On January 30, 2020, the U.S. Securities and Exchange Commission (SEC) issued a proposed rulemaking designed to “Modernize and Enhance” Regulation S-K, with a stated intent to eliminate duplicative disclosures for the benefit of investors and simplify filings for registrants. See Management’s Discussion and Analysis, Selected Financial Data, and Supplementary Financial Information, 85 Fed. Reg. 12,068 (Feb. 28, 2020). Not all SEC Commissioners were in complete agreement with key provisions of the proposed action. In fact, in a concurrently issued statement, Commissioner Allison Herren Lee criticized the proposed rulemaking’s failure to address matters associated with certain environmental, social, and governance (ESG) concerns, specifically calling out the issue of climate change. Going further, the SEC’s Investor Advisory Committee issued a report on May 20, 2020, that recommended the SEC adopt disclosure policies regarding ESG issues. In addition, the focus of ESG concerns were echoed in certain comments filed on the proposed rulemaking. For example, one notable set of comments came from the office of U.S. Senator Elizabeth Warren, who, among other matters, added that the current global COVID-19 pandemic exacerbates the purported need for explicit climate change requirements in the SEC’s reporting requirements. See Letter from E. Warren to Chairman Clayton (Apr. 28, 2020).
Commissioner Lee’s statement underscores the past decade’s advancing trend in corporate institutional investing regarding the examination of corporate valuation and investment risk within the context of ESG issues, or sustainable investing. ESG criteria are a set of standards for a company’s operations that some investors use to screen potential investments. Environmental criteria generally consider how a company performs as a steward of nature and the impacts from its operations on the environment. Social criteria examine how it manages relationships with employees, suppliers, customers, and the communities where it operates. Governance deals with a company’s leadership, executive pay, audits, internal controls, and shareholder rights. ESG considerations for publicly traded companies have become more focused, and companies find themselves confronted with inquiries and performance demands from the investment community that involve wide-ranging ESG concerns, including those specific to climate change; stakeholder outreach and advocacy; and internal policies, procedures, and management systems associated with ESG matters. Many, if not most, companies now voluntarily report, to some degree, on ESG matters and performance in various publications, such as corporate sustainability reports. Publicly traded companies also are required to address and assess to what extent ESG issues, such as climate change, implicate a “material” concern or risk in required financial reporting.
In recent months, the issue of material financial risks has been significantly influenced by the economic outfalls of the global pandemic. In many cases, ESG-focused commenters have responded to the crisis of the pandemic by highlighting the exacerbation of ESG concerns from the effects of the pandemic and stressing recovery actions should align with ESG principles to provide for a sustainable economic recovery. In addition, and despite the clear economic challenges that have resulted from the pandemic, commenters indicate that research from the first four months of 2020 suggests that investments in funds that invest in ESG practices have continued to perform well with better-than-average returns relative to counterparts, regardless of the asset classes of the funds. Caitlin McCabe, ESG Investing Shines in Market Turmoil, with Help from Big Tech, Wall St. J., May 12, 2020.
No longer is it viable for regulators or publicly traded companies to avoid the issue of climate change in the evaluation and disclosure of potential material impacts and risks from products, projects, and/or operations on long-term sustainability. As state and federal policy agendas move to counter or mitigate the impacts from climate change, more and more arguments are made to suggest that governing agencies should promote regulatory actions to meaningfully address the risk of climate change. As highlighted by Commissioner Lee with respect to her concerns with the proposed rulemaking, “much has changed in the last decade with respect to what we know about climate change and the financial risks it creates for global markets. Investors have increased their demands on companies and regulators for consistent, reliable, and comparable disclosures . . . and regulators around the globe are taking action.” See Allison Herren Lee, “Modernizing” Regulation S-K: Ignoring the Elephant in the Room, U.S. Sec. & Exch. Comm’n (Jan. 30, 2020).
In this article, we examine issues associated with corporate financial reporting of ESG risks and performance in required financial filings for public companies, the evolving SEC guidance and requirements on ESG concerns and standards of materiality, and the interrelationship between approaches for corporate disclosures under SEC standards and voluntary publication of ESG-related performance, with a specific focus on the issue of climate change.
