SEC proposes enhanced ESG disclosures with significant repercussions for private funds, private wealth advisers, and broker-dealers
Hilary Sunghee Seo
C. Wallace DeWitt
09 June 2022
The proposing release expresses the concern that investors face a lack of consistent, comparable, and reliable information among investment products and advisers that claim to consider one or more ESG factors; and that in the absence of rules tailored to ESG investing, advisers and funds may fail to match investor expectations. The Proposed Rule would therefore require prescriptive ESG-related disclosures that the SEC believes will lead to a “consistent, comparable, and decision-useful” regulatory framework to inform investors about ESG services and products.
This commentary focuses on the implications of the Proposed Rule for advisers that advise private funds and high net-worth individuals, as well as for SEC-registered broker-dealers.4 The Proposed Rule would affect all advisers with ESG-related objectives and, in particular, would significantly increase the ESG-related compliance and disclosure obligations of RIAs. In addition, advisers and SEC-registered broker-dealers (including the associated persons thereof) that engage in marketing and sales of products that include ESG-related objectives would need to ensure that they understand them, as well as their own ESG-related practices, and maintain policies, procedures and controls designed to ensure conformity with applicable regulatory requirements. For many firms, these obligations are likely to require considerable investments of resources and time to, among other things:
- evaluate, standardize and categorize products and services that consider ESG factors;
- upgrade systems to track and input relevant ESG metrics and developments; and
- centralize and enhance policies, procedures and controls to reasonably prevent inadvertent non-compliance.
1. Proposed ESG disclosure requirements for advisers
- An ESG-integration strategy is one where the RIA “consider[s] one or more ESG factors alongside other, non-ESG factors in [providing] investment advice, but such ESG factors are generally no more significant than other [non-ESG] factors in advising [the RIA’s] clients, such that ESG factors may not be determinative in providing advice with respect to any particular investment.”
- An ESG-focused strategy is one where an RIA “focuses on one or more ESG factors by using them as a significant or main consideration in advising [the RIA’s] clients with respect to investments or in [its] engagement strategy with the companies in which [the RIA’s] clients invest.”5
- An ESG-focused strategy would also be classified as an ESG-impact strategy if the RIA seeks to “achieve a specific ESG impact or impacts” with respect to a significant investment strategy or method of analysis.
The SEC states that the ESG-integration / focused / impact taxonomy for Adviser strategies is generally similar to the corresponding definitions proposed for registered funds in the Proposed Rule. Moreover, the SEC states that it believes ESG-integration and ESG-focused strategies are distinct investment advisory strategies that would not be employed together in one investment strategy, and requests comment on whether the distinction is sufficiently clear. Commenters should also consider whether the distinction is appropriate, including, whether a strategy should be classified as ESG-focused simply because it applies a screen to include or exclude investments based on ESG factors.6 For example, an ESG factor-based-screen, particularly an exclusionary one, may not be sufficiently material to warrant it being considered a “significant or main consideration” in advising the RIA’s clients.The SEC requests comment on whether the required “ESG-focused” classification would “raise concerns that investors would be misled into believing [a] screen is more comprehensive than it is.”7
Other additional disclosures that would be required in the Form ADV Part 2A brochure include:
- A description of the criterion and methodology used to evaluate, select or exclude investments, including whether and, if so how the RIA uses:
o an internal methodology, a third-party methodology (such as a scoring provider or framework) or a combination of both, including an explanation of how the adviser evaluates the quality of relevant third-party data;
o an inclusionary or exclusionary screen, an explanation of the factors the screen applies; and/or
o an index, including the name and description of the index and how it utilizes ESG factors in determining its constituents;
- An RIA that employs an ESG-impact strategy would need to explain the impact(s) the RIA seeks to achieve, how it will achieve such impact(s), the key performance indicators and relevant time horizons it will use to analyse progress, and the relationship between the impact sought to be achieved and financial return(s);
- A description of any relationship or arrangement material to the RIA’s business or clients that the RIA or its management persons have with any related person that is an ESG consultant or ESG service provider, and how the RIA addresses any conflicts of interest with clients;
- If the RIA has specific voting policies or procedures that include one or more ESG considerations, a description of those ESG factors and how the RIA considers them, whether clients can direct the RIA’s vote; and
- For RIAs that sponsor wrap fee programs, an explanation of whether and, if so how, they consider ESG factors when selecting, reviewing or recommending portfolio managers; a description of any criteria or methodology used to assess portfolio managers’ applications of relevant ESG factors, who conducts that review (the RIA or a third party) and the nature of that review; an affirmative statement, if applicable, that neither the RIA nor a third party assesses portfolio managers’ applications of relevant ESG factors and/or an explanation that the portfolio managers’ applications of the relevant ESG factors may not be calculated, complied, assessed, or presented in a consistent manner) and, if that is the case, why such limitations exist.
In general, an RIA with multiple significant strategies that each consider ESG factors differently would have to describe them separately.
In addition, the Proposed Rule would amend Form ADV Part 1A to require both RIAs and exempt reporting advisers to disclose specified ESG-related information.
