The Securities and Exchange Commission’s proposed rules on environmental, social, and governance disclosure obligations would “separate the wheat from the chaff,” by more starkly dividing investment advisors simply touting ESG strategies in their investment processes versus those that are truly incorporating them, according to several securities legal experts.
“Going forward, (it would) permit investors to discern, by evaluating disclosures, which funds and advisors are more serious about the ESG-related issues that they are involved in and evaluating,” said Amy Greer, a partner and co-chair of the North American Financial Regulation and Enforcement Practice at Baker McKenzie.
On Wednesday, SEC commissioners voted 3-1 in favor of the proposed rules (with Commissioner Hester Peirce the lone dissenting vote). The changes would require funds and investment advisors to provide more detailed disclosures on ESG strategies and methodologies in fund prospectuses, annual reports and advisor disclosure documents like Form ADVs.
The proposed rule follows numerous risk alerts and guidance from the SEC pertaining to ESG investments, as well as proposing rules to standardize disclosures for issuers. Chair Gary Gensler said the new proposal “gets to the heart” of the SEC’s mission by mandating disclosures touting an ESG focus.
“ESG encompasses a wide variety of investments and strategies,” he said. “I think investors should be able to drill down to see what’s under the hood of these strategies.”
While much of the new rule pertains to asset managers, RIAs that incorporate ESG strategies will also be impacted, particularly by proposed changes in Form ADV Part 2A.
Those disclosures would help clients better understand the investing approach an advisor uses, "as well as compare the variety of emerging approaches, such as employment of an inclusionary or exclusionary screen, focus on a specific impact, or engagement with issuers to achieve ESG goals,” the proposal read.
Advisors who do not market their services as using ESG strategies won't need to stipulate that fact explicitly, according to Dan Bernstein, MarketCounsel’s chief regulatory counsel. But those who partially integrate ESG strategies without much consideration to client disclosures could face a heavier lift.
“Most importantly, whatever they disclose and market, they have to follow it,” he said. “The rule will now mandate certain disclosures rather than suggest them as best practices.”
The Form ADV amendments would be where advisors would see the most impact, according to Jennifer Klass, the partner and co-chair of Baker McKenzie’s Financial Regulation and Enforcement Practice. Advisors would have to disclose not only their ESG methodology and process, but also approaches to proxy voting and whether they have affiliates that are themselves ESG providers.
Advisors would also need to tread cautiously when marketing their ESG strategies to ensure any advertising is consistent with the practice. She said the most onerous obligations would fall on advisors who have ESG strategies as a centerpiece of their practice, as the SEC would require they weave the ESG aspect into all relevant disclosures.
“I think part of the ESG objective here is to separate out the advisors who are just talking ESG but aren’t really incorporating that into their strategies in a meaningful way, from those who are really incorporating it into what they do day-to-day,” she said.
In a statement accompanying her vote against the proposal, Peirce argued that the rule would avoid explicitly defining "ESG" yet mandate disclosures to “induce substantive changes in funds’ and advisers’ ESG practices.” She also referenced the Enforcement Division’s recently settled charges with BNY Mellon Investment Adviser, which was accused of misrepresenting the ESG scrutiny applied to certain funds on clients’ disclosure documents.
“Yet while enforcement proceedings of this sort illustrate the problem, they also show that we already have a solution; when we see advisers that do not accurately characterize their ESG practices, we can enforce the laws and rules that already apply,” Peirce said. “A new rule to address greenwashing, therefore, should not be a high priority.”
But enforcement would not address the concern at stake in the proposal, which is to help investors compare existing advisors and funds using ESG screens, according to Greer.
“Enforcement identifies failures,” she said. “And if there’s not a regulation or rule or law to compare it against, investors don’t have anything to evaluate.”
The rule now goes to public comment for 60 days. Greer said even after a final rule is issued it would be a long time before any proposed changes become mandatory (she also expected a wave of litigation challenging a finalized ESG-related rule).
In the meantime, Bernstein expected there to be more enforcement actions like the BNY Mellon case, following on the SEC’s repeated risk alerts and emphasis on ESG in its annual exam priorities.
“There’s a difference between aspirational and actual. You’ve got to make sure all your marketing documents and disclosures are not aspirational, but actual,” he said. “I think we’ll see a continued focus on firms that disclosed things that were not being practiced."