On January 19, 2022, staff of the Canadian Securities Administrators (CSA Staff) released guidance on disclosure and marketing practices of investment funds that use environmental, social and/or governance considerations (ESG) as part of their investment objectives or strategies. While many of the recommendations in the guidance are intuitive, several go beyond what industry participants might expect. These heightened expectations are discussed later in this bulletin.
What is the Guidance Seeking to Achieve?
CSA Staff are attempting to bridge the gap between what an ESG fund does with its assets, and what retail investors may presume an ESG fund is doing with its assets. Whether this goal will be achieved to any degree is doubtful since most of the guidance relates to disclosure in prospectuses and management reports of fund performance which most investors never receive (let alone read and understand). As well, expectations regarding ESG outcomes cannot be effectively regulated until a generally accepted regime is created that standardizes ESG disclosures by public companies in which ESG funds make investments. If, instead, the concern of CSA Staff is that investors may be purchasing unsuitable ESG funds (even under the enhanced suitability obligations of the Client Focused Reforms), then perhaps the regulatory focus should be on enhancing the discussions between regulated advisers and their clients regarding investing in ESG funds, rather than the disclosures made by ESG funds.
Does Your Firm Need to Adopt All the Guidance?
OSC staff have indicated that they intend to apply this guidance to upcoming prospectus filings and future reviews of continuous disclosure and sales communications. The guidance is using interpretations of general standards in relevant securities legislation to implement specific changes in the investment funds industry. It would be preferable if such changes were implemented through amendments to relevant instruments or companion policies in order to allow industry the opportunity to provide feedback on the proposals and clarify implementation. Instead, the roll-out of the guidance likely will experience the vagaries of the prospectus comment process, resulting in uneven application of the new expectations between fund complexes. Unless fund managers extend the timelines for their prospectus filings, they likely will need to accept and implement the guidance in order to obtain prospectus receipts in a timely manner.
The guidance uses a variety of terminology to signal which aspects are considered more important than others by CSA Staff. When cross-referencing specific securities law requirements, the guidance uses “must” and, when providing CSA Staff’s interpretation of general standards, the guidance uses “should”. “Encourage” is the CSA’s codeword for a recommended, but not obligatory, best practice. Some guidance simply is introduced with “may consider”. Managers should expect that CSA staff will be raising all “should” guidance during future prospectus filings and regulatory sweeps.
There are some minor differences in prescribed disclosure requirements between funds that use a long form prospectus rather than a simplified prospectus. In particular, under existing securities laws, simplified prospectuses “shall” use plain language while long form prospectuses “should” use plain language. CSA Staff appear to equate the word “plain” in “full, true and plain disclosure” with a requirement to use plain language drafting (which may surprise other issuers that use a long form prospectus). Since these general standards are the basis for the guidance, it is not clear whether these differences could result in different adoptions of the guidance depending on the form of prospectus used.
Does the Guidance Apply to Your Pooled Funds and Managed Accounts?
Technically, the guidance is based on general standards that apply only to public investment funds. However, there is a tendency for regulatory expectations in the public investment funds space to transfer to other managed products. CSA Staff may take the position at a later date that managers should adopt this guidance for their pooled funds in order to avoid making a “misrepresentation” in their offering memoranda, and to deal honestly and in good faith with their clients. We do not believe this guidance is of immediate application to pooled funds and managed accounts, but we expect some spillover to occur in the future.
Fund Name, Investment Objectives and Investment Strategies
The guidance does not change the existing regulations and understanding of the relationships between a fund’s name, its investment objective and its investment strategies. The guidance reiterates these requirements without adding any further commentary on how they apply to ESG considerations. However, compared to other types of funds, the guidance expects more detailed disclosure about (i) how funds apply ESG criteria when selecting investments and (ii) the quantity and types of non-ESG investments the fund may hold. CSA Staff would like to see prospectuses do the following:
- Explain each ESG factor used by the fund in its investment selection process, including whether that factor is quantitative or qualitative, how it is evaluated and monitored, and the extent to which third party data is used. This includes defining ESG terminology (such as “involvement in a severe controversial event” and “clean air”). If multiple ESG factors are applied other than simultaneously, the prospectus should describe the order in which they are applied. For example, a fund that defines its investable universe by the issuers in an ESG index would identify that factor as the first step.
- If the fund’s objective or strategies refer to seeking a measurable goal (such as investments that lower emissions), the prospectus preferably includes a target. This target then becomes a reference point for the fund’s continuous disclosure (discussed below).
