Friday, October 30, 2020

Regulators Want ESG Funds to Justify their Strategies

Author: David Schwartz J.D. CPA

Today the Department of Labor (DOL) issued final rules clarifying the regulatory guideposts for fiduciaries of private-sector retirement and other employee benefit plans in light of recent trends involving environmental, social, and governance (ESG) investing. The DOL is not the only regulator with ESG funds in their cross-hairs. The Securities and Exchange Commission (SEC) has begun verifying asset managers’ and mutual funds’ ESG strategies through examination and is considering amending the mutual fund “name test rule” to ensure funds are living up to their ESG promises to shareholders.  




The DOL’s new rules require that when selecting investments, ERISA plan fiduciaries must base their selection on “pecuniary factors.” “Pecuniary factors” are described as any factor that the responsible fiduciary prudently determines is expected to have a material effect on risk and/or return of an investment based on appropriate investment horizons consistent with the plan’s investment objectives and funding policy. In the rule’s proposing release, Secretary of Labor Eugene Scalia said that ERISA funds should remain true to their basic functions: 


“Private employer-sponsored retirement plans are not vehicles for furthering social goals or policy objectives that are not in the financial interest of the plan. Rather, ERISA plans should be managed with unwavering focus on a single, very important social goal: providing for the retirement security of American workers.”


The practical effect of this new DOL guidance is that plan sponsors wanting to employ ESG investment strategies must be able to demonstrate that investing using ESG principles generates superior financial performance or other qualitative or quantitative benefits versus other strategies that were considered. The DOL’s new rule makes ESG investing more challenging for plan fiduciaries. While not eliminating entirely a fund’s ability to employ ESG strategies, ESG factors may only be considered if they constitute “material economic considerations.”  The press release for the final rule even goes as far as saying plainly that the DOL “expects the final rule will result in higher returns by preventing fiduciaries from selecting investments based on non-pecuniary considerations and requiring them to base investment decisions on financial factors.”




The SEC has also taken an interest in the way that mutual funds employ ESG strategies, and are looking at ways to make them justify how these strategies are employed. In March, the SEC requested comments on whether Rule 35D-1 under the Investment Company Act of 1940 (the “Names Rule”) should apply to mutual funds that include terms such as “ESG” and “sustainable” in their name. The rule requires mutual funds with a name suggesting that the fund focuses on a particular type of investment to invest at least 80% of its assets accordingly. Though the comment period has closed, the SEC has not yet issued any formal rule proposals. Then in May, the SEC’s Investor Advisory Committee recommended that the SEC mandate disclosures concerning ESG for registered issuers of securities.


In January 2020, the SEC’s Office of Compliance Inspections and Examinations (OCIE), commenced an exam sweep of investment advisers that manage investment funds that employ ESG principles when making investment choices for clients. These exams focused on issues related to whether fund managers and advisers are managing their investors’ funds in accordance with their stated ESG strategies. In addition, in its 2020 exam priorities, OCIE included a “… particular interest in the accuracy and adequacy of disclosures provided by [advisers] offering clients new types or emerging investment strategies, such as strategies focused on sustainable and responsible investing, which incorporate ESG criteria.” 


More to Come

As funds and asset managers respond to growing demand from investors for “sustainable investing,” they should expect more scrutiny from US regulators. The EU is already examining how to integrate sustainability considerations into its financial policy framework, including amendments to the AIFMD and UCITS regimes as well as imposing organizational and disclosure requirements for investment firms.

Tags: SEC , DOL , ESG