06/29/2022 | News release | Distributed by Public on 06/28/2022 16:20
In this issue, we discuss, among other things, proposed disclosure requirements for investment advisers regarding ESG investment practices.
In a May 25, 2022 release (Proposing Release), the SEC proposed amendments (Proposal) to rules and forms under the Investment Advisers Act of 1940, as amended (Advisers Act), and the Investment Company Act of 1940, as amended (Investment Company Act), with respect to disclosure of ESG investment practices in fund registration statements, fund annual reports, adviser brochures and census-type reports, including: Forms N-1A, N-2, N-CSR, N-8B-2, S-6, N-CEN and Form ADV. The Proposing Release notes that the Proposal is designed to facilitate enhanced disclosure of ESG practices to clients and shareholders in order to create a consistent disclosure framework, as "[i]t is important that investors have consistent and comparable disclosures about asset managers' ESG strategies so they can understand what data underlies funds' claims and choose the right investments for them." The Proposal would apply to registered and certain exempt investment advisers (advisers), registered investment companies and business development companies (funds).
The SEC was prompted to issue the Proposal by the inconsistency of information provided by funds and advisers to investors regarding the ESG factors that such funds and advisers use in their investment strategies. According to the Proposing Release, there is currently no standard for how funds and advisers report ESG factors, and therefore it is difficult for investors to determine what ESG strategies the funds and advisers employ, whether the funds and advisers are meeting the ESG-related targets they claim to meet and whether the strategies funds and advisers employ are effective. In response, the Proposal is designed to create consistent standards for funds and advisers to disclose ESG-related strategies. These disclosures would apply to disclosures to investors and in regulatory reporting regarding ESG-related strategies. The Proposal also includes amendments to Form N-CEN that would require index funds to report certain information about the index, regardless of whether the fund tracks an ESG-related index. The Proposal also will require funds to submit these ESG-related disclosures in a structured data language so the data can be readily analyzed.
The SEC has requested public comments on the Proposal, to be received by the SEC on or before August 16, 2022.
Some key takeaways of the Proposal include:
As discussed in the Proposing Release, in the 1970s and 1980s, asset managers began to integrate ESG factors into funds with social and environmental investment objectives, and the first socially responsible index was launched in the 1990s. Beginning in the mid-2000s, many financial institutions signed on to climate and sustainability-related investment frameworks and a variety of organizations were formed to create disclosure frameworks designed to consider environmental measures. As a result, the asset management industry has increasingly focused on environmental issues related to climate change, among other issues and an "increasing number of funds market themselves as 'green,' 'sustainable,' 'low-carbon,' and so on." According to the Proposing Release, there has been a rapid increase in investors seeking to invest in ESG-related strategies, funds and services. Funds and advisers are subject to general disclosure requirements concerning investment strategies and are required to disclose certain information, such as material information on investment strategies, risks, governance and fund performance. However, while ESG-related strategies may fall into these categories of required disclosures, the Proposing Release noted that there are no specific requirements regarding the information funds and advisers must disclose about their ESG-related investment strategies and, as a result, there is "currently a huge range of what asset managers might disclose or mean by their claims." Because there is currently no specific disclosure framework, there is a risk of funds and advisers marketing themselves as focusing on ESG factors when in actuality their ESG strategies are limited, which is misleading to investors. Additionally, because inconsistent information is provided about funds' and advisers' ESG-related investment strategies, it is difficult for investors to understand such strategies and to compare strategies across various funds and advisers. In response, the SEC has submitted the Proposal, which is designed to create a consistent disclosure regime that standardizes ESG reporting and requires funds and advisers to disclose specific and detailed information about their ESG-related investment strategies. The Proposal is intended to enhance disclosure so that investors and the public have more information about funds' and advisers' ESG investment strategies and are better able to understand and compare ESG investment strategies. Further, requiring specific and standardized reporting seeks to prevent funds and advisers from making exaggerated claims about their ESG investment strategies, thus protecting investors from potentially misleading claims.
Proposed prospectus ESG disclosures
The amount of additional disclosure that would be required for funds under the Proposal would depend on the extent to which the fund considers ESG factors in its investment strategies and decisions. Such ESG disclosures would be in addition to the information funds currently are required to disclose in the prospectus regarding their investments. Integration Funds would be required to provide relatively limited disclosure of their ESG investing strategies, while ESG-Focused Funds would be required to disclose more detailed information. These prospectus-related amendments would apply to both open-end and closed-end funds that consider one or more ESG factors in their investment process.
Proposed fund annual report ESG disclosure
The Proposal also would require additional ESG disclosure in the management's discussion of fund performance (MDFP) or equivalent section of a fund's annual report.
