Why private fund advisers should pay attention to the SEC’s ESG focusSEC is expanding its ESG focus to the private funds industry
As the Securities and Exchange Commission (SEC) continues to focus on Environmental, Social and Governance (ESG) investing, private fund advisers should be informed about their existing legal obligations, as well as the potential for new reporting and disclosure requirements in this area.[i] Recent SEC enforcement proceedings demonstrate that even without a new rule to address ESG disclosures, the SEC can bring enforcement actions against advisers that do not accurately characterize their ESG practices.[ii]
In addition to the SEC’s focus on ESG strategies, private fund advisers are increasingly facing pressure from investors to provide more information with respect to the advisers’ ESG-related activities.
What should private fund advisers be doing now?
Private fund advisers that market themselves as having an ESG focus should ensure that they:
- Accurately disclose their ESG investing approach (ie, not overstating or misrepresenting their ESG focus)
- Adopt and implement policies, procedures, and practices that accord with their ESG-related disclosures and
- Maintain documentation supporting any representations or other statements made to investors about their ESG practices.
All SEC-registered investment advisers and exempt reporting advisers, including advisers to private funds, are subject to existing legal obligations, such as the general anti-fraud provisions of the Investment Advisers Act of 1940.[iii] Registered investment advisers are also specifically prohibited under the Marketing Rule from distributing advertisements with false or misleading information.[iv] Further, the Marketing Rule requires investment advisers to substantiate any statements of material fact upon demand from the SEC, including ESG-related statements.
The SEC settled an enforcement proceeding earlier this year illustrating the agency’s concerns on this front. In this proceeding the SEC alleged that the investment adviser represented or implied in various statements that all investments in its funds had been subject to an ESG quality review, even though that was (allegedly) not always the case.[v] The investment adviser’s alleged misrepresentations in this area were viewed by the SEC as constituting a willful violation of certain anti-fraud and compliance rules under the Advisers Act.[vi]
SEC focus on “greenwashing”
The SEC has increased its focus on ESG-related misconduct stemming from investor reliance on climate and ESG-related disclosures and investments.[vii] Most recently the SEC reiterated this priority in its enforcement results for fiscal year 2022 by highlighting several ESG-related actions concerning materiality, accuracy of disclosures and fiduciary duty.[viii]
There is an ongoing concern that funds and advisers marketing their products or strategies may exaggerate their ESG practices or the extent to which their investment products or services address ESG factors. With respect to environmental and sustainability matters, this practice is often referred to as “greenwashing.”
The SEC has argued that the absence of a common disclosure framework makes it difficult for investors to find the applicable disclosures and 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. This concern over fragmented and inconsistent disclosures has resulted in several regulatory proposals from the SEC, which are summarized below.
Public company climate-related disclosures: Under this proposal, domestic and foreign registrants would be required to include certain climate-related information in their registration statements and periodic reports, such as Form 10-K.[ix] As proposed, a registrant would be required to disclose information about how it addresses climate-related risks when conducting its operations and developing its business strategy and financial plan, generally including:
- Climate-related risks and their actual or likely material impacts on the company’s business, strategy, and outlook
- Governance of climate-related risks and relevant risk management processes
- Greenhouse gas emissions, which, for accelerated and large accelerated filers and with respect to certain emissions, would be subject to assurance
- Certain climate-related financial statement metrics and related disclosures in a note to its audited financial statements and
- Information about climate-related targets and goals, and transition plan, if any.
ESG-focused rules aimed at funds and investment advisers: The SEC later proposed a pair of rules focusing on the use of ESG investment practices by registered investment companies, business development companies, and, to a lesser extent, registered investment advisers. The first proposal introduced a robust disclosure and reporting framework for funds qualifying as registered investment companies, along with less robust additional disclosure for investment advisers;[x] the second proposal would add new naming requirements for funds qualifying as registered investment companies that consider ESG factors in connection with their investment practices.[xi]
How would the SEC’s ESG disclosure proposal impact private funds and their advisers?
The ESG disclosure proposal, if adopted, would significantly impact registered investment companies and business development companies that consider ESG factors in their investment process by requiring specific, detailed disclosure regarding their ESG strategy in their prospectus and other disclosure documents. To a lesser extent, the proposal, if adopted, would impact registered investment advisers and exempt reporting advisers that consider ESG factors by requiring them to report certain ESG information in their annual Form ADV filings with the SEC.
