The rules around ESG investing might soon change. On September 20, the SEC updated its rules that govern environmental, social and governance (“ESG”) investment funds. The new rule updates how these funds are named, requiring a fund that advertises itself as ESG to hold at least 80% of its investments in related assets. From a regulatory perspective, this is a minor change. It only updates the SEC’s naming rule, meaning that it just changes how funds can name and advertise themselves. However, in practice, this will likely have a significant impact on the ESG industry.
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What Is ESG?
Environmental, social and governance (ESG) funds are a form of investing that has gained popularity in recent years. An ESG fund is a mutual fund or exchange-traded fund that selects its assets based on a commitment to one or more social or political factors. For example, as the SEC writes in one explainer, these are funds that might invest in companies that have a strong track record on environmental issues or corporate transparency. Or they might invest away from companies that perform poorly in these areas, for example choosing not to invest in fossil fuel companies or high-pollution industries.
It’s important to understand that, contrary to significant political rhetoric, no regulation or rule requires funds to invest around ESG principles. Nor are these funds exempt from traditional rules of fiduciary duty. Investors uninterested in ESG investing can simply choose another fund, and investors who do choose an ESG fund are still protected by the standard duty of care.
What Is the New SEC Regulation?
As part of its general oversight duties, the SEC recently updated a regulation known as the “Names Rule” (Rule 35d-1). In the relevant part, this update changes how the rule applies to ESG funds. As the agency wrote in its announcement, it changed the naming rule to address “materially deceptive and misleading use of environmental, social or governance (“ESG”) terminology in fund names” by requiring “that terms in a fund’s name be consistent with those terns’ plain English meaning or established industry use.”
In practice, this means that the SEC now requires a fund to have a policy of holding at least 80% of its value in assets directly related to the fund’s name, as understood either through plain English or industry terms of art. It will consider funds that do not meet this standard to have materially deceptive naming and advertising.
This does not mean that the fund must hold an exact 80% balance at all times. The rule allows for market fluctuations. Rather, it requires that the fund must have an enforced policy of holding or working toward this balance of assets. In case of market volatility, the fund must generally trend toward rebalancing, even if the process does not have to be real-time.
What Does This Policy Mean?
While in theory, this is a small matter of naming, in practice this is a relatively big deal for the ESG industry. This is because many environmental, social and governance funds are almost anything but. This is a practice known as “greenwashing,” when a company or investment will market itself as having lofty social goals while doing little to advance those ideas. In the case of ESG funds, greenwashing would refer to a fund that markets itself as an environmental, social or governance-oriented investment while largely ignoring those principles in its actual investments.
Even though this is common in consumer advertising, and certainly misleading, greenwashing actually rarely breaks the law. However, securities have a higher bar than consumer goods. A fund or asset must market itself honestly. When it misleads investors about what strategies it will pursue or what assets it holds, for example by suggesting the fund will not invest in the fossil fuel industry while holding shares in oil companies, it constitutes a form of fraud.
This kind of greenwashing is a significant problem with ESG funds because many such funds have very little invested in assets related to their names and mission statements. What assets they do hold tend to do little to advance their stated cause. For example, an ETF branded as a climate-focused fund may in fact hold few climate-related assets, investing instead toward higher-performing companies regardless of environmental criteria.
Bottom Line
The SEC has updated its rules governing how funds, and particularly so-called ESG funds, are named. Going forward, a fund that names itself based on environmental, social or governance branding will need to hold at least 80% of its value in related assets. It’s important to understand these rules if you plan on navigating any type of ESG investing in your practice.
Social Investing Tips
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- The ESG movement has picked up a lot of steam in recent years. Some investors argue that they simply want their money to represent their values, while others believe that it’s a better long-term strategy.
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