By Jon-Luc Dupuy, Abigail P. Hemnes, and Cal J. Gilmartin, K&L Gates LLP
February 14, 2022
In an April 2021 risk alert titled “The Division of Examinations’ Review of ESG Investing,” the SEC staff stated that attention will continue to be focused on whether investment advisers “are accurately disclosing their [environmental, social and governance (“ESG”)] investing approaches and have adopted and implemented policies, procedures, and practices that accord with their ESG-related disclosures.”
The alert identified three areas of focus: disclosure, compliance, and marketing. Advisers should facilitate coordination across these groups to help protect against any allegations of “greenwashing” where investor communications do not align with investment practices.
One area that advisers should pay particular attention to is Rule 35d-1 (the “Names Rule”) under the Investment Company Act of 1940. While the Names Rule is not applicable to all investment products, any advisers seeking to integrate ESG and create corresponding policies and procedures can be informed by the approaches that registered investment companies have taken historically and should themselves begin reconsidering now.
In March 2020, the SEC published a request for public comment on whether the Names Rule should “apply to terms such as ‘ESG’ or ‘sustainable’ that reflect certain qualitative characteristics of an investment.” Potential amendments to the Names Rule continue to be listed on the SEC’s Regulatory Flexibility Agenda, and recent statements by SEC Chair Gary Gensler and other senior SEC officials suggest the amendments may require funds with names that include ESG-related terminology to adopt policies to invest at least 80% of their net assets in ESG investments.
Indeed, many fund sponsors are already receiving comments to this effect from the SEC staff when launching new funds with ESG-related terminology in their names. The current version of the Names Rule would not apply to funds that incorporate ESG factors in their strategies if they do not include ESG terminology in their names.
But how do you define ESG investments?
The Names Rule requires a fund with a name that suggests investment in certain types of investments to adopt a policy to invest, under normal circumstances, at least 80% of the value of its assets in the particular type of investment (an “80% Policy”). Historically, the SEC has not applied the Names Rule to names that correspond to a particular investment strategy. Unlike traditional Names Rule terms such as “real estate” or “large capitalization” that are broadly understood and easily quantified, ESG investing is frequently a subjective aspect of a fund’s strategy, often tied to an individual adviser’s own ESG criteria. While funds may use any reasonable definition for terms within an 80% Policy, defining ESG requires measuring a concept that many in the industry have historically viewed as an investment strategy, rather than a type of investment.
Below are some of the more common approaches taken by funds that already elect to include ESG concepts in 80% Policies and various considerations related to each approach. These approaches have largely been developed in response to SEC comments, in particular where a fund is reliant upon the SEC to be declared effective. This is by no means an exclusive list, and examples abound of funds that use combinations and permutations of these approaches.
Approach: The adviser establishes a model or itself assigns individual scores to portfolio companies using specific proprietary ESG criteria to analyze and compare potential investments.
Considerations: This approach can be more costly and time consuming to create, especially when considering whether and to what extent third-party data and resources are used. The methodology should be documented and measurable. Can it be recreated after the fact to support the results? Is there any discretion to adjust scores? How are different sectors/industries weighted against the ESG criteria?
Approach: The adviser establishes specific ESG criteria that are used by portfolio managers to judge potential investments.
Considerations: This approach is more flexible to implement, but more difficult to substantiate against compliance controls and marketing materials. Even more than other approaches, disclosure should clearly outline the factors considered and how proprietary and third-party research influences the analysis, if at all. How much variance is permitted when a potential investment is only strong in one or two of the ESG factors?
Approach: The 80% Policy is tied to the securities included in an index or similar grouping of securities.
Considerations: An index-based approach makes it easy to document compliance, but limits the universe of investments and opportunities for the adviser to apply its own ESG criteria. If relying on third-party resources, certain information and data may be incomplete, inaccurate, or unavailable.
Approach: This “top-down” approach excludes “bad” ESG criteria (e.g., weapons, coal) and/or focuses on “good” ESG criteria (e.g., renewable energy, women and minority-owned businesses).
Considerations: Focusing on narrowly described themes can limit the universe of investments and opportunities to diversify, but also simplifies compliance documentation. If only screening out “bad” ESG, how much of the resulting portfolio would be considered “good” ESG? If focusing on “good” ESG, how does the strategy account for investments strong in one or two of the ESG factors and weak in others?
Approach: With this type of approach, investments are intended to generate social benefits and/or focus on companies that demonstrate willingness to engage with ESG initiatives.
Considerations: How is the impact measured, and how long is the time horizon to judge results? Even more than other approaches, ESG must be considered for proxy voting policies. How much variance is permitted when a potential investment is only strong in one or two of the ESG factors?
Regardless of which approach best suits a particular fund, the disclosure describing the 80% Policy and ESG considerations should be clear and approachable to help investors understand how ESG factors are, or are not, applied to investment decisions. The disclosure should also be consistent with the fund’s marketing materials and compliance program. Fund sponsors should consider how an individual fund’s disclosure fits within the broader scope of ESG integration across affiliated products that may be subject to different regulatory schemes and/or jurisdictions.
ESG means different things to different people. This is likely to continue to be the case, despite the potential for more specific ESG guidance and regulation in the U.S. fund industry. The lack of consensus only amplifies the importance of clarity and consistency in disclosure and investment practices for individual funds and their sponsors.
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Jon-Luc Dupuy and Abigail Hemnes are partners and Cal Gilmartin is an associate in K&L Gates’ Boston office. They are members of the firm’s Asset Management and Investment Funds practice group.
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