FrontLine Compliance on making sense of the SEC’s proposed ESG rule

The firm's founder and president, Amy Lynch, talks about what concerns advisers have and gives advice on how they should react.

As the SEC works through the process for its proposed ESG rule for advisers, Private Funds CFO caught up with Amy Lynch, founder and president of FrontLine Compliance, to discuss its importance.

Lynch’s professional background, spanning over 25 years, includes regulatory experience at the SEC and at FINRA.

The following interview has been edited for clarity.

Amy Lynch

What are the key parts of the SEC’s proposed ESG rule?

Amy Lynch: Key parts for investment companies and investment advisers are: new reporting requirements both to investors and the SEC, new SEC filings and new investor reporting and disclosures. Also, mutual funds will have additional board reporting requirements that will enable board members to make more informed decisions regarding fund ESG mandates.

The SEC is looking to gather as much information as possible from the asset management space to essentially determine if these ESG investment practices that funds and advisors are claiming to follow are actually being followed and are being properly disclosed to investors and shareholders.

The SEC has recently found, via some targeted examinations that have been conducted over the past two years, that this isn’t always the case. And we’ve seen a couple of high-profile enforcement actions that have come out against firms, for example claiming firms were greenwashing – marketing and advertising their funds in a way that made it appear that they were following specific ESG-level strategies and protocols – when in reality they were not. They’re trying to create controls around the ESG practices within the asset management industry.

Which parts directly impact private funds?

AL: Private funds under the SEC’s proposal would be impacted under the criteria for registered investment advisers.

That means essentially that new disclosures will need to be made to investors, primarily via their Form ADV, but also in their offering documents and solicitation materials. The primary disclosure vehicles utilized within the private fund industry are offering documents, quarterly newsletters, pitch decks, fact sheets, and term sheets. Any solicitation documentation for fundraising needs to be brought up to speed with the new disclosures that would need to be made for ESG strategies.

Which portions of the proposed rule are private funds advisers most concerned about?

AL: The private fund industry is realizing that having actual written policies and procedures is going to be the future of compliance with any regulation that comes into play. It will be a challenge to put written controls in place when there is yet to be a standardized way to calculate certain matters, like investment-level criteria regarding environmental strategies and climate change – carbon emissions, greenhouse gases, various energy saving techniques, for example.

There’s no standardized way to say, “this is how you do these calculations across the board.” There are some global standards out there. You’ve got the Principles for Responsible Investment – that is probably the most used by firms in the US, and it is a good guide, but it’s not the only way, and the SEC does not typically prescribe to firms exactly how to go about compliance.

It also depends on where a fund is located geographically and who they’re marketing to. Those factors determine which standard fits a given fund the best. Private funds today are struggling with the question of how to write a policy or create internal controls that make sense for their investor base, while also fitting within these new proposed regulations from the SEC.

Which sections of the rule would you like to see changed before it’s finalized, and which ones do you want to remain?

AL: Anything that requires written documentation, policies, and procedures, is a good thing because it promotes a firm-wide understanding that all employees then have to follow.

But it would be exceedingly difficult to force all the firms out there to comply in the same specific way. The SEC proposal perhaps goes a bit too far in that regard, essentially saying, “this is how you have to calculate it.”

Unless they take a bit of a step back from that and say, “okay, these are the components that need to go in the policy,” including how you calculate GHG, for example. How you calculate it for Firm A may be different than for Firm B, Firm C, Firm D, but it’s important to make sure the firms employ the required elements of the policy and they do it in a consistent way.

What steps should private fund advisers take to comply?

AL: Step number one is: understand the rules and regulations. These are proposals to take into consideration and they are not yet finalized. Firms will need help understanding the key components that will survive the rulemaking process and then comply with the final rule.

There will be changes to the proposal that will take place, but the chances of a rule being adopted are remarkably high.

Secondly, firms should look at their current policies in relation to the proposal now. The written policy requirement will almost certainly be within any final rule adopted by the SEC.

Having adequate policies in place is important, and firms should conduct a gap analysis of their current firm practices in relation to the rule proposal as well as their internal practices. This will help them to identify where changes need to be made and if perhaps they need to approach things differently from a portfolio construction perspective. This would be a critical area they need to find out sooner rather than later.