SEC Proposes Regulations to Address “Greenwashing” By Investment Funds

On May 25, 2022, the SEC issued two new sets of proposed rules: “Investment Company Names” (“Names Rule”),[1] and “Environmental, Social, and Governance Disclosures for Investment Advisers and Investment Companies” (“ESG Disclosure Rule”).[2]  Taken together, these two proposed rules are intended to combat “greenwashing.”  The practice of “greenwashing” refers to when firms or companies claim they are abiding by ESG principles, especially environmental, when in fact they do not so comply.[3]  Here, the newly proposed rules provide that only funds with an ESG purpose would be permitted to label themselves accordingly, and a new set of mandatory disclosures for ESG-focused funds would enable outside parties to confirm whether such a purportedly ESG-focused fund is in compliance with its stated investment purpose.  As the SEC stated in an accompanying press release, these “proposed amendments to rules and reporting forms [would] promote consistent, comparable, and reliable information for investors concerning funds’ and advisers’ incorporation of environmental, social, and governance (ESG) factors.”[4] 

Both the Names Rule and the ESG Disclosure Rule reflect a broader agenda by the Biden Administration’s SEC to advance efforts to combat climate change through implementing regulations that will compel the financial sector to provide meaningful environmental information to governments and the investing public.  The intended (but unstated) secondary effect of such regulations is to thereby shift capital into more environmentally-conscious uses.  Although these regulatory efforts are similar to those being undertaken by other advanced economies (e.g., the European Union and the United Kingdom), there is perhaps a greater focus on the SEC’s efforts to advance President Biden’s climate agenda as most of his other efforts in this area have been stymied by Congress, leaving this initiative as one of the more prominent surviving stratagems to obtain a demonstrable degree of success.

Investment Company Names

The original names rule was adopted in 2001; the proposed Names Rule reflects an update to and revision of the original names rule.  In March 2020, the SEC requested “public comment on the framework for addressing names of registered investment companies and business development companies that are likely to mislead investors about a fund’s investment and risks . . . particularly in light of market and other developments since the adoption of [the] rule [] in 2001.”[5]  The proposed Names Rule reflects the result of that process.

The changes proposed by the Names Rule are relatively straightforward.  As stated by the SEC, “this rule helps to ensure that investors’ assets in funds are invested in accordance with their reasonable expectations based on the fund’s name.”[6]  Here, the principal thrust of the Names Rule is to specify that it applies “to any fund name with terms suggesting that the fund focuses in investments that have, or investments whose issuers have, particular characteristics . . . includ[ing], for example, fund names with terms indicating that the fund’s investment decisions incorporate one or more ESG factors.”[7]  

Besides making clear that the Names Rule expands the scope of SEC regulation to include funds labelling themselves as focused on ESG, there are a handful of other significant regulatory requirements established by the Names Rule.  In particular, one noteworthy aspect of the Names Rule is that an integration fund—defined as a fund that considers ESG factors along with one or more other factors, but does not privilege the impact of ESG factors when making an investment decision—shall not be allowed to incorporate “ESG” (or similar phrases) into the name of the fund.  Additionally, one of the more stringent technical requirements imposed by the Names Rule is that a fund—which is required to maintain eighty (80) percent of its investments in the relevant area identified by its name—may only deviate from this strict limit temporarily.  The Names Rule mandates that a firm must return to compliance with the eighty (80) percent threshold within thirty (30) days, as otherwise “departures may begin to change the nature of the fund fundamentally, which would undermine investor expectations created by the fund’s name.”[8] 

Enhanced Disclosures by Certain Investment Advisers and Investment Companies About Environmental, Social, and Governance Investment Practices

The ESG Disclosure Rule is designed to improve the consistency and comparability of ESG-related disclosures among various investment funds and advisors focused on ESG investing.  As the SEC states, the ESG Disclosure Rule “propos[es] various disclosure and reporting requirements to provide shareholders and clients improved information from funds and advisers that consider one or more ESG factors . . . [to] make more informed choices regarding ESG investing and better compare funds and investment strategies.”[9]  The ESG Disclosure Rule is designed to provide “specific requirements about what a fund or adviser following an ESG strategy must include in its disclosures,” as otherwise “the lack of a more specific disclosure framework[] increases the risk of funds and advisers marketing or labelling themselves as ‘ESG,’ ‘green,’ or ‘sustainable’ in an effort to attract investors or clients, when the ESG-related features of their investment strategies may be limited.”[10]  There are a number of specific requirements proposed; for brevity’s sake, only a handful of the most significant will be addressed here.

