In an effort aimed at the environmental, social, and governance (“ESG”) investment industry, the U.S. Securities and Exchange Commission (“SEC”) has reportedly been investigating how vote trading impacts fund decisions on ESG issues.
Lawyers with the SEC Enforcement Division’s Asset Management Unit have reportedly been questioning firms offering ESG funds over how they lend shares and whether there are policies in place for recalling votes before corporate elections.
It has been reported that “sustainable” exchange-traded funds and mutual funds managed $2.5 trillion globally as of the end of June. This growth has reportedly fueled concerns by top regulators at the SEC that without measures in place requiring certain disclosures, firms lacking accountability may exaggerate the purported environmental and societal factors purportedly considered by the fund.
Specifically, shareholders can generally lend securities to other investors to hold temporarily, often for the purpose of shorting the stock or hedging. Because the owners lend their shares for a fee, this practice is often highly profitable for the lenders. When this is implemented in the ESG investment industry, the concern is that securities owners lend both their shares and their vote on decisions about critical ESG issues—therefore forgoing their own ability to affect ESG issues at the company while granting vote possession to short-sellers who have an oppositional interest in the fund.
The lending issue specifically brings into focus whether ESG funds and their respective fiduciaries can simultaneously meet claimed goals related to environmental, sustainability, and social governance issues while profiting from a short-selling practice that involves proxy voting.
In March 2021, former Democratic Commissioner and then-acting SEC chair Allison Herren Lee said funds should provide enhanced disclosures on how they vote for investors on related issues. In May, SEC chair Gary Gensler introduced a proposed rule that would require funds to disclose specifically how proxy voting fits into fund strategies that claim to consider ESG factors.
Supporters of the short-selling practice as it applies to all funds, including ESG, claim that money managers can recall shares if they want to vote on shareholder resolutions related to ESG issues.
This inquiry comes as the SEC under the Biden Administration continues to press regulation and enforcement of sustainability claims across the investment industry. In March 2021, the SEC announced the creation of a Climate and ESG Task Force in the Division of Enforcement to identify possible misconduct related to climate and ESG disclosures. News of this latest investigation comes as the SEC has both proposed significant new rules and initiated enforcement actions aimed at ESG-related disclosures.
The SEC has recently proposed three significant rules aimed at requiring ESG disclosures:
- Climate-related disclosures: On March 21, 2022, the SEC proposed a rule that would mandate certain climate-related disclosures for all companies with SEC reporting obligations under Securities Exchange Act of 1934 (“Exchange Act”) Section 13(a) or 15(d) for companies filing a registration statement pursuant to the Securities Act of 1933 (“Securities Act”). The rule would require disclosures in annual reports and registration statements related to direct and indirect greenhouse gas emissions, climate-related key performance metrics, and corporate governance practices mitigating climate risks.
- Investment adviser and investment company disclosures: On May 25, 2022, the SEC proposed a rule that would require funds and advisers engaging in ESG investing to provide more detailed disclosures related to the ESG strategies in fund prospectuses, annual reports, and adviser brochures. This would apply to registered investment companies, business development companies, registered investment advisers, and certain unregistered advisers. Related to this vote lending inquiry, this rule would also require enhanced disclosures by funds using proxy voting or relying on an issuer to implement ESG strategies, as well as information concerning their ESG engagement meetings.
- Extending the “Names-Rule” requirement: In an effort to combat “greenwashing,” or the process of conveying a false impression about an entity’s posture as environmentally conscious, on May 25, 2022, the SEC proposed an additional rule to amend the Investment Company Act “Names Rule” to address changes in the fund industry. Currently, the Names Rules requires registered investment companies whose names suggest a focus in a particular type of investment, industry, or geography to invest at least 80% of the value of their assets in those investments.
This proposed rule change would explicitly extend the Names Rule to funds indicating their investment decisions incorporate one or more ESG factors. In addition, the rule would make clear that integration funds—or funds that consider ESG factors along with, but not more significantly than, other factors—cannot use ESG-related terms in their names. In a statement on the proposed rule, Chair Gensler noted that the proposal “would modernize this key rule for today’s markets and enhance the transparency of the asset management field.”
While the SEC has yet to publicly announce any lawsuits related to this purported lending inquiry focusing on ESG funds, the agency recently began bringing cases and conducting investigations over ESG disclosures:
- On May 23, 2022, the SEC announced a settlement with Bank of New York Mellon Investment Adviser Inc., in which BNY Mellon paid a $1.5 million penalty to settle allegations—which are neither admitted nor denied—that it made material misstatements and omissions regarding ESG factors related to its management of certain mutual funds.
- On April 28, 2022, the SEC charged Brazilian mining company Vale S.A. with allegedly making false and misleading claims through its ESG disclosures regarding the safety of its Brumadinho dam prior to the dam’s collapse in January 2019. The collapse killed 270 people and caused significant environmental and social harm.
- In June 2022, it was reported that the SEC is investigating Goldman Sachs over its ESG mutual funds.
While it is unclear where this purported investigation will lead, a focus on clarity in disclosures and adherence to stated investment characteristics can broadly be viewed as a positive development for investors in the marketplace.