On September 20th, the SEC finalized the Investment Company Names rule and, despite recent suggestions by Chair Gary Gensler that at the SEC they "try not to do things against a clock," the SEC is expected to take action in the near future on two other ESG proposals that could have a significant impact on investment advisers and public companies. Meanwhile, both pro-ESG and anti-ESG state lawmakers have been taking an increasingly aggressive stand to assert their own authority in the ESG space, including in California, where lawmakers recently passed two climate disclosure laws that could "change the baseline" of the climate reporting landscape. Global investment managers are preparing now for these significant developments.
U.S. Federal ESG Efforts
SEC's Final Rule on Investment Company Names
The recently adopted amendments to Rule 35d-1 under the Investment Company Act of 1940 (the "Names Rule") expands the scope of the requirement for certain registered investment companies and business development companies (together, "funds"). The Names Rule will now apply to fund names with terms like "growth" and "value" as well as certain names that suggest a thematic focus, most notably, those suggesting that the fund makes decisions based on ESG factors. The Names Rule will require funds using such terms to ensure that at least 80% of the value of a fund is invested in accordance with the focus that the name suggests, will require funds that drift outside the 80% metric to come back into compliance within 90 days, and will require each fund to reassess the characteristics of its investments on a quarterly basis. In addition, the Names Rule will create new prospectus disclosure requirements and new recordkeeping and reporting requirements.
The Names Rule will be effective 60 days after publication in the Federal Register and will have a compliance date of 24 months after the effective date for funds with net assets of over $1 billion and 30 months after the effective date for smaller funds.
SEC Climate Disclosure and ESG Strategy Proposals
The proposed rule on the Enhancement and Standardization of Climate-Related Disclosures for Investors (the "Climate Disclosure Proposal") continues to be a highly anticipated rulemaking for industry participants and may be the most controversial of the SEC's ESG proposals.1 If the rule is approved in its final form, asset managers that are public companies or affiliates of public companies would have to gather and aggregate climate-risk and GHG emission data to meet their disclosure obligations under the rule. In response to concerns voiced by industry participants, SEC Chair Gary Gensler has recently indicated that the SEC will consider appropriate adjustments to its proposed climate risk disclosure framework, and has acknowledged that there are important issues to be worked out regarding Scope 3 emissions.
The SEC's proposal on Enhanced Disclosures by Certain Investment Advisers and Investment Companies about ESG Investment Practices (the "ESG Strategy Proposal") was announced on May 25, 2022, and the SEC is currently expected to take further action on the matter in October 2023. If adopted, the ESG Strategy Proposal would require (i) registered investment advisers, exempt reporting advisers, registered investment companies, and certain other funds2 to make specific and standardized disclosures regarding their ESG strategies and (ii) certain environmentally focused funds to disclose information regarding the GHG emissions associated with their investments.
Greenwashing and SEC Enforcement Actions
Greenwashing remains a central examination and enforcement priority for the SEC. The SEC has focused on the veracity of ESG claims in various formats, from disclosures within documents such as annual reports or prospectuses, to statements on company websites and social media.3 The SEC's 2023 Examination Priorities state that the SEC's examiners will continue to focus on "whether ESG products are appropriately labeled and whether recommendations of such products for retail investors are made in investors' best interests."
Even if an SEC examination does not ultimately lead to an enforcement action, heightened scrutiny around greenwashing raises litigation risk (in particular, the risk of follow-on private litigation). As the SEC continues to bring enforcement actions against registered investment advisers purportedly engaged in greenwashing and other deceptive ESG practices, advisers should ensure that they are actively reviewing their ESG-related activities and ensure that they have accurate and consistent ESG disclosures that take into consideration the increasingly divergent approaches that states are taking in the ESG space.
U.S. State Law Developments
As noted in our March 2023 client note, Upcoming Climate-Related Disclosure Rules and the Divide among States Over ESG Considerations, lawmakers across the United States have had starkly different responses to ESG. Some state lawmakers have sought to expand upon federal efforts and implement even more stringent ESG policies while others have strongly pushed back against ESG-related efforts and have sought to limit the impact of ESG within their borders.
