July 18, 2022 - As previously reported, the SEC is requesting comment on a lengthy proposal that, if adopted, would usher in specific ESG disclosure obligations for registered investment advisers (RIAs), registered funds and business development companies (BDCs). While nearly all investment managers will be impacted in some way by the new rules, below we take a look at the key impacts and issues focusing on the players and strategies most prevalent in private credit markets.[1]
Why?
The SEC’s stated goal in proposing the new ESG disclosure requirements is to promote consistent, comparable, and reliable information for investors concerning funds’ and advisers’ incorporation of ESG factors. The SEC is concerned that this lack of consistent, comparable, and reliable information can create a risk of a mismatch between advisers’ and funds’ actual ESG considerations and investor expectations, and that funds and advisers may be marketing such strategies in a way that exaggerate their ESG practices (known as “greenwashing”).
Who?
Since the changed regulatory landscape post-Dodd-Frank, advisory firms active in the credit markets have registered with the SEC as RIAs. These advisers invest in the loan market through a number of vehicles, including loan mutual funds, ETFs, BDCs and private funds, like CLOs and other credit funds, and separately managed accounts (SMAs). Any fund or adviser that incorporates one or more ESG factors in its investment selection process is potentially in scope of the SEC’s proposal, but whether a fund or adviser and the extent to which ESG is considered will determine the applicable requirements, as described below.
- Registered Funds: The proposal tags ’40 Act Funds, which includes open-end funds, e.g., mutual funds, ETFs, and closed-end funds, as well as BDCs with the greatest disclosure obligations. These obligations will be dictated by the fund’s classification under the proposed system of Integration Funds, ESG-Focused Funds and Impact Funds (a subset of ESG-Focused Funds). Any fund that falls within one of these categories will have new ESG disclosure requirements, with ESG-Focused Funds and Impact Funds being subject to the most prescriptive disclosure requirements. The proposal does not purport to define “E,” “S” or “G”, but defines “ESG Integration,” “ESG-Focused” and Impact funds and strategies as follows:
- ESG Integration: A fund where one or more ESG factors may be considered in the investment selection process but is generally not dispositive compared to other factors when selecting or excluding a particular investment. We know that many ESG considerations have historically been integral to credit analysis, but recent years have seen a more specific focus on those, and even broader, ESG considerations relevant to investment selection. The proposal does not distinguish the use of ESG considerations in fundamental credit analysis as being different from the use in, for example, marketing materials or product labeling. Under such a broad, subjective categorization, it may be challenging to find a fund or strategy that would not fall in this category – even a fund or strategy not traditionally seen as ESG, or that does not hold itself as such.
- ESG-Focused: A fund that focuses on one or more ESG factors by using them as a significant or main consideration (i) in selecting investments or (2) in the engagement strategy with investee companies. One example of “ESG-Focused” proposed by the SEC is the use of screens – where certain investments are excluded or included based on particular ESG criteria. The use of screens, particularly negative screens, is a common practice in investment management. In some cases, this may be due to investor preferences and in others perhaps because of investment policies that the adviser has adopted at a firm level. Without any clarification around the scope of “ESG” or the motivation behind the screen, there is a risk that this category is overly broad. For instance, if certain investments are excluded largely on the basis of weak governance, it seems such a screen could bring the strategy in scope. This category explicitly includes any fund that (1) has a name including terms indicating that the fund’s investment decisions incorporate one or more ESG Factors and (2) any fund whose advertisements or sales literature indicates that the fund’s investment decisions incorporate one or more ESG factors by using them as a significant consideration in investment selection. The SEC helpfully clarifies that a mere mention of ESG considerations or a description of the relationship between ESG considerations and other considerations would not rise to this level.
- ESG Impact: A fund with a stated goal that seeks to achieve a specific ESG impact or impacts that generate specific ESG-related benefits. This is a subset of ESG-Focused Funds which carries enhanced disclosure requirements. It is not anticipated that many credit funds would currently fall in this category and this category and its implications is not a focus of this article.
- RIAs: The proposal adopts a similar categorization (Integrated, ESG-Focused, and Impact) for strategies pursued by RIAs with more detailed disclosures being required about ESG-Focused and Impact strategies than Integration strategies. As discussed further below, it is important to note that an RIA will need to report on each of their strategies that falls into one of the three categories. RIAs that advise private funds will be required to make ESG disclosures, for instance, if a CLO includes one or more exclusionary screens and thus is an ESG-Focused strategy.
Where?
The proposal adopts a “layered” reporting approach which would see brief, check-the-box type information presented early in a filing with more detailed information being set forth later in the filing. Registered funds – depending on their ESG categorization – would provide the required ESG disclosures in their prospectuses and annual reports. There would also be new census-type information on ESG-related funds that would be collected through amended Form N-CEN. RIAs that consider ESG factors in their advisory business would offer the required information in their adviser brochures on Form ADV Part 2A and about private funds and SMAs on Form ADV Part 1A.
What?
