The U.S. Securities and Exchange Commission (“SEC”) has announced it has proposed to amend Investment Advisers Act of 1940 (“Advisers Act”) and the Investment Company Act of 1940 (“Investment Company Act”) requiring additional disclosures related to their Environmental Social and Governance (ESG) practices. The new disclosure rules aim to provide more consistent, comparable, and reliable information that is material to decision making for retail investors who seek to prioritize socially responsible investments.
Where Will New Disclosures Be Required?
Under the amended rules, registered advisers and investment companies, as well as some advisers and business development companies that are exempt from registration, will be required to provide disclosures on their fund prospectuses, annual reports, and adviser brochures as well as ADV Part 1A and Forms N-CEN for index funds.
Incorporated into the disclosure forms will be uniform terms for advisers and firms to use when identifying their strategies, giving investors better opportunity to compare different approaches:
- ESG-Integrative strategies consider ESG factors alongside other non-ESG factors like company price-to-earnings ratios, and macroeconomic trends.
- ESG-Focused strategies use ESG factors as a significant consideration in inclusion or exclusion of specific investments and may involve more proxy voting or direct engagement.
- ESG-Impact strategies drive measurable ESG outcomes and target their investments based specifically on a particular described impact.
Further, the disclosure rules would require advisers or firms to disclose specific information depending on their marketing claims. For example, firms claiming to prioritize “environmental” funds will need to report greenhouse gas emissions numbers.
Firms will be required to describe their impact goals, whether their focus is faith-based, sustainability, diversity and inclusion, or another cause, providing measurable metrics. They also will need to summarize progress on achieving their specific impact(s) in both qualitative and quantitative terms, and annually evaluate the manager’s ability to achieve the impact.
Disclosures related to the adviser’s proxy voting on ESG matters will also be required, and firms will need to demonstrate that their proxy voting aligns with their stated ESG policies and procedures.
SEC’s Increased Focus on ESG
These amendments come as no surprise as the SEC has become heavily focused on ESG factors over the past several years. As demand for socially responsible investments has continued to dramatically rise over the past decade, many ESG-focused investments and services have become available. Registered investment companies and investment advisers have increasingly marketed the ability to provide investors with socially responsible investment options.
The SEC has noted that due to the wide variety of approaches, unclear definitions, and a lack of disclosure requirements, information provided to investors is often confusing, misleading, or false, and creates a substantial risk. In fact, it was such a concern that ESG was the topic of a Risk Alert the SEC issued in 2021.
The Commission has also named ESG investments as an exam priority for 2022, announcing it will review RIA’s compliance policies and procedures, confirming they match firm disclosures and are consistent with all marketing and advertising.
In order to hold registered investment companies and investment advisers accountable for ESG-related misconduct, the SEC appointed a 22-person enforcement task force last year and has brought charges against firms they have found that have made false statements or misled investors.
How Can Core Compliance Help You Prepare
Given the SEC’s continued focus on ESG investing, registered advisers and investment companies will benefit from a strategic approach toward tightening their compliance practices with regard to ESG investments whether or not these particular proposed amendments pass. These include but are not limited to:
- Develop or revise policies and procedures to include your approach toward ESG investments. Clearly define ESG terminology and goals, as well as your firm’s processes for researching investment options, performing due diligence, and selecting and monitoring investments with regard to ESG performance.
- Ensure processes for due diligence are performed and documented in line with policies and procedures to ensure third-party consultants and investments are aligned with your firm’s stated ESG practices and goals.
- Document and disclose how your firm’s portfolio management process is aligned with your policies and procedures.
- Add ESG reviews to your firm’s compliance calendar to confirm that your policies and procedures, disclosures, and marketing materials are consistent and accurate regarding ESG.
Core Compliance specializes in creating and reviewing firm’s policies and procedures, compliance practices and disclosure documents and can help your firm stay ahead of these changes. We can help ensure that your marketed ESG approaches are compliant and align with your policies, procedures, and disclosures, and you have internal controls that mitigate your risk. Contact us at 619.278.0020 to schedule a consultation.