SEC Proposed Changes Regarding ESG Disclosures: Considerations for Fintech-Oriented Investment Advisors | Wilson Sonsini Goodrich and Rosati
Recently proposed environmental, social and governance (ESG) changes to the ADV form under the Investment Advisers Act of 1940 (Advisers Act) underscore the need for federally regulated investment advisers to disclose the material conflicts and risks associated with their investment management programs. . In particular, advisers who manage assets based on a combination of financial technology (fintech) and ESG-related factors should consider whether they provide sufficient information about the potential characteristics and results of their advisory programs. Not only are these disclosures generally required under existing law and guidance, but it is possible that the US Securities and Exchange Commission (SEC) will pursue ESG-based enforcement actions against investment advisers in light of the proposed changes, as it often does when it pursues with new regulations and/or see concerns in a focus area.
Summary of the Advisers’ Act proposal
As part of a recent focus on ESG-related compliance and disclosure,1 SEC Proposed Amendments to Form ADV, Registration and Disclosure Filings 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,3 a key purpose of the proposed changes 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 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 analysis, any ESG consultants or other similar partners they work with and the nature of the ESG-specific strategies they use to manage private funds and separately managed account client assets. The changes will also require disclosure of 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 material consideration; or “ESG Impact” strategies that have a stated objective that seeks to achieve a specific ESG impact or effects 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 proposed 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 amendments are adopted, advisers should consider whether their current ESG-related disclosures fully describe the functions, conflicts and risks associated with their investment management programs.
Consideration of Fintech-based advisory programs
For fintech advisors, ESG-related disclosures may require specific assessments of how the use of ESG-related concerns in asset management may interact with the use of fintech to affect performance and other issues. For example, fintech advisors may need to consider the following types of issues:
- Information scraping. Some investment advisors 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 must ensure that it understands and fully discloses the reliability and limitations of that data. For example, an advisor who scrapes data to find out which energy sources a company uses and manages assets based on that information will 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 using artificial intelligence (AI) to integrate ESG-related factors into their investment management programs may need to consider whether an AI-based system will address the uncertainty these factors bring to both investment and to support the ESG-related objectives they pursue is. designed to continue, especially when an AI-based system changes in response to new data and results.6 The concept of “ESG” itself is relatively new, and it is unclear whether and how ESG-based decision-making will advance investors’ investment goals, influence the success of businesses, or achieve long-term environmental, social, or governance changes, all of which may be among the goals of ESG-based approaches. Advisers should review and disclose their methods for defining, monitoring and evaluating the success of AI and ESG-based programs – both at launch and over time, given that advisers will be accountable for the results of AI-based programs even after those programs adapt new data and previous results.
- Robo-advisor portfolio programs. Many “robo-advisors” that manage client funds on a portfolio basis rely on Rule 3a-4 of the Investment Company Act of 1940 (the 1940 Act) to ensure that the portfolios are not treated as funds subject to registration under the 1940 Act. Rule 3a-4 requires, among other things, that investors are allowed to place reasonable restrictions on how their money is invested. However, an Adviser may reject restrictions 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 restrictions an investor seeks to impose will fundamentally change or weaken the adviser’s program – in which case the adviser should either limit the restrictions investors can set or provide disclosures about the potential effects of investor restrictions. This can be particularly important in the context of ESG-focused or ESG Impact programmes.7
Finally, although the findings so far are mixed, at least a few analyzes suggest that ESG-based investment strategies may underperform similar investment strategies without an ESG focus.8 In this context, all advisers may have to state that an ESG overlay may reduce the investment return.
Whether or not the SEC adopts the proposed changes to Form ADV, fintech advisors should consider the unique issues ESG-based management raises in light of their ESG-based programs.
 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 the Securities Exchange Act of 1934. The Enhancement and Standardization of Climate-Related Disclosures for Investors. , Release No. 33-11042 (March 21, 2022), In addition, in 2021 the SEC established the Climate and ESG Task Force (“Task Force”) in the Division of Enforcement to develop initiatives to identify ESG-related misconduct, identify material gaps or misstatements in issuers’ climate risk disclosures, and analyze disclosure and compliance issues related to advisers’ ESG strategies. SEC, SEC Announces Enforcement Task Force Focused on Climate and ESG Issues (March 4, 2021), The SEC’s Division of Examinations also issued a risk alert in April 2021 to highlight observations from recent examinations of investment advisers, registered investment companies and private funds that offer ESG- products and services. SEC Division of Examinations, Risk Alert, The Division of Examinations’ Review of ESG Investing (April 9, 2021), A month earlier, 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 (4 March 2021),
 Exempted reporting advisers are generally advisers who are exempt from registration under Sections 203(l) and 203(m) of the Advisers Act. These advisers must submit a shortened version of Part 1A of the ADV form.
 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), The Proposing Release also includes amendments under the Investment Company Act of 1940, which we do not discuss in this notice.
 Suggests release at 7-9.
 Proposed 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 ESG factors into account.”