On March 2, 2020, the SEC issued a request for comment on amending its Rule 35d-1, the so-called “Names Rule” under the Investment Company Act of 1940.1 Among other questions for which the Commission asked for comments were several related to the category of funds promoted as focused on “sustainable” and “socially responsible” investment strategies. The SEC asked whether it made sense to expand the Names Rule to give funds and their promotors better guidance regarding the proper use of words like “sustainable” or “ESG” (a common acronym used to refer to “environment, social, governance” investing styles). There has been some movement in the industry and the consulting community to converge on a common set of principles that can better sustain the aims of ESG investing. The push to better regulate claims around ESG and “sustainable” investing styles is part of a larger project by advocates to convince the SEC to speak more clearly about what constitutes acceptable disclosure regarding “socially-responsible investing” more broadly. We at Practus believe that amending the “Names Rule” to clarify the proper use of these terms is a good idea.
The SEC is asking for comment on whether: (i) investors are relying on terms like “ESG” and “sustainable” as indications of the type of assets funds hold, the strategies they employ (i.e. the degree they engage in activism to improve performance) or whether the funds pursue so-called “non-economic goals” in addition to traditional profit-maximization; or (ii) investor’s perceptions about these terms are mixed or indeterminate. If the answer is (ii) the SEC asks for views as to whether the SEC should put more specific requirements on funds who use these terms in their names. The SEC further asks for comments as to whether the use of “ESG” should be reserved for funds who pursue all three objectives (“environment, social and governance”) or whether those using ESG should at least explain which of the objectives are within their focus or strategy.
We welcome our clients and friends to contact us to discuss comments that we would prepare in response to this request. From what we see, investors do rely on words and acronyms in evaluating suitability of a fund for their long-term wealth-building strategy. While the use of “ESG” and similar terms need not mean the exact same thing for each fund, we believe that investors would benefit from SEC insisting on more clarity and consistency in the use of these terms. For example, the SEC should consider requiring that funds who put “ESG” in its name state a commitment to pursue all three goals (“environment”, “social” and “governance”) implied in its name. Use of the words “social”, “socially-conscious” or “sustainable” should imply a tangible commitment to pick investments based on criteria related to achieving “social” or “environmental” goals. The UN Compact for Sustainable Development Goals are widely used by operating companies in crafting their own “corporate social responsibility” and “sustainability” policies. Although it is not the only source for guidance on E+S aspects of ESG, if the Names Rule were to require funds to adopt a fundamental policy to evaluate investments based on portfolio company’s committing to a recognized third-party standard such as the UN Compact and reporting steady progress towards achieving them verified by an independent audit, the quality of information available to fund managers and investors would be meaningfully improved. We note that “governance” does not appear to be a separate investment strategy and we see little evidence that the use of this term alone merits separate attention by the SEC.
This request is an opportunity for the industry and others to help the SEC decide on how to address the challenge of ESG and “sustainable” and “socially-responsible” investing more broadly. Players in the industry that have made a real commitment to ESG investing can help the SEC frame matters in ways that strengthen their appeal to customers and reduce the freedom of competitors to promote funds that use these and similar catch-phrases to appeal to the same investors, but who offer less real rigor in choosing investments or engaging with issuers of securities in their portfolios.
Critics have accused promoters of ESG and similar “corporate social responsibility” and “sustainability” language of selling a type of “green-wash”—an appealing salad of virtue-signaling PR words used without any rigor and lacking any enforcement measures to back them up. Self-governance or, better stated, “soft” governance models, do not have to be empty exercises in virtue signaling, however. The credibility and effectiveness of voluntary “soft governance” can be enhanced by clear reference to principles that have been developed by third-party organizations or firms who state their principles publicly and have transparent processes for adopting and amending these principles. Many of these entities also offer third-party audits of compliance as a service. Such audits can increase the quality of information available to funds to monitor how their investments are performing and to make portfolio decisions that further investor goals. There is an abundant social science literature on self-governance, and there is broad agreement that private standards can increase information efficiency, help overcome collective action problems and the reluctance of private actors to provide public goods. Good performance information around ESG and “sustainable” investing is a public good and a private governance system can help overcome barriers for the generation and propagation of good information to market participants.
Our bottom Line
The SEC should amend the Names Rule to require that funds whose names indicate a commitment to ESG and “sustainable” styles of investing adopt as policy commitment to management systems for evaluating ESG investments and to disclose to investors what choices the funds have made and explain why certain standards and procedures were adopted and not others. The SEC should avoid prescribing in detail as no “one-size-fits-all” approach will be right for all such funds. Nevertheless the SEC could achieve good results if it required funds to commit in their disclosures to their own set explicit standards and procedures, report on performance in a reliable and consistent fashion and either subject themselves to verifiable standards developed by an independent third-party or explain why they chose not to reference third-party standards or why they choose not to subject their compliance to third-party verification.
The comment period is set to expire on May 5, 2020.
1 The Names Rule was issued in the late 1990s to give administrative guidance to registered investment companies who wished to include descriptive terms in the names of their funds. The rule specified that if fund sponsors wished to include in their names words that suggested that the funds’ investments would focus on certain asset classes, specific industries or geographies or in instruments that are tax-exempt, the Fund would have to adopt a policy that at least 80% of its assets would be within that class of investments, disclose the existence of this policy and either give investors advance notice of, or the right to approve, changes to that policy. The Names Rule did not apply if the names related only to “objective, strategy or policies” of funds. Use of names would still be subject to investigation and sanction under the statute if the names were found to be to be materially deceptive or likely to mislead investors. The Commission is now asking for comments on whether the Names Rule should be abolished or amended to reflect today’s market conditions. As part of that request, the SEC is looking for guidance as to whether the terms “ESG” and “sustainable” should be subject to specific guidance in the rule.