Pro-ESG State Activities
California recently passed two climate disclosure laws, the Climate Corporate Data Accountability Act (SB 253) and Greenhouse Gases: Climate-Related Financial Risk ( SB 261). These laws will require certain firms doing business in the state that meet certain minimum annual revenue thresholds to make climate-related disclosures that go even further than those expected under the SEC's Climate Disclosure Proposal. For more in-depth analysis of these laws, please see our recent client note California Legislature Passes Landmark Climate Disclosure Laws.
In May 2023, Governor Mike Dunleavy of Alaska released the state's first sustainability report called "The Alaska Standard" detailing how Alaska will align its ESG goals with the UN Sustainable Development Goals. On August 14, 2023, a Montana district judge ruled in favor of a group of younger plaintiffs (each between 5 and 22 years old) who had alleged that their state constitutional right to a clean and healthful environment was violated by certain provisions of the Montana State Energy Policy Act and Montana Environmental Policy Act that had barred state officials from considering GHG emissions or climate change in their environmental reviews.
Anti-ESG State Activities
At the other end of the ESG spectrum, at least a dozen states have enacted laws to combat ESG efforts within their borders. Several of these states have introduced legislation, passed resolutions, or issued policy guidance stating that ESG investing may violate fiduciary duties of prudence and loyalty in relation to state investments, and certain states have also passed "energy discrimination laws" prohibiting state governments from contracting with (i) companies that have boycotted the fossil fuel industry and (ii) financial institutions that have committed to no longer financing fossil fuel producers.
Notably, on May 2, 2023, Florida passed a law that requires state and local officials to make investment decisions "based solely on pecuniary factors." The legislation deems the consideration of ESG factors an "unsafe and unsound practice," and may subject financial institutions considering these factors to sanctions and penalties. The legislation also prohibits state and public issuers from selling ESG bonds, including green bonds.
Even in the absence of state legislative action, some state officials have sought to combat ESG efforts on their own. For example, the Secretary of State of Missouri issued a rule that would require broker-dealers and investment advisers to obtain client consent prior to recommending any investments that take into account a "social objective or other non-financial objective" instead of focusing "solely on maximizing a financial return."4
Conclusion
Global investment managers are preparing in light of the passage of the Names Rule and the potential imminent adoption of the Climate Disclosure Proposal and ESG Strategy Proposal in the U.S. Managers are planning for if the rules go into effect as proposed, how this will impact their firm, ESG positioning, strategies, and disclosures. This is all against the backdrop of the activity taking place at the state level. Investment managers are considering how these significant changes will impact their ESG disclosures across Form ADV, websites, prospectuses and offering memoranda, and marketing materials. Managers are seeking to reach the right balance in the United States on ESG. It is critical that global investment managers carefully navigate these issues so as not to run afoul of the new SEC rules, greenwashing risks, and state ESG initiatives, mindful that key decisions may also impact capital raising in the United States.
Footnotes
1. For additional information on the SEC's ESG proposals, please see our March 2022 client note: Climate-related disclosure may soon become mandatory in the United States, our May 2022 client note: ESG spotlight moves to investment advisers and registered funds under SEC proposals, and our September 2022 client note: The three SEC proposals that will redefine the ESG regulatory landscape.
2. The proposal defines "funds" as RICs, certain unit investment trusts, and business development companies ("BDCs"), but not private funds as defined under the Advisers Act.
3. Some market participants have raised concerns that the focus on greenwashing is causing companies to deliberately communicate less detail about their sustainability work to minimize the risk of appearing to be "too green" or "not green enough," a phenomenon that has been referred to as "greenhushing."
4. The Securities Industry and Financial Markets Association ("SIFMA") has since filed a complaint challenging the rule, arguing that federal rules already compel advisers to evaluate factors that are secondary to maximizing returns, and alleging that the rule violates the First Amendment by forcing financial professionals to adopt a government position on a controversial matter of public debate.
We are also grateful to Bhavishya Barbhaya, Haanbee Choi, Michal Folczyk, Matthew Gallot-Baker, and Daniel Kim for their contributions to this regulatory update.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
