One of the basic questions the Securities and Exchange Commission (SEC) is seeking to answer is whether environmental, social, and governance risks are material—that is, do ESG-related risks directly affect a company’s bottom line? Another is whether the SEC should align required disclosures with an established ESG framework, akin to regimes being developed by regulators in the United Kingdom and European Union.
If the SEC writes rules that order public companies to disclose ESG-related risks in the areas of climate change, board diversity, corporate political donations, ethical supply chain procurement, and more, should the agency establish its own ESG framework on which those disclosures would be based? Or should it simply peg them to established ESG standards, like those being developed by the International Financial Reporting Standards Foundation?
With a nod to 80s pop music icon Madonna, SEC Commissioner Allison Herren Lee on Monday made the argument that ESG risks are material and should be disclosed in remarks entitled, “Living in a Material World: Myths and Misconceptions about ‘Materiality.’” She delivered the speech to the American Institute of CPAs, the Chartered Institute of Management Accountants, the Sustainability Accounting Standards Board, and the Center for Audit Quality.
“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.”
SEC Commissioner Allison Herren Lee
“Materiality is a fundamental proposition in the securities laws and in our capital markets more broadly. The system for public company disclosure is generally oriented around providing information that is important to reasonable investors,” Lee said. “Although the SEC must craft the rules, and companies, with the help of lawyers and accountants, must comply with them, the viewpoint of the reasonable investor is the lens through which we all are meant to operate.”
Lee listed several examples where the SEC’s current requirements for disclosure fall short of investor expectations. Despite clear interest among investors about a company’s lobbying efforts, SEC regulations do not currently require public companies to disclose how much money they donate to political candidates and causes and which ones they support. As a result, most companies do not disclose them.
In the aftermath of the Jan. 6 attack on the U.S. Capitol, a number of companies pledged to cease or curtail political donations. Those companies may now be obligated to prove through disclosures that their public statements were not inaccurate or misleading. Taking a public stand on such issues can force companies to be more transparent.
John Coates, acting director of the SEC’s Division of Corporate Finance, likened ESG disclosures to the early reluctance of public companies to make disclosures about liabilities related to the production of asbestos in a March 11 statement.
“For years, asbestos-related risks were invisible, and information about asbestos would likely have been called ‘non-financial.’ Over time, those risks went from invisible to visible to extremely clear, and clearly financial,” he wrote. “Not surprisingly, disclosure about these risks did not initially show up in SEC filings, but there too, they went from invisible to increasingly disclosed.”
He said the SEC should “lead the creation of an effective ESG disclosure system so companies can provide investors with information they need in a cost effective manner,” and that investors who cannot find a way to compare the ESG performance of companies may be holding back their investment in those companies as a result.
Coates argued the SEC has an obligation to provide tangible guidance to public companies about what they should disclose about ESG risks, either by relying on a global ESG framework or establishing one of its own.
Contentious path forward
Absent any SEC requirement that ESG disclosures be pegged to an established standard, companies are left to determine materiality for themselves, based on what a “reasonable investor” would want to know. That approach is open to wide interpretation, of course, and sometimes companies get it wrong, like Bank of America did when it failed to disclose billions in estimated losses connected to a merger with Merrill Lynch in 2008, Lee noted. Bank of America paid damages and penalties of nearly $2.5 billion in that case.
“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,” Lee said.
Lee’s view is not unanimous at the SEC. Fellow Commissioner Hester Peirce recently warned the agency is moving too hastily in seeking to require public companies to disclose ESG-related risks. The risks are complicated and ever-evolving, she argued in an April 14 statement, unlike financial accounting, “which lends itself to a common set of comparable metrics.”
“The result of global reliance on a centrally determined set of metrics could undermine the very people-centered objectives of the ESG movement by displacing the insights of the people making and consuming products and services,” she wrote.
Requiring ESG risks be disclosed and pegging them to one standard would constrain the market, Peirce argued.
“Such a regime would likely expand the jurisdictional reach of the Commission, impose new costs on public companies, decrease the attractiveness of our capital markets, distort the allocation of capital, and undermine the role of shareholders in corporate governance,” she said. “Let us rethink the path we are taking before it is too late.”
Peirce, a Republican, is making the minority argument. With Gary Gensler seated as chair of the SEC, it leans 3-2 to Democrats, with all the power and responsibility that a majority, however slim, possesses.
Even before Gensler joined the agency, its commissioners made a series of personnel moves and policy announcements indicating it would require public companies to disclose ESG risks (and opportunities). The question of exactly how such disclosures will work in practice is still very much unanswered.
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