Navigating the Waters: The SEC's Focus on ESG
Holland & Knight Partner and former SEC Enforcement Assistant Director Scott Mascianica sat down on March 28, 2022, with Eric Werner, Associate Regional Director for Enforcement in the SEC's Fort Worth Regional Office, to discuss the agency's history on matters of Environmental, Social and Governance (ESG), the existing disclosure framework and materiality paradigm, existing rules that involve ESG considerations and the agency's recently proposed rule that, if enacted, will mandate sweeping new climate-related disclosures for public companies. Holland & Knight's ESG team recently summarized the proposed rule, and in this post, we break down today's discussion with Werner.
Why the SEC Cares About ESG
- Current and recent commissioners have offered a variety of reasons why a majority of them support a new, climate-centric set of disclosure requirements for public companies. Chief among them is to ensure that investors have access to relevant and material information when deciding whether to make, or keep, an investment.
- Today, more than ever, investors are interested in more than just the audited financial statements of a company in which they may invest – they are interested in how the company is impacting their communities and the environment. Notably, companies are often keen to disclose to the investing public far beyond that which is required for SEC filings. As companies are increasingly inclined to provide the investing public with more information on their ESG efforts, ensuring a method by which investors can assess the information with consistency and comparability is paramount.
Unpacking the Social Component of ESG
- Much has been written on the Environmental component of ESG and, indeed, that is the focus of the SEC's recently proposed disclosure rule. But the Social component of ESG is also significant, even though the through-line from social concerns to a company's financial performance may be harder to evaluate.
- Werner shared his view that the Business Roundtable's 2019 Statement on the Purpose of a Corporation (Statement) provides helpful context when considering how Social issues matter to a company and its investors. The Statement, signed by 181 CEOs, underscores that companies should deal fairly and ethically with suppliers, and value and invest in their employees and communities. Through that lens, social concerns and their relationship to a company's overall viability and bottom line come into focus.
- For instance, addressing human trafficking risks posed by a company's operations illustrates the importance of the Social component to the company's bottom line, especially as companies carry out their compliance function and assess how such risks, and the costs associated with implementing effective anti-human trafficking internal controls and procedures (or failing to), impact the organization and its investors.1
The SEC and ESG Over Time
- The SEC isn't a newcomer on ESG. The agency has issued interpretative guidance since the 1970s concerning compliance with environmental laws. For instance, in 1975, it considered a variety of "environmental and social" disclosure matters. In 2010, the SEC published an interpretive release to provide public companies guidance on how existing disclosure requirements could apply to climate change matters. And in 2016, it issued a concept release seeking public comment on modernizing disclosure requirements in Regulation S-K.
- More recently, the Division of Examinations identified climate-related risks as an annual exam priority, the Division of Corporation Finance published a sample letter to public companies relating to climate change disclosures and the Division of Enforcement formed the Climate and ESG Task Force.
- Of course, just last week, the SEC released its long-awaited proposed rule for mandatory climate-related disclosure, which is summarized in this Holland & Knight Info Flash.
SEC Enforcement's Potential Areas of Focus
- If the proposed rule is adopted, as is expected, it will naturally take time for the SEC's Enforcement Division to get up to speed and pursue legal action.
- Well before the proposed rule was announced, however, the SEC formed the Climate and ESG Task Force. So far, the Task Force, and the Division of Enforcement more generally, has been looking into material gaps or misstatements in issuers' SEC filings relating to climate and other ESG issues. In so doing, the staff considers what companies are already disclosing on ESG topics, how fulsome and robust those statements are and whether everything that should be disclosed is included. Werner described this as not being a prescriptive approach to existing disclosure, but rather the staff's normal efforts and undertakings to understand what companies are saying, how and why they're saying it, and whether what they're saying is accurate and complete.
- Werner observed that the SEC's Fort Worth Regional Office, where he oversees the Enforcement program, has built an expertise in the energy sector that can be leveraged to address ESG investigative and enforcement issues. He went on to note that his office is in more of an information-gathering stage, looking at regional issuers, becoming familiar with their disclosures and if the staff observes potential disclosure gaps, determining whether there is cause for concern.
- Comparable to the agency's enforcement actions involving cybersecurity issues, including an action last year involving alleged violations of Exchange Act Rule 13a-15(a) requirements relating to disclosure controls and procedures, it seems likely that apart from instances of alleged ESG disclosure fraud, the Enforcement Division is prepared to utilize a variety of non-scienter, controls-based provisions for enforcement actions, including potential strict liability provisions involving ESG disclosure. As a practice pointer, therefore, companies should consistently and carefully consider what information they're choosing to disclose and why it is material, and take care to operate with effective internal controls and procedures to monitor for accuracy and completeness.
Existing Disclosure Obligations and Considerations
- The existing and long-standing disclosure regime, including as it pertains to ESG, can generally be summarized in two buckets:
- Principles-based disclosure crafted within the rubric of materiality – a non-prescriptive format that allows for flexibility based on the issuer's particular company makeup and what it determines is material to investors. Some opine that ESG rulemaking is unnecessary and will be unduly prescriptive, and that the long-standing principles-based approach is a superior methodology for companies being sufficiently self-aware and able to inform investors about what is important on environmental, social and governance topics. Others, including a majority of the SEC's commissioners, conclude that some companies simply are not getting it right or going far enough, resulting in the need for a new rule.
- Targeted rules addressing ESG-related issues that already exist largely under Regulation S-K and require disclosure on ESG-related topics such as environmental-related capital expenditures, board diversity and governance requirements. Dissenters point to these as a basis for arguing against any new rule. For the time being, the United States operates under a hybrid disclosure model allowing companies the breadth to exist in a principles-based disclosure environment but in which they are also expected to address specific issues investors care about, and in a way that provides consistency and comparability.
