Insight Analytical Note

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ESG Disclosure Rule Proposal

On May 25th, 2022, the U.S. Securities and Exchange Commission proposed a rule to enhance disclosures made by investment advisers and investment companies about Environmental, Social and Governance practices (the “ESG Rule”).  This note will highlight the potential impacts of this rule on private fund managers and alternative investment advisers.

Summary:

  • For private fund managers, the rule has four components:
    • Modifications to Form ADV Part 1A
    • Modifications to Form ADV Part 2A
    • A reaffirmation that the development of business appropriate ESG policies and procedures are required under Rule 206(4)‐7.
    • A reaffirmation that ESG disclosure will be viewed as material in the context of marketing and advertising.

Key Provisions:

  • Form ADV Part 1:
    • Under Item 6: Information about whether the adviser is also an ESG consultant or ESG service provider.
    • Under Item 7 A: Information about whether a related person is an ESG consultant or ESG service provider.
    • Under Schedule D Section 6A: Information about whether any business is an ESG consultant or ESG service provider.
    • Under Schedule D Section 7A: Information about related ESG consultants or ESG service providers.
    • Under Schedule D Section 7.B (1): Information about whether the strategy is an ESG Integration strategy, an ESG Focused strategy or an ESG Impact strategy and which ESG factors are considered.
    • See Appendix A
  • Form ADV Part 2A:
    • A change in instructions for Item 8. Methods of Analysis, Investment Strategies and Risk of Loss to include information about how ESG factors are considered, a description of any ESG methodologies used, whether ESG scoring is used, how third‐party data is used and other detailed ESG information.
    • A change in instructions for Item 10: Other Financial Industry Activities and Affiliations to describe any material relationships with ESG consultants.
    • A change in instructions for Item 17. Voting Client Securities to include information about how ESG is factored into proxy voting.
    • See Appendix B
  • The Compliance Rule:
    • An affirmation that compliance policies be reasonably designed to ensure an adviser manages the portfolios consistently with how ESG was described to investors.
  • Marketing and Advertising:
    • An affirmation that it would be materially misleading for an adviser to overstate the extent to which it utilizes or considers ESG factors in managing client portfolios.

Fund Categories:

While the Names Rule only applies to Registered Investment Companies, private fund advisers will have to categorize any of their funds that follow ESG strategies into the following categories for the purposes of ADV reporting.

  • The ESG Rule defines ESG Integration strategies as ones that consider any ESG factors as a part of their strategy but where ESG is not a dispositive investment criteria.
    • This category is very broad and could encompass activities already engaged in by most managers.
  • The ESG Rule defines ESG Focused strategies as ones that leverage ESG factors as the primary investment consideration.
  • The ESG Rule defines ESG Impact strategies as ones that seek to achieve a specific ESG benefit through investment activities.

Takeaways:

  • Written Policies and Procedures: While many managers currently incorporate ESG factors into their investment process, this rule would require written compliance policies and procedures to ensure that ESG disclosures are followed.  Among other things, this may require compliance to take a role in the investment diligence process and may require further documentation of investment decisions.
  • Examination Risk: With additional ADV ESG disclosure, exam staff will more accurately be able to select ESG examination candidates and will be able to use an adviser’s ESG ADV disclosure as the basis for additional violations.
  • Every Fund Can Be an ESG Integration Fund: The definition of ESG Integration strategies is broad and can comfortably fit many existing investment criteria.  For instance, an investment process that evaluates company management and governance could be considered an ESG Integration strategy because of its focus on governance.  Many funds will be flagged as ESG Integration on ADV.