Newly proposed environmental, social, and governance (ESG)-related amendments to Form ADV under the Investment Advisers Act of 1940 (Advisers Act) underscore the need for federally regulated investment advisers to fully disclose the material conflicts and risks associated with their investment management programs. In particular, advisers that manage assets based on a combination of financial technologies (fintech) and ESG-related factors should consider whether they are providing adequate disclosures regarding the potential features and outcomes of their advisory programs. Not only are these disclosures generally required under existing law and guidance, but it is possible that the U.S. Securities and Exchange Commission (SEC) will pursue ESG-based enforcement cases against investment advisers in light of the proposed changes, as it frequently does when it is pursuing new rulemaking and/or sees concerns in an area of focus.
Summary of Advisers Act Proposals
As part of a recent focus on ESG-related compliance and disclosure,1 the SEC has proposed amendments to Form ADV, the registration and disclosure filing for registered investment advisers and exempt reporting advisers2 (together with registered investment advisers, "Advisers"), to require certain ESG-related disclosures.
According to the proposing release for the changes (Proposing Release),3 a central purpose of the proposed amendments is to ensure that investors receive consistent, comparable, and reliable information about how advisers use ESG factors in their investment management programs.4
To that end, the SEC proposed changes to Form ADV Part 1A and the instructions for the Form ADV Part 2A "Brochure" that would require Advisers to describe, among other things, the ESG-related factors they consider within each significant investment strategy or method of analysis, any ESG-consultants or other similar partners they work with, and the nature of the ESG-specific strategies they use to manage private fund and separately managed account client assets. The changes would also require disclosures regarding whether an adviser uses "ESG Integration" strategies that consider one or more ESG factors alongside other, non-ESG factors; "ESG-Focused" strategies that use one or more ESG factors as a main or significant consideration; or "ESG Impact" strategies that have a stated goal that seeks to achieve a specific ESG impact or impacts that generate specific ESG-related benefits, by targeting investments that drive specific and measurable environmental, social, or governance outcomes.
Importantly, the SEC noted in the Proposing Release that current regulations already require Advisers to disclose material information about the ESG-related aspects of their advisory programs.5 As a result, regardless of whether the changes have been adopted, Advisers should consider whether their current ESG-related disclosures fully describe the features, conflicts, and risks associated with their investment management programs.
Considerations for Fintech-Based Advisory Programs
For fintech Advisers, ESG-related disclosures may require specific consideration of how the use of ESG-related concerns in asset management might interact with the use of fintech to impact performance and other issues. For example, fintech Advisers may need to consider the following types of issues:
- Information Scraping. Some investment advisers analyze and learn from "alternative data," which can include information such as data from credit card transactions, social media posts, satellite images, and questions posed to smart speakers. If an Adviser scrapes ESG-related data from third-party websites as part of its asset management program, it will need to ensure it understands and fully discloses the reliability and limitations of those data. For example, an Adviser that scrapes data to determine what energy sources a company uses and manages assets based on that information would need, among other things, to evaluate and disclose the quality of the scraped information and its potential and measured effects on returns.
- Use of Artificial Intelligence. Advisers that use artificial intelligence (AI) to integrate ESG-related factors into their investment management programs may need to consider whether an AI-based system will adequately address the uncertainty those factors bring to both investing and to supporting the ESG-related goals they are designed to further, particularly as an AI-based system changes in response to new data and outcomes.6 The concept of "ESG" itself is relatively new, and it is unclear whether and how ESG-based decision-making will further investors' investment goals, impact the success of businesses, or achieve any long-term environmental, social or governance changes, all of which may be among the goals of ESG-based approaches. Advisers should consider and disclose their methods for defining, monitoring, and assessing the success of AI- and ESG-based programs—both at launch and over time, given that Advisers will be responsible for the results of AI-based programs even after those programs adjust to new data and prior outcomes.