The Proposed Rule and the Comment Process
- Although the recently proposed rule has no current enforceability, the issue – and the content of the proposed rule – are advanced enough and important enough to the Commission and Chair Gary Gensler that it is widely understood that some rule, and one likely to be substantially similar to the proposal, will be adopted.
- In the typical life cycle from a proposed-to-final rule, some tweaks are made along the way as a result of the public comment process. With regard to ESG-specific rulemaking, Commissioner Allison Herren Lee previously requested comment in 2021, and there was a significant response that was clearly considered, and even referenced, in the proposed rule. This fact, as well as the sense of momentum and a majority of commissioners favoring the proposal, may indicate that the proposed rule is unlikely to undergo significant change.
- Nevertheless, the comment process is extremely important and now is the time to read and digest the proposed rule and for the SEC to listen to investors, companies and other interested stakeholders on how to make it better, how portions of it may be unduly burdensome and the like.
Distilling the Proposed Rule
- Key Highlights. Werner offered a general summary of the proposed rule and pointed to the Commission's fact sheet. He noted:
- certain disclosures in registration statements and annual financial reports will be required for climate-related risks that are reasonably likely to have a material impact on a company's business or consolidated financial statements
- companies will need to disclose certain governance and risk management information about board and management processes addressing climate-related risks
- companies will also need to disclose certain greenhouse gas (GHG) emission metrics around what are commonly called Scope 1, Scope 2 and Scope 3 emissions – which have been much discussed in advance of, and following the release of, the proposed rule
- certain companies may need to include an attestation requirement around GHG emissions
- companies will need to disclose certain financial statement metrics under Regulation S-X
- a phase-in period and certain safe harbors will accompany the new requirements
- companies that have already set or disclosed particular climate targets or goals, will be required to disclose information about what has been done to meet them, and to review progress toward targets and goals going forward
- Climate Related Risks. Under the proposed rule, "climate-related risks" is a defined term that means "actual or potential negative impacts of climate-related conditions and events on a registrant's consolidated financial statements, business operations, or value chains, as a whole." Of particular interest to many will be whether this term arrives in a final rule as it is proposed or if it will be revised in the comment process. Notwithstanding what its ultimate definition may be, Werner expects the concept itself to be in a final rule.
- Value Chain. As proposed, the new rule will include required disclosure relating to upstream and downstream activities in a company's operations. For the vast majority of companies, this would include activities by parties other than the company itself, e.g., its vendors and suppliers. Hence, the full value and supply chain may need to be vetted for both actual and potential climate-related risks. And while the proposed rule's disclosure threshold remains premised on company-bespoke materiality, for many companies, this will mean an enterprise-wide assessment of vendor and supplier activities.
- Reasonably Likely. Under the proposed rule, companies would be required to disclose material climate-related risks that are "reasonably likely to have a material impact" on their operations and results. This is not an altogether new term for public companies; its use – in connection with assessing forward-looking disclosure of trends, demands, commitments, events or uncertainties in Management's Discussion & Analysis (MD&A) – dates to a 1989 interpretive release.
- Safe Harbors. In its release of the proposed rule, the SEC makes multiple references to forward-looking "safe harbors" that would apply to certain aspects of the rule under the Private Securities Litigation Reform Act (PSLRA). However, the agency notes that there are important limitations to the PSLRA safe harbor. For example, it would not apply for disclosure in registration statements for an initial public offering. Additionally, the PSLRA safe harbor would not have any applicability to the SEC's ability to bring enforcement actions. Werner noted that the agency can bring, and historically has brought, enforcement actions based on what a company claims is a forward-looking statement.
- Governance. From a governance perspective, the SEC's proposed ESG rule follows a similar blueprint seen in its recent cybersecurity rule proposal, specifically requiring disclosure addressing, among other things, processes for how boards and management are informed of climate-related risks.
While a reasoned approach requires continued study and consideration of the SEC's more than 500-page release, it is clear that certain aspects of the proposed rule are unsurprising and, if enacted, suggest at least in some part a reasonable path ahead, such as the proposed phase-in, certain requirements applicable based on size of filer and certain safe harbors. However, the proposed rule also represents the SEC's most extensive, comprehensive and complicated disclosure initiative in decades and, based on the sheer quantity and quality of information required, is not free of serious concerns and, we expect, continued debate and potential legal challenge.
What steps should companies and their counsel take now, from a process perspective, with the proposed rule in mind? Every company, no doubt, is different and there is no easy or one-size-fits-all answer. In Werner's view, companies do well to remember that words matter. He noted, in parting comments, that companies spend a lot of money and time crafting and revising the language that they choose to include in their SEC filings, and they should take equal care to consider the words they choose, whether they need to be stated and why, what they truly mean and are intended to convey and, ultimately, whether they are accurate and complete.
Of course, ESG is a deceptively simple term comprising years of increasing focus on an array of issues and questions as wide as varied as the companies grappling with them. The SECond Opinions Blog, along with Holland & Knight's ESG and Securities Enforcement Defense teams, will continue to monitor the agency's activity in this space and provide further updates, and be ready to assist when you want more information on this rapidly evolving issue.
1 For more on the intersection of corporate compliance, ESG and anti-human trafficking efforts, contact Holland & Knight Partner Barbara Martinez, a former chief of the Special Prosecutions Section for the U.S. Department of Justice in the Miami U.S. Attorney's Office.