Reporting companies and asset managers in the United States and abroad are evaluating the potential impacts of the incoming Biden administration. President-elect Joseph Biden has signaled an intention to pursue a broad climate agenda and to seek to re-establish the United States as a leader with respect to climate change. This includes: rejoining the Paris Climate Accord; convening a world summit to directly engage the leaders of climate-emitting nations to make more ambitious pledges; and seeking to position the United States to achieve a 100% clean energy economy and net-zero emissions by 2050. While the specific approaches have yet to be announced, it is not too early to anticipate, and to prepare for, the changes in policies with respect to environmental, social and governance issues that are expected to take place under the Biden administration.
Recap: Where Are We Today?
Environmental, social and/or governance (commonly referred to as ESG) factors and diversity and inclusion (sometimes referred to as human capital) are not new considerations for reporting companies, asset managers and regulators, but they increasingly are cited as a priority of each.2 Therefore, before discussing how the Biden administration might be expected to implement change in these areas, it is useful to briefly review the current requirements applicable to reporting companies and asset managers.
The content of reporting company public disclosures is governed by two considerations: applicable disclosure requirements (e.g., Regulation S-K); and a principles-based framework for determining the materiality of information provided. However, there are very few specific requirements mandating ESG-related disclosures by reporting companies. In fact, the SEC expressly declined to impose such requirements in August 2020 when adopting amendments to Regulation S-K.3 As a result, whether a reporting company discloses ESG considerations in public filings generally turns on whether the corporate issuer deems such information to be “material” to investors.
In the context of financial statements, the SEC deems a matter to be material where “there is a substantial likelihood that a reasonable investor would consider it important.”4 Omitting or misstating a matter is material “if, in the light of the surrounding circumstances, the magnitude of the item is such that it is probable that the judgment of a reasonable investor relying upon the report would have been changed or influenced by the inclusion or correction of the item.” This principles-based framework, premised on the notion that materiality can only be determined by those who possess all material facts,5 “provides management with the flexibility to tailor effectively its disclosure to provide the information about its specific financial condition that is material to an investment decision.”6 Within this framework, reporting companies historically have disclosed various ESG and/or diversity considerations.7 However, the nature, scope and frequency of such disclosures have varied across industries, as well as across reporting companies within a given industry. In this context, many financial market participants, as well as certain current SEC Commissioners, have alleged that the consumers of reporting company public disclosures do not have the information necessary to make fully-informed decisions regarding the financial prospects of, and risks facing, reporting companies.8
In contrast, the SEC recently introduced new disclosure requirements as part of its efforts to modernize Regulation S-K, which are intended to provide additional insights into human capital considerations. Specifically, in certain SEC filings, reporting companies are required to disclose certain human capital matters (if material), including: the number of employees and description of human capital resources; and any human capital objectives. However, similar to the principles-based approach to determining the materiality of financial statement disclosures, the SEC declined to define the term “human capital” for purposes of these requirements.
U.S. Asset Managers and Registered Funds
As with their approach to reporting companies, the SEC and its staff have not adopted any rule or regulation, or imposed specific requirements, governing an investment adviser’s use of ESG principles or an investment company’s disclosure of ESG-related strategies. However, in a manner comparable to the reporting company context, there are certain core principles that indirectly govern such activities and disclosures.
Any incorporation of ESG principles into an investment adviser’s investment process is subject to the adviser’s fiduciary duty to its clients under the Investment Advisers Act of 1940. The SEC historically has interpreted Section 206 of the Advisers Act to impose a fiduciary duty on investment advisers, under which the adviser has an affirmative duty to act solely in the best interests of its clients and to make full and fair disclosure of all material facts. As a result, investment advisers must structure their ESG investing programs to be reasonably sure that the use of ESG principles is consistent with the client’s best interests, as could be reasonably understood from any client agreements, offering documents or other investor disclosures (including marketing materials) indicating the objectives and scope of the client relationship.
