Several months after first calling on investors, registrants, and other market participants to provide comments on its current climate change disclosure policies and practices, the U.S. Securities and Exchange Commission (“SEC”) has reinforced its attention on – and its “endeavor to craft a rule proposal for” – climate and ESG disclosures. At the 2021 ESG Disclosure Priorities Event on May 24, SEC Commissioner Allison Herren Lee spoke to the “important and timely topic,” focusing primarily on a number of misconceptions about ESG disclosures, particularly when it comes to “materiality,” which she stated is “a fundamental proposition in the securities laws and in our capital markets more broadly,” and the general standard for determining what information should be disclosed by public companies.
Addressing one of the “most prevalent” myths regarding the SEC’s quest to draft and implement rules specific to ESG disclosures in light of concerns about whether current disclosure rules adequately inform investors about “known material risks uncertainties, impacts, and opportunities [in regard to ESG], and whether greater consistency could be achieved,” Commissioner Lee claimed that the SEC “frequently hears that new climate or ESG disclosure requirements are unnecessary because the existing disclosure regime already requires the disclosure of all material information” – i.e., information that a reasonable investor would consider important in making an investment or voting decision – and thus, new reporting rules specific to ESG would be superfluous.
“This is simply not true,” Lee asserted, saying that such an argument “reflects a fundamental misunderstanding of the securities laws,” since the disclosure of information by a public company is “not automatically triggered by the occurrence or existence of a material fact.” Beyond that, there is “no general requirement under the securities laws to reveal all material information.” In actuality, she stated that “disclosure is only required when a specific duty to disclose exists,” which is significant, as “securities laws currently include little in the way of explicit climate or other sustainability disclosure requirements.” The result? “In many instances,” disclosure may only be required in connection with something else that is disclosed by a company, such as to ensure that another disclosure is not misleading.
At the same time, Commissioner Lee claimed 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.”
With that in mind, climate and ESG information that may be important to a reasonable investor is not necessarily required to be disclosed – and many times, is not disclosed – just because it is “material,” making it so that investors may be deprived of ESG and climate impact information. This is compounded by the fact that management “frequently sees things,” including determinations of what is and is not “material” information, “differently from investors,” according to Lee, who stated that “even when a duty to disclose exists, however, a principles-based standard that broadly requires disclosure of ‘material’ information presupposes that managers, including their lawyers, accountants, and auditors, will get the materiality determination right, [when] in fact, they often do not.”
Another noteworthy “misconception”? The alleged inability of the SEC to mandate disclosures if they are not directly related to a company’s income. “Many [people] have come to believe (incorrectly) that the SEC is legally prohibited from requiring specific disclosures unless it can demonstrate that each disclosure is individually material to the bottom line of every public company,” Lee asserted. However, she argued that the SEC’s authority is not limited by a requirement that “each individual metric required is material to each and every public company subject to the rule,” and instead, it has “full rulemaking authority to require disclosures in the public interest and for the protection of investors.”
As for what such potential ESG disclosures would look like, John Coates, the SEC’s Acting Director for the Division of Corporation Finance stated in March that “many ESG-related issues are similar to ones we have faced before,” pointing to “Asbestos-related disclosure” as a “great example, [as] for years, asbestos-related risks were invisible, and information about asbestos would likely have been called ‘non-financial.’” Yet, over time, he noted that those risks “went from invisible to visible to extremely clear, and clearly financial.”
Doing away with these “misnomers” and others is necessary, Lee argues, in light of the fact that “all manner of market participants [are] embracing ESG factors as significant drivers of decision-making, risk assessment, and capital allocation precisely because of their relationship to firm value,” and investors have “been overwhelmingly clear in their views that climate risk and other ESG matters are material to their investment and voting decisions.”
In terms of what the SEC’s enduring focus on the ESG realm and the increasing-likely “prospect of SEC disclosure requirements specific to corporate climate and ESG impacts of corporate supply chains” means for publicly-traded companies, including fashion industries entities, Baker McKenzie attorneys Maria Piontkovska and Reagan R. Demas contend that it increases the risk for those that “have not yet developed risk-based responsible sourcing, sustainability and ESG compliance programs.” In preparation for the expected enactment of climate and ESG disclosure rules that “are under development,” they advise companies to prepare by “considering the efficacy of current policies, procedures, and other program elements to cover the risk of climate, social, and governance failures both in supply chains and in broader business operations.”
On a broader scale and in much the same vein as the SEC’s proposed rule-making on standardized ESG and climate disclosures is being hailed as likely to allow for “apples-to-apples” comparisons across different companies’ disclosures, and therefore, to potentially give rise to more transparency for the benefit of investors (and consumers), there is a globally-spanning push for governments to mandate “climate-related disclosures to properly assess” climate and ESG-related progress, such as efforts to cut down on greenhouse gas emissions.
Experts are urging governments in the Asia-Pacific region, for instance, to adopt “standardized rules on climate-related financial disclosures by companies, as sustainability is increasingly becoming an important consideration in investment decisions,” and particularly, as countries in the region set “net-zero goals for carbon emissions,” S&P Global’s Rebecca Isjwara recently reported. On that note, Sarah Barker, a partner and the head of climate risk governance at Australia-based law firm MinterEllison, stated that “investors are concerned about the lack of comparability in information that is published” by companies due to a lack of “universal assumptions, trajectories and/or metrics.”
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