Stock index providers like MSCI inc. and S&P Dow Jones Indices LLC could be drawn into the federal crackdown on greenwashing as the SEC mulls changes that would subject them to strict record-keeping requirements, reviews and less discretion to shape their products.

The Securities and Exchange Commission is considering whether index providers, model portfolio providers and pricing services – which are responsible for directing trillions of dollars in investments – should be regulated more like fund managers rather than data managers.

The SEC raised concerns about “specialist indices” that focus on targeted areas such as environmental, social and governance issues in a broad request for information in June. Specialist index providers often exercise significant discretion in creating and adjusting their models and also offer varying degrees of customization to clients – criteria that might require them to register as investment advisers, said the SEC.

Such a move would give the SEC more tools to fight greenwashing — the deceptive or false marketing of funds as sustainable or socially responsible — and potential conflicts of interest. It could also offer investors more transparency on the fees associated with ESG funds, which tend to be higher than for standard funds.

“Index providers should be more careful and be more careful about how they design ESG or any index for that matter,” said Harvard law professor John Coates, who was previously acting director. of the Corporate Finance Division and General Counsel at the SEC.

MSCI, S&P Dow Jones indices, Nasdaq Inc.Bloomberg LP and London Stock Exchange Group Plcwhich operates FTSE Russell, declined to comment on what investment adviser status would mean for indices in the ESG space.

More broadly, MSCI said it plans to respond to the SEC’s request for information. S&P Dow Jones Indices said it speaks regularly with regulators and policymakers about the “robust governance regime and control framework” it has in place for “independence, transparency and integrity”. of its benchmarks.

Bloomberg LP, the parent company of Bloomberg Law, is also the parent company of Bloomberg Index Services Limited, which administers indices that compete with indices from other providers.

Rapid growth

Index providers have taken advantage of the growing popularity of sustainable investing in recent years, producing dozens of ESG-related indices that asset managers can pay to license for use in their exchange-traded funds. and their mutual funds. The number of indices that measure ESG metrics grew by a record 43% globally in 2021, according to the Index Industry Association.

Global index industry revenue grew by nearly a quarter to $5 billion in 2021, Burton-Taylor International Consulting said in a recent report. ESG indices saw the fastest growth, with revenue up more than 80% year-on-year.

Specialized indices have become a flashpoint in Washington, as regulators and lawmakers fret over the largely unregulated power they wield in global markets. Index providers are not required to publicly disclose information about the methodology they use to construct an index, including the “ESG ratings” they often use to determine which securities are added or removed.

“That begs the whole question of what does it mean to be environmental? How do you reconcile the environment with the social, etc.? ? said Adriana Robertson, a professor at the University of Chicago Law School, whose to research whether the index providers act as investment advisers was cited in the SEC’s request for information. “It just drags this whole debate into the index provider space.”

Some indices follow a combination of rules, such as market capitalization, liquidity, or profitability thresholds, while others are designed at the discretion of an index committee. Fund managers can even ask index providers to tailor indices to certain criteria.

Index providers would have a fiduciary duty to act in the best interests of clients and to disclose any conflicts of interest if the SEC decides they should register under the Investment Advisers Act of 1940 . ESG-focused indices would also be subject to inspections by the SEC Division of Examinations, which has describe ESG as a main compliance risk.

The SEC did not respond to a request for comment.

SEC exams

Some index providers could face SEC reviews immediately as the division tends to prioritize newly registered entities and those it considers high risk, said Gail Bernstein, general counsel at Investment. Advise Association.

“If all of these indices were to suddenly register, the SEC would probably want to come in, at a fairly short notice, and see what these companies look like? What are they doing? How do they try to conform to this new framework? Bernstein said.

Index providers who create specialized ESG indices could even face separate anti-money laundering rules if they were required to register as investment advisers, according to Robert Jackson, a law professor at the University of New York who served as SEC commissioner between 2018 and 2020.

“They claim these indices are different from non-ESG indices,” Jackson said. “I think if you’re an index provider that claims to make decisions based on that, you should expect the SEC to hold you to your investor agreement.”

The SEC launched a proposal this year that would require funds to make “specific disclosures in fund prospectuses, annual reports and advisor brochures based on the ESG strategies they pursue.”

A separate proposal from the SEC would require more funds that use ESG or other names that “suggest focusing on a particular type of investment” to invest at least 80% of their asset value in those investments. This would likely steer funds away from ESG indices that do not meet this requirement.

“If these index providers are regulated as advisers, either with the full Advisers Act regime or a more tailored version, they would likely be subject to these rules as well,” Robertson added.

Publisher opt-out

The SEC challenges the long-held view that index providers play a passive role in the markets, a stance that has allowed them to largely avoid the regulations that asset managers and other advisors recorded placement must follow.

Index and financial data providers who oppose the SEC should report Lowe vs. SECa 1985 Supreme Court ruling that excluded newspapers and certain other publishers from the Investment Advisers Act.

The publisher exclusion covers “good faith” publishers who provide impersonal and disinterested advice that is disseminated on a regular basis, rather than in response to changing market conditions.

Index providers have historically concluded that they can rely on the exclusion “even if they meet the definition of investment adviser,” the SEC said in its request for information. But “new business models” have emerged since Lowe was decided, the agency said, which “could raise issues of investment adviser status.”

“Costly and problematic”

Registration with the SEC would increase costs for index providers and the funds they work with, which could be passed on to investors through higher fees, according to industry players.

Fund managers could also face more ESG-related regulations if index providers become registered investment advisers. Under the Investment Company Act of 1940, the SEC requires funds to provide detailed information about the investment advisers they work with.

Funds should obtain board and shareholder approval to hire or change index providers who are registered investment advisers. That could lead to costly proxy campaigns and discourage funds from making improvements, according to Matthew Thornton, associate general counsel at the Investment Company Institute.

“When you expand the definition of ‘investment adviser’ to include other entities, it creates more work for a board of directors with arguably little benefit,” Thornton said. Adding them could prove “expensive and problematic”, he said.

In a annual 10-K filed with the SEC last year, MSCI said it believes products and services outside of its investment management subsidiary “do not constitute or provide investment advice” under the Act. The advisers. However, new regulations could “change that status”, he said.

“To the extent our customers are subject to increased regulation, we may be indirectly impacted and may incur increased costs which could negatively impact the profitability of certain products,” MSCI said.