In the context of registered investment companies, applicable registration statement disclosures could be required to reflect ESG considerations in two contexts. First, if the fund’s adviser incorporates ESG principles as a principal investment strategy, associated disclosure of strategies and risks would be required under in the investment company’s registration statement. Second, Rule 35d-1 under the Investment Company Act of 1940 requires a registered investment company with a name suggesting that the company focuses on a particular type of investment to invest at least 80% of its assets in the type of investment suggested by its name. The SEC staff often seems to take the view that the use of terms like “ESG” or “sustainable” in a fund name triggers this requirement, notwithstanding the SEC staff’s general distinction that investment strategies (i.e., “growth” or “value”) – but not investments in particular securities (i.e., “emerging markets equities” or “high yield bonds”) – do not trigger Rule 35d-1.9 Consistent with this prior guidance, the industry generally believes that these names are more reflective of investment objectives or strategies. The SEC staff did publish a request for comment in March 2020 to evaluate whether Rule 35d-1 should be deemed to apply to ESG investment mandates.10
Views of the SEC Commissioners and Chairman
Based on a review of publicly-available statements, the current SEC Commissioners appear to differ on whether and how to proceed with more prescriptive requirements (disclosure or otherwise) for reporting companies, asset managers and/or registered funds in the context of ESG and diversity matters. With respect to reporting companies, the Commissioners appear to be divided both as to (i) the adequacy of the existing principles-based disclosure framework rooted in concepts of materiality; and (ii) the need for, and the SEC’s ability to mandate rationally-designed, climate-risk disclosure requirements.11 With respect to asset managers and investment funds, the Commissioners’ current views vary along the spectrum of potential SEC action in this area. For example, Commissioner Roisman has suggested that he could support requiring ESG disclosures from asset managers,12 as well as expressed skepticism as to whether, and the extent to which, an asset manager’s incorporation of ESG principles may improve returns.13 By contrast, Commissioner Lee has acknowledged that asset managers and other financial market participants utilize ESG factors and metrics as “significant drivers in decision-making, capital allocation, pricing and value assessments” and, therefore, she calls for “transparency” in asset managers’ competition for capital in the ESG space.14
Comparison with ESG Standards Outside the United States
The development and implementation of ESG standards in the United States historically has lagged the development and implementation of ESG standards in the European Union (including its member states) and other foreign jurisdictions. In fact, the EU and its member states already have begun to take formal actions with respect to ESG as applied to reporting companies and investment managers. In several instances, these formal actions have the force of law – including (among others): the EU’s Disclosure and Taxonomy Regulations; Shareholder Rights Directive; amendments to the Alternative Investment Fund Managers Directive 2011/61/EU (AIFMD); and amendments to the Undertakings for Collective Investment in Transferable Securities Directive 2009/65/EC (UCITS Directive). Even if such regulations are not directly applicable to a U.S. investment manager’s registered fund operations, the regulations may indirectly apply to other mandates, as non-U.S.-based investors become accustomed to and begin to request compliance with such standards. Furthermore, it is possible that, over time, relevant ESG standards applicable to, and frameworks utilized by, U.S. and EU investment managers could begin to converge as ESG nomenclature and investment practices mature. Also, as a practical matter, the U.S. and EU products offered by global managers typically are managed together for efficiency.
Looking Forward: What Can We Expect Under the Biden Administration?
While it is impossible to predict the specific developments that will occur during the Biden administration, it is reasonable to expect an increased attention to ESG and diversity matters, as well as integration of such matters into the administration’s policies. The nature and extent of those developments likely will be affected by the factors discussed below.
In January 2021, a “run-off” election will be held in Georgia to determine control of two seats in the Senate. If Democrats win both seats, the Senate will not be controlled by either Democrats or Republicans, and Vice President-elect Kamala Harris would be the deciding vote on 50-50 matters. However, if the Republican candidates win both seats, then the Republicans would retain a 52-48 majority in the Senate. A Republican majority in the Senate (or even a 50-50 Senate) could limit President-elect Biden’s ability to pass legislation, including with respect to ESG and diversity matters.
Nevertheless, even if Republicans control the Senate, President-elect Biden has signaled a willingness to exercise his authority as the head of the executive branch of the government to enact certain measures by executive order. This includes requiring public companies to disclose climate risks and the greenhouse gas emissions in their operations and supply chains.15
Appointment of Key Regulatory and Other Leadership Positions
The Biden administration also could seek to influence future actions on ESG and diversity matters through the appointment of key positions. Specifically:
- Securities and Exchange Commission: The Biden administration will have the opportunity to appoint a new SEC Chair and, therefore, ensure that three of the five Commissioners are appointed by Democrats. A new SEC Chair under the Biden administration could be expected to prioritize the development of more prescriptive rules or standards governing ESG disclosure and other regulatory requirements for reporting companies, asset managers and registered funds. This could include requiring companies to adopt a third-party reporting framework, such as that developed by the Sustainability Accounting Oversight Board.16 The precise nature of any such action is not known at this time, but may be informed by the recommendations of the ESG Subcommittee of the SEC’s Asset Management Advisory Committee (discussed in further detail below). When coupled with the potential appointment of new SEC Commissioners as current terms expire or current Commissioners step down, the Biden administration’s SEC could be positioned to develop and adopt meaningful regulations in these areas.