- Prospectus ESG Disclosure Enhancements (Registered Funds and BDCs): An Integration Fund would need to summarize in a few sentences how the fund incorporates ESG factors into its investment selection process, including what ESG factors the fund considers. This would take the form of a concise description upfront with a more detailed discussion appearing later in the prospectus. Each ESG factor considered in investment selections will need to be discussed. In addition, if GHG emissions of portfolio holdings are considered in investment selection, then a description of how the fund considers GHG emissions must be disclosed, including a description of the methodology the fund uses in its consideration. An ESG-Focused Fund would provide key information about their ESG considerations in a tabular, standardized format. This includes brief descriptions of how the fund incorporates ESG factors in its investment selection and engagement process as well as indicating any and all ESG strategies the fund employs and the percentage of the portfolio to which each strategy applies (if less than 100%). Later in the prospectus the fund would describe how the fund incorporates ESG in its investment process in more detail, including any internal methodology use, the scoring or rating system of any third-party used by the fund, the factors applied by any screen, a description of any third-party framework used, and a description of the objectives of any engagement activities. Many firms have spent significant resources to develop a sophisticated, proprietary internal ESG rating system, particularly for private companies. It should be clarified that the required disclosures should not result in the disclosure of proprietary information.
- Annual Reporting (Registered Funds and BDCs): Of particular note, ESG-Focused Funds that consider environmental factors as part of its investment strategy would be required to disclose the carbon footprint and the weighted average carbon intensity (“WACI”) of the portfolio – unless the fund affirmatively states that it does not consider greenhouse gas (GHG) emissions of a portfolio company in its investment strategy. (The Appendix in Ropes & Gray’s recent client alert includes the sections of the proposal that outline the technical calculation of a fund’s carbon footprint and WACI.) Given the focus on climate by investors and now the SEC, it seems unlikely that many funds will be able to state they give no consideration to GHG emissions. Registered investment companies would include this disclosure in the management’s discussion of fund performance section of the fund’s annual shareholder report. BDCs would include this disclosure in the MD&A in the fund’s annual report on Form 10-K. It is clear that the disclosures here contemplate that climate-related information will be more available once the SEC’s separate climate-related disclosures for reporting companies (including by BDCs) takes effect. While those disclosure requirements once adopted may lead to more climate-related data being available, private companies would neither be required to provide that information nor would they be in a position to do so. Climate-related data is seldom available for private companies. If a BDC considers environmental factors in its investment strategy – and is therefore required to report the carbon footprint and WACI of its portfolio – the BDC would most likely have to rely on good faith estimates (and describe the data on which the estimates were based) in the absence of reported data by investee companies. Because of the definition of “portfolio company” used for both the carbon footprint and WACI calculations, a BDC would have to take into account GHG emissions of its investments in private funds, such as CLOs. Given the lack of GHG emissions data on private companies – which comprise most of a CLO’s investable universe – and the fact that CLOs would not be required to report their carbon footprint or WACI under these rules, BDCs would be in the position of estimating most of the inputs in its calculations. In addition, environmentally focused funds would be required to disclose Scope 3 emissions (emissions relating to a company’s value chain) of its portfolio companies to the extent that Scope 3 emissions data is reported by these companies. While Scope 3 emissions are part of the SEC’s disclosure requirements for reporting companies, little if any Scope 3 emissions public reporting is done by private companies. Given the stated goal of the SEC to further reliable, comparable ESG information for investors, it seems inappropriate to have a requirement that will result in good faith estimates and variance in how funds arrive at these estimates.
- Adviser Brochure Enhancements (RIAs): RIAs would need to explain what it means when it states that it incorporates ESG factors in its investment recommendation, including describing the ESG factors. For each ESG strategy, the RIA would describe how ESG factors are incorporated, which factors are considered, and any criteria or methodology used to evaluate, select, or exclude investments based on this consideration (e.g., the use of screens, internal and/or third-party methodologies. For Integration Strategies, this also includes a discussion of whether and how ESG factors are considered alongside other non-ESG factors. For each ESG-Focused Strategy, an RIA would describe how ESG factors are considered and explain whether and how the strategy focuses on one or more factors. For advisers that use ESG criteria or methodologies to evaluate, select, or exclude investments based on this consideration, the disclosure would include details concerning those criteria and methodologies. If an RIA’s criteria or methodologies include following a third-party ESG framework, it would describe, and explain how it uses, the framework.
- SMA and Private fund-related Enhancements (RIAs): Amended Form ADV Part 1A would expand the information an RIA would need to report on its advisory services to SMAs and reported private funds. For its significant investment strategies, an RIA would provide information about the use of ESG factors, including type of ESG strategy, in managing each private fund and SMA. The RIA would also need to report the name of any third-party framework that is follows in connection with their advisory services.
When?
Sooner than you might think! The effective date of the rule, i.e., when funds and RIAs would need to ensure compliance is only one year or 18 months (depending on the disclosure form or report in question) after the effective date, which would be sixty days after the final rule is published in the Federal Register. If the final rule is adopted in any form similar to the proposal, there will be a lot of work to do between now and then. It is not clear that a one-year time frame is practicable and will likely be a focus of commenter feedback.
Comments are due by August 16th. It is expected that the SEC will receive significant comments on this proposal, including by trade associations representing fund and investment management interests. The LSTA is currently preparing its submission, which will focus on the impact of the proposal on the credit markets and our members active in them.
[1] Please note that a discussion of specific compliance requirements included in the proposal is outside of the scope of this discussion. Also, given that engagement with the borrower is unlikely to be a significant ESG strategy for a lender, a detailed discussion of engagement-related requirements is not included.
