The term “ESG” – Environment, Social, Governance – is everywhere, including its use in the rise of any number of “ESG” targeted investment funds—currently there is an estimated $3.1 trillion in assets under management invested in “ESG.” But uncertainty concerning what precisely an “ESG” fund is has led to questions of how the Securities and Exchange Commission (“SEC”) intends to regulate them. Speaking before the Future of Asset Management North America Conference on September 29, 2021, SEC Chair Gary Gensler noted that one of the Staff’s current projects relates to “ESG” disclosures, particularly with respect to fund naming and marketing using terms like “green,” “sustainable,” or “low carbon.”
These comments offer critical insight into the SEC’s perspective, but there is still little guidance regarding what the SEC’s boundaries will be with respect to “ESG” disclosures. While fund managers wait for guidance from the SEC, they should remember that the core issue is the same as with any other disclosures: are they saying clearly what it is that they do, and, importantly, are they actually doing it? Advisers should focus on reviewing their disclosures and comparing them with the investments and their own due diligence practices and policies, and proceed with caution on any future disclosures or over-reliance on the term “ESG” in marketing materials. With the announcement of an SEC Enforcement task force focused on climate and ESG related disclosures, funds that misuse the term “ESG” are clearly at risk.
Why is the SEC so focused on “ESG” when the core issue is nothing new? The answer is twofold: (1) “ESG” itself is an incredibly broad term, and (2) there is a moral psychological component.
With respect to the first point, the history is important. In 2004, Paul Clements-Hunt, the Head of the UNEP Finance Initiative sought to name a capital markets report on social, environmental, and governance issues. Mr. Clements-Hunt explains that he was looking for “sexy phraseology” to “capture the mainstream’s imagination,” and his “journalistic instincts” were that “ESG” had a good ring to it. He was obviously right. The problem, of course, is that sexy shorthand is the antithesis of sufficient disclosure.
A few examples highlight the uncertainty derived from the breadth of the term. An “ESG” fund could be comprised of portfolio companies that are focused on sustainability but are led by all white male boards. Or it could invest in exclusively companies with diverse boards but whose product expands the hole in the ozone. And yet, multiple funds include “ESG” in their names and/or marketing materials (websites, prospectuses, etc.), as flagged by Chair Gensler and the SEC’s request for comment on the fund Names Rule (noting that the number of funds with terms like “ESG” or “Clean” in their names has increased from 65 in 2007 to 291 in 2019). To be sure, many investors decide to invest in an “ESG” fund based on those three letters alone.
The moral question is more complicated. The premise that an investor would think her money is working toward improving the world and then it is not feels worse than, say, she thought she was investing in real estate and instead her money was put into tech. But the failure to disclose is the same – so why do we hold the adviser who falsely advertises an “ESG” fund more accountable (i.e. through creation of a specialized task force on the issue)? There’s clearly a moral psychological issue at play.
A good comparative example is the SEC’s reaction to references to “Blockchain” in fund names. In January 2018, the SEC encouraged two ETFs that invested in companies involved in developing the digital technology for cryptocurrency transactions to remove the word “Blockchain” from their names. But while cryptocurrency is another SEC priority, the SEC’s cryptocurrency task force is focused on the underlying regulation of cryptocurrency itself, not disclosures based on use of the term “blockchain,”
So, what to do to fulfill the moral desire to regulate the “ESG” minefield? One answer is for the SEC to simply prohibit the use of the term “ESG” in fund names and marketing materials. The other option, of course, is for the SEC to offer clear guidance with respect to “ESG” disclosures. Generally the SEC rejects the provision of bright-line thresholds for disclosure. And in the ever-changing landscape of climate and social issues, even if the SEC were to provide guidance tomorrow, it would likely need to change in the future. (While the SEC has indicated it will propose rulemaking this Fall 2021, it may take years before a rule is operative).
In the interim, as with all disclosure-based issues, advisers should go back to basics and review the disclosures—particularly the use of the term “ESG”—carefully and critically, as the SEC certainly will.