- New Senior Climate Positions: President-elect Biden has selected John Kerry as special presidential envoy for climate (Climate Envoy). The Climate Envoy would be a member of President-elect Biden’s cabinet and would sit on the National Security Council. Underscoring President-elect Biden’s commitment to climate risk, this would be the first time that an official dedicated to climate change would sit on the National Security Council. Mr. Kerry, who helped negotiate the Paris Climate Accord, has a significant track record both in ESG matters and building global consensus. In addition to the Climate Envoy, President-elect Biden has announced the appointment of former EPA Administrator, Gina McCarthy as his national climate adviser (or “climate czar”), where she will coordinate the U.S. domestic climate and energy policy. The creation of two new senior administration positions with domestic and global climate policy responsibilities illustrates how the Biden administration will prioritize climate policy goals both domestically and in international relations.
- National Economic Council: President-elect Biden has selected Brian Deese, a former BlackRock Inc. executive responsible for sustainable investing strategies and economic adviser to President Barak Obama, to lead the National Economic Council. Mr. Deese’s prior experience with ESG matters, coupled with the Biden administration’s expected prioritization of these issues, suggests that he may direct the National Economic Council to address climate and diversity issues in potentially meaningful ways.
- Department of Labor: As of the date of this OnPoint, President-elect Biden has not announced his choice for Secretary of the Department of Labor. However, acting in furtherance of President-elect Biden’s ESG and diversity priorities, the Secretary ultimately selected could determine to repeal or otherwise affect recent DOL rulemaking governing the incorporation of ESG considerations into retirement account portfolios subject to ERISA.17 The possibility that eliminating or revising the recent rulemaking may not be as high a priority as it might have been, in light of changes made over the course of finalizing the DOL’s rules.18
- Federal Reserve Bank: Although he has not been mentioned as a Biden appointee, Randall Quarles (the current Vice Chair of the Federal Reserve for Supervision) indicated that the Federal Reserve has applied to join the Network for Greening the Financial System. Because it is independent of the executive branch, President-elect Biden cannot direct the U.S. Federal Reserve’s policy choices – including with respect to ESG and/or diversity and inclusion matters.
While these appointments and changes in policy will no doubt have an impact, it is important to remember that rulemaking by U.S. regulatory bodies must be conducted through a prescribed process. Agency rulemaking requires time and resources to be committed to fact-finding, drafting, the public comment process and, often, an implementation period. In addition, more far-reaching rulemaking efforts likely will be subject to legal challenges, as a number of constituencies oppose these initiatives. Further, while appointees under the Biden administration are expected to include ESG and diversity matters among their priorities, there will be competing priorities for regulatory agency resources devoted to rulemaking, which would be implemented over an extended timeframe.
SEC Asset Management Advisory Committee
At its most recent meeting on December 1, 2020, the Asset Management Advisory Committee’s ESG Subcommittee provided its potential draft recommendations.19 The ESG Subcommittee is comprised of industry participants rather than SEC staff members. As a result, the Subcommittee’s recommendations are not binding on the SEC or its staff, but can be expected to inform the direction of future SEC rulemaking and SEC staff guidance. The ESG Subcommittee’s final recommendations are expected in early 2021.
In relevant part, the Subcommittee’s draft recommends that:
- Corporate Issuer Disclosures: The SEC should:
- Mandate the adoption of standards by which issuers disclose material environmental, social, and governance risks;
- Utilize standard setters’ frameworks to require disclosure of material environmental, social and governance risks; and
- Require that material environmental, social and governance risks be disclosed in a manner consistent with the presentation of other financial disclosures.
- Investment Product Disclosures: The SEC should suggest best practices to enhance ESG product disclosure, including with respect to investment strategy and investment priorities (such as non-financial objectives).
