Environmental, social and governance investing: recent developments

October 2020 | SPOTLIGHT | FINANCE & INVESTMENT

Financier Worldwide Magazine

October 2020 Issue

Environmental, social and governance (ESG) investing is now mainstream. Forbes reports 25 percent of investment in the US goes to companies that have adopted ESG programmes, a fact that would appear to support this observation. Another metric of ESG’s ascent is the federal government’s regulatory focus on ESG investing, which is also on the increase. This article discusses several such developments.

ESG’s growing influence

While the definition of ESG remains somewhat elusive, there is little doubt ESG investing has accelerated. As a concept, ESG encompasses a broad range of topics, including traditional environmental metrics, social practices (including human rights, diversity and inclusion, and labour practices), and governance practices (including fair trade, competitive behaviours and procurement). According to Bain & Company, a growing number of private equity firms have agreed to sign on to the United Nations’ supported Principles for Responsible Investment (PRI). The PRI includes six principles, one of which is to pledge to incorporate ESG issues into how the signatories select and manage investments.

How companies express their commitment to ESG varies greatly, of course, but there is little doubt that the concept is gaining traction. According to the US Securities and Exchange Commission (SEC), based on EDGAR data, the number of funds that contain ESG as an investment mandate is growing.

Recent developments

The first regulatory development is the SEC’s focus earlier this year on ESG criteria when offering investment strategies focused on sustainable and responsible investing in its Office of Compliance Inspections and Examinations (OCIE), ‘2020 Examination Priorities’. This publication summarises OCIE’s review of key risks, trends and examination priorities for fiscal year 2020. In its review, the OCIE expressed interest in “the accuracy and adequacy of disclosures provided by RIAs (registered investment advisers) offering clients new types [of] emerging investment strategies, such as strategies focused on sustainable and responsible investing, which incorporate environmental, social, and governance (ESG) criteria”. The mention of ESG in this context cements its significance and, of course, its identification as a priority reflects the SEC’s ongoing scrutiny of it. The publication is light on details, but ESG’s inclusion, in this context, should not be overlooked.

A second development is the SEC’s 6 March 2020 request for comment on mutual fund names, pursuant to Section 35(d) of the Investment Company Act of 1940, the so-called ‘Names Rule’. The SEC adopted the Names Rule in 2001 as an ‘investor protection’ measure to help ensure that investors are not misled or deceived by a fund’s name. The rule is anchored in the belief that a fund’s name is typically the first piece of information an investor sees about a fund and thus the name tends to have a disproportionate impact on an investor’s decision. In the request for comment, the SEC noted that it is assessing whether the existing rule is effective in prohibiting funds from using names that are “materially deceptive or misleading”.

According to the SEC, it requested comment in part due to a “current challenge” that relates to ESG criteria. Specifically, the “number of funds with investment mandates that include criteria that require some degree of qualitative assessment or judgment of certain characteristics (such as funds that include one or more environmental, social and governance-oriented assessments of judgments in their investment mandates (for example, ‘ESG’ investment mandates)) is growing. These funds often include these parameters in the fund name. The staff has observed that some funds appear to treat terms such as ‘ESG’ as an investment strategy (to which the Names Rule does not apply) and accordingly do not impose an 80 percent investment policy, while others appear to treat ‘ESG’ as a type of investment (which is subject to the Names Rule)”.

This lack of clarity relating to the application of the Names Rule to ESG as an investment strategy or an investment policy is what prompted the SEC to go public with the issue. The SEC asked several specific questions, including whether the Names Rule should apply to such terms as ‘ESG’ or ‘sustainable’, whether investors rely on such terms as indications of the types of assets in which a fund invests or does not invest, whether investors rely on these terms as indications of the funds’ objectives, and many related questions. Comments were due in early May. Clarification on the scope of the Rule’s application to ESG will be consequential for registered investment companies and business development companies alike.

A third development relates to a 30 June 2020, US Department of Labor (DOL)-proposed rule applicable to Employee Retirement Income Security Act (ERISA) pension plan fiduciaries. The proposal considers investments based on non-financial considerations, such as ESG objectives. According to the DOL, the proposed rule is intended to make clear that the ERISA plan fiduciaries “may not invest in ESG vehicles when they understand an underlying investment strategy of the vehicle is to subordinate return or increase risk for the purpose of non-financial objectives”. Interestingly, DOL Secretary Scalia remarked “private employer-sponsored retirement plans are not vehicles for furthering social goals or policy objectives that are not in the financial interest of the plan”. Secretary Scalia’s remark begs the question of how best to define ‘financial interest’ when taking the long view of the impacts of potentially catastrophic environmental harm caused by climate change on pension plans, to name one example.

Discussion

Private equity firms and investors are taking note of ESG when making investment decisions, as is the federal government. The SEC’s focus on ESG as an OCIE 2020 examination priority and for purposes of fund naming conventions are more neutral than the DOL’s apparent crackdown on plan fiduciaries’ consideration of non-financial factors, including ESG vehicles, when making investment decisions. The focus on ESG investing is unlikely to abate. Managers and investors alike can expect greater government scrutiny of, and regulatory engagement in, this space in the future.

Lynn L. Bergeson is managing partner of Bergeson & Campbell, P.C. She can be contacted on +1 (202) 557 3801 or by email: lbergeson@lawbc.com.

Lynn L. Bergeson

Bergeson & Campbell, P.C.