Mandatory ESG and Climate-Risk Disclosures: An Appraisal of the SEC’s Proposition
ESG disclosures have become front and center for businesses and corporations in recent years. Findings from a recent 2019 survey conducted by the Harvard Business Review show that ESG issues were “almost universally top of mind” among seventy senior business executives that cut across investment banks and asset management firms. Earlier in July, the U.S. Securities and Exchange Commission (“SEC”)’s Chairman Gary Gensler said: “Investors are looking for consistent, comparable, and decision-useful disclosures so they can put their money in companies that fit their needs.” The regulatory landscape for these disclosures however still largely remains a grey area. Uniform standards or procedures are yet to be incorporated into securities laws, and currently there is insufficient regulatory guidance on how to report ESG activities and on compliance with the requisite minimum disclosure standards.
The SEC’s Attitude on ESG Reporting
The SEC, as the primary regulator of the US securities market, has been very bullish in its approach and vocal about its desire for companies to adhere to these standards, honestly report compliance with ESG standards, and refrain from making unfounded ESG claims.
As far back as 2010, the SEC has issued guidance to public companies, providing its expectations for companies to disclose the physical impact of climate change on the companies’ businesses, including threats to hard assets, how environmental legislation and regulation could affect operations, and strategies, among other things. The guidance also provided that companies may need to make climate change disclosures under Regulation S-K.
Earlier in March, the SEC published a document requesting input on its proposed changes to climate change disclosures and other broad ESG disclosures. In a bid to eliminate the lack of clarity on ESG reporting and set clear standards for company climate risk reporting and disclosures, the SEC has recently announced a new proposal for mandatory climate-related disclosure requirements for public companies, which the SEC expects will be in effect starting this month (October 2021).
Concerns have arisen around the power of the SEC to impose these rules on companies at all and the broader impact of another disclosure layer on the securities market, particularly whether it will further impede capital raising for companies. SEC Commissioner Hester Pierce has publicly criticized the SEC’s proposal for enhanced ESG reporting, arguing that it was outside the scope of the SEC’s powers. Marc Steinberg pointed out there is already an information overload, as a lot of SEC disclosure documents currently exceed 100 pages. Few individuals and organizations already don’t have the patience to review these documents in depth.
Some of the broad statutory and constitutional arguments that could be raised to challenge the SEC’s powers are considered in the ensuing paragraphs.
Statutory Limits on the SEC’s Authority
There is a large consensus among companies and other stakeholders that ESG disclosures cannot be mandated without some measure of congressional approval or amendment to existing law. A case can be made that the SEC, in enforcing mandatory standards for climate risk disclosures, would be exceeding the scope of its powers under the Exchange Act. Section 13 (a) of the Exchange Act limits the SEC’s authority to require ongoing public reporting from issuers to circumstances where it is considered “necessary or appropriate for the proper protection of investors and to insure fair dealing in the security….” Arguendo, the SEC can only exercise these powers for the proper protection of investors and to insure fair dealing in society.
It can also be argued that the SEC is misguided in its reliance on the materiality concept which derives from Rule 10b-5 – a prohibition of the purchase and sale of securities by a public company where such company conceals any material fact or information. The disclose requirement under Rule 10b-5 for investor protection can be construed as being limited to disclosure of material fact that is necessary to prevent fraudulent conduct by public corporations, and climate risk disclosures are not within that remit.
This point has been made by a number of stakeholders, including the Attorney General of the State of West Virginia in his response to the SEC Commissioner Gary Gensler. However, in a recent dispute over mandatory conflict minerals disclosure imposed by the SEC, the court rejected arguments by the National Association of Manufacturers that the disclosures were neither necessary nor appropriate. Given current precedent, the courts may take a different approach if an action is brought before it.
There may be constitutional arguments against the SEC’s proposal based on a violation of free speech under the First Amendment of the US Constitution: requiring mandatory climate risk disclosure restricts speech in violation of the First Amendment and ESG disclosures fall outside the scope of the traditional materiality view on disclosures of information considered important for the objective, efficient, rational, profit-maximizing investor. Sixteen Republican attorney generals submitted a letter pushing back on the SEC’s call for public commentary on the formation of ESG disclosure rules. Their position is that it is a stretch to the treat the possibility of environmental cataclysm (which is broadly what the disclosures aim to safeguard) as a government interest, and the imposition on companies of mandatory disclosure of climate change risks is a violation of free speech under the Constitution.
Recently, the United States Court of Appeals for the District of Columbia partially invalidated the Dodd-Frank Act’s conflict minerals disclosure requirement on the grounds that it compelled speech in violation of the First Amendment. This is similar to the mandate on companies to disclose climate risk information.
Although there are viable arguments that the SEC’s proposal is ultra vires, there is no indication that the SEC will back off from this proposal. Starting October 2021, public companies will be required to make these mandatory disclosures as part of their required public reporting in annual and quarterly reports, at the very least until the SEC’s powers are successfully challenged in an action in court, perhaps all the way to the Supreme Court, given the possible constitutional grounds.
Looking ahead, regardless of any outcome of a court action, the expectation is that ESG reporting will still remain a priority for most companies. In today’s world, companies are accountable not just to their regulators, but to a broad range of stakeholders including shareholders, employees and the government. Institutional investors are also increasingly prioritizing ethical investing and enhanced corporate scrutiny, and they are demanding more transparency by companies in their approach to ESG issues. The expectation is that this trend will continue.
Rilwan Shittu serves as a Graduate Editor of the NYU Journal of Law & Business. He is a Corporations LLM candidate at NYU where he focuses on banking, finance and securities law. He is also currently a Research Fellow at the NYU Pollack Center for Law and Business and will be an International Finance and Development Fellow at the World Bank in Spring 2022. Prior to attending NYU, he worked as a Finance and M&A Lawyer at Olaniwun Ajayi LP, a top tier commercial law firm in Lagos, Nigeria.