Interest in ESG investing and the broader area of sustainable finance has exploded over the past few years. Both institutional and retail investors are clamoring for ESG investment options. According to one recent Morgan Stanley survey, 95% of millennials and 85% of all investors are now interested in sustainable investing strategies. Consequently, the highly competitive mutual fund industry has gone into overdrive, creating ESG mutual funds to attract these investors. Given the high demand and the growth of new mutual funds aimed at these ESG-conscious investors, it was only a matter of time before the regulators noticed. Over the past year, the SEC has been unfolding a larger plan to police and regulate sustainable and ESG finance.
ESG Disclosure Exams
The Securities and Exchange Commission is putting mutual fund environmental, social, and governance (ESG) disclosures under a microscope. Included in their March 2 examination priorities, the SEC announced that the SEC's investigators would be scrutinizing (among other things):
- whether firms' ESG processes and practices match their disclosures,
- fund advertising for false or misleading statements, and
- proxy voting policies and procedures and votes to assess whether they align with the fund's ESG strategies.
Name Test Rule
Making mutual fund ESG disclosures an exam priority is just the latest step in the SEC's focus on sustainable investing. This focus has only intensified with investors' interest in sustainable finance. The SEC's opening salvo into ESG-focused mutual funds was just a year ago. In March 2020, the SEC sought public comment on its plans to revisit the mutual fund name-test rule.
While the terms "ESG" and "sustainable" are commonplace in the investment industry and frequently appear in mutual fund names, precisely what they mean in practice remains elusive because investors and mutual funds apply their own definitions. The SEC is concerned that these products' names may mislead investors, given the lack of a universal definition of what ESG or sustainable investing means.
"The number of funds with investment mandates that include criteria that require some degree of qualitative assessment or judgment of certain characteristics (such as funds that include one or more environmental, social, and governance-oriented assessments or judgments in their investment mandates (e.g., "ESG" investment mandates)) is growing.  These funds often include these parameters in the fund name. The staff has observed that some funds appear to treat terms such as "ESG" as an investment strategy (to which the Names Rule does not apply) and accordingly do not impose an 80 percent investment policy, while others appear to treat "ESG" as a type of investment (which is subject to the Names Rule)."
The SEC staff will no doubt be factoring in the results of exams of ESG mutual funds as they craft any changes to the name-test rule, looking for the specific kinds of sloppiness or abuses the regulation is meant to address.
Since floating changes to the name-test rule, the SEC's regulatory activity around ESG issues has picked up momentum. In May of 2020, the SEC's Investor Advisory Committee recommended that the SEC update its reporting requirements for issuers to include ESG factors. This recommendation likely prompted the SEC to include ESG disclosures in its 2021 examination priorities in early March 2021.
In February, the Commission named a Senior Policy Advisor for Climate and ESG in Acting Chair Allison Herren Lee's office. In this new role, Mr. Khanna will advise the agency on environmental, social, and governance matters and advance related new initiatives across its offices and divisions.
And most recently, on March 3, 2021, the SEC announced the formation of an enforcement group focused solely on climate and ESG issues, including "analyz[ing] disclosure and compliance issues relating to investment advisers' and funds' ESG strategies." This enforcement group will be taking the most egregious findings of the SEC's examinations to the next step, formally investigating, imposing fines, and holding funds accountable.
Given the ambiguity around ESG terms and the fluid nature of the SEC's regulatory and enforcement policies and intentions, mutual funds engaging in the ESG space should examine their disclosures closely to ensure they match what they are actually doing. Some proactive introspection will help ESG mutual funds ensure that they are prepared when the SEC comes knocking at the door.
 Based on EDGAR data, approximately 65 funds (excluding unit investment trusts) included the terms "ESG", "Clean", "Environmental", "Impact", "Responsible", "Social", or "Sustainable" in their names as of December 31, 2007. The number of funds increased to 291 as of December 31, 2019.