The pair of proposals by the US Securities and Exchange Commission (SEC) on May 25 concerning how environmental, social and corporate governance (ESG) funds are described to investors came on the heels of the SEC’s prior March 21 proposal about climate risk disclosures. The newer proposals set a disclosure and reporting framework for ESG investments and add provisions to the 20-year-old “Names Rule” so funds named with references to ESG compliance or similar goals must actually use that compliance criteria in the fund’s management. The proposed changes to the Names Rule are a follow-up to the ESG disclosure proposal, intended to elaborate on its guidance. The March 21 proposal set three categories of ESG funds to be covered in fund prospectuses or annual reports:
- Integration funds – consider ESG and non-ESG factors in their investment decisions. Disclosures can brief to avoid overstating ESG factors.
- ESG-focused funds – significantly center on ESG factors, so these are subject to detailed disclosures for compliance.
- Impact funds – pursue a specific ESG goal and must disclose how it measures progress toward that stated goal.
The proposed revision of the Names Rule includes a controversial provision that funds can still be non-compliant even if they meet an 80% requirement. That requirement means 80% of the investments in the fund can be characterized as having whatever trait is being included in the fund’s name, whether that’s growth, value, income, global or international, much less any ESG-related descriptions or traits.
Dissent toward the SEC Names Rule Revision
Dissenting SEC commissioner Hester Peirce said the 80% requirement could force portfolio managers to make undesirable investments just to stay compliant. The proposal does allow for temporary deviations from meeting the 80% threshold, but doesn’t define what normal circumstances are or are not. Peirce added that terms related to ESG principles may not neatly fit into one of its categories, and this could create confusion around what exactly the principles or traits are for the 80% threshold.
In its “Key Takeaways,” the Holland & Knight law firm states that the proposal, if approved, would codify the 80% threshold for all descriptive terms for funds, which had only previously been a guideline or a policy statement.
The SEC’s climate risk disclosure proposal from March is also reaping criticism. Three BlackRock executives, including the firm’s global head of sustainable investing Paul Bodnar, wrote to the SEC that this proposal will detract from the goal of reliable and consistent climate-related information for investors. The BlackRock executives stated that the SEC should revise the proposal to allow more reporting flexibility, consistent with global ESG requirements.
Arguments in support
There are counterarguments in support of the SEC’s climate risk disclosure proposal. Compliance costs would not be a significant part of companies’ market caps, according to Shivaram Rajgopal, a Columbia Business School professor. Furthermore, compliance costs can be benchmarked to a company’s net income, Rajgopal says. More disclosure would reduce the risk of inaccurate estimates of climate problems, he adds.
It remains to be seen whether the objections to all of these SEC proposals will lead to any adjustments by the agency before these are finalized.
One thing’s for sure, though. Investment firms may already have a work-around in mind, as a researcher told the Financial Times. Rather than adjusting portfolio holdings to comply with the 80% threshold in the Names Rule, they may just change the names of the funds in question so they don’t include wording that the SEC considers indicating ESG. The Names Rule gives fund managers a full year to make adjustments.