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On May 25, 2022, the U.S. Securities and Exchange Commission, by a vote of three-to-one, proposed for public comment a long-anticipated framework requiring certain funds and certain U.S. investment advisers to disclose their environmental, social and governance (ESG) investment practices (the Proposal).1 The Proposal, which is a companion to a separate release issued the same day proposing changes to Rule 35d-1 under the Investment Company Act of 1940, would amend rules and forms under both the Investment Advisers Act of 1940 and the Investment Company Act.
The Proposal is intended to promote the provision of “consistent, comparable, and reliable” information to investors to facilitate informed decision-making related to ESG investment product and strategy offerings. In particular, the Proposal would seek to change existing disclosure practices by (among other provisions): expressly requiring ESG-related disclosures in fund prospectuses and annual reports and investment adviser regulatory filings (where funds use and strategies use ESG investment techniques); implementing a standardized approach for certain types of ESG funds to disclosure their ESG investing processes; and for the first time, requiring disclosure of the use of greenhouse gas (GHG) emissions data in certain circumstances.2 The Proposal comes in the wake of substantial scrutiny of disclosure practices involving ESG investment practices by the SEC and its Staff.
Although not related specifically to ESG investing, the Proposal also would amend Form N-CEN to require index funds to provide certain identifying information about the index tracked.3
The Proposal would require funds4 that consider ESG factors in their investment process to disclose additional information regarding their investment strategies in registration statements and the management discussion of fund performance section of annual reports. The disclosure requirements would vary depending upon whether a fund is categorized as an “integration fund,” “ESG-focused fund” or “impact fund”:
An integration fund is a fund that considers one or more ESG factors alongside other, non-ESG factors in its investment decisions, but those ESG factors are generally no more significant than other factors in the investment selection process, such that ESG factors may not be determinative in deciding to include or exclude any particular investment in the portfolio.
Disclosure Required (Summary Prospectus)
If ESG factors are part of the Item 9 principal investment strategies, summarize how the fund incorporates ESG factors into the investment selection process, including what factors are considered.
Disclosure Required (Statutory Prospectus)
Describe how the fund incorporates ESG factors into the investment selection process, including: the ESG factors considered and if the fund considers the greenhouse gas (GHG) emissions of its portfolio investments, describe how it considers such information (including the methodology the fund uses).
ESG-Focused Funds (Including Impact Funds)
An ESG-focused fund is a fund that 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 it invests.5
Impact funds are a sub-set of ESG-focused funds. An impact fund is an ESG-focused fund that seeks to achieve a specific ESG impact or impacts.
Disclosure Required (Summary Prospectus)
Disclose information in tabular format related to three broad categories: Overview of the Fund’s Strategy;) How the Fund Incorporates [ESG] Factors in its Investment Decisions;6 and How the Fund Votes Proxies and/or Engages with Companies about [ESG] Issues.
Disclosure Required (Statutory Prospectus)
Describe how the fund incorporates ESG factors into its investment process, including information related to: the index methodology for any index tracked; internal methodologies used and how they incorporate ESG factors; scoring or ratings systems of any third-party data provider used; factors applied in any inclusionary or exclusionary screen; description of any third-party frameworks followed and how they are used; and with respect to engagement, a description of any specific engagement objectives and associated key performance indicators.
Disclosure Required (Annual Report)
ESG-Focused Funds: To the extent applicable based on certain responses to Form N-CEN,7 disclose information related to: the percentage of ESG proxy voting matters where the fund voted in favor of the initiative; the fund’s progress on engagement strategies; and/or GHG emissions data for portfolio investments (carbon footprint and weighted average carbon intensity).8
Disclosure Required (Annual Report)
Impact Funds: Summarize the fund’s progress (quantitative and qualitative) in achieving the impacts disclosed in the fund’s prospectus, including key factors affecting results achieved.
The SEC also proposed to amend Form ADV Part 2A to require registered investment advisers that consider ESG factors as part of their advisory business to disclose information similar to that required in fund registration statements and annual reports. Specifically, the Proposal would require registered advisers to provide: a description of the ESG factors considered in providing advisory services and how they are incorporated and, if ESG factors are considered when selecting, reviewing or recommending portfolio managers, a description of the factors considered and how they are incorporated.
The Proposal also includes proposed amendments to Forms N-CEN and Form ADV Part 1A for funds and advisers.
The Proposal would add new Items C.3(b) and (j) to Form N-CEN. Specifically, these items would require:
Form ADV Part 1A
The Proposal would amend Form ADV Part 1A to provide additional information about the advisory services provided to separately managed account clients and reported private fund clients. Unlike many aspects of the Proposal, certain aspects of the Part 1A amendments would be inapplicable to exempt reporting advisers. This information would generally parallel certain of the information required to be reported with respect to funds on Form N-CEN.
