Pressure Mounts on SEC to set standards for “Environmental, Social, Governance” corporate disclosures and fund investment styles:
What Can We Expect?
SEC Chairman Jay Clayton has continued to engage with investment advisers, fund sponsors, academics, investor advocates and environmentalists on the problem of environmental, social and governance (often referred to as “ESG”) disclosure. His position until now has been of respectful listening and issuing advice that any changes should be within the context of the SEC’s long-standing approach to “materiality” in its integrated disclosure system, which he contrasts with a more prescriptive “one-size-fits-all” approach advocated by some critics and like that recently enacted by the European Union.
In early March, the SEC asked for comments on the “Names Rule” under the Investment Company Act of 1940 (the “1940 Act”). Chief among its questions were those seeking input on the extent to which investors rely on fund names in making decisions and the extent to which more guidance on use of ESG words in fund names would be helpful to investors and capital markets generally. To date the Commission has received 47 written comments (including one by this author) representing a variety of industry groups, law firms, academics and activists and filed notice of one private meeting between SEC Commissioner Hester Peirce, her counsel and representatives of BlackRock.
Last month, the Investor-as-Owner subcommittee (the “Subcommittee”) of the SEC’s Investor Advisory Committee issued its recommendations that the Commission should lead a “well-structured” response to the challenge of ESG investing, citing the global nature of markets and the efforts of the European Union to define “sustainable finance” by means of a detailed taxonomy.
What should such a well-structured response look like? One model might be that taken by the European Union in their Regulation on Sustainable Finance Disclosure. One element of the regulation is the Disclosure Regulation, which imposes transparency and disclosure requirements regarding the manner in which the investment adviser integrates sustainability risk in investment decision-making and advisory processes and provides relevant sustainability information. The Disclosure Regulation seeks to eliminate greenwashing and apply uniform disclosure standards to a wide variety of investment products. The regulation, approved by Parliament and the European Council in December 2019, also calls for the creation of a detailed taxonomy that would define in precise terms the share of a firm’s revenue (turnover) or capital or operational spending on environmentally sustainable economic projects. The taxonomy would then drive corporate disclosure to the market on non-financial measures of performance and also impact the responsibilities of fund advisers, fiduciaries and asset managers. This Taxonomy Regulation, taken together with the Disclosure Regulation, will require firms to disclose information regarding the degree of environmental sustainability of those financial products that they claim pursue environmental objectives. The full impact of this effort is now becoming more clear with the release in March 2020 of the report of the Technical Expert Group for Sustainable Finance, which offers prescriptions to a great level of detail on what constitutes a environmentally sustainable economic investment in a variety of specific industries. Once the European Commission writes legislation to enact these recommendations, energy producers and manufacturers of diverse products from private automobiles to chemicals (for example, there is specific technical guidance on soda ash!) will be expected to report what percentage of their activities are in pursuit of a “sustainable” future. The guidance is explicit on what is included and what isn’t and how entities should aggregate total percentages of their activities for disclosure purposes.
The SEC’s Subcommittee recommendations do not call on the SEC to match the rigor of the European model, but to “begin in earnest an effort to update the reporting requirement of Issuers to include material, decision-useful, ESG factors.” It bases its recommendations on the following:
- Investors require reliable, material ESG information on which to base investment and voting decisions
- Issuers should directly provide material information to the market relating to ESG issues used by investors to make investment and voting decisions (as opposed to third-party commercial firms now filling in this gap by developing information from questionnaires answered by issuers and publishing ratings reports that they sell to investors, advisers and managers).
- Requiring material ESG disclosure will level the playing field among issuers
- Flow of capital to the US markets and US issuers of all sizes will be ensured.
- The US should take the lead on disclosure of material ESG matters.
The Subcommittee in its recommendations highlights the existence of reporting standards developed by the Global Reporting Initiative (GRI), the Sustainability Accounting Standards Board (SASB) and the Task Force on Climate-Related Financial Disclosures (TCFD) as efforts that might help the SEC “shape its thinking.”
The wider debate on corporate disclosure standards has had an impact on the discussion of possible changes to the Names Rule. Those providing comments in response to the SEC request for the most part take expected positions. Representatives of the fund industry tended to advocate against applying the Names Rules 80% Requirement to funds that use ESG terms in their names. Industry commenters doubted that a requirement that now applies to funds that incorporate into their name the type of security they invest in (i.e. obligations of the US government, particular industries, certain countries or geographic regions or tex exempt status) should apply to investment strategies, and that is what these commenters say an ESG fund would be required to do if it were subject to the 80% requirement. According to the authors of these letters, the general prohibition under Section 35(d) of the Investment Company Act against the use of names that are “deceptive and misleading” is sufficient to curb abuse. Some industry commenters recognized that ultimately the SEC should move towards a “principle-based” approach to disclosure, without specifying in detail what such an approach might mean. Presumably there is some overlap between this and what the Subcommittee is recommending. Consumer and investor advocates called for an enhanced system of self-governance around “common standards for assessing ESG information.” Two academic commenters stressed the need for fund disclosures to be crafted to distinguish between the direct benefits of ESG strategies (evidence of better long-term returns for E and S is limited) and the indirect benefits (i.e. social impacts that don’t redound to the traditional bottom line) that some investors are willing to pursue.
