ESG – The Disclosure Debate Continues
The ESG debate continues, including within the SEC and amongst other regulators and industry participants. Firmly in support of ESG disclosures, and especially climate change matters, is SEC Chair Gary Gensler and Commissioner Allison Herren Lee, while opposing additional regulation is Commissioners Eliad L. Roisman and Hester M. Peirce. Regardless of whether new regulations are enacted (I firmly believe they are forthcoming), like all SEC disclosure items, the extent of disclosure will depend upon materiality.
Materiality
The U.S. Supreme Court’s definition of materiality is that information should be deemed material if there exists a substantial likelihood that it would have been viewed by the reasonable investor as having significantly altered the total mix of information available to the public [TSC Industries, Inc. v. Northway, Inc.]. The concept of materiality represents the dividing line between information reasonably likely to influence investment decisions and everything else.
Rule 405 of the Securities Act defines “material” as “[T]he term material, when used to qualify a requirement for the furnishing of information as to any subject, limits the information required to those matters to which there is a substantial likelihood that a reasonable investor would attach importance in determining whether to purchase the security registered.”
Despite the case law and statutory definition, the concept remains fact-driven and difficult to apply. There are no numeric thresholds to establish materiality, and market reaction is inconsistent and not always available. Ultimately professionals and company management must consider all facts and circumstances available to them on any given day to determine the materiality of a given disclosure. The SEC has been consistent in its description of materiality for purposes of disclosure in all of its guidance, commentary and rule releases. Information is material if there is a substantial likelihood that a reasonable investor would consider it important in deciding how to vote or make an investment decision, or put another way, if the information would alter the total mix of available information.
In its recent request for public comment on climate change disclosure, the SEC sought input on, among other items, what disclosure would be material to an investment or voting decision. Likewise, the SEC’s 2010 Climate Disclosure Guidance seeks disclosure of material information. Although some environmental disclosures are prescriptively required by Regulation S-K or S-X, climate matters would be disclosable if they fell under the general materiality bucket of information (i.e., such further material information, if any, as may be necessary to make the required statements, in light of the circumstances under which they are made, not misleading) (see for more information on the request for comment and 2010 guidance HERE.
In determining materiality, practitioners need to consider Regulation FD, which prohibits the selective disclosure of material information. Regulation FD requires that if material information is to be disclosed, it must be disclosed to the entire market, either through a press release or Form 8-K or both, and not selectively, such as to certain analysts or market professionals.
In May 2021 Commissioner Allison Herren Lee gave a speech on ESG disclosures expressing her well known support for disclosure. As the concept of materiality has arisen as a gating question in the need for ESG disclosure, Ms. Lee focused on that concept in her speech. Beginning with the inarguable position that materiality is based on “information that is important to reasonable investors,” she posits that management, lawyers and accountants often get it wrong. Rather, she believes that a “disclosure system that lacks sufficient specificity and relies too heavily on a broad-based concept of materiality will fall short of eliciting information material to reasonable investors.”
Ms. Lee continues that despite this concept of materiality, she does not believe that the disclosure rules are, or should be, constrained by materiality. She points to many prescriptive disclosure requirements that are not guided by materiality, such as related party transactions, share repurchases and executive compensation – which leads to ESG disclosures. Commissioner Lee believes that ESG is material in and of itself and thus disclosure is required. She continues that “investors, the arbiters of materiality, have been overwhelmingly clear in their views that climate risk and other ESG matters are material to their investment and voting decisions.”
This is where I put the brakes on. SEC disclosures are not meant to provide specific factions of, or for that matter any faction of, investors with particular disclosures. Rather, the standard is well settled that disclosures are meant to provide a “reasonable investor” with information useful in making decisions (investment, voting, etc.). The test is objective. The SEC should not be catering to particular factions on investors, especially on a clearly partisan political subject. That doesn’t mean that I am opposed to climate change disclosures, but rather, that I don’t agree the rulemaking on such disclosures should deviate from the long-standing objective principals of materiality.
More on ESG and Climate Change Disclosures
The SEC request for public comment has been met with an enthusiastic response on both sides of the fence. However, as many great thinkers are pointing out, although the view that climate change will impact society is fairly accepted, the view that it will impact specific economic sectors, is far less so. For a financial regulator like the SEC, that discrepancy between societal costs and costs to public companies and markets creates a potential disconnect.