The Proposal would also modify Form N-CSR by adding proposed Item 7, which would require granular information about the process used for calculating and estimating the GHG emissions of a fund’s portfolio.9
The Release also contains guidance related to fund and adviser compliance policies, as well as marketing materials, in the ESG context.
Addressing compliance policies and procedures, the Release highlights the Commission’s current expectation that policies and procedures address the “accuracy of disclosures made to clients, investors and regulators, as well as portfolio management processes, including consistency of portfolios with investment objectives and disclosures by the adviser and/or fund.” It then translates this obligation to the context of ESG, noting that “ESG strategies, including integration, ESG-focused and impact strategies, will necessarily require different levels and types of compliance policies and procedures.” With this in mind, the SEC explained that policies and procedures “should address the accuracy of ESG-disclosures made to clients, investors and regulators. . . . [and] portfolio management processes to help ensure portfolios are managed consistently with the ESG-related investment objectives disclosed by the adviser and/or fund.” The Release provides specific examples of what the SEC deems to be “effective” ESG-related disclosure, policies, procedures, and practices.
The ESG Release also explains the SEC’s views on the application of current advertising requirements to the ESG context by) indicating that “greenwashing” may represent a form of false or misleading statement and affirmatively stating that, in the SEC’s view, “it generally would be materially misleading for an adviser materially to overstate in an advertisement the extent to which it utilizes or considers ESG factors in managing client portfolios.”
The SEC proposed a one-year transition period for: the proposed disclosure requirements in prospectuses under Forms N-1A and N-2; the proposed disclosure requirements for UITs under Form N-8B-2; the proposed regulatory reporting under Form N-CEN; and the proposed disclosure requirements and regulatory reporting under Form ADV Parts 1 and 2.
The SEC proposed an 18-month transition period for the proposed disclosures in shareholder reports and those filed under Form N-CSR.
Comments on the SEC’s proposal are due 60 days after the Proposal is published in the Federal Register.
An upcoming Dechert OnPoint will provide further analysis of this proposal.
1) See Enhanced Disclosures by Certain Investment Advisers and Investment Companies about Environmental, Social, and Governance Investment Practices, Rel. Nos. IA-6034 & IC-34594 (May 25, 2022) (ESG Release). Unless otherwise specified, the term “fund” as used in this Dechert OnPoint refers to registered investment companies (i.e., open-end funds, closed-end funds, and unit investment trusts (UITs)) and business development companies (BDCs), and the term “investment adviser” refers to any investment adviser registered under the Advisers Act and exempt reporting advisers under Sections 203(l) and 203(m) of the Advisers Act. At times, this NewsFlash tracks the ESG Release without the use of quotation marks. Terms not defined in this NewsFlash have the meaning assigned to them in the ESG Release.
2) In addition, the amendments would require tagging of certain of their ESG disclosures using the Inline Extensible Business Reporting Language (“Inline XBRL”) structured data language. This would apply to funds that file registration statements on Forms N-1A, N-2, or S-6 and annual shareholder reports on Form N-CSR and annual reports on Form 10-K.
3) For purposes of Form N-CEN, the term “index fund” is defined as “an investment company, including an Exchange-Traded Fund, that seeks to track the performance of a specified index.”
4) The proposed amendments in this section would apply to open-end funds (including ETFs) and closed-end funds (including BDCs) – but not UITs – that incorporate ESG factors into their investment process. The Proposal would also amend Form N-8B-2 to require a UIT to, if one or more ESG factors are used to select portfolio securities, briefly describe how the factors are incorporated (including which factors are used). UITs would not be subject to the proposed annual report requirements because a UIT is not required to provide a management’s discussion of fund performance section of its annual reports.
5) This would include: any fund that has a name including terms indicating that the fund’s investment decisions incorporate one or more ESG factors and any fund whose sales literature or advertisements 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. The ESG Release indicates that it would also capture funds that track an ESG-focused index and funds that apply inclusionary or exclusionary screen based on ESG factors.
6) Specific requirements apply with respect to Impact Funds.
7) As a general matter, disclosure would be required if proxy voting or engagement is a “significant means” of implementing its ESG strategy. The Release provides guidance on circumstances where proxy voting or engagement activities could be considered “significant”.
8) Both methodologies would require Scope 1 and Scope 2 emissions be included in the emissions calculation but would not require Scope 3 emissions. The GHG emissions requirements would leverage information newly-available information under the SEC’s proposal in March 2022 related to rules for the enhancement and standardization of climate-related disclosures. For additional information, see the Dechert OnPoint titled “SEC Proposes Comprehensive Climate-Related Disclosure Rules”.
9) A proposed new Instruction 10 to Item 24 of Form N-2 would impose parallel disclosure requirements for BDCs on Form 10-K.