On September 20th, the SEC finalized its amendment to the Investment Company Act of 1940 (“Act 40”) that addresses the naming convention of certain investment companies.
Included in these changes are a variety of impacts to funds using ESG terms, including, but not limited to, “green”, “sustainable” and “impact.” Funds must be in compliance within 24 months of final publication of the ruling to the federal register. The likely compliance date will be sometime in 2025.
The growth of investing in ESG and Sustainable funds across both Europe and the US has been substantial over the past three years. Despite peaking in Q4 of 2021 at $3.0 trillion, cumulative assets under management (“AUM”) in ESG funds have been steadily rising again over the last year and reached their second-highest total by the end of Q2 2023:
Image Source: https://www.morningstar.com/lp/global-esg-flows
Furthermore, the number of funds launched in the US with ESG and Sustainable names has stayed relatively steady over the past several years, despite decreasing in Europe and other parts of the globe:
Image Source: https://www.morningstar.com/lp/global-esg-flows
In Europe, tenets of the Sustainable Finance Disclosure Regulation (“SFDR”) govern the way that funds promoting environmental or social characteristics (“Article 8”) or those with a sustainable investment objective (“Article 9”) must disclose their intent both qualitatively and quantitatively to align with their stated objectives. Furthermore, periodic reporting back to the client is mandated in order to monitor progress against those espoused objectives.
All of this is to say that there has not been a corresponding regulatory initiative in the US to address a number of the concerns that exist in the marketplace. These concerns include the alignment of a fund’s assets to the strategy of the fund, the way in which a fund defines how it invests from an ESG perspective and treatment of items such as portfolio drift and derivatives. The expansion of the SEC Names Rule provides this clarity and focuses on the following key elements:
Funds with names indicating that they emphasize or incorporate ESG factors must now align 80% of their investments to those factors. It’s important to note that the final ruling does not crystallize how funds should define certain terms; for example, two funds’ names with ‘Climate Change’ in the byline may have radically different definitions of that terminology and how their investments will align accordingly.
The final ruling provides slightly more flexibility from departures from the mandated 80% alignment. “Under normal circumstances,” funds should be aligned to the 80%.’ This is a slight softening of language from the original proposal indicating departure is only allowed under specified circumstances. Furthermore, funds must have a process to review alignment to the 80% at least quarterly.
Lastly, the finalized rule allows funds 90 days to realign to their mandated 80% if the portfolio is out of alignment due to natural portfolio drift or another departure falling under the “normal circumstances” clause.
The final ruling emphasizes the notional amount, standardized to the 10-year bond equivalent of derivative holdings must be used to calculate 80% alignment as opposed to the market value of the holding. Additionally, any derivatives used as currency hedges must be removed from the calculation of the 80% and can deduct cash or US treasuries with maturities under 1 year from the final calculation.
Funds will need to begin adding definitions in their prospectus relating to ESG factors that they emphasize. As previously mentioned, the final ruling provides flexibility for funds in defining these terms.
On a quarterly basis, funds will now need to specify whether each investment holding aligns with one of the emphasized ESG factors and quantify what % of their total portfolio is aligned, as they define it.
This could be a heavy lift for funds’ Risk Management and Compliance departments and should be considered one of the most extensive parts of the final ruling!
A fund must maintain written records at the time of investment that state whether the investment is included in the 80% bucket, what the basis for the inclusion of that investment is and the % value of the aligned assets relative to total assets. Additionally, funds must maintain records that their internal functions, likely 1st and 2nd line, have reviewed portfolio holdings and justification for inclusion in the 80% bucket on at least a quarterly basis. Lastly, any departure from the 80% alignment due to portfolio drift or as a result of the “under normal circumstances” clause must be rationalized, reviewed and documented accordingly.
A notable omission from the final legislation is an explicit direction from the SEC on ESG funds emphasizing “ESG Integration.” ESG integration is a complicated and opaque part of the ESG investing world and has generated scrutiny and regulatory action from the SEC previously related to greenwashing claims of fund managers.
Despite the lack of regulatory direction here, the message from the SEC is clear:
If you’re publicly disclosing how your fund invests in the ESG space, you need to have clearly defined and implemented the methodology, governance, and controls to defend it.
If you have any questions about this article or other ESG-related topics, please contact our ESG team at [email protected].
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With our industry expertise and extensive knowledge of the risk advisory landscape, the Schneider Downs team can help your organization perform a gap assessment relative to the finalized regulation, suggest areas of improvement, and meet the SEC Name disclosure requirements.
Learn more about our ESG consulting services at www.schneiderdowns.com/esg or contact the team at [email protected].
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