On October 1, 2018, two law school professors—Cynthia Williams of York University and Jill Fisch of the University of Pennsylvania—together with numerous institutional investors that collectively manage more than $5 trillion in assets submitted a petition for rulemaking to the Securities and Exchange Commission (“SEC”) calling for the SEC to develop a standardized comprehensive framework under which public companies would be required to disclose identified environmental, social, and governance (“ESG”) factors relating to their operations.
The Petition
The petition represents the latest in a series of concerted efforts over the past decade to pressure the SEC to adopt mandatory disclosure requirements for certain ESG matters, which would bring the United States in line with the nearly two dozen other countries that require public companies to provide such disclosures to investors. In addition, seven stock exchanges already require ESG disclosures as part of their listing requirements, and many other countries, including the U.K. and Sweden, require public pension funds to disclose the extent to which the fund incorporates ESG information into their investment decisions.
The petition references the SEC’s 2016 Concept Release that requested public comment on various potential disclosure reforms, including potential new requirements for disclosures related to sustainability, public policy, and climate change, and the comments responding to the questions about enhanced climate change. The petition also cites public comments to the Concept Release to support the need for a mandatory disclosure framework for ESG disclosures in SEC filings. The petitioners argue that the SEC has the express statutory authority to create ESG disclosure rules under Sections 2(b) of the Securities Act of 1933 and Section 23(a)(2) of the Securities Exchange Act of 1934, both of which provide that the SEC may engage in broad rulemaking that “promote[s] efficiency, competition, and capital formation.” Because ESG issues have potentially huge impacts on large swathes of the national economy, the petitioners posit that they implicate the ability of public companies to be globally competitive and to efficiently form capital. For example, the petitioners note that the Sustainability Accounting Standards Board (“SASB”) concluded that 72 of 79 industries, representing 93% of U.S. capital market value, are vulnerable to material financial implications from climate change.
The petition argues that ESG disclosures not only impact a large cross-section of the U.S. economy but are also currently the subject of a patchwork of poorly-organized corporate disclosures that magnify the burden on public companies while inhibiting the flow of useful information to the investing public. Leading institutional investors have noted that the inconsistent and haphazard nature of corporate ESG disclosures makes it difficult to compare and analyze this information for companies in the same industry. Michael Bloomberg encapsulated the concern of many such investors when he stated in his 2015 Impact Report:“[F]or the most part, the sustainability information that is disclosed by corporations today is not useful for investors or other decision-makers… The market cannot accurately value companies, and investors cannot efficiently allocate capital, without comparable, reliable and useful data on increasingly relevant climate-related issues.”
SEC Disclosure Framework
There is reason to be skeptical about any forthcoming ESG rulemaking from the SEC, at least in the immediate future. The adoption of specific rules governing ESG disclosures runs counter to the SEC’s long-standing principles-based disclosure framework which centers almost entirely on materiality. The Supreme Court defined materiality in TSC v. Northway, stating that information is material if it is information that a “reasonable shareholder might consider important” to his or her investment decision. In Basic v. Levinson, the Supreme Court held that the standard for materiality is whether a reasonable investor would have viewed the undisclosed information as having significantly altered the total mix of information made available. Materiality forms the core of information required to be disclosed in periodic filings and registration statements pursuant to SEC Regulation S-K. Therefore, unless a specific ESG issue is material to a public company’s investors, its disclosure would not be required under the current statutory framework and rules and regulations dictating disclosure requirements in filings with the SEC.
This deference to materiality is the approach previously applied by the SEC in 2010 when it published interpretive guidance on the issue of climate change. While this guidance provided some clarity around the types of issues that companies should consider when crafting their disclosures concerning climate change, the SEC ultimately left it up to the individual companies to decide what information should be disclosed on the basis of materiality. In the absence of a mandatory SEC statutory framework for reporting on climate change or other ESG metrics, a number of other reporting frameworks have been used by U.S. public companies to report certain ESG metrics on a voluntary basis. As a result, disclosures vary greatly within each industry, with some opting to make limited ESG disclosures in periodic reports, while others issue stand-alone sustainability and corporate social responsibility reports (“CSRs”). For example, while some oil and gas companies disclose a proxy carbon cost estimate that factors in the anticipated costs of future regulation related to the extraction, transportation, and refinement of hydrocarbons, there is no uniform methodology for calculating such estimates, and companies report a wide range of different metrics which are difficult to compare.