- Robo-Adviser Portfolio Programs. Many "robo-advisers" that manage client assets on a portfolio basis rely on Rule 3a-4 under the Investment Company Act of 1940 (1940 Act) to ensure the portfolios are not treated as funds subject to registration under the 1940 Act. Among other things, Rule 3a-4 requires that investors be allowed to impose reasonable limitations on how their money is invested. An Adviser can, however, reject limitations that are clearly inconsistent with the stated investment strategy or philosophy or the nature or operation of the relevant investment program. Advisers may need to consider whether certain limitations an investor seeks to impose will fundamentally change or impair the Advisers' program—in which case the Adviser should either limit the restrictions investors can make or provide disclosures as to the potential effects of investor restrictions. This may be particularly important in the context of ESG-Focused or ESG Impact programs.7
Finally, although findings thus far are mixed, at least a few analyses suggest that ESG-based investment strategies may underperform similar investment strategies without an ESG focus.8 In this context, all Advisers might need to disclose that an ESG overlay could reduce investment returns.
Conclusion
Whether or not the SEC adopts the proposed changes to Form ADV, fintech Advisers should consider the unique issues ESG-based management raises in light of their ESG-based programs.
For additional information, please contact Amy Caiazza or Jin Ahn, or any member of the fintech and financial services practice.
[1] For example, in March 2022, the SEC proposed rule changes that would require certain climate-related disclosures in registration statements and periodic reports under the Securities Act of 1933 and Securities Exchange Act of 1934. The Enhancement and Standardization of Climate-Related Disclosures for Investors, Release No. 33-11042 (Mar. 21, 2022), https://www.sec.gov/rules/proposed/2022/33-11042.pdf. In addition, in 2021 the SEC created the Climate and ESG Task Force (“Task Force”) within the Division of Enforcement to develop initiatives to identify ESG-related misconduct, identify material gaps or misstatements in issuers’ disclosures of climate risks, and analyze disclosure and compliance issues relating to Advisers’ ESG strategies. SEC, SEC Announces Enforcement Task Force Focused on Climate and ESG Issues (Mar. 4, 2021), https://www.sec.gov/news/press-release/2021-42. The SEC’s Division of Examinations also issued a Risk Alert in April 2021 to highlight observations from recent exams of investment advisers, registered investment companies, and private funds offering ESG products and services. SEC Division of Examinations, Risk Alert, The Division of Examinations’ Review of ESG Investing (Apr. 9, 2021), https://www.sec.gov/files/esg-risk-alert.pdf. A month prior, the Division of Examinations had announced that its 2021 examination priorities included a greater focus on climate-related risks. SEC Division of Examinations, 2021 Examination Priorities (Mar. 4, 2021), https://www.sec.gov/files/2021-exam-priorities.pdf.
[2] Exempt reporting advisers are generally advisers that are exempt from registration under sections 203(l) and 203(m) of the Advisers Act. These Advisers must file a truncated version of Part 1A of Form ADV.
[3] SEC, Enhanced Disclosures by Certain Investment Advisers and Investment Companies about Environmental, Social, and Governance Investment Practices, Securities Act of 1933 Release No. 11068, Securities Exchange Act of 1934 Release No. 94985, Advisers Act Release No. IA-6034, Investment Company Act Release No. IC-34594 (May 25, 2022), https://www.sec.gov/rules/proposed/2022/33-11068.pdf. The Proposing Release also includes amendments under the Investment Company Act of 1940, which we do not discuss in this alert.
[5] Proposing Release at 168. For example, Advisers Act Rule 206(4)-1 already requires Advisers to disclose material information about their advisory programs and would, the SEC stated, prohibit greenwashing, i.e., exaggerating “ESG practices or the extent to which their investment products or services take into account ESG factors.”
[6] A central feature of AI-based programs is that they “learn” and adjust over time based on new data inputs and the outcomes of prior decisions.
[7] Similar issues could also arise if an investor imposes its own ESG-related restrictions in the context of a non-ESG-focused advisory program.
[8] See, e.g., Terrence R. Keeley, “ESG Does Neither Much Good nor Very Well,” The Wall Street Journal (Sept. 12, 2022) https://www.wsj.com/articles/esg-does-neither-much-good-nor-very-well-evidence-composite-scores-impact-reports-strategy-jay-clayton-rating-agents-11663006833. Several state attorneys general have signed a letter to the Chief Client Officer of BlackRock stating that BlackRock’s ESG focus may be a violation of its fiduciary duties to clients because it does not necessarily prioritize returns over all else. See https://www.azag.gov/sites/default/files/2022-08/BlackRock%20Letter.pdf. In contrast, however, see Paul Sullivan, “Investing in Social Good Is Finally Becoming Profitable,” The New York Times (Aug. 2, 2020) https://www.nytimes.com/2020/08/28/your-money/impact-investing-coronavirus.html.