In my comments I was explicit about the need for the SEC to encourage investment managers to seek better disclosures from corporate issuers by requiring advisers who want to use ESG terms in their names to adopt fundamental policies based on third-party criteria about what constitutes E and S investing or explain to their investors why they have chosen to adopt their own criteria. I advocated extending the Names Rule 80% Requirement to funds incorporating terms related to E and S goals in their names, but left to the firms themselves to decide what selection criteria and screening systems they would employ in order to meet the requirements of their policy. To encourage transparency and clarity, I advocated the SEC require that if the fund did not make reference to established third-party criteria they explain why they decided to adopt their own independent criteria. In other words, silence about available third-party reference points is not enough. Some affirmative disclosure is necessary. Such disclosure would also need to specify how the criteria were applied depending on the type of screen or selection method used, whether it is a negative screen, affirmative selection or an integrated approach. The purpose of this would be to aid investors in comparing funds and developing appropriate measures of performance.
In discussing my letter with clients of my firm, Practus LLP, and others, I faced questions about whether my recommended approach would require firms to ascribe to third-party standards to meet my proposed extension of the 80% Requirement to funds claiming to follow E and S goals. The answer I gave is “no.” Under my recommended approach, funds could adopt their own standards. For example, if a sponsor of a fund wanted to promote a fund as “sustainable” or “socially-responsible” and explain to investors that its approach was to invest in companies with particularly strong employee-centered cultures, the fund would be permitted to do so, but it would need to be clear that the sponsor considered third-party standards but elected to adopt its own standards instead. My approach would be to give official push to the movement toward self-regulation by the securities industry in pushing for more and better (more “decision-useful”) ESG disclosure without the SEC needing to go as far as adopt its own version of the EU’s taxonomy, or simply defer to it as a de-facto international standard.
The US, its corporate issuers and its investment industry are now at a crossroads. As the Subcommittee notes, capital markets are global with investors and issuers seeking each other out in markets across the globe. In order for capital to continue to flow into US markets, regulators will need to update their approach to ensure that US markets remain the deepest, most-efficient markets in the world. Self-regulation, when done correctly, has many advantages. One-size-fits all solutions often fall short. But markets left to themselves to self-correct without clear standards and abundant high-quality information run the risk of failure, particularly when there are conflicts of interest among the interests of the parties making the disclosures and the parties consuming the disclosures.
SEC Chairman Clayton has kept the door open to voices of reform, while clearly pushing until later difficult decisions about setting standards for ESG disclosures and investing styles that could be interpreted as accommodating Europe’s strong efforts to restructure capital markets to help achieve Paris Accord climate goals, a goal that the Trump Administration has resisted. This year’s national elections could bring a change in US policy direction. The U.S. Business Roundtable has put its flag down in this debate by setting forth principles to redefine the purpose of a corporation. Many in the investment industry have called for it to rally around robust Principles for Responsible Investing. The SEC is an independent agency, but a new chairman would feel great pressure in a Democratic administration to bring the US into closer harmony with international standards, both non-governmental and governmental.
The question will be whether that pressure will result in the US taking the approach of the EU with its “taxonomy.” I believe that this would be a mistake. The EUs efforts are based on a preference for single sets of comprehensive standards that reflect the “consensus” of experts. This “consensus” is often subject to political attack and is at the end of the day, contingent and subject to amendment. Consensus also tends to push difficult decisions down the road. A good example is the failure of the EU taxonomy to take any position on nuclear power, despite its clear role in any balanced energy system that strives for net-neutrality on carbon emissions. It also sets standards that puts roadblocks in the way of investments in more climate-efficient investments based on fossil fuels. In my view, the American preference for plurality is not a bad thing. If several standard-setting bodies with transparent processes and demonstrated independence from domination by any one set of actors with an ax to grind, compete for adherents in the marketplace of ideas, then the result may in the end by stronger than forced consensus brokered by supranational institutions, whether in Brussels or New York. Reluctant consensus is unstable, and rigid administrative systems based on them are politically fragile, as the EU is learning in other areas. But the U.S. and its financial services industries will have a more difficult time correcting the shortcomings of the efforts of foreign regulators, if its institutions do not embark on a serious reform agenda of their own.