The petition asks the SEC to develop a “comprehensive framework for clearer, more consistent, more complete, and more easily comparable information relevant to companies’ long-term risks and frameworks” to provide clarity on ESG reporting for U.S. public companies; additionally, the petition argues that ESG disclosures should be required under the existing SEC reporting framework because such disclosures are per se material to the decision-making of investors. The petitioners cite a litany of recent reports and analyses performed by top-tier investment banks, research institutes and scholars that suggest that ESG information is material under the existing case law interpreting the materiality standard and form the type of information that a reasonable shareholder would consider important when making investment decisions. The petition also notes the substantial amount of capital—$64.8 trillion—managed by investors that are committed to incorporating ESG factors in their investing and voting decisions under the United Nations Principles for Responsible Investment and growing investor interest in non-financial information across all sectors as further support for specific ESG disclosure requirements.
A decision by the SEC to create specific rules for ESG disclosures would not be entirely unprecedented. In 2011 and 2018, the SEC issued interpretative guidance related specifically to cybersecurity that went beyond the standard materiality analysis in response to increased investor concerns on disclosure of cybersecurity risks. This is an example of the SEC maintaining materiality as its key principle while providing specific guidance on an issue that it believes is per se material to investors. Accordingly, it is possible that such an approach could be applied by the SEC to require disclosure regarding certain ESG issues.
However, given the current political climate, the SEC is unlikely to initiate a special rulemaking process addressing ESG disclosures. Although key issues such as sustainability and global climate change remain at the forefront of many investors’ minds, it is no secret that the Trump administration does not consider these top policy priorities. Recent actions such as withdrawal from the Paris Climate Agreement and repeal of the Clean Power Plan make it clear that the current political environment may not be favorable for enhanced ESG disclosures. Comments from SEC commissioners and staff since the filing of the petition also indicates that specific ESG rulemaking is unlikely to happen any time soon and that the SEC will continue to evaluate the need for specific ESG disclosures by public companies based on the standard of materiality.
Practical Guidance
In the absence of additional SEC guidance, as companies look to the future and consider the adequacy of their own disclosures, it is paramount to consider the material risks relating to ESG factors on the operations and financial results of the company. ESG issues will continue to prove important to both investors and regulators. Whether or not the SEC responds to this particular call for rulemaking concerning ESG disclosures, the impact of global climate change and related issues are not going away. One market report estimates that the number of investors who fully integrate ESG into their investment process are managing more than 10% of the shares in listed companies globally, and that this percentage is above 50% when investors that consider some aspects of a company’s ESG performance are included. Investor support for ESG shareholder proposals, particularly environmental and social proposals, also continues to rise. Only days after the petition was submitted to the SEC, the United Nations Intergovernmental Panel on Climate Change released a major new report warning that global temperatures could reach an irreversible tipping point as soon as 2030. And in late fall 2018, Senator Elizabeth Warren introduced the Climate Risk Disclosure Act of 2018, which would require public companies to disclose a substantial amount of new climate-related information in their SEC filings. While this legislation is unlikely to pass during the Trump administration, private ordering may still result in enhanced ESG disclosures on a company-by-company basis even without legislation or SEC rulemaking action.
In the wake of the petition and given the current environment, public companies should evaluate their current sustainability and CSR reporting as well as their SEC reports to avoid pitfalls.
- Carefully review sustainability and CSR reports, website disclosures, and other materials prepared for investors to ensure that these materials do not conflict with prior disclosures or internal analyses. Any discrepancy may form the basis for a lawsuit, as in the recent high-profile case brought by the New York State Attorney General against Exxon alleging that it essentially kept two separate sets of books when accounting for the potential impacts of climate change.
- Similarly, review SEC filings and other public statements for consistency with sustainability and CSR reports and other public statements on ESG factors. A company’s SEC filings should address all material risks to the company’s business, including ESG-related risks. The anti-fraud provisions of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder prohibit companies from making any untrue statement of material fact, or failing to state a material fact necessary to make a statement not misleading, and the anti-fraud provisions apply to all corporate communications, and not just SEC filings.
- Review the company’s process for preparing sustainability and CSR reports. The need for public companies to maintain effective disclosure controls extends beyond the corners of the company’s SEC filings. Ensure that legal, operations, and all other internal stakeholders who collect data and respond to requests for information or questions on ESG topics are represented in the review process.
- Verify the data in sustainability and CSR reports, particularly specific statistics (such as carbon or greenhouse gas emissions or targets) contained in such reports. Sustainability and CSR reporting documents should be vetted through internal audit or some other independent fact check process to guard against inadvertent errors that may give rise to claims if investors rely on the inaccurate data in making an investment decision.
Conclusion
The petition for ESG rulemaking is the latest in a series of efforts to require mandatory ESG disclosures for U.S. public companies. While it is unlikely that the SEC will act on the petition, given the focus on ESG factors by investors in the current environment, companies should carefully review their ESG voluntary reporting and SEC filings under the lens of the heightened investor scrutiny on ESG issues to minimize potential liability under the federal securities laws.