SEC investigators looking into ESG-related investing are intensely interested in the consistency of the language funds use to disclose information to investors, a panel of industry experts said.
Recent changes in disclosure-based rules have made communication with investors a priority, but disclosures related to environmental, social, governance (ESG)-related investing attract particular attention, according to lawyers and regulatory officials at the annual Securities Enforcement Forum held Nov. 15 in Washington D.C.
“From the SEC’s perspective, if you’re making a statement about ESG, the SEC’s going to consider it to be material,” according to Kelly Gibson, co-leader of the enforcement practice at Morgan Lewis, one of several members of a panel focused on recent SEC rulemaking.
The focus on public statements about ESG is so intense that it’s probably not worth making the argument that some of the statements SEC officials ask about are not material, Gibson said.
The SEC has proposed two ESG-related rules for funds and registered investment advisers.
One would require funds whose names refer to ESG or sustainable investing to dedicate at least 80% of their assets to investment strategies consistent with the terms used in their names or descriptions. The second rule would establish three classifications that would impose different disclosure requirements depending on how ESG-focused the fund’s strategy was.
Both proposals responded to a perceived need to define terms related to ESG and standardize marketing practices of funds created to take advantage of the rising popularity of ESG among fund investors, especially retail investors. SEC officials have repeatedly said the proposed rules and their enforcement efforts are focused on the need for fund firms to follow investment strategies consistent with the terms they use in their names and marketing materials rather than simply using ESG-related language to attract investors.
The proposed ESG rules reflect regulator’s view that a company’s marketing language around ESG could matter to investors even if it did not directly represent the company’s financials, according to another panel member, Carolyn Welshhans, associate director at the SEC’s Division of Enforcement.
“It’s not just quantitative. It’s not just, does something impact the bottom line?” Welshhans said. “There can be other ways that information can be material to a business, and some of the guidance around the rules in the proposals … get to that concept, that something can be material to a company, for example, specific to that company’s business or its operations, not just its financial statements.”
The current staff of the SEC clearly views all public statements involving ESG as within the scope of regulating ESG disclosures, according to Gibson.
“Especially where you’re making pronouncements that are of a definitive or categorical nature, these are things that we’re that we’re seeing the SEC drill down on, on the investigative side but also on the examinations side,” Gibson said.
Gibson offered a list of actions asset managers could take to get ahead of compliance with the ESG rules that would define ESG-related funds according to how focused on ESG they are in their investment decisions and objectives.
First, she said, fund managers have to decide which of the three categories they want to find themselves in, if any, and make sure they know what the requirements are for each one.
“Then look at your policies and procedures [and compare them] against your investment practices to make sure that they all align,” Gibson said.
There is no firm definition for many ESG terms, however, and it is unclear how far fund managers have to go to demonstrate they are living up to their promises, according to Andy Sohrn, an examinations manager in the SEC’s Los Angeles Regional Office who spoke at the SEC’s Compliance Outreach Program seminar that was also held Nov. 15.
If, for instance, an asset manager tells customers that it does not invest in oil and gas companies but does not clarify that it does invest in companies that have oil and gas subsidiaries, should the asset manager be faulted for misleading disclosures?
There is no final answer to many ESG questions, but most of the interim discussions seem to involve as much disclosure and detail as possible, Sohrn said.
“The importance of being specific in disclosures and marketing cannot be understated,” Sohrn said.
It’s also important to be sure the people involved in marketing or managing the fund, not just the documents describing it, are clear on what specific ESG terms mean and how those concepts relate to the strategy or operation of the fund, she said.
Someone at the firm should also go through company presentations, due diligence questionnaires and other types of internal communications, to make sure they reflect the same picture of ESG principles and strategy as well, she said.
Public comments were unusually heavy for both fund-focused ESG rule proposals, but neither is close to approval. The comment period for both was reopened for two weeks in October after a technical glitch prevent the SEC from receiving some comments on 11 different proposals, which could delay finalization even further.
Representatives of the SEC Enforcement Division and SEC Chair Gary Gensler have consistently said, however, that the commission would continue to enforce ESG-related names and terminology under the existing names rule, which forbids fund names or marketing material content that could mislead potential investors about risks or investment strategies.
FD editor Kevin Fogarty contributed to this report.