On March 2, 2020, the U.S. Securities and Exchange Commission (SEC or Commission) issued a Request for Comment on the framework for addressing names of registered investment companies and business development companies (SECThe SEC Request, subsequently published in the Federal Register on March 6, 2020, represents an effort “to improve the investor experience and modernize current regulatory While requirements exist under the Investment Company Act of 1940 to protect investors from misleading fund names, the Commission has not updated its “Names Rule” since 2001. In that time, the investment fund industry has become more complex, and funds committed to sustainability, social impact, and environmental, social, and governance (ESG) objectives (collectively, ESG Funds) are markedly on the Accordingly, the SEC Request sets forth questions related to ESG Fund naming practices. It is unlikely, however, that any updated rule would dramatically affect current ESG Fund naming practices unless commenters expose serious and widespread issues with these investment vehicles.
A fund manager’s ESG analysis involves assessing non-financial information. This non-financial information, which includes data related to environmental compliance, social performance, and corporate governance practices, is material to investors in manyESG information provides context to stated financial information and allows investors to benchmark companies on a broader range of metrics. It is becoming increasingly common for investors to equate poor ESG performance with poor management overall.
For ESG, environmental data points can include greenhouse gas emissions, climate change risks to companies and supply chains, energy efficiency, water usage, waste management, and pollution mitigation. Social data can consist of diversity, human rights, labor standards, employee welfare, product safety, privacy, and community impact. Corporate governance can consist of board structure and composition, executive compensation, political contributions and lobbying, oversight policies, and board resources dedicated to sustainability
A Short History of ESG Investing
ESG Funds trace back a few decades, although their popularity has risen notably in the last several years. The concept of sustainable investing originated with groups seeking to establish ethical parameters within portfolios. They utilized “negative screening” or “exclusionary screening” practices to avoid investments in sectors such as alcohol and tobacco. Negative screening is one method used by ESG Funds to create portfolios that do not support specific industries. However, the practice is now one of several approaches to the investment process—the others being impact analysis, shareholder engagement, and “positive screening” (i.e., best-in-class despite the
Early versions of ESG investing, known in the 1970s and later as “socially responsible investing,” manifested in the first sustainable mutual funds of that time. These initial steps gave way to movements in the late 1970s and 1980s promoting “corporate social responsibility” and drawing attention to climate-change issues. Well-known organizations such as CERES (Coalition of Environmentally Responsible Economies) were founded due to investors’, businesses’, and public interest groups’ desires to address sustainable practices and a transition to a low-carbon economy. The 1990s saw the introduction of capitalization-weighted indexes tracking sustainable investments and a growing number of related funds. The use of the term “ESG investing” became popular in the 2000s as specific organizations determined that a broader range of factors, i.e., ESG factors, should be incorporated into investment decision-making. The 2000s and 2010s also saw the rise of initiatives and nongovernmental organizations such as the Global Reporting Initiative (GRI), the UN’s Principles for Responsible Investment (PRI), the Global Impact Investing Network (GIIN), and the Sustainability Accounting Standards Board (SASB). These initiatives and organizations focused on ESG-centric investing, leveraging these investments to influence corporate policies, and encouraging more robust environmental disclosures. Most recently, the 2015 Paris Agreement motivated some investors to enhance their ESG analyses to assess whether a company’s actions are “in line” with Paris-related emissions reduction
As of December 31, 2019, there were approximately three hundred mutual funds and exchange-traded funds available in the U.S. market having an ESG focus, representing approximately $137 billion in assets underOne survey shows that approximately 85 percent of investors now look at ESG factors, and an overwhelming percentage of younger investors (95 percent) take ESG into This interest is reflected in recent net flows of new monies into ESG Funds, with approximately $5.5 billion in 2018 and nearly quadruple, or more than $20 billion in A remarkable start to 2020 was seen in the first quarter despite the impending coronavirus crisis, with $10.5 billion of net flows (trailing off toward
The SEC Request
Against this backdrop, the SEC requested public comment on its requirements that restrict the use of potentially misleading investment fund names. SEC Chairman Jay Clayton stated in the March 2, 2020 release that the Commission is “looking to investors and market participants for input on how our framework can be improved to help ensure that fund names inform and do not mislead
The Names Rule’s purpose is to protect investors from money managers who may portray their funds as committed to specific goals when that is not the case. Because a fund name is the first thing a potential investor sees, the Names Rule prohibits funds from using materially deceptive or misleading names. It requires that if a fund uses a name suggesting a type of investment such as an industry sector, a country, or a geographic focus, that the fund must invest at least 80 percent of its assets accordingly. The Names Rule, however, does not apply to investment objectives, strategies, and
The SEC adopted the Names Rule in 2001, codified as Rule 35d-1 under section 35(d) of the Investment Company Act ofThe SEC Request is based on the length of time since the Names Rule was issued and recent changes seen in the investment industry. Among these changes are the increased uses of derivatives and other instruments providing leverage, hybrid financial instruments, index-based funds, and ESG Funds. The Commission’s staff notes that “some funds appear to treat terms such as ‘ESG’ as an investment strategy . . . while others appear to treat ‘ESG’ as a type of
Accordingly, the SEC requested comment on several general issues to “inform potential future steps.” These issues included: (1) how funds select their names and for what purposes, (2) the Names Rule’s effectiveness in preventing deception, (3) the 80 percent investment requirement, (4) challenges presented by funds that gain exposure to a type of investment through derivatives, (5) determining whether a portfolio investment is a part of a particular industry, (6) whether investment strategies should be differentiated from types of investments, and (7) issues presented by certain terms in fundThe SEC Request’s focus on ESG Funds is primarily related to the last category.
Concerning ESG Funds, the Commission’s questions can be summarized as follows:
- Should the Names Rule apply to “qualitative” terms such as “ESG” or “sustainable”?
- Do investors interpret “ESG” or “sustainable” to mean the type of assets in which the fund invests or the investment strategy, or as non-economic objectives?
- Do investors interpret these terms as some mix of the above? Or is the conclusion indeterminate?
- If mixed or indeterminate, should the terms “ESG” or “sustainable” be subject to specific requirements or limitations?
- Does an “ESG” fund have to be invested in assets that satisfy all three criteria (i.e., Environmental, Social, and Governance)?
- How do funds determine whether an investment satisfies one or more ESG factors?
- Should funds have to tell investors what is meant by terms such as
The SEC accepted comments through May 5, 2020. The Commission’s next steps are uncertain.
An initial analysis suggests that the SEC’s action poses little risk to the naming practices of ESG Funds. If the administration does not change in 2021, the SEC will either maintain the Names Rule in its current form or attempt some regulatory adjustment. While the Commission may issue guidance on existing regulations, any significant material changes to the Names Rule would require a formal rulemaking process. If the SEC moves forward with such a rulemaking, we should not expect the Commission to mandate that funds clarify terms such as “ESG” and “sustainability.” Funds based on ESG and sustainability, while increasingly popular, still represent a niche area of the overall investment fundAdditionally, the SEC would have little incentive to override existing industry expertise unless there was a compelling reason, such as widespread abuse and fraud among ESG Funds. Finally, should the administration change in 2021, these regulatory efforts will likely be suspended or superseded.