Statutory and Regulatory Provisions
The Securities Act of 1933 (Securities Act) (15 U.S.C. § 77z-1) and the Securities Exchange Act of 1934 (Exchange Act) (15 U.S.C. § 78u-4) govern most of the federal securities requirements in the United States. The Securities Act and the Exchange Act were passed in the wake of the stock market crash of 1929 to ensure the integrity of capital markets. The Securities Act requires companies to register securities with the SEC prior to offering for sale and to provide certain disclosures in connection with the offerings for sale or registration of securities. The Exchange Act requires publicly traded companies to file certain periodic reports and provides the statutory requirements for annual, periodic, and episodic reports.
The Securities and Exchange Acts require public companies generally to do the following with respect to environmental issues: (1) present material environmental financial information in accordance with generally accepted accounting principles (GAAP); (2) present narrative and quantitative environmental information in the nonfinancial section of financial filings; (3) provide additional information, either within financial statements or outside, as necessary to enable investors to make informed decisions; and (4) implement and maintain a reporting system capable of providing reasonable assurance the foregoing requirements are met. Importantly, the statutes collectively provide the enabling framework for regulatory standards associated with what is material for the purpose of corporate disclosures in financial filings. Materiality, or what constitutes material information for disclosure purposes, is a frequent consideration and issue in securities litigation. As stated by the U.S. Supreme Court:
The question of materiality, it is universally agreed, is an objective one, involving the significance of an omitted or misrepresented fact to a reasonable investor. Variations in the formulation of a general test of materiality occur in the articulation of just how significant a fact must be or, put another way, how certain it must be that the fact would affect a reasonable investor’s judgment.
TSC Indus., Inc. v. Northway, Inc., 426 U.S. 438, 445 (1976). An omitted fact is material if “there is a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.” Basic, Inc. v. Levinson, 485 U.S. 224, 232 (1988).
Through the Securities and Exchange Acts, Congress authorized the SEC to issue rules and regulations to require the reporting of information “necessary or appropriate in the public interest or for the protection of investors.” 15 U.S.C. § 77g(a)(1). Under this authority, the SEC promulgated Regulation S-K, which provides the requirements for disclosure of nonfinancial information in the periodic reports required for public companies. 17 CFR pt. 229, et seq. The key provisions of Regulation S-K that are frequently invoked in the context of ESG matters include Item 101, “Description of Business” (17 C.F.R. § 229.101); Item 103, “Legal Proceedings” (17 C.F.R. § 229.103); Item 105, “Risk Factors” (17 C.F.R. § 229.105); and Item 303, Management’s Discussion and Analysis (17 C.F.R. § 229.303).
Item 101, among other matters, requires corporations to disclose the “material effects that compliance with Federal, State and local provisions which have been enacted or adopted regulating the discharge of materials into the environment, or otherwise relating to the protection of the environment, may have upon the capital expenditures, earnings and competitive position of the registrant and its subsidiaries.” 17 C.F.R. § 229.101(c)(1)(xii). Item 103 requires the disclosure of “any material pending legal proceedings, other than ordinary routine litigation incidental to the business, to which the registrant or any of its subsidiaries is a party or of which any of their property is the subject,” which, for environmental matters, includes actions that may result in monetary sanctions in excess of $100,000. 17 C.F.R. § 229.103. As discussed further below, the SEC has recently proposed to raise this threshold to $300,000. Modernization of Regulation S-K Items 101, 103, and 105, 84 Fed. Reg. 44,358, 44,359 (Aug. 23, 2019).
Item 105 provides for filings to include “a discussion of the most significant factors that make an investment in the registrant or offering speculative or risky.” 17 C.F.R. § 229.105. The SEC has moved to align this standard with the concept of materiality, specifically seeking to change the standard from disclosure of “significant” to “material” risk factors. 84 Fed. Reg. at 44,361.
Item 303 sets the requirements for management’s discussion and analysis (MD&A), which provide for the disclosure of certain specific items associated with the financial condition and results of the operations of the company. 17 C.F.R. § 229.303. Item 303 generally requires the disclosure of known trends, events, or uncertainties that have affected, will affect, or are reasonably likely to affect the registrant’s liquidity, capital resources, or results of operations. Id. These MD&A requirements can create a conflict between what information is appropriately disclosed under the regulation and what may otherwise be of interest to stakeholders over ESG issues. For example, recent research from Morningstar indicates that asset-manager proxy voting support for ESG-related shareholder resolutions has increased considerably over the past five years—with support at 46% in 2019, up from 27% in 2015. See Jackie Cook, How Fund Families Support ESG-Related Shareholder Proposals, Morningstar (Feb. 13, 2020).
