On May 25, 2022, the U.S. Securities and Exchange Commission (“SEC”) proposed amendments to rules and related reporting forms under the Investment Advisers Act of 1940 (the “Advisers Act”) and the Investment Company Act of 1940 (the “Investment Company Act”) that are ostensibly intended to provide additional transparency regarding the use of environmental, social, and governance (“ESG”) factors by investment advisers and investment companies (the “Proposal,” available here), but which will also give SEC Examination and Enforcement staff additional tools to track and target advisers and funds pursuing an ESG strategy.

Notably, the proposal follows immediately on the heels of the inaugural enforcement case against an investment adviser by the SEC’s much hyped ESG Task Force (discussed here).  While the Proposal’s amendments for private funds are predominantly limited to new disclosures on Form ADV, the Proposal also cautions advisers against overstating the extent to which they consider ESG factors or overstating their role in shaping the ESG practices of their portfolio companies.  The Proposal reminds investment advisers that the Section 206 Antifraud Rules of the Advisers Act prohibit advisers from making false or misleading statements to private fund investors, and that the new Marketing Rule prohibits advisers from directly or indirectly distributing advertisements that contain any untrue statement of material fact (or omit a material fact necessary to prevent a statement from being misleading).  The Proposal notes that “it generally would be materially misleading for an adviser materially to overstate in an advertisement the extent to which it utilizes or considers ESG factors in managing client portfolios.” With Marketing Rule compliance becoming mandatory on November 4, 2022, advisers should pay particular attention to reviewing ESG-related disclosures, and updating policies and procedures relating to their marketing activities, to make sure they are practicing what they preach. For additional information relating to the impending Marketing Rule, see our related Alert Memorandum.

Form ADV Updates

With respect to private funds and their advisers, the Proposal would require specific disclosure in Form ADV Part 1 regarding the adviser’s use of ESG factors in providing advisory services:

  • The Proposal would amend individual private fund reporting (Section 7.B.(1) of Schedule D) for both registered advisers and exempt reporting advisers to add questions about the ESG strategies and services employed to manage each private fund, including:
    • whether an adviser considers ESG factors as part of one or more significant investment strategies or methods of analysis in the advisory services provided to the private fund (and if so, whether it focuses on environmental, social, governance or all three), and
    • whether the strategy employs an “integration” approach (i.e., ESG factors are considered, but not determinative) or “ESG-focused” approach (i.e., ESG factors are a significant or main consideration), and if ESG-focused, whether it also seeks to achieve a specific ESG impact.
  • The Proposal would amend reporting of an adviser’s Other Business Activities (Item 6.A.) and Financial Industry Affiliations (Item 7.A.) to include whether the adviser or any of its related persons is an ESG consultant or ESG service provider. This information would be required from both registered advisers and exempt reporting advisers.
  • The Proposal would amend reporting for Separately Managed Account Clients (Item 5.K.) to require disclosure of any ESG-related strategies, similar in scope to the proposed new questions for private funds described above.

In addition, the Proposal would modify Part 2A of Form ADV (the Brochure) as follows:

  • Methods of Analysis, Investment Strategies and Risk of Loss (Item 8) would require, for each significant investment strategy or method of analysis for which the adviser considers ESG factors, a description of the ESG factors considered (including whether such factors are considered on an integration, ESG-focused and/or ESG-impact basis), as well as a description of the criteria or methodology used for evaluating, selecting or excluding investments with respect to each such investment strategy/method of analysis.
  • Other Financial Industry Activities and Affiliations (Item 10) would require disclosure of any material relationship or arrangement between the adviser and any related person that is an ESG consultant or ESG service provider.
  • Voting Client Securities (Item 17) would require disclosure of whether the adviser has voting policies or procedures that include ESG considerations, and if so, the ESG factors the adviser considers and how it considers them.

As has become standard with each new rule release, the Proposal also reminds advisers that the Advisers Act requires them to have policies and procedures reasonably designed to prevent violations of applicable law and to review such policies and procedures annually.  Specifically, an adviser’s policies and procedures should address the accuracy of ESG disclosures made to clients, as well as the portfolio management processes required to ensure that portfolios are managed consistently with disclosed ESG-related investment objectives.  The Proposal noted that staff have observed a range of compliance failures relating to advisers’ incorporation of ESG factors into its advisory services, and indeed recent enforcement actions have uniformly included policy and procedure failures, including where the SEC did not allege fraud or other wrong-doing.

Registered Investment Companies

The Proposal would require registered investment companies to disclose in their S-6 prospectuses (and other reporting) additional information about the extent to which they consider ESG factors in their investment processes and proxy voting, as well as additional information regarding the GHG emissions (carbon footprint and weighted average carbon intensity) of their investments.   In addition, on May 25, 2022, the SEC separately proposed amendments to Investment Company Act Rule 35d-1 (the “Names Rule, ” available here), which would require registered investment companies to adopt a policy to invest at least 80% of their assets in accordance with the investment focus suggested by the fund’s name. The Names Rule proposal is intended in part to prevent “greenwashing” by funds with names that suggest they have ESG objectives even when not consistent with their actual investment activities.

There had been some question as to whether the SEC would propose something similar to the Names Rule for advisers to private funds.  While the Proposal is not applicable to unregistered private funds, both the proposed S-6 amendments and the revised Names Rule are helpful markers when determining whether ESG disclosure meets the more nebulous standards under the Marketing Rule and Antifraud Rules (and we expect commentators may suggest applying the Names Rule’s 80% asset threshold to private equity funds).

Comment Period

The comment period for the Proposal will run for 60 days from publication in the Federal Register, a pleasant change in approach from the 30 day comment period imposed on (and then abandoned for) February’s meatier PE Proposal and Cybersecurity Proposal.  If adopted, the Proposal contemplates that there would be a one-year transition period for compliance following the effective date of the final amendments, which would be 60 days after publication in the Federal Register.