#1ROPES & GRAY February 29, 2024 2024 Asset Management ESG Roadshow: San Francisco#2Today's presenters EVE ELLIS Partner, London [email protected] +44 20 3201 1530 Navigating ESG Issues During the Private Fundraising Process JOSH LICHTENSTEIN Partner, New York [email protected] 212 841 5788 CATHERINE SKULAN Partner, San Francisco [email protected] 415 315 6387 2#3Today's presenters ROB SKINNER Partner, New York [email protected] 212 596 9927 Enforcement and Examinations JOEL WATTENBARGER Partner, New York Joel. [email protected] 212 841 0678 3#4Today's presenters EVE ELLIS Partner, London [email protected] +44 20 3201 1530 Planning in Dynamic Regulatory Environments MICHAEL LITTENBERG Partner, New York [email protected] 212 596 9160 CATHERINE SKULAN Partner, San Francisco [email protected] 415 315 6387 4#5Agenda ◉ Navigating ESG issues during the private fundraising process ■ Enforcement and examinations ☐ Planning in dynamic regulatory environments ROPES & GRAY 5#6Agenda ◉ Navigating ESG issues during the private fundraising process Enforcement and examinations Planning in dynamic regulatory environments ROPES & GRAY 6#7Navigating state regulation of ESG investments CA ROPES & GRAY AK OR WA NV HI ID MT ND MN SD WY WI MI NH VT ME MA NY -RI NE JA PA UT OH NJ IL IN CO DE KS WV MD MO VA KY DC NC TN AZ OK NM AR SC MS AL GA TX LA FL Promote ESG Factors in Investment and/or Proxy Voting Decisions Promote Divestment from Certain Industries Affirmatively Not Restricting ESG Restrict Use of ESG Factors; Focus on Pecuniary Characteristics Target Entities That Boycott Certain Industries Prohibit Discrimination on Basis of Social Credit or ESG Scores 7#8SFDR classification ROPES & GRAY Article 9 Private equity, real estate, infrastructure and credit Article 6 Private equity Real estate Infrastructure Credit Article 8 Article 6 Article 8 Article 9 8#9Categories of ESG side letter provisions Acknowledgment of investor's ESG policies ■ Example: Adviser acknowledges that it has read investor's internal ESG policies, which often are attached as an exhibit to the side letter Agreement to take into account certain widely recognized ESG frameworks ■ Example: Adviser acknowledges that it is a signatory to the UNPRI, UN Global Compact Principles or IFC Performance Standards and in some cases agrees to consider such principles when making investment decisions Representations and covenants regarding adviser's ESG policies Example: Adviser makes reps as to its own policies and/or undertakes to encourage fund's portfolio companies to pursue certain ESG-related goals (e.g., diverse board membership) Reporting/notices Example 1: Adviser agrees to provide regular reporting on ESG metrics at the portfolio company level. Can be driven by regulatory requirements (e.g., SFDR) or commercial factors Example 2: Adviser agrees to notify investor of material changes to ESG policies or negative ESG-related incidents Opt-out rights ■ Example: Adviser agrees to excuse investor from participating in fund investments in oil / gas sector ROPES & GRAY 9#10ESG and fundraising: practical considerations Engage with ESG at an early stage with all relevant stakeholders Think about ESG holistically - consider different regulatory regimes and investor demands Manage side letter requests carefully to ensure that they don't cut across regulatory/ investor requirements / demands Include robust risk factors and reps in subscription agreements acknowledging the regulatory uncertainty and obtaining confirmations that investors are not investing because of a fund's ESG status Ensure marketing materials reflect your ESG disclosure category Ensure that all ESG-related claims are accurate and reflect what you are able to do / commit to ROPES & GRAY 10 10#11Agenda ■ Navigating ESG issues during the private fundraising process Enforcement and examinations Planning in dynamic regulatory environments ROPES & GRAY 11#12SEC examinations The SEC examines compliance with ESG disclosure ■ Client disclosure ■ Adviser disclosure Disclosures Can be found anywhere a firm makes statements to investors or potential investors (e.g., PPMs / prospectuses, DDQs, websites, marketing decks, side letters, etc.) ■ Ensure that all investor-facing communications are consistent with ESG standards and application (and each other) Disclosures should be clear and precise and tailored to actual practices - Consider including definition of what the adviser means by "ESG" Disclose how ESG is used Consider careful disclosure of internal or third-party standards or scoring ■ Do not overstate the extent to which the firm may consider ESG - be aware of vague laudatory statements ◉ ■ ROPES & GRAY Review current disclosures and representations