Evolving SEC Approach
In 2010, the SEC made its first meaningful effort to address issues regarding climate change through its guidance document titled “Commission Guidance Regarding Disclosure Related to Climate Change.” 75 Fed. Reg. 6290 (Feb. 8, 2010). Following the U.S. Environmental Protection Agency’s newly released greenhouse gas reporting rules, the SEC sought to align its reporting standards to address regulatory, legislative, and other developments associated with climate change. The SEC guidance for the first time specifically identified varied climate change impacts as implicated under the reporting standards, noting, “in addition to legislative, regulatory, business and market impacts related to climate change, there may be significant physical effects of climate change that have the potential to have a material effect on a registrant’s business and operations.” Id. at 6291. The effects noted by the SEC can impact a registrant’s personnel, physical assets, supply chain, and distribution chain. Notably, the SEC observed that much of the climate change–related information companies disclose is found outside of formal financial filings. Id. at 6292. Taking specific notice of reporting platforms such as the Carbon Disclosure Project (now known as CDP) and reporting standards developed by the Global Reporting Initiative (GRI), the SEC found although much of this reporting is provided voluntarily, registrants should be aware that some of the information they may be reporting pursuant to these mechanisms also may be required to be disclosed in filings with the Commission pursuant to existing disclosure requirements. In the 2010 guidance, the SEC devoted its attention to the specific concern of climate change under the regulatory reporting requirements in Items 101, 103, 105, and 303.
Under the current administration, the SEC has holistically amended its regulatory reporting standards. In April 2019, the SEC amended Regulation S-K and simplified its reporting requirements. FAST Act Modernization and Simplification of Regulation S-K, 84 Fed. Reg. 12,674 (Apr. 2, 2019). The proposal was a departure from the 2010 Guidance, which arguably complicated the nature of a company’s financial disclosures, by specifically seeking to have climate change–focused matters addressed in a registrant’s filings.
In August 2019, the SEC also issued a proposed rule to amend the regulatory requirements of Regulation S-K for the first time in 30 years. Without any specific identification or discussion of ESG concerns, the SEC’s proposed amendments sought to emphasize the principles-based approach “because the current disclosure requirements may not reflect what is material to every business, and, as past developments have demonstrated, disclosure requirements, and in particular prescriptive disclosure requirements can become outdated.” 84 Fed. Reg. at 44,360.
Building on the August 2019 proposal, the SEC recently moved to amend Regulation S-K’s MD&A requirements to “modernize and enhance” MD&A disclosures. 85 Fed. Reg. at 12,068. Although facially designed to take advantage of technological advancements and changes to GAAP standards, SEC stated its proposal also “considered the benefits and appropriateness of a principles-based approach in reviewing [MD&A] items and our proposals are intended to promote the principles-based nature of MD&A.” Id. at 12,070. Combined with the August 2019 proposed amendments to Items 101, 103, and 105, the February 2020 proposal reflects a codification of preexisting instructions for certain disclosures and a streamlining of Item 303’s requirements. Id. at 12,075–91. Notably, and as lamented by Commissioner Lee in her statement regarding the proposal, the proposed MD&A revisions seem to support a need for more robust climate change disclosures but do not directly address the issue. The proposed revisions to Item 303’s provisions around “known trends or uncertainties,” for example, seek to provide for a corporation to discuss and analyze “events that are reasonably likely to cause (as opposed to will cause) a material change in the relationship between costs or revenues.” Id. at 12,080.
The revised proposed standards seem to more appropriately provide for climate change discussions in a MD&A narrative. Although the proposed rulemaking was silent on the issue of ESG concerns, it was not a topic that went unaddressed. In addition to Commissioner Lee’s criticism, Chairman Clayton issued a lengthy statement in support of the proposed rule and the manner in which the SEC staff and Commissioners evaluate ESG issues and interact with stakeholders, the regulated community, and international counterparts to assess ESG and climate change–related issues. Likewise, Commissioner Hester Pierce issued a statement in which she supported the rulemaking and responded to the repeated calls for ESG-related adjustments to the disclosure requirements. The collective focus of the Commissioners’ statements on ESG matters, and specifically climate change concerns, features clearly the importance of these issues and the continued support they receive from the broader stakeholder community. This importance was made clear with the May 20, 2020, report from the SEC’s Investor Advisory Committee calling for specific disclosure requirements around ESG issues and climate change specifically. Tom Zanki, SEC Urged to Establish ESG Disclosure Policies, Law 360, May 21, 2020.
