A few months back, the Securities and Exchange Commission (SEC) asked for feedback on its proposals to prevent greenwashing, and has seen no shortage of responses – particularly on how the rules would affect funds and advisers that use ESG without making it a primary focus.
The proposals, which cover fund names and disclosures for advisers and investment providers, could in some cases discourage the use of ESG factors or even lead to more greenwashing, commenters wrote in their letters to the Securities and Exchange Commission.
In May, the SEC moved forward with the two proposed rules. The fund names proposal would update current 2001 regulation to prohibit companies from putting a badge on products that don’t use factors in their name as primary ones in their investment processes, including ESG. The other proposal, for ESG disclosures for investment companies and advisers, would put funds into three different groups and require environmentally focused funds to report greenhouse gas emissions tied to their portfolios.
The SEC will review the comments before revising the proposed rules, which the commissioners will later vote to finalize.
Some asset managers asked the SEC to nix provisions for “ESG integration” funds, or products that would include ESG factors in their processes alongside non-ESG factors. That would be the lowest tier in the agency’s proposed buckets for ESG funds, with the successive ones being “ESG-focused” funds and impact funds. At least several groups pressed the SEC to make the distinctions between those categories clearer than it did in its proposal.
PGIM, for example, said it was “concerned with the broad designation of ESG-integration funds given that funds that merely incorporate ESG factors as a consideration in a fund’s investment process would fall into the [category],” the firm wrote, asking the SEC to remove the integration-fund classification. “Requiring all such funds to provide the enhanced disclosures required of an ESG-Integration Fund in offering materials and shareholder reporting could mislead investors by overstating the role ESG factors play in a fund’s investment decisions versus other factors.”
Meanwhile, Franklin Templeton asked the SEC to limit integration funds to those that consider environmental and social factors, as most actively managed funds weigh governance.
But even with that, the proposal would seem to elevate environmental and social criteria in such funds “above any other factors that may be equally important inputs in the investment process, but that do not have the same mandated disclosure requirements,” that company wrote. “This presents a heightened risk of greenwashing and could mislead investors by overstating the role ESG factors play in a fund’s investment decisions.”
That is because integration funds would need to include ESG disclosures in statutory and summary prospectuses, which currently are required to cover principal investment strategies, the firm noted.
Franklin also said that Form ADV disclosures for advisers would face similar issues around ESG factors potentially playing a disproportionately large role in disclosure. And if advisers significantly use ESG factors, they would likely have to disclose non-public information, such as their methodologies for separately managed accounts, private fund trading or other strategies, the company said. That could lead to firms giving away intellectual property to competitors, Franklin said.
Industry wish list
The SEC is unlikely to consider input that conflicts with the its truth-in-labeling policy objective, but it will almost certainly take technical points about the rules’ application to heart, said Lance Dial, partner at Morgan Lewis.
For example, a theme in comments from active managers is compliance, Dial said.
The names rule would require funds to have at least 80% of assets invested in line with what a product’s moniker suggests, expanding that to include ESG factors and thematic investments. The commission also proposed more concrete language around when a fund can stray from that 80% figure.
But it could create problems for certain products, including unit investment trusts, or UITs, the Investment Company Institute wrote in its comment letter.
“UITs— by law and contract— are limited with regards to why they may sell a security, when they may sell a security, and the weighting of additional securities purchased,” the letter stated. “If a UIT were to no longer comply with its 80% investment policy after the initial date of deposit solely due to market fluctuations, the proposed names rule would require the UIT sponsor to come back into compliance with the 80% policy within 30 days.”
Some of the compliance concerns raised by commenters are valid, Dial said.
Active managers could generally have difficulty validating their compliance programs, and a proposed change to apply the 80% rule to “at all times” from “time of purchase” could have consequences for portfolio holdings, he said.
“The concerns raised there are that that shift would require more compliance resources, but could make funds do forced divestment, particularly in bad markets,” he noted. “It creates a brand-new burden.”
On the disclosure proposal, a helpful suggestion for the SEC has been to allow companies to opt in, such as for being classified as an integration fund or ESG-focused fund, he said.
Clients have been asking about whether their funds will fall into the integration category just because they consider some ESG factors in investment decisions, he said.
“What you’re seeing a lot of people worried about are what I call ‘inadvertent ESG funds’,” he said.
Opting in, conversely, is “an approach the SEC will certainly consider,” he said.
A group of attorneys general for New York, California, Delaware, Illinois, Maryland, Minnesota and New Jersey said they supported virtually every aspect of the proposed ESG disclosure rule, but they still offered ideas for improvement.
Specifically, non-ESG funds should make themselves known, and thus not have to worry about compliance, the group wrote.
“The final rule should allow funds that do not adopt any type of ESG moniker to affirmatively disclose early in their prospectuses and annual filings … that they do not consider ESG factors in their investment decision making,” the comment letter read. “Any fund that provides this clear and upfront disclosure will have affirmatively put investors on notice that they are not an ESG fund and thus will not have an obligation to provide further ESG disclosures mandated under any final rule.”
Meanwhile, the head of one socially responsible investment firm asked the SEC to go a step further in disclosure requirements.
“The proposal fails to draw a sharp distinction between investment strategies that use ESG data for the sole purpose of selecting or weighting companies that advisers believe will outperform financially, and those strategies that use ESG data for the purpose of investing more in companies that advisers believe will actually help humanity and the world in some way,” said Humankind Investments CEO James Katz, in his letter.
“Without a distinction between business risk-driven and ethics-driven strategies, investors who come to the table with ethical concerns may be duped into investing in ‘ESG’ products that only aim to minimize business risks.”