line by line 12 12#13SEC examinations Policies and procedures ■ Requires coordination across IR, legal and compliance, investment, and ESG teams ■ Tailor policies to specific business lines (e.g., PE v. RE v. credit v. public equity v. fund of funds) ■ Service providers ROPES & GRAY Two sets of policies - ESG policy Compliance with ESG disclosures - For example, voting securities consistent with policies Red state vs. blue state 13#14SEC examinations Documentation ■ Ensure that documentation regarding the consideration of ESG factors is created and preserved throughout the investment process, consistent with any standards established by disclosures and policies/procedures Create contemporaneous disclosure demonstrating that disclosures align with actual practices during investment process, including at investment (e.g., investment committee memos), monitoring, voting and exit Demonstrate adherence to scoring / standards Oversight Ensure that investment teams are aware of policies, procedures and disclosures Enforce and provide regular training to employees on all ESG policies ■ ROPES & GRAY Develop controls and consensus over ESG frameworks and memberships ■ Perform annual reviews and mock ESG reviews to test adherence to policies and procedures 14#15SEC enforcement: BNYM and GSAM These actions arose out of the SEC's 2021 and 2022 examination priorities ☐ ☐ BNY Mellon Investment Adviser, Inc. (May 23, 2022) BNYM was charged with material misstatements and omissions concerning ESG considerations used in making investment decisions for certain mutual funds (ESG integration strategies) First ESG enforcement action relating to ESG disclosures made by a registered fund BNYM settled and agreed to pay $1.5 million penalty Timing coincided with SEC ESG proposals Goldman Sachs Asset Management, L.P. (Nov. 22, 2022) Goldman was charged with policies and procedures violations involving two mutual funds and a separately managed account strategy marketed as ESG investments Similar to BNYM with focus on statements by adviser about the specific implementation of ESG factors Goldman settled and agreed to pay a $4 million penalty A handful of small mutual funds had rebranded as "ESG" ROPES&GRAY 15#16Current SEC enforcement approach and its impact on ESG Gensler's enforcement focus ■ Sweeps Large dollar awards Message cases Focus on compliance programs Practical application of policies ■ Discipline UK developments Impact on ESG advisers ROPES & GRAY 16#17Litigation and enforcement threats from the right Multistate Attorney General investigation ■ Theories: antitrust, consumer protection ■ Coordinated subpoenas / CIDs issued to multiple asset managers Private action against NYC pension plans ■ Theory: fiduciary duty breach due to fossil fuel divestment policy ■ Filed June 2023, funded by conservative activist organization Tennessee AG action against BlackRock Theory: consumer protection Filed Dec. 2023, allegations based solely on public statements U.S. House Judiciary Committee investigation ■ Theory: antitrust Focus on climate initiative membership and “decarbonization❞ targets ROPES & GRAY 17#18Legal theories Consumer protection claims ■ State consumer protection laws prohibit “unfair and deceptive acts and practices” AGs have broad discretion to define what is "unfair and deceptive" Fiduciary duty claims ■ Duty of loyalty: Sole objective must be maximizing client's financial returns - Other objectives reflect inappropriate "mixed motives" Social or "political" goals such as climate and diversity gains (NYC pension plan action) Joining pro-ESG initiatives shows manager's mixed motives, including in ostensibly non-ESG products Duty of care: No reasonable basis to believe ESG investing maximizes financial returns, as underlying assumptions are factually unsupported Antitrust claims " Group boycott / concerted refusal to deal Anticompetitive standard setting ROPES&GRAY ■ Anticompetitive information sharing 18#19Agenda Navigating ESG issues during the private fundraising process Enforcement and examinations Planning in dynamic regulatory environments ROPES & GRAY 19#20Approaching new regulation European Union's Sustainable Finance Disclosure Regulation (SFDR) United Kingdom Sustainability Disclosure Requirements (SDR) SEC proposed rules ■ Enhanced Disclosures by Certain Investment Advisers and Investment Companies about ESG Investment Practices Climate-Related Disclosures California state rulemaking ■ SB 253; SB 261: Greenhouse gases: climate-related financial risk ■ SB 252: An act relating to public retirement systems ■ SB 54: Fair Investment Practices by Investment Advisers Balancing rules that currently apply and looking to future rules ROPES & GRAY 20 20#2121 24 The