Climate Change and Corporate Reporting
Climate change disclosures are a topic that will continue to receive heightened attention and scrutiny from the investment community. How a company goes about framing and structuring its risk statements and considerations for climate change in its financial filings, for example, can potentially leave a company in the crosshairs for negative actions from external stakeholders and shareowners. Many commenters highlight the importance that ESG considerations make in disclosures and that the divergence between SEC requirements and other nonregulatory standards can make the issue difficult to assess from a standardized baseline. Advocates for more transparent and clearer reporting around climate change impacts in financial filings claim historical attempts to integrate sustainability factors in nonfinancial filings, as disclosed in a corporate sustainability report, with financial factors disclosed in SEC reports have proved inadequate.
These concerns are precisely the reason why Commissioner Lee took issue with the recent proposed amendments to the MD&A requirements. Commissioner Lee echoed the common frustration of commenters over the need for consistent, reliable, and comparable disclosures of the risks and opportunities related to sustainability measures, particularly climate risk. As stated by Commissioner Lee, “the broad, principles-based ‘materiality’ standard has not produced sufficient disclosure to ensure that investors are getting the information they need—that is, disclosures that are consistent, reliable and comparable.” Commissioner Lee bemoans the SEC’s routine disclosure review process and the lack of attention to improving the standard for comment on climate disclosure. She notes what she terms the “unprecedented and massive campaign to obtain climate-related disclosure from issuers” undertaken by investors and shareholders, and the result of most large public companies providing some sustainability disclosure, including in reports separate and apart from the SEC’s required disclosure regime. Lee, supra.
There are numerous reporting tools and programs available to companies to begin to gauge or incorporate ESG-related topics into management programs and disclosures, including those associated with climate change. Three of the most commonly employed and long-standing reporting structures are provided by GRI, SASB, and the Principles for Responsible Investing (PRI). Although the focus of these reporting platforms varies, generally the programs are designed to provide nongovernmental standards for the reporting of ESG risks and how a company’s management of ESG risks relates to industry peers.
Companies are commonly asked to consider or are confronted with participation in ratings disclosures that provide the investment community with ready-made sources of information on a company’s ESG performance and undertakings. Programs and services such as CDP or the Dow Jones Sustainability Indexes are frequently used for such evaluations. The degree to which companies are responsive to or involve themselves in these programs can dictate to what extent the company becomes subject to further specific stakeholder actions, such as shareholder proposals designed to influence and change corporate focus or action.
A recent example of how ESG concerns are becoming a main driver behind investment scrutiny can be seen in the annual letter to CEOs from BlackRock Chairman and CEO Larry Fink. In the communication, Mr. Fink expresses his belief that climate change and sustainability were paramount considerations in investment risk assessments. Mr. Fink posits that ESG matters “are driving a profound reassessment of risk and asset values. And, because capital markets pull future risk forward, we will see changes in capital allocation more quickly than we see changes to the climate itself. In the near future—and sooner than most anticipate—there will be a significant reallocation of capital.” Larry Fink, Letter to CEOs: A Fundamental Reshaping of Finance, BlackRock (2020) (emphasis in original). Mr. Fink specifically highlights potential impacts from climate change as an investment risk, such as the concerns around the unknown scale and scope of government action on climate change, which will generally define the speed with which a move to a low carbon economy occurs. Mr. Fink also acknowledges that “[u]nder any scenario, the energy transition will still take decades . . . [and] despite recent advances, the technology does not yet exist to cost-effectively replace many of today’s essential hydrocarbons.” Id. He stresses the need for government and the private sector to work together to pursue a “fair and just” transition that does not come at the cost of certain parts of society or countries in developing parts of the world. Id.
