Policy Corner | July 6, 2022

The S.E.C.’s new rules (Part One): An opportunity to rein in greenwashing in asset management

John Kostyack

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Guest Author

John Kostyack

Fossil fuel industry-supported activist groups and politicians have launched a campaign to discredit ESG investing as “woke capitalism.”

This new push appears to be part of the broader fossil fuel industry-supported disinformation campaign, which has moved beyond climate change denialism into cultural warfare and dismissal of concerns about social and environmental justice as elitist and hypocritical.  As this anti-woke capitalism campaign moves to the Congressional arena, investors must speak out and defend their rights to deploy their assets as they see fit, including, if they so choose, divestment from fossil fuels. 

The rights of investors to pursue ESG goals includes the right to obtain accurate information from asset managers marketing ESG funds. Under the Investment Company Act and Investment Advisers Act, asset managers owe fiduciary duties of loyalty and care to investors, and it is incumbent upon the SEC to act when these duties are not being honored. Regulatory action is especially important to protect retail investors, who typically lack the information and expertise to evaluate asset managers’ claims. 

Fortunately, the SEC has proposed two rules aimed at improving the reliability and comparability of ESG investment products and strategies offered by managers of mutual funds, Exchange-Traded Funds and closed-end funds: the so-called Fund Names Rule Amendment and the ESG Disclosure Rule.  

The proposed rules would set important new marketing limits and disclosure requirements for asset managers. Significantly, under these proposals, if a fund doesn’t make one or more ESG factors a significant focus in its investment selections, it cannot be marketed as an ESG fund; if a fund makes ESG factors a significant focus, it must disclose how well-established ESG investing strategies are being employed.

For the first time ever, investors in ESG funds would have reliable information on investment selection, including the use of third-party indexes and internal screens and related policies, and engagement, including the use of proxy voting and communication with company management. 

This initiative comes in response to growing evidence that asset managers – investment companies regulated by the Investment Company Act and advisors regulated by the Investment Advisers Act – are greenwashing and otherwise misleading investors into believing that they are taking rigorous approaches to climate change and other environmental, social and governance problems. This ESG marketing is having a dramatic impact: in 2021, over $120 billion poured into investments marketed under some form of a sustainability label, more than double the $51 billion invested in 2020. Ensuring that this marketing does not deceive investors is a fundamental responsibility of the SEC.

The recent raids of the offices of asset manager DWS and its parent Deutsche Bank, charges filed against BNY Mellon Investment Advisers and investigation of Goldman Sachs shows that those making questionable ESG claims are now facing the risk of increased anti-fraud enforcement.

The standardized disclosure framework now being proposed would create a more predictable regulatory environment for all asset managers and bring to an end the Wild West of greenwashing that gives financial advantages to the worst actors. Asset managers should welcome this standardization, embrace the rights of investors – their clients, to whom they owe loyalty – and publicly support the SEC’s initiative. 

The Fund Names Rule Amendment

The Fund Names Rule Amendment would change the way that ESG and other funds managed by SEC-registered investment companies are labeled and would require those investment companies to provide disclosures about the meaning of and rationale for those labels. The Commission proposes two significant steps to address the problem of misleading fund names. 

No More ESG Labels When ESG is Not the Focus. First, the SEC would significantly limit the types of funds that would be allowed to put “ESG” or any related term in its name. If 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,” the use of ESG-related terms in the fund’s name would be prohibited. These types of funds, referred to as ESG Integration funds in the SEC’s parallel ESG Disclosure Rule, likely represent the majority of ESG funds currently available to investors. 

Eliminating the use of ESG-related labels for these funds could have a dramatic impact on the ability of these funds to attract investment dollars. More importantly, investors – especially retail investors, who are less likely to look beyond fund labels than institutional investors – would be less likely to be deceived about an asset manager’s commitment to attending to social, environmental and governance matters when making investment decisions.

Consistency Between Funds’ Labels and Portfolios. Second, the SEC would require, with minor exceptions, that 80% of the asset value in a fund be consistent with “the [ESG] investment focus that the fund’s name suggests.” The existing Names Rule already prohibits funds from using names that are inconsistent with a fund’s investing focus (this is known as the “80% Investment Policy”). Under the proposed amendment, the SEC would clarify that this policy applies to ESG and other funds focused on investments with “particular characteristics.” 

ESG Disclosure Rule

The Commission proposed the ESG Disclosure Rule for the same reason as the Fund Names Rule Amendment – to remedy the problems encountered by investors in obtaining reliable and comparable information about ESG funds. The ESG Disclosure Rule has broader reach than the Fund Names Rule Amendment because it applies to investment advisors and business development companies as well as investment companies. 

Amount of Required Disclosures Tied to Extent of ESG Focus. The Commission would require a host of disclosures about ESG products and strategies, with the amount of required disclosure tied to the extent to which ESG factors are considered relative to other factors.  The SEC would place funds into three categories, with greater disclosure requirements for each successive category:

  • ESG Integration Funds would be those in which environmental, social or governance factors may be considered in the investment selection process but are “generally not dispositive” compared to other factors when selecting or excluding a particular investment. 
  • ESG-Focused Funds would be those in which ESG factors are a “significant or main consideration” in selecting investments or in engaging with portfolio companies. 
  • ESG Impact Funds, a subcategory of ESG-Focused Funds, would be those that seek to achieve a specific ESG impact or impacts.

Marketing of Environmental Funds Gets Special Attention. The Commission also would create a special category of funds called Environmentally Focused Funds. For any ESG-Focused Fund that considers environmental factors as part of its investment strategy, the Commission proposes to treat GHG emissions as presumptively material to investors. Two types of aggregated GHG emissions data – the fund portfolio’s carbon footprint and its emissions intensity – would be required to be disclosed unless the fund affirmatively states that it does not consider issuers’ GHG emissions as part of its investment strategy.

Demonstrating Support While Improving the Rules

The two proposed rules put forward by the SEC are important landmarks. As investors and other stakeholders prepare to weigh in during the 60-day comment period (closing on August 16), I have mapped out five key elements that should receive special consideration in an accompanying article. This is a critical moment for supporting and strengthening the SEC’s efforts to help those investing in ESG funds to secure reliable and comparable disclosures from asset managers.

John Kostyack is founder and principal of Kostyack Strategies.