readable for investors. The SEC believes this would allow investors to better access and evaluate ESG data.
For more information, and to see all of the proposed changes, view the Proposed Rule in full here. The SEC is currently accepting comments on the Proposed Rule, which may be submitted online here and must be received by the SEC by Aug. 16, 2022. Comments submitted to the SEC will be made public.
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