The distinction between mandated requirements for reporting companies but best practices for investment product manufacturers is intentional, and reflects the Subcommittee’s view (which is shared by asset management industry participants, as well as several SEC Commissioners) that the absence of a common nomenclature for describing material ESG risks, or a framework for identifying and disclosing such risks, challenges the SEC’s ability to impose more prescriptive requirements on asset managers. In this regard, it is important that the ESG Subcommittee signaled that third-party standard-setters should play a key role in their recommendations for SEC action in this space. For example, the Subcommittee highlighted the Sustainability Accounting Standard Board (SASB) standards as a strong baseline on which to model corporate issuers’ disclosures, and the recent Investment Company Institute (ICI) taxonomy as a baseline of nomenclature for investment product disclosures.20
In addition, on the same day, the Diversity and Inclusion Subcommittee of the Asset Management Advisory Committee held a panel discussion related to diversity and inclusion matters in the asset management space. While the Diversity and Inclusion Subcommittee has not formulated recommendations with the same degree of specificity as the ESG Subcommittee, it is reasonable to expect diversity and inclusion-related recommendations in the near- to medium-term.
Irrespective of the actions taken by executive order, regulatory action or otherwise under the Biden administration, ESG and diversity-related initiatives are gaining prominence at an accelerating pace with private market actors. As indicated above, the SASB, ICI and other third parties are developing or refining existing frameworks for describing and disclosing ESG and diversity and inclusion matters. This trend may be expected to accelerate over time, particularly as calls for uniform reporting of companies’ ESG and diversity disclosures become more prominent. Perhaps more importantly, firms are incorporating ESG and diversity considerations with greater frequency into the investment products they roll out. Many investment funds increasingly incorporate ESG factors into their investment process, and many issuers and raters of asset-backed securities increasingly are considering the ESG and human capital impacts of the underlying assets. As investor demand – both in retail and institutional markets – continues to grow for these types of products, calls for regulatory action to support the continuing maturity of the ESG market will intensify.
While it is too early to precisely determine what the Biden administration will be able to accomplish with respect to ESG and diversity matters, it is clear that these issues will be moved to the forefront. Accordingly, asset managers and other financial market participants may want to consider the potential changes discussed in this OnPoint, and to plan for any heightened prioritization and integration of ESG and diversity matters into the policies pursued by the Biden administration.
1) For further information regarding the potential impact the Biden administration could have in other areas, please refer to Dechert OnPoint, Election 2020: President Biden’s Potential Impact on Business.
2) For example, according to the U.S. SIF: The Forum for Sustainable and Responsible Investment, U.S.-domiciled assets under management using ESG strategies grew from approximately $12 trillion at the start of 2018 to $17.1 trillion at the start of 2020. 2020 Report on US Sustainable and Impact Investing Trends. Business. This represents a significant increase from the $639 billion of assets under management first measured by the U.S. SIF in 1995. Id. The U.S. SIF also estimates that U.S.-registered investment companies account for approximately 19% of asset manager ESG assets, with mutual funds representing the most common type of registered fund incorporating ESG principles. Id. Formerly known as the Social Investment Forum, the U.S. SIF is a membership organization that seeks to advance sustainable, responsible, and impact investing across asset classes.
3) See, e.g., Regulation S-K and ESG Disclosures: An Unsustainable Silence, Public Statement by Commissioner Allison Herren Lee (Aug. 26, 2020) (stating that “[t]he final rule the majority adopts today, however, is silent on two critical subjects: diversity and climate risk disclosures.”); see also Statement on the “Modernization” of Regulation S-K Items 101, 103, and 105, Public Statement by Commissioner Caroline Crenshaw (Aug. 26, 2020) (stating that “the rule before us today fails to deal adequately with two significant modern issues affecting financial performance: climate change risk and human capital. As Commissioner Lee noted in her statement, the final rule also is silent on diversity, an issue that is extremely important to investors and to the national conversation.”).
4) SEC Staff Accounting Bulletin No. 99 – Materiality, 17 C.F.R. §211, Sbpt. B (Aug. 12, 1999) (AB 99). This definition draws on precedent decided by the Supreme Court in TSC Industries, Inc. v. Northway, 426 U.S. 438, 449 (1976) (stating that a fact is material if there is “a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote… Put another way, there must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.”) and Basic Inc. v. Levinson, 485 U.S. 224, 231-32 (1988) (reiterating the standard in TSC Industries, and stating that a matter is material if there is “a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.”).
5) See AB 99.
6) See Statement on Proposed Amendments to Modernize and Enhance Financial Disclosures, Public Statement of Commissioner Hester M. Peirce (Jan. 30, 2020).
7) According to a survey conducted by the Governance & Accountability Institute, Inc., 90% of companies in the S&P 500 Index issued sustainability reports. This represented a 20% increase from 2011. See Companies Could Face Pressure to Disclose More ESG Data, Wall Street Journal (Dec. 6, 2020). Such ESG risk disclosures are most commonly provided by issuers whose assets or business model are affected by climate change.