XBRL tagging proposals
The Proposal would require funds to submit all ESG-related disclosures filed with the SEC in Inline XBRL, which would allow investors, other market participants, and the SEC to easily extract and analyze the disclosed information. According to the Proposing Release, the requirements would allow for automated extraction and analysis of the disclosed data which would make it easier for users to analyze and compare data across funds.
Amendments to Form ADV Part 2A
The Proposal would also amend Form ADV Part 2A to include information about advisers' ESG practices. Such requirements would provide current and prospective investors with information to assist them in evaluating the ESG strategies and services the advisers utilize.
Reporting on Form N-CEN and ADV Part 1A
The Proposal would also amend Form N-CEN and ADV Part 1A to collect information on funds' and advisers' use of ESG factors. Such amendments seek to help the public and the SEC understand evolving trends relating to ESG investing.
Compliance procedures and marketing
In the Proposing Release, the SEC emphasized the importance of reviewing the accuracy of statements regarding ESG investment strategies, and advisers' and funds' compliance obligations under relevant federal securities laws, including the Advisers Act and Investment Company Act. The SEC noted in particular the importance of reviewing statements regarding ESG strategies in marketing materials to ensure that such statements do not violate applicable rules, such as the Advisers Act marketing rule, regarding false and misleading advertisements.
The SEC proposed a one-year transition period from the date of publication of the final rule in the Federal Register, if adopted, to provide time for advisers to prepare for compliance with the final rule.
The SEC's 2022 Examination Priorities characterized "disclosure of fees and expenses" as a "perennial priority[]"-as reflected in a number of enforcement actions relating to fee and expense allocations over the past decade. Most recently, on June 14, 2022, the SEC issued an order (ECP Order) instituting and settling administrative and cease-and-desist proceedings against Energy Capital Partners (ECP), a private equity and credit investment adviser, arising out of allegedly undisclosed, disproportionate allocation of fees and expenses to certain investors in one of its managed private equity funds.
In 2013, ECP launched Energy Capital Partners III, LP (Fund III); that fund closed in April 2014 with approximately $5.05 billion in capital commitments. According to the ECP Order, Fund III's organizational documents disclosed that the fund would allocate fund expenses "based on the relative investment and/or benefits derived among" the funds, and/or "in any manner determined equitable, in the good faith judgment" of ECP.
In May 2017, Fund III entered into negotiations to acquire a certain target company; Fund III signed an agreement to purchase the target company in August 2017, under which Fund III was required to provide proof of funding for the approximately $5.5 billion equity component of the transaction. ECP directed that approximately $1.95 billion of Fund III's available capital be allocated to funding the transaction; the remainder would be funded by certain co-investors (which the ECP Order calls the "Pre-Deal Co-Investors") and a bridge facility.
In September 2017, ECP launched Energy Capital Partners IV, LP (Fund IV); ECP allegedly anticipated eliminating the bridge facility for the transaction by investing capital of Fund IV and certain co-investors (which the ECP Order calls the "Post-Deal Co-Investors"). Ultimately, when the transaction closed in March 2018, Fund III invested approximately $1.4 billion, the "Pre-Deal Co-Investors" invested approximately $2.55 billion, the "Post-Deal Co-Investors" invested approximately $1 billion, and Fund IV invested approximately $450 million.
As stated in the Order, although ECP intended to allocate approximately $27 million in fees for the bridge facility pro rata, the "Pre-Deal Co-Investors" objected to bearing any share of those fees. ECP allegedly agreed not to allocate any of the bridge facility fees to the "Pre-Deal Co-Investors," and, instead, allocated to Fund III approximately 39% of the bridge facility fees even though Fund III was allocated only 27% of the equity investment in the target. This decision allegedly caused Fund III to bear about $3.3 million more in expenses than it would have had the fees been allocated pro rata.
The SEC asserts that ECP should not have allocated to Fund III more than its proportional share of the bridge fees absent disclosure in the organization documents or to Fund III investors by another means, thereby violating Sections 206(2) and 206(4) of the Advisers Act and Rule 206(4)-8 thereunder. The SEC also alleges that ECP thereby failed to implement its written policies and procedures designed to prevent violation of the Advisers Act and rules relating to expense allocation, in violation of Section 206(4) of the Advisers Act and Rule 206(4)-7 thereunder.
The ECP Order notes that ECP remediated the allocation by paying to Fund III the excess $3.318 million (plus interest) in fees over what it would have had to bear had the fees been allocated pro rata.
ECP agreed to cease and desist from future violations, to be censured, and to pay a civil money penalty of $1 million.