SEC Seeks Input on ESG Funds
Growth in ESG Investing
Environment, social, and governance (“ESG”) investing continues to experience exponential growth in the American and European marketplaces, and companies are increasingly focused on how ESG fits into their overall risk profile and growth potential, especially with regard to attracting investment. According to Morningstar, sustainable funds captured $20.6 billion in new money in 2019, almost four times the $5.5 billion seen in 2018. Moreover, approximately 85% of investors are interested in sustainable investing, according to a Morgan Stanley survey, up by almost 15% from 2015 (71%). This trend is not expected to wane, particularly as younger generations are focused on impact investing, putting their money where their interests lie. According to the Morgan Stanley survey, 95% of millennials polled in the survey expressed interest in ESG investing, and Bank of America predicts that ESG investing could hit $50 trillion by 2040.
In addition to the more socially conscious purposes behind ESG, the attention to ESG comes in the broader context of companies’ increased focus on identifying and managing risk. In August 2019, the Business Roundtable issued a new Statement of the Purpose of a Corporation, moving away from the primacy of the shareholder and towards commitments to all stakeholders, including customers, employees, suppliers, shareholders, and communities. With the climate change crisis, the #MeToo movement, and more, ESG has moved from a “nice-to-have” to a business imperative. Intel, for example, started its ESG journey twenty years ago, well ahead of the current ESG trend. Then, as now, Intel continues to make the business case for sustainability and social impact policies in order to increase efficiency and performance, reduce risk, and remain competitive in the long term. In its energy conservation project, Intel reportedly invested over $200 million, which resulted in a cumulative energy savings of more than 4 billion kilowatt hours and a cost savings of approximately $500 million through the end of 2018.
For a number of years, institutional investors have also been at the forefront of forcing positive change by making clear that they would invest their money according to certain ESG priorities. Blackrock recently issued its new Standard for Investing, noting an increasing shift by clients to focus on the impact of sustainability on their portfolios, “driven by an increased understanding of how sustainability-related factors can affect economic growth, asset values, and financial markets as a whole.” Blackrock sent letters to companies announcing that it would make investment decisions based on environmental sustainability goals because, as Blackrock notes, climate change represents risk “not only in terms of the physical risk associated with rising global temperatures, but also transition risk—namely, how the global transition to a low-carbon economy could affect a company’s long-term profitability.” Blackrock further noted that “because sustainable investment options have the potential to offer clients better outcomes, we are making sustainability integral to the way Blackrock manages risk, constructs portfolios, designs products, and engages with companies.” Similarly, J.P. Morgan Asset Management recently announced a range of initiatives in order to advance ESG solutions for clients. Some of these initiatives include: (1) developing an internal ESG framework, (2) becoming a signatory to Climate Action 100+, and (3) enhancing its engagement with companies with respect to climate change.
While climate change has understandably garnered significant attention, other ESG-related considerations, particularly related to good corporate governance, are similarly being prioritized. At the World Economic Forum at Davos in February 2020, Goldman Sachs CEO, David Solomon, announced that Goldman Sachs would not take any company public if it did not have at least one woman on its board of directors. Characterizing this announcement as formalizing advice it regularly gives to clients, Goldman Sachs has stated that a prerequisite for going public is “increased diversity of experience, gender identity, race, ethnicity, and sexual orientation on boards [which] reduces the risk of groupthink and unlocks creative and impactful solutions for their companies.” In addition, it was recently reported that Goldman Sachs’ asset management unit would institute a global policy whereby it would vote against nominating committees that fail to include at least one woman on the board.
However, this growth in ESG focus and investing has led to increased potential for confusion among the investing public as to what ESG means for a particular company, fund, or investor. One of the main reasons for the confusion is the lack of standardized metrics. Thus, assets managers are likely to take different approaches to developing an ESG portfolio. For example some may avoid certain stocks completely (like weapon or tobacco manufacturers), while others will build a portfolio considering a company’s adherence to international compliance standards (like the UN Global Compact or the UN Sustainable Development Goals). Furthermore, some asset managers may rely on third-party service providers for data and metrics on ESG. However, third-party service providers may also rely on their own in-house developed, subjective data. These varying approaches may lead to one ESG investor completely avoiding fossil fuel-related investments, and refusing to invest in the oil and gas industry entirely while another ESG investor may prioritize companies championing ESG strategies within that very same sector. Further, some 85% of S&P 500 companies now voluntarily report ESG data, although their reporting approaches and benchmarks may vary widely, primarily due to the fact that there are currently no SEC rules mandating that issuers publicly report standardized ESG data.
Together, there is growing concern that the lack of standardization may affect whether investors are really able to make informed investment decisions when trying to select ESG funds. As a result, some industry participants have asked whether the Securities and Exchange Commission (“SEC”), similar to its European counterparts, should propose rulemaking requiring standardized ESG disclosure. For example, SEC Commissioner Allison Herren Lee recently criticized the SEC for not making any attempt to address investor need for standardized disclosure on climate risk. While to date the SEC has been reluctant to propose new rules that would require companies to provide standardized ESG disclosure, SEC’s Division of Investment Management has asked for input on funds that pursue ESG investment strategies.