2. Policies and procedures guidance
The SEC states that different ESG strategies – whether integration, ESG-focused, or impact strategies – will necessarily require different compliance approaches. The SEC cautions that its staff have observed a range of compliance practices that do not effectively address ESG factors and provides several specific examples of effective ESG-related disclosure, policies, procedures, and practices. These examples should be of interest not only to RIAs but also to exempt reporting advisers, who, while exempt from many of the substantive requirements under the advisers Act and its implementing rules, are nevertheless still subject to federal anti-fraud provisions, including advisers Act Rule 206(4)-8, which prohibits advisers to pooled investment vehicles from making false or misleading statements to existing or prospective investors.
3. Considerations for advisers and broker-dealers
Advisers should take steps now to prepare themselves for enhanced ESG-disclosure requirements and heightened regulatory scrutiny of their ESG practices. Although the final rules, if and when adopted, may depart materially from the Proposed Rule, many of the proposed measures are likely to find their way into any rule that is ultimately adopted by the SEC. It would behove advisers to begin consideration of how the Proposed Rule may affect their business or compliance.
Specifically, advisers should consider taking the following steps:
- Evaluate the firm’s current ESG offering and practices, including taking inventory of the specific ESG factors it considers and how they are used in formulating investment strategies and in selecting and managing investments to achieve stated ESG objectives.
- Confirm that the firm’s regulatory disclosures and marketing materials are consistent with what the firm does in practice, focusing on consistency across various product categories (e.g., registered funds, private funds and separately managed accounts).
- Create and apply a consistent taxonomy of ESG factors, criteria, and methodology to the firm’s full product suite, including introduction of period review and update mechanisms to account for new products and other industry and regulatory developments.
- As much as possible, standardize the ESG-characteristics of products and services and categorize them according to relevant ESG-factors, criteria and/or methodology, in order to facilitate their access and appropriate deployment by financial advisors in making investment recommendations and managing investment portfolios.
- Conduct a central review of existing compliance policies, procedures, and controls. Firms should confirm that their existing compliance architecture mitigates the risk of inadvertent mismatches between the firm’s stated ESG objectives and its practice. For example, if marketing materials state that the firm adheres to a particular global ESG framework or that it uses ESG-related positive or negative screens, are the firm’s compliance policies, procedures and controls reasonably designed to ensure its investment practices and processes align with those statements? If the firm permits clients to specify ESG-related preferences or goals, are there controls and supporting infrastructure reasonably designed to ensure financial advisers are able to meet these objectives?
- Educate and train financial professionals to ensure that they adequately understand the firm’s approach to ESG products and services. Representatives should be equipped to articulate the firm’s ESG practices and objectives and to put these into effect in managing client portfolios or making investment recommendations.
- Strengthen supervisory functions and processes. Firms should review and confirm that their internal reporting structures and processes for monitoring and stress testing ESG-related offerings, disclosures and metrics are sufficiently robust.
Although the Proposed Rule does not purport to regulate broker-dealers, to the extent that an SEC-registered broker-dealer recommends or distributes ESG-related products, many of the foregoing considerations are likely to impact the process. For example, broker-dealers and their associated persons should ensure that they understand the material ESG characteristics of the products and services they recommend to customers and potential customers, as such an understanding will be essential to compliance with any applicable suitability requirements and Regulation Best Interest. Like advisers, broker-dealers should review their existing policies, procedures, and controls relating to, without limitation, the classification of existing ESG products, onboarding new products, managing conflicts, ensuring fair and balanced communications, and accurate disclosures.
4. Comment period; compliance dates
As of this writing, the release accompanying the Proposed Rule has not yet been published in the Federal Register. The comment period for the Proposed Rule will close 60 days following such publication.
If adopted as proposed, the amended disclosure rules governing advisers would be subject to a one-year transition period after the effective date.
1 For an adviser entity whose principal office and place of business is outside of the United States, it is permitted not to register with the SEC and to operate as an exempt reporting adviser if it has no client that is a United States person except for one or more qualifying private funds, and all assets managed by it in the United States are attributable to private fund assets the total value of which is less than $150 million.
2 See Enhanced Disclosures by Certain Investment advisers and Investment Companies about Environmental, Social, and Governance Investment Practices, Rel. Nos. IA-6034 & IC-34594 (May 25, 2022), available at https://www.sec.gov/rules/proposed/2022/ia-6034.pdf. See also Fact Sheet: ESG Disclosures for Investment advisers and Investment Companies (May 25, 2022), available at https://www.sec.gov/files/ia-6034-factsheet.pdf.
3 See Investment Company Names, Rel. Nos. 33-11067; 34-94981; IC-34593 (May 25, 2022).
4 This commentary does not address the provisions of the Proposed Rule relating to registered funds or the Names Rule Proposal.
5 Unlike its proposal for registered funds, the SEC does not propose to require different levels of disclosure for an ESG-integration versus an ESG-focused strategy (unless the ESG-focused strategy is also an ESG-impact strategy).
6 In Question 37, the SEC states, “[a]s proposed, funds that apply an inclusionary or exclusionary screen would be considered an ESG-Focused fund regardless of how extensive or narrow the screen is.”