On June 3, 2021, Commissioner Elad L. Roisman gave a poignant speech on ESG disclosure, and its inevitable costs. Mr. Roisman is vocally against the SEC issuing prescriptive, line-item disclosure requirements on ESG matter and in particular environmental and social issues. Echoing prior speeches by former Chair Jay Clayton, Mr. Roisman states the obvious that standardization is extremely difficult. The data is imprecise and fraught with political motivations.
Commissioner Roisman is focused on the costs of disclosure. The SEC has a mandate to consider the costs of compliance with any new regulations. Certainly, companies would incur costs in obtaining and presenting the new information and liability for the adequacy of such information. To counter some of these costs, Roisman suggests (i) scaled disclosure for smaller reporting companies; (ii) flexibility in methodologies in fashioning disclosure (for example, a company’s ability to calculate Scope 3 greenhouse emissions depends on it gathering information from sources wholly outside the company’s control, both upstream and downstream from its organizational activities and can be daunting and expensive); (iii) safe harbors similar to forward looking statements disclaimers to reduce litigation risks; (iv) allow disclosures to be furnished not filed; and (v) an extended implementation period.
He also poses basic structural questions such as what standards would the SEC use; if they rely on third parties, how will those standards be monitored and supervised going forward (especially if that party changes political views); and is the SEC the best regulator to require disclosures, especially related to the external impact a company has on society/the environment (as opposed to the potential impact on the company itself).
Staying true to form, Commissioner Hester M. Peirce made a pragmatic and pointed statement on ESG disclosures. Ms. Peirce points out that “[T]he task before us is to find a way to bring about lasting, positive change to our countries on a range of issues without sacrificing in the process the very means by which so many lives have been enriched and bettered.” Ms. Peirce also takes aim at the push to follow European disclosure requirements and to create a comprehensive international disclosure regime. However, ESG factors are complex, evolving and not readily comparable across issuers and industries. Peirce notes that “[T]he European concept of ‘double materiality’ has no analogue in our regulatory scheme and the addition of specific ESG metrics, responsive to the wide-ranging interests of a broad set of ‘stakeholders,’ would mark a departure from these fundamental aspects of our disclosure framework.” Clearly, the U.S. capital markets are number one for a reason and an international homogenous disclosure system is likely to impose new costs on public companies, decrease the attractiveness of our capital markets, distort the allocation of capital, and undermine the role of shareholders in corporate governance.
Turning back to the SEC request for comments, one such comment letter response submitted by UVA law professors Paul and Julia Mahoney, argues that the movement to require disclosure is being led by institutions whose purpose is in part “to pursue public policy goals outside the normal political process,” and whose statements asserting the supposed financial value of ESG are “cheap talk that conveys no information other than that the institution wants the SEC to require the disclosures.” The article suggests that by requirement disclosure the SEC “risks eroding public trust in its capacity and willingness to serve as an apolitical, technocratic regulator of the capital markets.”
Realizing that climate change disclosures are likely forthcoming, the Securities Industry and Financial Markets Association (SIFMA) advocates for the SEC to start slowly with climate change disclosures and hold off on other ESG matters. SIFMA suggests requiring disclosures of metrics related to greenhouse gas emissions and so-called carbon footprints based on a materiality standard and principles approach.
Illustrating that the issue follows party lines, supporting disclosure is the New York Department of Financial Services; California Attorney General Rob Bonta and the Attorney Generals for Connecticut, Illinois, Maryland, Massachusetts, Michigan, Minnesota, New York, Oregon, Vermont and Wisconsin.
Congress is getting in on the act as well. On June 16, 2021, the U.S. Democratic run house narrowly passed H.R. 1187, the Corporate Governance Improvement and Investor Protection Act, which would require the SEC to issue rules within two years requiring every public company to disclose climate specific metrics in financial statements. The Act would modify Section 14 of the Exchange Act which governs the solicitations of proxies, information statements following shareholder consents, and tender offers and require specified disclosures in proxy solicitations and information statements for annual meetings. The Act also requires the SEC to create a Sustainable Finance Advisory Committee. Next the Act goes to the Senate and if passed, to the President to be signed into law or vetoed. Many Acts are passed by either the House or Senate but never go the distance. Since this Act is so narrow compared to the SEC’s much broader request for comment on climate disclosure, even if passed, I suspect the SEC rulemaking will be broader than this requires.
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