SEC Seeks Comments on the Names Rule (the “Request for Comment”)
As perhaps an acknowledgment of the rising popularity of ESG funds , the SEC has stepped in with the Request for Comment regarding whether Rule 35d-1 under the Investment Company Act of 1940, as amended (“Rule 35d-1” or the “Names Rule”) should apply to funds that include terms such as ESG and sustainable in their name.
The Names Rule was adopted by the SEC in 2001 and it was adopted as an investor protection measure, designed to help ensure that investors are not misled or deceived by a fund’s name. Specifically, the Names Rule prohibits any fund from adopting as part of its name “any word or words that the Commission finds are materially deceptive or misleading.” While it does not apply to fund names that describe a fund’s investment strategy or policies, it requires that a fund purporting in its name to cover a certain type of investment (e.g., stocks or bonds), industry (e.g., oil and gas, health care, etc.), or geographic area (e.g., country or region) have at least 80 percent of its assets invested in accordance with the fund’s name. The rule acknowledges the importance of a fund’s name to investors, which is often the first piece of fund information investors see, and it can substantively influence investment decisions.
In the Request for Comment the Commission acknowledged that the Names Rule has not been amended since 2001 and since that time, the investment market has obviously changed greatly. Those changes include a substantial development of index-based funds, hybrid financial instruments, and derivatives and the Request for Comment specifically seeks industry input on the applicability of the Names Rule to funds that pursue such investment strategies. With respect to ESG Funds, the Request for Comment acknowledges that “funds with investment mandates that include criteria that require some degree of qualitative assessment or judgment of certain characteristics (such as funds that include one or more environmental, social, and governance-oriented assessments or judgments in their investment mandates (e.g., “ESG” investment mandates))” may present novel challenges under the Names Rule. Indeed, the SEC further recognizes the inconsistent use of the term “ESG” among funds. Some treat it as “an investment strategy (to which the Names Rule does not apply) and accordingly do not impose an 80 percent investment policy, while others appear to treat “ESG” as a type of investment (which is subject to the Names Rule).” A recent Bloomberg article noted that more than 330 of the nearly 2,800 ESG-themed funds have “ESG” in their title, and another 162 contain the word “sustainable.” While these funds may have ESG or sustainable in their name it does not mean that they are all created equal and this may result in investor confusion or greenwashing. Recently, Peter Driscoll, Director of the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) noted that “we’re worried about if someone claims they’re ESG, are they really ESG?” He further asked, “are they taking the S&P and pulling out three or four securities and then branding themselves ESG investment style or manager?” Similarly, in the OCIE 2020 Examination Priorities, OCIE noted that it has “particular interest in the accuracy and adequacy of disclosures provided by [registered investment advisers] offering clients new types of emerging investment strategies, such as strategies focused on sustainable and responsible investing, which incorporate environmental, social, and governance (ESG) criteria.”
Based on the foregoing it is evident that the SEC is looking at how asset managers are marketing ESG funds and implementing ESG investment strategies. The Request for Comment is further evidence of their focus in this area and in particular, SEC’s desire to understand how, if at all, the Names Rule should apply to funds that include ESG or sustainable in their name. Accordingly, the Request for Comment includes general questions, such as how funds select their names and whether funds use their names to market themselves to investors or convey information about their investments and risks. It also includes more probative questions, such as whether the Names Rule is effective at preventing funds from using deceptive or misleading names, and whether the requirement that a fund invest at least 80 percent of its assets in the type of investment suggested by its name still makes sense. Regarding ESG specifically, the SEC is not only seeking comment on names and titles, but is focusing on issues that go to the very core of what is an ESG investment. The Commission asks:
Should the Names Rule apply to terms such as “ESG” or “sustainable” that reflect certain qualitative characteristics of an investment?
Are investors relying on these terms as:
describing the types of assets in which a fund invests or does not invest (e.g., investing only in companies that are carbon neutral, or not investing in oil and gas companies, or companies that provide substantial services to oil and gas companies);
indicating a strategy (e.g., investing with the objective of bringing value-enhancing governance, asset allocation or other changes to the operations of the underlying companies); or
signaling that the funds’ objectives include non-economic objectives?
Should the Names Rule impose specific requirements on when a particular investment may be characterized as ESG or sustainable and, if so, what should those requirements be?
Should there be other limits on a fund’s ability to characterize its investments as ESG or sustainable? For example, because ESG relates to three broad factors (environment, social, and governance), must a fund select investments that satisfy all three factors to use the “ESG” term?
For funds that currently treat “ESG” as a type of investment subject to the Names Rule, how do such funds determine whether a particular investment satisfies one or more “ESG” factors? Are these determinations reasonably consistent across funds that use similar names?
Instead of tying terms such as “ESG” in a fund’s name to any particular investments or investment strategies, should we instead require funds using these terms to explain to investors what they mean by the use of these terms?
The SEC requests comments on these fundamental questions by May 1, 2020. To discuss the Request for Comment and what it may mean for your business, please contact a member of the Paul Hastings