SEC Defends Controversial ESG Rule

The agency says its proposal seeks to curtail greenwashing, provide clarity for investors and reduce the number of enforcement actions.  

How environmentally, socially and governance-focused are the growing number of funds sporting ESG monikers? The Securities and Exchange Commission aims to find out.

The SEC explained its proposed ESG disclosure rules at the Practising Law Institute’s SEC Speaks 2022 conference September 8-9 in Washington. In particular, it sought to dispel industry criticism that the rule is an overreach that could bump up the need for enforcement actions, increase the potential for “greenwashing” and further confuse investors.

“The opposite is the intent,” said Melissa Harke, an assistant director in the SEC’s Division of Investment Management, during the division’s panel discussion.

“Providing clarity and providing a framework and providing specific rules when it comes to ESG is designed to prevent having to deal with things through enforcement, through exams, through a much more inefficient and less effective method,” she said.

Michael Spratt, another assistant director in the Investment Management division, told attendees, “The principle is simple and it’s similar to what we’re looking for for other funds — say what you do and do what you say.”

The panel reminded the audience that the SEC staff’s statements reflect their own opinions and not necessarily those of the Commission and their colleagues.

A fact-finding mission›

Funds can approach ESG in a variety of “very reasonable ways,” said Spratt, including integration, positive screens, negative screens and impact investing. “Without that specificity, investors aren’t going to be able to compare across products and make an informed decision.” He then explained what the SEC is looking for funds to disclose.

“First and foremost, how central is ESG criteria to the investment selection process? Is it one of several factors considered, or is it driving investment selection?” he said.

“Second, what is the fund focusing on: Is it ‘E’ criteria? Is it “S’ criteria? Is it ‘G’ criteria? Is it some combination?” said Spratt. “To just say ‘ESG’ is so open-ended that it just doesn’t provide investors with the information they need to make an informed decision.”

Being specific even within those three buckets — such as whether an “E” fund focuses on climate, carbon emissions, water usage or biodiversity — can also help investors understand the exposure and ESG-related risks that should be disclosed, he says.

Finally, “if we see a fund name that has an ESG-related term in that name, you can expect that the staff is going to ask the fund to have, consistent with the Names Rule, a policy to invest 80% of its assets in investments suggested by the name,” said Spratt.

Follow the playbook

“When the Commission has brought some cases in the ESG space, it’s been because there have been statements that haven’t been followed,” said Spratt. “When you make disclosure, you need to follow that disclosure. And if not, then you lead yourself to potential enforcement actions.” This is not specific to ESG, he said.

Three kinds of ESG funds

Harke explained that the SEC has identified three kinds of ESG funds — ESG integration, ESG focused and impact. ESG integration funds consider one or more ESG factors alongside non-ESG factors when making investment decisions. ESG-focused funds use ESG factors as a significant or main consideration. An ESG impact fund is an ESG-focused fund that seeks to achieve a specific impact.

The proposed ESG rule would require additional disclosure regarding ESG strategies in fund prospectuses, annual reports and advisor brochures, but the level of reporting would vary for each of these three types of ESG funds, said Harke.

Turning to the Names Rule, Harke noted that ESG integration funds can’t use ESG-related terms in their names because it could mislead investors into thinking ESG factors are more central to their investment process than they are.

“If a fund’s name includes terms like green or sustainable, it seems reasonable that an investor would expect the fund to be predominantly invested in companies that are green or sustainable, as defined by the relevant fund,” she said.

Under proposals to modernize the Names Rule, funds that drift below the 80% requirement would generally be required to come back into compliance in 30 days, said Harke.

Fund trends

Spratt also shared some statistics and trends during the Investment Management panel.

Over the past year, the division has reviewed approximately 9,500 filings, including about 1,400 filings by new funds and about 2,000 material amendments by existing funds, he said.

“To say that the number of filings is immense is an understatement,” he said, noting the increasing complexity of offerings. “The days of us spending the bulk of our time reviewing plain vanilla, long-only equity funds are in the distant past.”

The SEC has been seeing more filings for single-stock funds and funds looking to invest in digital assets and less liquid assets, he said, such as CLOs and catastrophe bonds in an open-end wrapper. Another trend he noted: Nearly 30 mutual funds converted to ETFs this past year.


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