different regulatory regimes and market environments EU: Sustainable Finance Disclosures Regulation (SFDR) Article 6 (conventional funds) Funds that are neither Article 8 nor Article 9 (i.e., conventional funds) Cannot promote environmental and/or social characteristics nor have a sustainable investment objective Must integrate ESG risks into the investment decision making process Article 8 (funds promoting environmental/social characteristics) Binding investment strategy which promotes environmental and/or social objectives Any exclusion screening requirements should be part of the binding investment strategy and be meaningful to it Investee companies (i.e., portfolio investments) must follow good governance practices May also make 'sustainable"¹ investments Currently no minimum threshold although this may change Article 9 (funds with sustainable investment objectives) " Makes exclusively 'sustainable' investments (a small proportion of other investments may be available for hedging or liquidity purposes) Investments must do no significant harm to any other environmental or social objectives by reference to the principal adverse impact indicators Investee companies must follow good governance practices U.S.: SEC Proposed Rules ESG Integration Integrates ESG factors alongside non-ESG factors in investment decisions ESG factors are generally no more significant than other factors in the investment selection process, such that ESG factors may not be dispositive with respect to any particular investment ESG Focus ESG factors are a significant or main consideration in selecting investments or in engaging with portfolio companies (e.g., screens for carbon emissions, board or workforce diversity and inclusion, or industry-specific issues) ESG Impact Seeks to achieve a specific ESG impact or impacts that generate specific ESG-related benefits (e.g., financing the construction of affordable housing units or advancing the availability of clean water) 1 Sustainable investments' means an investment in an economic activity that contributes to an environmental objective or an investment in an economic activity that contributes to a social objective provided that such investments do not significantly harm any of those objectives and that the investee companies follow good governance practices, in particular with respect to sound management structures, employee relations, remuneration of staff and tax compliance. Managers also need to disclose how these investments align with OECD Guidelines for Multinational Enterprises and UN Guiding Principles of Business and Human Rights. ROPES&GRAY#22UK SDR Labelling regime Customer disclosures Sustainability reporting Anti-greenwashing rule Distributor rules Scope UK fund managers that manage UK funds UK fund managers that manage UK funds UK fund managers that manage UK funds which meet certain AUM thresholds (see "implementation timetable") All FCA-authorised firms; all products and services (both retail and professional) FCA-authorised firms distributing recognized funds to retail investors Requirements Four opt-in sustainable labels focusing on various ESG investment strategies, comprised of "sustainable focus", "sustainable improvers", "sustainable impact" and "sustainable mixed goals". Consumer-facing disclosures (summarising how the product will pursue and measure the sustainability objectives) and pre-contractual disclosures (with more detailed information on the product's sustainability profile. Entity-level report focusing on the manager's sustainability-related risks and opportunities, focusing on governance, strategy, risk management, and metrics & targets (as under the TCFD framework). All claims made about the sustainability characteristics of a product or service must be clear, fair and not misleading. Disclosures when distributing UK funds that have a sustainable label or notices for certain overseas funds that use ESG terms. Implementation timetable 31 July 2024 31 July 2024 December 2, 2025 (largest managers: £50bn or more AUM) December 2, 2026 (smaller Managers: £5bn-50bn AUM) 31 May 2024 31 July 2024 (labelled funds) 2 December 2024 (overseas funds) ROPES & GRAY 22#23Building a compliance program and disclosures Role of the compliance department vs. the overall organization (investment teams, investor relations, marketing etc.) ESG policies vs. guidelines ☐ What are the pros and cons of adopting a formal Advisers Act Rule 206(4)-7 ESG policy? ■ Ways to differentiate compliance policies v. statements Recordkeeping Approach to disclosures ROPES & GRAY ■ Aligning public and private disclosures ■ Interaction with gatekeepers 23#24ROPES & GRAY February 29, 2024 2024 Asset Management ESG Roadshow: San Francisco