Stephen Hall, our legal director and securities specialist, spoke at the CFA Institute Climate Risk and Returns Conference this April. Steve’s panel explored how public policymakers, corporations, the investment community, and individual citizens all must work together to address climate change. The following is a blog based on his presentation at the panel. 

Regulation Of The ESG Market Will Protect Investors And Give Them Information They Need To Navigate This Complex Investment Landscape

Better Markets is a non-profit, public interest organization founded 12 years ago to fight for a more stable, fair, and transparent financial system.  Our advocacy has focused largely on financial stability and investor protection.  But we have also increasingly focused on the need to support increased oversight of the rapidly expanding “environmental, social, and governance” investment marketplace, known as ESG investing.

Strong regulation in this area is essential for two reasons: first, to protect investors from abuses such as greenwashing, and second, to respond to investor demands for more clear, standardized, and comparable disclosures in this complex market.  In short, regulation in the ESG marketplace is necessary not only to protect investors but also to foster an environment in which it can thrive.  And that will likely mean more efficient capital formation, better returns for investors, a more sustainable planet, and progress toward greater social justice.

Over the last two years in particular, the Securities and Exchange Commission (“SEC”) has ramped up its enforcement and regulatory efforts in the ESG space. In the Spring of 2021, it announced the creation of the “Climate and ESG Task Force” within the Division of Enforcement to focus on inadequate information and material misstatements in ESG-related disclosures.[1]  In April of 2021, the SEC’s Division of Examinations issued a Risk Alert.  It found that the “rapid growth in demand, increasing number of ESG products and services, and lack of standardized and precise ESG definitions present certain risks.”[2]  It detailed a number of problems, including unsubstantiated or misleading claims of ESG approaches, proxy voting inconsistent with ESG strategy, inadequate internal controls, weak or unclear documentation, and more.  And the SEC continues to bring enforcement actions in this area.[3]

On the regulatory front, the SEC has proposed three important rules: one to prevent the use of misleading mutual fund names;[4] one to provide investors in ESG funds with more detailed, consistent, and comparable disclosures about ESG investment strategies;[5] and a third to provide investors with more robust and useful disclosures about how companies are addressing the risks they face from climate change and disclosures about their greenhouse gas emissions.[6]

As to the other elements of ESG beyond environmental concerns, the SEC has already done a considerable amount of work in the corporate governance arena, finalizing a number of rules concerning executive compensation and proxy voting reform.[7]  And on the racial justice front, the SEC’s rulemaking agenda indicates that it will be proposing rules that require issuers to disclose information about corporate board diversity and human capital management.[8]

All of this stands to reason, based on the very nature of the ESG investment movement.  It has experienced huge demand and explosive growth, and it has spawned a complex ESG industry that provides a daunting array of investment options.  There are hundreds of ESG mutual funds, hundreds of ESG rating providers using different methodologies, and countless ESG indexes.  Tens of trillions of dollars are at stake, and the trend is expected to grow.  Under these circumstances, the potential for abuse and the need for a strong disclosure framework are clear.

The case gets even stronger given the appropriate role for preventive regulation.  Given the massive scale, popularity, and importance of ESG investing, the optimal approach is to get ahead of potential and foreseeable problems.  As the D.C. Circuit has said, regulatory agencies have the latitude to “adopt prophylactic rules to prevent potential problems before they arise.  An agency need not suffer the flood before building the levee.”[9]

Finally, it is equally important to appreciate what the SEC is not doing in its regulatory approach.  It is not mandating any specific ESG strategies or methodologies, and it is taking a layered approach in its rules.  Both the climate risk disclosure rule and the ESG mutual fund rule are scaled according to the size and nature of the companies and funds to which they apply, and they include a number of exemptions and safe harbors.

Above all, the SEC is not seeking to tip the scales against ESG investing.  This approach stands in contrast to what the Department of Labor (“DOL”) attempted to do under the prior administration, when it issued a misguided rule that inhibited the use of ESG investment options by ERISA fiduciaries. Fortunately, the DOL under the Biden Administration has amended that rule,[10] and it recently survived a Congressional Review Act resolution of disapproval thanks to President Biden’s veto.

