Enhanced Regulatory Oversight in ESG Investing

Over the past two decades, investors have become increasingly conscious of the environmental and social impact of their investment choices. By the end of 2022, sustainable funds held one out of every eight U.S. investor dollars, amounting to around 12.6 percent of all U.S. assets under management.

Environmental, Social, and Governance (ESG) investing refers to investment practices that aim to adhere to higher environmental standards, generate positive social impacts, and promote equality and inclusion in corporate governance structures. Some evidence indicates that long-term returns from socially responsible investments are comparable to, and often surpass, those from non-ESG-based investments. According to a recent survey conducted by PwC, 78 percent of investors are willing to pay higher fees for ESG funds. In addition, three quarters of investors view ESG as a part of an asset manager’s fiduciary duty—their legal obligation to act in the investors’ best interest.

A key challenge to the growing demand for ESG investment products is the lack of clear, consistent labeling standards. Many funds misuse the ESG label and rely on misleading buzzwords to attract investors. In response to this challenge, the U.S. Securities and Exchange Commission (SEC) updated its Names Rule in September 2023 to ensure better alignment between a fund’s portfolio and its name. Under the original 2001 Names Rule, if a registered investment company’s name suggests a specific focus on certain types of investments, the fund must establish a policy to invest at least 80 percent of its assets in alignment with its name.

Since September 2023, the SEC has expanded the scope of the Names Rule to include funds whose names use words such as “sustainable,” “green,” and “socially responsible.” Moreover, funds must disclose how they define the terms used in their names. When a fund departs from the 80 percent requirement, it must come back into compliance within 90 days. Proponents of the change argue that these new requirements will ensure greater transparency in advertising and a more accurate reflection of each fund’s portfolio in its name.

In addition to the updated Names Rule, the SEC has adopted rules to enhance and standardize ESG-related disclosures. In March 2024, the SEC issued final rules requiring public companies to disclose climate-related data, including climate-related risks and the registrant’s activities intended to mitigate those risks. The SEC claims that these more robust disclosure requirements will help investors gain access to more transparent, data-driven information on corporate sustainability and make better-informed decisions about the value of investment opportunities.

Since March 2024, the new climate disclosure rules have encountered significant opposition. Twenty-five states, along with various business groups, energy companies, and trade associations, have filed petitions challenging the legal validity of the rules. Opponents to the climate disclosure rules argue that the SEC has overstepped its authority and that the disclosure requirements violate corporations’ First Amendment rights. Scholars have attributed the resistance to the influence of the fossil fuel industry in the United States.

In this week’s Saturday Seminar, scholars debate the market impacts of ESG regulations.

• In an article in the Stanford Journal of Law, Business & Finance, Michal Barzuza and Quinn Curtis of the University of Virginia School of Law and David H. Webber of Boston University School of Law argue that ESG is not a continuation of management entrenchment, but instead a product of the social demand for responsible corporate behavior. The Barzuza team claims that the promotion of ESG results from market incentives, risk aversion among CEOs, activist index fund and hedge fund managers who embrace ESG, and pressure from lobbying groups. They extrapolate this theory to argue that, for major firms, embracing ESG promotes long-term success and cost internalization, and advances securities law by encouraging disclosure of social or environmental issues.
• In an article in the University of Pennsylvania Journal of Business Law, Thomas M. Madden of the Marist College School of Management and Gerlinde Berger-Walliser of the University of Connecticut School of Business argue for mandatory environmental-related investment fund disclosures. Madden and Berger-Walliser note that the recent SEC proposal for mandatory climate-related reporting is imperfect in its scope and coverage. They argue, however, that the proposal represents a positive first step toward increased uniformity and accountability in ESG reporting. Such improvements will, Madden and Berger-Walliser conclude, better protect investors and counterbalance the negative effects of volitional reporting.
• In an article in the NYU Environmental Law Journal, Jason J. Czarnezki and Joshua Ulan Galperin, professors of law at Pace University School of Law, and Brianna M. Grimes, a recent graduate of Pace Law, set forth a potential law school curriculum for ESG law to meet market demands for lawyers equipped to navigate the fast-changing landscape of ESG regulations. The ultimate design of the coursework, according to the Czarnezki team, should function to attract both “traditional” environmental studies students as well as those with an interest in business law. Czarnezki, Galperin, and Grimes argue that an ESG curriculum should center around real work done by ESG-law practitioners in addition to covering core subjects of business and environmental law.
• As regulators around the world become more active in developing ESG disclosure rules, an increasing number of domestic disclosure requirements will apply to foreign companies, argues Stephen Kim Park of the University of Connecticut in a recent article in the North Carolina Journal of International Law. The extraterritorial authority that domestic regulators exercise over foreign firms raises several concerns, Park argues. First, Park notes that firms with a global footprint face higher compliance costs as a result of jurisdictional overlap. Moreover, jurisdictional regulatory differences create uncertainty on compliance issues and increase legal risks, he notes. To address these challenges, Park suggests harmonizing ESG disclosure rules globally through multilateral treaties and mutual recognition of domestic regulations.
• In an article in the Santa Clara Journal of International Law, Allen Mendenhall and Daniel Sutter of Troy University observe a recent increase in demand for ESG disclosure reform propelled by the increasing agreement among mainstream investors that all companies should include material ESG information in their public filings. Mendenhall and Sutter note that over 60 jurisdictions, including all G20 countries, require or encourage corporations to disclose ESG-related data, mostly “through financial regulation, corporate law, or stock exchange listing rules.” Mendenhall and Sutter argue that governments can use a combination of carrots and sticks to promote ESG, for example by using targeted incentive programs and public investments in addition to regulation to achieve their ESG goals.
• ESG disclosure requirements promote diversity in corporate governance structures, argues Atinuke O. Adediran of Fordham School of Law in an article in Virginia Law Review. Requiring companies to disclose their diversity data not only increases transparency for shareholders but also benefits employees, customers, and communities in which companies operate, Adediran argues. These actors, she notes, have an interest in knowing the diversity status of a company to make informed decisions about employment, consumption, and investment. Adediran contends that legislators should use ESG disclosures to increase corporate diversity and benefit all stakeholders. More specifically, she argues that the U.S. Congress should intervene to create a diversity disclosure requirement that can enhance diversity in both public and private companies.