09 July 2021

“How to Be ESG” — A Registered Fund Board’s Guide to ESG Compliance

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How can directors of mutual funds and exchange-traded funds (ETFs) that focus on environmental, social, and governance (ESG) investing prepare for the increased regulatory scrutiny by the U.S. Securities and Exchange Commission (SEC)? The SEC, which is primarily concerned with “greenwashing,” the practice of conveying a false image to investors that a product is ESG-friendly, is focused on registered funds’ disclosures, controls, and policies and procedures.

ESG investing can fall squarely in the fund directors’ primary oversight role. As part of their fiduciary duty to a fund, boards must oversee the fund’s compliance function, proxy voting disclosures, investment performance, and risk management. Fund boards will need to educate themselves on the fund’s ESG-related investments, disclosures, practices, fund performance, written policies and procedures, and stewardship activities.

In this post, we offer practical steps that fund boards can take and key questions they might ask to satisfy their oversight obligations with respect to ESG investing. Some of those questions, which are discussed in more detail below, include (i) Does the fund have “ESG” in the name, and does the Names Rule apply? (ii) Do the fund’s disclosures accurately reflect and not overstate the fund’s ESG investing and stewardship activities? (iii) What data and criteria does the fund have in place to ensure it is meeting investors’ targets? (iv) Does the fund have appropriate controls, policies, and procedures in place around ESG investing? (v) How does the manager view the interplay between an ESG investing mandate and performance for shareholders?

SEC’s ESG Developments 

Early indications of the SEC’s focus on ESG investing by registered investment companies began as early as March 2020, rapidly increased under Acting Chair Allison Lee, and have continued under Chair Gary Gensler, who was sworn into office on April 17, 2021.

In March 2020, the SEC requested public comment on the Names Rule under the Investment Company Act of 1940, which prohibits a registered investment company from adopting a materially deceptive or misleading name and requires the fund to invest at least 80 percent of its assets in the manner suggested by its name. In the request, the SEC noted that funds with “ESG” in their name consider applying the Names Rule depending on whether they treat ESG as an investment strategy (to which the rule does not apply) or investment type (which is subject to the rule). The SEC requested comment on whether the Names Rule should apply to terms such as “ESG” or “sustainable,” which can reflect certain qualitative characteristics of an investment.

The SEC’s ESG focus ramped up on February 1, 2021, when, as one of her first significant public actions, Lee appointed the first-ever Senior Policy Advisor for Climate and ESG. The following month, Lee announced an Enforcement Task Force focused on climate and ESG issues and requested public input on climate change disclosures. While nearly all of the 15 questions posed in Lee’s request for public comment focused on public issuer disclosure, one item asked how the SEC’s rules should address “its oversight of certain investment advisers and funds.”

The SEC’s attention to fund advisers as part of its ESG focus became evident when the SEC’s Division of Examinations (EXAMS) published its 2021 Examination Priorities on March 3, 2021, which identified ESG disclosures by investment advisers and funds as an examination priority. On April 9, 2021, EXAMS issued a Risk Alert highlighting observations from recent exams of investment advisers, registered investment companies, and private funds1 offering ESG products and services.

Gensler has continued to focus on ESG investing. On June 14, 2021, the SEC announced its annual regulatory agenda, which included recommending proposed requirements for investment companies and investment advisers related to ESG factors, including ESG claims and related disclosures. Most recently, on July 7, 2021, in remarks before the SEC’s Asset Management Advisory Committee, Gensler expressed concern about the variability in ESG definitions and practices among funds and questioned whether the Names Rule should be updated to apply to ESG investing regardless of whether it is characterized as an investment type or investment strategy.

Areas of Focus for Registered Funds

The SEC is examining registrants for consistency and adequacy of disclosures concerning ESG investment strategies and is focused on internal definitions and criteria for selecting ESG investments. The SEC is also examining ESG-related policies and procedures and marketing materials for potential false or misleading statements. Finally, the SEC is examining proxy voting practices, and related policies and procedures, for consistency with disclosures.

Some of the deficiencies EXAMS has identified in the course of registrant examinations, as described in the Risk Alert, include instances when:
  • portfolio management practices were inconsistent with disclosures about ESG approaches
  • controls were inadequate to maintain, monitor, and update clients’ ESG-related investing guidelines, mandates, and restrictions
  • proxy voting may have been inconsistent with advisers’ stated approaches
  • advisers made unsubstantiated or otherwise potentially misleading claims regarding ESG approaches
  • controls were inadequate to ensure that ESG-related disclosures and marketing were consistent with the firm’s practices
  • compliance programs did not adequately address relevant ESG issues

What This Means for You

With the increased demand for ESG investments as an asset class, fund firms must ensure that they appropriately balance the growing market for ESG investments against the regulatory scrutiny of ESG-related marketing and disclosures. Moreover, managers that are required, or wish, to comply with the European Union Sustainable Finance Disclosure Regulation should consider how to make required disclosures in a manner that also passes U.S. regulatory scrutiny. Some questions boards might consider asking about the fund’s ESG investing include these:

  • Does the fund have “ESG” in the name? If so, does the manager view the use of ESG and the potential application of the Names Rule?
  • Do the fund disclosures state that management considers ESG factors in making investment decisions or conducts ongoing due diligence on portfolio investments for ESG factors or limit that due diligence? Do they make claims about ESG goals, metrics, or performance results? Do they make claims about management’s ESG-related stewardship activities?
  • Do the fund disclosures accurately reflect, and not overstate, the fund’s mandate and ESG practices? Does the proxy voting process demonstrate that management is exercising its stewardship activities consistent with disclosures?
  • Does management have controls in place to ensure that management is acting consistent with those disclosures?
  • Does management have written policies and procedures regarding ESG investing that are reasonably designed to prevent violations of the federal securities laws by the fund and that match up to disclosures and practices?
  • How does the manager view the interplay between an ESG investing mandate and its responsibility to deliver performance for shareholders?
  • Do the manager’s compliance professionals have sufficient insight into and oversight over the investment and/or due diligence procedures to be effective?

And as in all things, oversight depends on the facts. For some fund complexes, ESG investing is new or its scope varies fund by fund, while for others it is a well-established and central element of a firm’s investment philosophy. A board’s questions and next steps will reflect those differences.

What Should You Do?

More and more funds are pursuing ESG investing. That means you will need to be familiar with ESG investing generally and with the ESG investment goals and disclosures of the funds you oversee. There are concrete steps you can take to prepare for the increased regulatory scrutiny in this area. Those steps include:

  • educating yourself about the fund’s ESG investing by asking the right questions
  • confirming there has been consideration of the fund’s disclosures, policies and procedures, and performance profile
  • consulting with experienced counsel to make sure you are asking the right questions and seeking the right information based on the particular ESG focus of the funds you oversee

1 For an overview of private fund factors to consider, see “‘How to Be ESG’ — A Private Fund’s Guide to ESG Compliance” (June 23, 2021), available here.