One of the more significant aspects of the ESG Disclosure Rule is the schematic it imposes upon ESG-related funds.  Specifically, the ESG Disclosure Rule identifies three categories of ESG funds:

• Integration Funds, which integrate ESG factors alongside non-ESG factors in investment decisions, and which would be required to describe how ESG factors are incorporated into their investment process;
• ESG-Focused Funds, which identify ESG factors as a significant or principal consideration, and which would be required to provide more detailed disclosure, including a standardized ESG strategy overview table; and
• Impact Funds, which are a subset of ESG-Focused Funds that seek to achieve a particular ESG impact, and which would be required to disclose how the fund measures progress towards this objective.  

In effect, the proposed schematic establishes a sliding scale of disclosure correlated with the degree of ESG focus of the entity, with correspondingly more detailed disclosures demanded the greater the focus on ESG by the fund or advisor in question.

Additionally, ESG-Focused Funds (and thus also Impact Funds) would be required to disclose further information concerning the GHG emissions associated with their investments.  (This requirement does not apply to Integration Funds, unless Integration Funds specifically consider GHG emissions as part of their ESG strategy.)  Specifically, these funds would disclose the carbon footprint and the weighted average carbon intensity of their portfolio—both items of interest to investors focused on environmental issues.

Political Reaction

All of the four current SEC Commissioners issued a statement concerning each of the proposed rules.  Predictably, these statements were divided along political lines—the three Democratic appointees, including Chairman Gensler, voiced support for these proposed rules, while the lone Republican SEC Commissioner, Hester M. Peirce, critiqued both of the proposed rules.

Specifically, the three Democrats serving as SEC Commissioners endorsed both the content and the purpose behind the proposed rules.  As to the Names Rule, Chairman Gensler proclaimed that it would “modernize this key rule for today’s markets and enhance the transparency of the asset management field,”[11] a sentiment echoed by Commissioner Lee (“the proposal quite sensibly seeks to align the branding of funds with the reasonable expectations of investors”)[12] and Commissioner Crenshaw (“[t]oday’s proposed rule is a step in the right direction of bringing market practices in line with investor expectations”).[13]  In essence, these Commissioners emphasized that the proposed Names Rule was necessary in order to ensure that investors who sought to invest in an ESG-focused fund would be able to do so without being deceived by a misleading label.

Similarly, with respect to the ESG Disclosure Rule, the Democratic SEC Commissioners likewise focused on the perceived need for information by investors as to the content of a self-professed ESG fund’s ESG strategy. As Chairman Gensler stated, there is an investor requirement for “consistent and comparable disclosures about asset managers’ ESG strategies so they can understand what data underlies funds’ claims and choose the right investments for them.”[14]  This principle—that the content of ESG funds’ investment strategy is a necessary and currently absent disclosure—was also echoed in comments from Commissioners Crenshaw and Lee.  As Commissioner Crenshaw remarked, in the “absence of a cohesive framework, investors are left without accurate, reliable and comparable ESG disclosures that would allow them to: understand how funds and advisers are incorporating ESG factors into investment strategies; substantially differentiate between investment products; and, measure whether funds and advisers are meeting their stated goals.”[15]  Commissioner Lee also emphasized the “increasing need for consistent, comparable, and reliable information—information to help protect investors from ‘greenwashing,’ or exaggerated or false claims about ESG practices.”[16]  Basically, these Commissioners viewed the ESG Disclosure Rule as a necessary corollary to the Names Rule, in that the ESG Disclosure Rule would compel funds to release information that would confirm whether or not they could continue to label themselves as an ESG-focused firm—with corresponding interest from investors.    

