SEC Steps Up ESG Enforcement and Issues Proposed Rule on Diligence and Disclosure for ESG and Impact Funds

The Securities and Exchange Commission (“SEC”) continues to focus on Environmental, Social, and Governance (“ESG”) as an area of enforcement priority for 2022. This trend is most recently demonstrated by an enforcement action against BNY Mellon Investment Adviser, Inc. (“BNYMIA”) and proposed amendments to SEC disclosure rules that would establish new requirements for funds claiming to have an ESG focus. These developments highlight the need for ESG and Impact fund managers and advisors to take care in conducting ESG diligence and communicating with investors about portfolio company ESG policies and goals.

SEC Order

On May 23, 2022, the SEC announced a $1.5 million settlement with BNYMIA relating to what the SEC found to be misstatements regarding ESG considerations in BNYMIA’s investment decision making for certain mutual funds it managed (the “Funds”). BNYMIA consented to the issuance of the order without admitting or denying the SEC’s findings.

The SEC found that BNYMIA represented to investors that it performed ESG quality reviews as part of its investment research process for all investments made by the Funds, but in reality the individuals who selected investments for the Funds were allowed to and ultimately did select investments that did not undergo ESG quality reviews.

According to the SEC’s order, BNYMIA’s misrepresentations were contained in board minutes, Fund prospectuses, and written responses to requests for proposals from other investment firms considering investments on behalf of their own clients. In particular, the SEC found that BNYMIA’s Fund prospectuses created the misimpression that all investments were subject to ESG quality reviews.

The SEC found that BNYMIA violated Sections 206(2) and 206(4) of the Investment Advisers Act of 1940 and Rules 206(4)-7 and 206(4)-8 and Section 34(b) of the Investment Company Act, and the SEC imposed a cease-and-desist order, a censure, and a $1.5 million civil penalty.

This enforcement action is the latest originating from the SEC’s Climate and ESG Task Force. For example, our Client Alert from May discusses the SEC’s enforcement action against Vale S.A. for allegedly misleading ESG disclosures. More broadly, the SEC has stepped up its enforcement efforts across an array of subject areas as more fully detailed in our Current Alert.

Proposed ESG Rule

On May 25, 2022, the SEC proposed amendments to its existing rules and disclosure forms that would establish disclosure requirements for funds and advisers that market themselves as having an ESG focus. More specifically, the rule proposal would require specific disclosures of ESG or Impact fund strategy in registration statements, annual reports, and advisor brochures. This would include, for example, whether a fund tracks an index, applies a commercially available or proprietary screen and/or seeks to achieve a specific ESG outcome. The SEC announced on May 26, 2022, that ESG and “Impact” advisory services and investment products, including evaluation and disclosure of and execution on ESG investing approaches, will be a key focus area for the SEC’s Examinations Division in 2022. (So-called “Integration” funds — where multiple strategies are deployed — are excluded from the focus area.) The SEC has also said that ESG and Impact funds should comply with Investment Company Act Rule 35d-1, the “Names Rule,” such that 80% of a fund corpus must objectively be invested consistent with the strategy.

These developments suggest that ESG and Impact fund managers and advisors need to ensure that investment criteria are clearly defined and deployed as represented. The BNYMIA action also highlights the importance of taking special care in statements relating not just to criteria applied at the time of initial investment, but also on an ongoing basis to ensure that investor disclosures accurately represent portfolio company progress toward stated ESG goals. The manager and advisor should also be alert for other, and perhaps conflicting, guidance from federal and state regulators, including potential guidance from the Department of Labor on ERISA Funds, and should work with legal counsel to ensure that differing guidance from various regulators is considered when conducting ESG diligence and making ESG statements to investors.