The U.S. Securities and Exchange Commission convened for a public hearing Wednesday afternoon, during which the commissioners voted to propose two different regulations, the first focused on fund naming rules and the second on new mandatory disclosures by registered investment advisers related to environmental, social and governance investment practices.
The first regulation is referred to as “ESG Disclosures for Investment Advisers and Investment Companies.” According to the SEC’s fact sheet about the proposal, ESG strategies have existed for decades, but investor interest in these strategies has rapidly increased in recent years, with significant inflows of capital to ESG-related investment products and advisory services.
As the fact sheet points out, asset managers have responded to this increased demand by creating and marketing ESG products. In practice, the SEC says, the ways that different funds and advisers define ESG can vary widely. Similarly, there are significant differences in the data, criteria and strategies used as part of ESG strategies.
According to the majority of the SEC commissioners, the lack of disclosure requirements and a common disclosure framework tailored to ESG investing make it harder for investors who seek to understand which investments or investment policies are associated with a particular ESG strategy. In the absence of informative disclosures, the SEC says, a fund or adviser disclosure could exaggerate its actual consideration of ESG factors.
“The proposed rule and form amendments are designed to provide consistent standards for ESG disclosures, allowing investors to make more informed decisions as they compare various ESG investments,” the fact sheet states. “The proposal’s framework for ESG-related strategy disclosure is designed to allow investors to determine whether a fund’s or adviser’s ESG marketing statements translate into concrete and specific measures taken to address ESG goals and portfolio allocation. The proposal also requires certain environmentally focused funds to disclose information regarding the greenhouse gas emissions associated with their portfolio.”
According to the fact sheet, the proposed changes would apply to registered investment companies, business development companies, registered investment advisers and certain unregistered advisers. They would enhance disclosure by requiring additional specific disclosure requirements regarding ESG strategies in fund prospectuses, annual reports and adviser brochures; by implementing a “layered, tabular disclosure approach” for ESG funds to allow investors to compare ESG funds at a glance; and by generally requiring certain environmentally focused funds to disclose the greenhouse gas emissions associated with their portfolio investments.
Separately, the SEC also voted Wednesday afternoon to propose amendments to its fund “Names Rule,” and in doing so it also published a fact sheet regarding the amendments.
As detailed in the fact sheet, the name of a registered investment company or business development company communicates information about the fund to investors and is an important marketing tool for the fund. As such, the Names Rule helps ensure that a fund’s name accurately reflects the fund’s investments and risks.
“As the fund industry has developed and practices regarding Names Rule compliance have continued to evolve over the past two decades since the rule was adopted, improvements to the Names Rule would help ensure that it continues to meet its purpose,” the fact sheet states.
The proposal specifically seeks to modernize the “80 percent Investment Policy Requirement.” This part of the broader Names Rule currently requires funds with certain names to adopt a policy to invest 80% of their assets in investments suggested by that name. The proposal would expand this requirement to apply to any fund name with terms suggesting that the fund focuses on investments that have, or investments whose issuers have, particular characteristics. This would include, for example, fund names with terms such as “growth” or “value” and those indicating that the fund’s investment decisions incorporate one or more environmental, social, or governance factors.
Further, to address the rule’s application to derivatives investments, the proposal would require a fund to use a derivatives instrument’s notional amount, rather than its market value, for the purpose of determining the fund’s compliance with its 80% investment policy.
Technically speaking, this second proposal would impact the SEC’s Rule 35d-1 under the Investment Company Act of 1940. According to the majority of SEC Commissioners, the proposed amendments would further serve the SEC’s mission of investor protection by improving and expanding the current requirement for certain funds to adopt a policy to invest at least 80% of their assets in accordance with the investment focus the fund’s name suggests; by providing new enhanced disclosure and reporting requirements; and by updating the rule’s current notice requirements and establishing recordkeeping requirements.
According to the fact sheet, the proposal would specify the particular circumstances under which a fund may depart from its 80% investment policy, such as sudden changes in market value of underlying investments, including specific time frames for returning to 80%. Further, the proposal would prohibit a registered closed-end fund or business development company whose shares are not listed on a national securities exchange from changing its 80% investment policy without a shareholder vote.
“This prohibition would ensure these investors could vote on a change in investment policy given their limited options to exit their investments if the change were made,” the fact sheet states.
Moreover, the proposal would include a number of amendments to provide enhanced information to investors and the Commission about how fund names track their investments. The proposal would require fund prospectus disclosure that defines the terms used in a fund’s name. To this end, the proposal also includes amendments to Form N-PORT to require greater transparency on how the fund’s investments match the fund’s investment focus.
The proposal would, furthermore, require funds to keep certain records regarding how they comply with the rule or why they think they are not subject to it.
Finally, under the proposal, a fund that considers ESG factors alongside, but not more centrally than, other non-ESG factors in its investment decisions would not be permitted to use ESG or similar terminology in its name. Doing so would be defined to be materially deceptive or misleading. For such “integration funds,” as the SEC refers to them, ESG factors are generally no more significant than other factors in the investment selection process, such that ESG factors may not be determinative in deciding to include or exclude any particular investment in the portfolio.
The proposal would retain the current rule’s requirement that, unless the 80% investment policy is a fundamental policy of the fund, notice must be provided to fund shareholders of any change in the fund’s 80% investment policy. The proposal would update the rule’s notice requirement to expressly address funds that use electronic delivery methods to provide information to their shareholders.
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