8) See e.g., Joint Statement on Amendments to Regulation S-K: Management’s Discussion and Analysis, Selected Financial Data, and Supplementary Financial Information, Commissioners Allison Herren Lee and Caroline A Crenshaw (Nov. 19, 2020) (stating that “A major purpose of requiring companies to disclose specific information about climate risk and human capital management is to allow market participants to accurately price and compare the risks and opportunities associated with these risks. But when disclosure metrics are not uniform and standardized the task of pricing and comparing these risks and opportunities is, at best, unduly burdensome. And without specific requirements, much of the information is simply not there to be worked into the analysis.”).
9) See Frequently Asked Questions about Rule 35d-1 (Investment Company Names) (Question 9: “Rule 35d-1 would not apply to the use of the term ‘income’ where that term suggests an investment objective or strategy rather than a type of investment.”).
10) Request for Comments on Fund Names, SEC Release No. IC–33809 (Mar.2, 2020).
11) See Remarks at Meeting of the SEC Investor Advisory Committee, Commissioner Hester M. Peirce (May 21, 2020) (stating that “[a] new SEC disclosure framework for ESG information, however, seems an unnecessary response when our existing securities disclosure framework is very good at handling all types of material information. As a practical matter, trying to treat ESG factors differently would be quite difficult.”); cf. Modernizing Regulation S-K: Ignoring the Elephant in the Room, Public Statement of Commissioner Allison Herren Lee (Jan. 30, 2020) (stating that “[i]t is also clear that the broad, principles-based ‘materiality’ standard has not produced sufficient disclosure to ensure that investors are getting the information they need – that is, disclosures that are consistent, reliable, and comparable.”). See also fn. 3.
12) Keynote Speech at the Society for Corporate Governance National Conference, Commissioner Elad L. Roisman (July 7, 2020).
13) See e.g., id.
14) Playing the Long Game: The Intersection of Climate Change Risk and Financial Regulation, Commissioner Allison Herren Lee (Nov. 5, 2020).
15) See The Biden Plan for a Clean Energy Revolution and Environmental Justice (pub. avail. at https://joebiden.com/climate-plan/) (last accessed Dec. 23, 2020).
16) Interestingly, at least one SEC Commissioner has begun to question, if a third-party framework is adopted, whether oversight of third-party standard-setters whose framework(s) are adopted would be necessary or appropriate. Statement at the Meeting of the Asset Management Advisory Committee, Public Statement, Commissioner Elad L. Roisman (Dec. 1, 2020) (asking the ESG Subcommittee, “to the extent that you are considering recommending that the SEC incorporate certain third parties’ disclosure guidelines into our rule set, have you thought about how the SEC should oversee those third parties? Also, should we extend our oversight further, for example, to ESG-index providers and ESG-rating agencies, since so many ‘ESG’ funds and investment products are derivative of their work?”). Whether and the extent to which the new SEC Chair appointed by President-elect Biden will share this view cannot be known at this time.
17) Specifically, DOL rulemaking issued on October 30, 2020, entitled Financial Factors in Selecting Plan Investments, emphasizes the need for ERISA plan fiduciaries to weigh pecuniary factors when selecting plan investments, and continues to require that consideration of non-pecuniary factors be empirical and supported by appropriate processes. The DOL rule expressly provides that: plan fiduciaries are not permitted to sacrifice investment returns or take on additional investment risk to promote non-pecuniary benefits or any other non-pecuniary goals; and a fiduciary may not subordinate the financial interests of plan participants and beneficiaries to other objectives. Although this rulemaking does not expressly prohibit consideration or inclusion of a portfolio investment merely because it pursues ESG-type goals, the DOL rule does require the ERISA plan fiduciary to make certain determinations before selecting such an investment.
18) For further information regarding ESG considerations in the context of ERISA, please refer to Dechert OnPoints, An ESGplanation of ERISA’s New Regulation on Social Investing and Voting on Principle – ERISA Proxy Regulation Finalized.
19) The materials prepared by the ESG Subcommittee for the December 2020 meeting, including a summary of draft potential recommendations, can be found at on the SEC’s website.
20) A white paper prepared by the ICI’s ESG Working Group, entitled Funds’ Use of ESG Integration and Sustainable Investing Strategies: An Introduction, discusses the ICI’s views on an ESG taxonomy.