In contrast, Commissioner Peirce (the lone Republican following the departure of SEC Commissioner Elad Roisman), criticized the proposed rules.  In particular, she focused on the failure to define the meaning of ESG, which, from her perspective, created an inappropriately vague set of rules.  Specifically, with respect to the Names Rule, Commissioner Peirce characterized it as “creat[ing] more fog than [it may] dissipate,” as “names . . . associated with ESG[] will rely on subjective judgments,” due to “the breadth of terms such as ESG, growth, and value,” and this “inability to draw discernible boundaries around a centrally important term renders creative enforcement actions based on second-guessing in hindsight almost inevitable.”[17]  Further, Commissioner Peirce expressed the belief that “the proposal would unduly constrain advisers’ ability to make decisions that are best for the funds they manage” due to the “strict 30-day time limit on temporary departures from the 80% rule.”[18]  As to the ESG Disclosure Rule, Commissioner Peirce criticized it as unnecessary since the SEC “can enforce the laws and rules that already apply,” and, moreover, because “E, S, and G cannot be adequately defined, nor will they be” as it is impossible to “imagine an issue that would not fit within the ambit of at least one of those letters, based on someone’s reading,” rendering the “proposal[] incapable of enforcement on a practical level.”[19]  Commissioner Peirce also expressed the belief that the ESG Disclosure Rule would fail on its own terms due to the inability of companies to achieve “consistency and comparability” of data due to the variety of different methodologies used to construct “estimates [that] will differ from fund to fund,” and, further, that the ESG Disclosure Rule would improperly “set a precedent for SEC micromanagement of asset management.”[20]  

However, perhaps the most significant aspect of the political reaction to these proposed rules is the relative lack of reaction by major political figures and the media.  Unlike the SEC’s proposed mandatory climate disclosures, which provoked—and continue to provoke—substantial reaction and commentary, the reaction to these proposed rules concerning greenwashing has been relatively muted.  Although there was an initial flurry of articles and reporting on this proposal,[21] it has failed to attract the same degree of attention as certain other SEC proposals.  This is likely due to the more limited scope of these rules, as they only apply to organizations claiming to engage in ESG-conscious investing (as opposed to the climate disclosure rules, which effectively target all registered companies), and that the SEC’s proposed rules—essentially, to compel companies to avoid falsely marketing themselves as engaged in ESG investing—are already encompassed within the SEC’s existing enforcement mechanisms.  

Recent Enforcement Activity

Indeed, recent enforcement activity by the SEC has demonstrated a keen effort to combat “greenwashing,” even without the benefit of the newly proposed regulations (which have still not been finalized nor taken effect).  For example, the SEC recently issued a $1.5 million penalty against an investment advisor for “represent[ing] or impl[ying] in various statements that all investments in the funds had undergone an ESG quality review, even though that was not always the case,”[22] and has been actively investigating another asset manager in response to a whistleblower complaint that the company “overstated how much it used sustainable investing criteria to manage its assets.”[23]  On a related note, the SEC has also filed a complaint against a publicly traded mining company based in part upon “making false and misleading claims” “about the safety of [a] dam through its environmental, social, and governance (ESG) disclosures.”[24] 

These enforcement actions, targeting allegedly misleading ESG disclosures, and prosecuted under the SEC’s existing authority and regulations (without the benefit of the recently proposed ESG-specific rules), demonstrate the SEC’s focus on this issue.  Further, these enforcement actions also indicate that, in the event the SEC’s proposed rules are withdrawn or substantively weakened, it is likely that the SEC will aggressively employ its existing authority to accomplish (to the extent possible) the regulatory agenda that the proposed rules would crystallize.

Conclusion

The SEC’s proposed Names Rule and ESG Disclosure Rule are designed to combat greenwashing, and, if ultimately promulgated as written, would likely advance efforts to do so.  According to the proposed rules, investment funds and advisors would only be able to label themselves as ESG-compliant if they truly abide by those principles, and the accompanying disclosures would enable confirmation of that status.  Still, these rules are not yet final, and the comments provided during the notice period may impact the final form of these rules.  Additionally, it is possible that these rules may be challenged in the courts—likely utilizing Commissioner Peirce’s critique as a legal road map—and these rules may not survive that process, or at least not in the same form.  Further, it should be emphasized that the scope of these rules is relatively limited—they apply only to investment advisors and funds, rather than the vastly wider array of all SEC registrants, who would be subject to the mandatory climate disclosure regime recently proposed by the SEC.  Finally, it must also be noted that—as demonstrated by recent enforcement activity—the SEC already has potent tools to combat greenwashing, which can be deployed against perceived violators even in the absence of these new proposed rules.

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