- Describe (with examples) the extent and types of investments that can be made by the fund outside its ESG focus, including an explanation of how these investments will meet the fund’s investment objective. The guidance includes an example where a fund makes an ESG-related investment that is not part of the fund’s primary ESG focus (for example, making an investment in an issuer that is not highly rated by ESG standards in order to commence shareholder engagement for change). The guidance does not discuss that a fund’s objective may include investing “primarily” in ESG issuers, which permits the fund to invest, to a lesser extent, in non-ESG investments (potentially up to 49% of its portfolio).
- If the fund’s objective includes a reference to ESG, consider including “ESG” in the Fund Type.
- Explain how the fund uses internal or external ESG ratings, scores, indices or benchmarks (ESG data) as part of the investment selection process. This includes identifying the indices and benchmarks used, and the third parties providing the ratings or scores. In all cases, describe the methodology behind the ESG data, including whether it is quantitative or qualitative, and the level of subjectivity included in the methodology.
The guidance indicates a level of discomfort with prospectus disclosure referencing discretionary actions that may or may not happen (for example, an ESG factor that “may” be applied, or that an issuer “may” be included or excluded from the portfolio). The guidance does not prohibit such discretionary investment practices, but expects that they will be clearly identified. It is unclear what further disclosure, if any, the CSA Staff expect in this regard.
According to the guidance, a prospectus may describe a fund as suitable for an investor seeking ESG exposure only if ESG is in the fund’s objective. It is not enough that the fund discloses ESG as one of its investment strategies. Further, if a fund’s ESG approach is limited, the suitability disclosure should be similarly limited.
ESG Risk Factor
The guidance recommends that funds with an ESG focus consider including an ESG risk factor in their prospectus. Suggested topics include reliance on third party ESG data, and whether the fund’s portfolio may be less diversified and produce lower returns based on a smaller universe of eligible investments. However, suggesting that ESG investments may cause a fund to underperform contradicts the thesis of some ESG proponents that issuers with higher ESG scores are expected to outperform their competitors over the long term.
The guidance suggests that all funds (not simply ESG funds) might consider adding an ESG risk factor in their prospectuses that discloses risks to the fund from such matters as climate change, bribery and corruption. However, in our view, funds should consider this risk disclosure only if the risk to the fund is “material” as prescribed by prospectus disclosure rules.
Management Reports of Fund Performance (MRFPs)
The theme of the guidance on continuous disclosure generally (and MRFPs specifically) is that it should include information and commentary specific to the fund’s ESG investments. For example, the guidance suggests that the summary of results of operations in a fund’s MRFP include discussions about:
- changes to the fund’s portfolio during the period due to the application of ESG factors (again, keeping in mind the “materiality” threshold for all disclosure in an MRFP) including, if proxy voting is an ESG strategy, how proxy voting was used,
- for fund’s that include ESG in their objectives, a description of the companies selected for ESG reasons and how they meet the fund’s objective, and
- where the fund’s objective includes a measurable “change” goal (e.g. make investments that may result in lower emissions), a quantitative report of the fund’s progress toward meeting its target.
Currently, there is no specific indication when MRFPs will be subject to a review for compliance with this guidance.
Most of the guidance on sales communications relates to ESG scores, ratings or rankings of the fund (ESG Evaluations). CSA Staff confirm that ESG Evaluations that are based primarily on the weighted average of the ESG ratings and scores of issuers in the fund’s portfolio are not “performance data”, a “performance rating or ranking” or a comparison of performance (and therefore need not follow the sales communications rules specific to those types of performance information). However, ESG Evaluations using other methodologies “may be” such types of performance information, and therefore “may not be” compliant with those sales communications rules (similar to Lipper and Fundata awards).
The guidance raises concerns that sales communications containing ESG Evaluations may fail to meet general standards primarily for one of four reasons: (1) there is a conflict of interest at the provider of the ESG Evaluation, (2) the manager cherry-picks the ESG Evaluation, (3) the ESG Evaluation is not representative of the fund’s true characteristics, or (4) the sales communication provides insufficient information about the methodology and qualifications of the ESG Evaluation. Some of the additional measures recommended by the guidance to address these concerns are:
- if the manager’s website discloses an ESG Evaluation for an ESG-focused fund, the website also should disclose the provider’s rating or ranking for all other ESG-focused funds of the manager (unless those other funds are in a different ESG category),
- if the manager’s website discloses an ESG Evaluation for a non-ESG fund, the website also should disclose all ESG ratings or rankings by that provider for all other non-ESG funds of the manager (to the extent available),
- include ESG ratings or rankings of more than one provider, and
- provide additional disclosure if the ESG Evaluation does not cover the fund’s entire portfolio.