The general investment thesis assumes that the promotion of ESG performance and initiatives not only supports the ethical management of social considerations but also sustainable profitability. As stated by Mr. Fink, “a company cannot achieve long-term profits without embracing purpose and considering the needs of a broad range of stakeholders.” Id. Investment analysts seek information or confirmation from companies on topics that range from how a company incorporates ESG concerns in its risk management programs or presents the issues to senior management and boards of directors, to what efforts companies take to measure or reduce emissions from its operations. Frequently, investment analysts consider whether companies tie executive compensation to ESG-related performance and the degree with which corporate governance and structures are designed to promote transparency of ESG factors.
Planning and executing on ESG-focused materiality assessments necessitate a systematic approach, with consistent controls to address and account for the legal issues that can be presented. Companies should cautiously review the inclusion or mention of activities or programs that they may not, or only half-heartedly, adhere to or employ in normal practice. It is essential that companies employ processes available to protect the development of information and data collected during these reviews because the results can implicate any number of deeper legal concerns. For instance, what if the results of the review reveal a systemic issue across an entire subsidiary or operations unit? Planning and execution on ESG assessments require thoughtful collaborations between counsel, internal subject matter experts, corporate operations personnel, and/or external consultants that a company may retain to conduct the review.
Companies that purposely include ESG-related issues and disclosures in external facing presentations and websites have begun to distinguish themselves from their industry peers in other ways beyond favorable financial performance. In as much as certain ESG ratings are relative to other companies within the same industry, companies can distance themselves from industry peers by employing and adhering to best ESG practices and reporting.
Recent legislative efforts have added to the pressures around corporate ESG disclosure requirements. On September 20, 2019, the U.S. House of Representatives Financial Services Committee passed H.R. 4329, the ESG Disclosure Simplification Act of 2019. The legislation would have public companies provide a “clear” description of both the connection between ESG metrics and long-term business strategies and the process used to determine how ESG metrics affect the long-term business strategies of the issuer. It would also require the SEC to establish a permanent advisory committee, called the “Sustainable Finance Advisory Committee,” comprising up to 20 members who may serve for up to four years. While it is unlikely that the law will be passed and signed into law under the current administration, the bill itself stands as a good example of the continuing efforts designed to force reporting companies to issue more meaningful and additional ESG disclosures.
The concerns over ESG-related disclosures have been implicated in recent months from the continued economic impacts from the global coronavirus pandemic. Some commenters, in support of ESG principles in investment disclosures, offer that recovery efforts should align with ESG principles, and not forsake the influence that the economic downturn can have on global ESG risks and opportunities. How Responsible Investors Should Respond to the COVID-19 Coronavirus Crisis, PRI Bull., Mar. 27, 2020. As included in PRI’s Bulletin, when the public health emergency of COVID-19 starts to subside, “government support should be prioritized for companies, sectors and business activities that help respond to crises such as the climate emergency and inequality, rather than those that risk exacerbating them.” Id. The SEC’s Division of Corporation Finance also recently addressed the matter in a guidance and identified how the risks of the virus must be accounted for in corporate filings.
The Division of Corporation Finance’s guidance documents state the Commission has made clear that its disclosure requirements can apply to a broad range of evolving business risks, even in the absence of a specific line-item requirement that names the particular risk presented. As a result, disclosure of these risks and COVID-19-related effects may be necessary or appropriate under several of the reporting standards in Regulation S-K. Div. of Corp. Fin., Secs. & Exch. Comm’n, Coronavirus (COVID-19) CF Disclosure Guidance: Topic No. 9 (Mar. 25, 2020).
The changing reporting standards of the SEC, and the current importance of ESG matters in relation to these standards, are an important area of concern for publicly traded companies in the United States. The at-times competing dynamics between private reporting protocols, voluntary sustainability reporting by companies, and the SEC requirements for reporting forecast a continued debate over the need for enhanced disclosure requirements devoted to ESG issues by the SEC. As ESG focuses will remain a primary component of how external stakeholders—most importantly, investors—view a company, it stands to reason that calls for more specific regulation around the subject of ESG performance will continue to permeate until more robust regulatory standards are advanced. Resolute and prudent efforts by companies to address these issues are paramount as they advance and respond to stakeholder ESG concerns because the reputational harm and impacts that may result from failing to do otherwise can make the difference for long-term sustainability of a business.