How does the SEC define ESG in the ESG disclosure proposal?
ESG is an expansive term that incorporates three broad categories: environmental issues, social issues, and governance issues. Instead of attempting to define ESG, the SEC identified a three-part spectrum to capture a variety of approaches to ESG investing:
- ESG Integration: These strategies consider one or more ESG factors alongside non-ESG factors in investment decisions. In such strategies, ESG factors may be considered in the investment selection process but are generally not dispositive compared to other factors when selecting or excluding a particular investment.
- ESG-Focused: These strategies focus on one or more ESG factors by using them as a significant or main consideration in selecting investments or in engaging with portfolio companies.
- ESG Impact: A subset of ESG-Focused, these strategies have a stated goal that seeks to achieve a particular ESG impact or impacts that generate specific ESG-related benefits.
What additional reporting would the proposed amendments require on Form ADV?
The proposed amendments to Form ADV would expand the information collected about an adviser’s use of ESG factors in its advisory business. Amendments to Part 1A of Form ADV would require census-like disclosures and apply to registered investment advisers and exempt reporting advisers, while the amendments to Part 2A of Form ADV (also referred to as the Firm Brochure) would require narrative disclosures and only apply to registered investment advisers.
The amendments would generally require an investment adviser to disclose whether it considers any ESG factors as part of one or more significant investment strategies or methods of analysis in the advisory services it provides to a reported private fund. If so, the investment adviser would be required to report whether it employs an ESG-integration or ESG-focused approach, and if ESG-focused, whether it also employs an ESG-impact approach. An investment adviser would also be required to report whether it incorporates one or more of the E, S and/or G factors. Finally, to the extent an investment adviser follows any third-party ESG framework(s) in connection with its advisory services, it would be required to report the name of the framework(s).
The amendments to the Firm Brochure would require an investment adviser to provide similar narrative disclosures, among them a description of the ESG factor or factors considered and how those factors are incorporated into its investment advice. This would include an explanation of whether and how the investment adviser incorporates a particular ESG factor (E, S, or G) and/or a combination of factors. In addition, an investment adviser would be required to include an explanation of whether and how it employs integration and/or ESG-focused strategies, and if ESG-focused, whether and how it also employs ESG impact strategies. An investment adviser that considers different ESG factors for different strategies would be directed to include the proposed disclosures for each strategy.
Investment advisers that do not disclose or promote ESG strategies would likely be unaffected by the rule proposals.
European Union’s Sustainable Finance Disclosure Regulation
The SEC is not the only regulator focused on ESG-related disclosures. In addition to compliance with existing and proposed regulations from the SEC, private fund advisers that market in the European Union should also be aware of relevant European regulations. The European Union’s Sustainable Finance Disclosure Regulation (SFDR) and the related Taxonomy Regulation establish a sustainability disclosure framework for providers of certain financial products and financial market participants, including private fund advisers.
SFDR, like the SEC’s disclosure proposal, distinguishes between three categories depending on a fund’s “ESG ambition” and provides for varying levels of disclosures based on the degree to which sustainability is incorporated into its investment strategy.
For more information on ESG disclosure rules in the EU and UK, please see the related DLA Piper publication Comparing ESG Disclosure Rules for Funds in the EU, UK and the US.
ESG investing and the related rule proposals remain priority items on the SEC’s Spring 2022 Regulatory Agenda.[xii] While the comment period for the proposals discussed here has formally closed, the SEC is still accepting comments.
If you have any questions about the SEC’s ESG disclosure proposal or current legal obligations, please contact the authors, your DLA Piper relationship attorney, or any member of the DLA Piper Investment Funds team.
[ii] BNY Mellon Investment Adviser, Inc., Advisers Act Rel. No. 6032 (May 23, 2022); https://www.sec.gov/news/press-release/2022-206; and https://www.sec.gov/news/statement/peirce-statement-esg-052522
[iii] Section 206 of the Investment Advisers Act imposes a fiduciary duty on investment advisers to provide full and fair disclosure of all material facts relating to the advisory relationship and to provide advice that is in the best interest of the client. Investment advisers also have anti-fraud liability with respect to communications to clients and prospective clients.
[vii] SEC Division of Enforcement’s Climate and ESG Task Force, https://www.sec.gov/spotlight/enforcement-task-force-focused-climate-esg-issues