The guidance also lists 17 items of additional disclosure to be included in sales communications containing ESG Evaluations. Many are based on equivalent requirements for performance ratings and rankings (including typical conditions in relief to cite Lipper and Fundata awards), but a few are noticeably new or different. They are that the sales communication should include:
- the percentage of the fund’s portfolio that was included in the ESG Evaluation,
- a warning if ESG is not in the fund’s objective,
- a warning (if applicable) that the ESG Evaluation does not evaluate the fund’s objectives, strategies or how well ESG factors are being used (unless it actually does),
- a statement that other ESG Evaluation providers may use different methodology, and
- separate ratings or rankings of the fund for each of the three ESG components.
The guidance also states that the foregoing should not be included in the fine print of the sales communication (i.e. including such disclosure using 10 point font is not necessarily sufficient). Like MRFPs, there is no specific indication when sales communications will be subject to a review for compliance with the guidance.
Proxy Voting and Shareholder Engagement
Not surprisingly, if a fund uses proxy voting and/or shareholder engagement as one of its ESG strategies, the guidance expects enhanced prospectus disclosure of these approaches. In the case of shareholder engagement, CSA Staff would like to see prospectus disclosure of the criteria used for selecting issuers for engagement, the goals of engagement, and how shareholder engagement is monitored for success. The guidance also encourages managers to make their policies and procedures regarding proxy voting and shareholder engagement available to investors. The guidance does not include any commentary confirming the extent to which funds may use shareholder engagement while remaining passive investment vehicles.
As a suggested (but not obligatory) “best practice”, the guidance recommends that:
- funds that use proxy voting as an ESG strategy post on their website their proxy voting records from all previous years (not simply their most recent year), and
- funds that use shareholder engagement describe their shareholder engagement activities on their website (even though this may constitute a sales communication) and in their MRFP’s summary of results of operations.
What Should Your Firm Be Doing Next in Response to the Guidance?
Managers should consider how they will respond to the guidance well in advance of their next prospectus filing. This would include the following:
- Confirm that each fund makes a correct distinction between its investment objectives, its investment strategies and the investment focus suggested by its name. Responding to the guidance may provide funds with a one-time opportunity to rearrange some of the disclosure in a manner that more accurately reflects the role of ESG in the fund.
- Assemble all relevant information about the ESG strategies of the fund and determine if more information can be included in the fund’s investment objectives or strategies. We recommend focusing, in particular, on how companies are selecting using ESG. If a fund uses a limited ESG strategy, consider adding a description of the fund’s limited approach to ESG.
- Review discretionary descriptions in the prospectus regarding how the fund invests its assets. Where this flexible wording is not reflective of actual practices, consider rephrasing the disclosure to be more definitive.
- Revisit the suitability disclosure in the prospectus and consider deleting references to ESG if the fund’s objective does not include ESG.
- If the fund’s prospectus does not include an ESG risk factor, consider adding one.
We strongly encourage funds to file their renewal prospectuses earlier than usual in order to afford more time to respond to CSA Staff comments based on the guidance.
Managers also should review the ESG-related disclosure included in each fund’s MRFP and enhance it where possible. We do not believe it would be reasonable of CSA Staff to expect this disclosure to be significantly changed by the March 31, 2022 deadline for MRPF’s relating to the year ended December 31, 2021. However, MRFPs filed after the next prospectus renewal should be updated.
Last, managers should review their policies and procedures for sales communications that include ESG statements or references to ESG Evaluations.
 Please also see our earlier bulletin CSA Issues ESG-Related Guidance for Investment Funds (January 26, 2022) which fully summarizes the guidance.
 See the January 26, 2022 e-mail to subscribers of IFSP eNews.
 For guidance on prospectus disclosure, CSA Staff cite the requirements in securities law for a prospectus to contain “full, true and plain disclosure”, and for a simplified prospectus to be drafted using plain language. For guidance relating to sales communications, CSA Staff cite the general requirements in National Instrument 81-105 that a sales communication not be untrue or misleading. CSA Staff also state that a sales communication cannot contain a statement that is vague or exaggerated or that cannot otherwise be verified, but this expectation is based on other guidance and is not mandated by National Instrument 81-105.
 It is well established that an investment fund with a name that contains a reference to an investment focus must include that focus in its investment objective. It also is well established that a particular investment strategy sometimes can be so important to a fund that it forms part of its investment objective. The guidance continues to permit funds to use ESG in a non-core manner, thereby avoiding its inclusion in the investment objective.