Travers Smith's Sustainability Insights: The regulatory focus on "greenwashing"

A regular briefing for the alternative asset management industry.

It has been clear for some time that regulators are concerned about "greenwashing", by which they mean the risk that companies, investors and asset owners will overstate their sustainability credentials in order to attract capital. But, in the last few weeks, the regulatory pressure has significantly increased. Recent announcements from the SEC, the US regulator, and ESMA, the pan-EU supervisor, will focus the minds of all asset managers, including those running private funds.

In the US, proposed new SEC rules for ESG disclosures by investment advisers will buttress an already sharp focus on sustainability claims by the Division of Enforcement. The SEC's proposal, published on 25 May, is designed to "promote consistent, comparable, reliable – and therefore decision-useful – information for investors". It will apply to all SEC-registered advisers but also (to a more limited extent) to "exempt reporting advisers", a category that includes many European firms with US investors. The change would be to Form ADV – the annual filing that investment advisers (including private fund advisers) are required to make – and would require detail on an adviser's use of "ESG factors", which are not themselves defined, as well as disclosure of third party frameworks that it uses and relationships with "related persons" who are ESG service providers.

In some respects the SEC's proposals resemble the EU's Sustainable Finance Disclosure Regulation (SFDR): the US rules would require firms to categorise their investment products according to whether they "integrate" ESG factors alongside other (non-ESG) factors; whether they are "ESG-Focused", using one or more ESG factors as a "significant or main consideration in selecting investments or engaging with portfolio companies"; or whether they adopt an "ESG-Impact" strategy, and therefore target portfolio investments that drive specific and measurable environmental, social, or governance outcomes.

Like the SFDR, these categories determine disclosure requirements, but are not labels: they do not guarantee any particular investment strategy or minimum ESG standards. It will be important, therefore, for the SEC to ensure that investors do not come to regard the categories as if they were labels – a significant problem with the EU rules, acknowledged by the EU regulators. But, although the scope of "ESG" is not defined in the currently proposed SEC rule, the three product categories seem clearer and easier to understand than their SFDR-equivalents.

In fact, despite that similarity, the SEC's proposals for private fund advisers are much less extensive than those which apply under the SFDR. Indeed, they are also less extensive than other SEC proposals (included in the same release) for US registered investment companies and business development companies. The additional information that needs to be provided in the Form ADV should help investors to understand the sustainability features of an investment product, and help the SEC to enforce its prohibition on misleading investors, but does not extend to detailed metrics or anything close to EU Taxonomy-style reporting. The focus on "greenwashing" may be acute, but investors have largely been left to define the detail of the required reporting for themselves.

...private fund managers should take careful note, because – despite their mostly institutional and sophisticated investor base – they are not likely to avoid the spotlight for long.

Meanwhile in Europe last week, ESMA issued a wide-ranging "Supervisory Briefing" that stressed the need for EU national regulators to look hard at compliance with the SFDR. When taken together with the European Commission's Q&A on the interpretation of the SFDR and the Taxonomy Regulation and a joint statement by the EU regulators also issued last week, the strict approach to application of the new rules is very clear – making an already tough job even harder for affected firms.

For example, the European Commission's guidance confirmed that legacy funds – those not made available to investors after the SFDR became effective – are subject to the SFDR's disclosure regulations if they promoted certain sustainability characteristics. In its briefing, ESMA argues that national regulators "could reasonably expect" an SFDR Article 9 product – that is, one that has sustainable investment as its objective – to disclose the detailed "principal adverse impact" metrics for all of its underlying investments, which goes further than the law strictly requires. ESMA goes on to give "guidance" on fund names: use of the term "sustainable" in a fund's name seems to be restricted to those making "sustainable investments" according to the EU's definition of that term. Moreover, if a firm wants to be categorised as a fund that "promotes environmental or social characteristics" – the lightest category of ESG fund in the SFDR – ESMA confirms that it must have some "binding criteria" as part of its investment strategy and/or objectives, although in our view these need only be binding in the sense that they must be done in the way described, and do not have to mean that certain investments must be excluded. (More commentary on these recent announcements is available in our client bulletin.)

These European "clarifications" and guidance are, in part, a recognition of the lack of clarity in the original rules, both those that are included in the Level 1 EU Directive and in the Level 2 implementing rules developed by the regulators and issued in final form by the Commission in April. But they are also an attempt to course correct: the regulators are concerned that the SFDR categories and self-certification process themselves give rise to a risk of greenwashing – something which they are now working hard to avoid. This ratcheting up of expectations will therefore continue.

As if to emphasise the current focus on greenwashing, prosecutors in Germany raided the offices of DWS last week to investigate allegations of greenwashing by the asset manager, and last month the SEC announced a settlement with BNY Mellon that involved a payment of $1.5 million. These related to public funds, which will of course be the prime focus for enforcement. But private fund managers should take careful note, because – despite their mostly institutional and sophisticated investor base – they are not likely to avoid the spotlight for long.

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