The SEC’s approach is very different, and reflected in the release for its ESG mutual fund disclosure proposal. As the SEC explained,

The proposed rules and form amendments are designed to create a consistent, comparable, and decision-useful regulatory framework for ESG advisory services and investment companies to inform and protect investors while facilitating further innovation in this evolving area of the asset management industry.[11]

In sum, regulation must be one of the pillars that help the ESG investment movement serve the best interests of investors, the capital markets, and the world at large.

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[1] Press Release, SEC Announces Enforcement Task Force Focused on Climate and ESG Issues (Mar. 4, 2021), https://www.sec.gov/news/press-release/2021-42.

[2] SEC, Division of Examinations, The Division of Examinations’ Review of ESG Investing 2 (Apr. 9, 2021), https://www.sec.gov/files/esg-risk-alert.pdf.

[3]Press Release, SEC Charges BNY Mellon Investment Adviser for Misstatements and Omissions Concerning ESG Consideration (May 23, 2022), https://www.sec.gov/news/press-release/2022-86; Press Release, SEC Charges Goldman Sachs Asset Management for Failing to Follow its Policies and Procedures Involving ESG Investments (Nov. 22, 2023), https://www.sec.gov/news/press-release/2022-209.

[4] Investment Company Names, SEC (File No. S7-16-22, RIN 3235-AM72), 87 Fed. Reg. 36,594 (Jun. 17, 2022); see also Better Markets Comment Letter on Investment Company Names Proposal (Aug. 16, 2022), https://bettermarkets.org/newsroom/sec-rules-will-help-provide-reliable-and-comparable-information-for-the-growing-number-of-investors-interested-in-esg-funds/.

[5] Enhanced Disclosures by Certain Investment Advisers and Investment Companies about Environmental, Social, and Governance Investment Practices, SEC (File No. S7-17-22, RIN 3235-AM96), 87 Fed. Reg. 36,654 (June 17, 2022); see also Better Markets Comment Letter on Investment Company and Adviser ESG Disclosure Proposal (Aug. 16, 2022),  https://bettermarkets.org/newsroom/sec-rules-will-help-provide-reliable-and-comparable-information-for-the-growing-number-of-investors-interested-in-esg-funds/..

[6] The Enhancement and Standardization of Climate-Related Disclosures for Investors, SEC (File No. S7–10–22, RIN 3235–AM87), 87 Fed. Reg. 21,334 (Apr. 11, 2022); see also Better Markets Comment Letter on Climate Risk Disclosure Proposal (June 17, 2022), https://bettermarkets.org/newsroom/we-support-the-secs-climate-risk-disclosure-proposal-a-very-strong-measure-that-can-be-made-even-better/.

[7] See generally archive of SEC final rules, at  https://www.sec.gov/rules/final.htm (including final rules on enhanced reporting of proxy votes by registered management investment companies, listing standards for recovery of erroneously awarded compensation, pay versus performance, proxy voting advice, and the universal proxy)

[8] Office of Information and Regulatory Affairs, Agency Rule List, Fall 2022, Securities and Exchange Commission, https://www.reginfo.gov/public/do/eAgendaMain?operation=OPERATION_GET_AGENCY_RULE_LIST&currentPub=true&agencyCode=&showStage=active&agencyCd=3235&csrf_token=AFE3C2AE3D0906593AE099B689FF3B4F7784CD7EDC89DB9868DB5D5E9D41B2BD5F5E6DF2F5EB2D979C45668363F6EB59993D.

[9] Stilwell v. Office of Thrift Supervision, 569 F.3d 514, 519 (D.C. Cir. 2009).

[10] Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights, Dept. of Labor (RIN 1210–AC03), 87 Fed. Reg. 73,822 (Dec. 1, 2022).

[11] 87 Fed. Reg. 36,654.