The United States Securities and Exchange Commission (“SEC”) is reviewing sustainability. On April 13, 2016 the SEC issued a “Concept Release” seeking public comments on 340 topics relating to business and financial disclosure requirements for publicly-traded companies under Regulation S-K. See 81 Fed. Reg. 23916 (April 22, 2016) (“CR”). Several topics addressed the disclosure of company information relating to sustainability and public policy issues. Such issues, including climate change, resource scarcity, corporate social responsibility (“CSR”), and good corporate citizenship, are often referred to generically as environmental, social, and governance (“ESG”) concerns. C.R., p. 206. The concepts of CSR and ESG overlap greatly if not entirely, and precise definitions of these terms are lacking. In this article, the terms “sustainability” and “ESG” will be used interchangeably in the context of corporate reporting. Many of the largest companies in the U.S. voluntarily publish annual sustainability reports and/or website ESG content. At issue is to what extent ESG reporting by publicly-traded companies should be required by SEC regulations.
By the comment due date of July 21, 2016, the SEC had received hundreds of comments from industry groups, environmental organizations, labor organizations, public entities, investment managers, foundations and charities, standards-setting organizations, consultants, legal and accounting firms, and others. Whether or not the SEC eventually adopts a new regulation requiring disclosures on sustainability or ESG matters, the pressure for such corporate reporting from the investment community and advocacy groups will likely continue to increase.
Is Sustainability Information “Material”?
In the Concept Release, the SEC sought comments on modernizing disclosures under Regulation S-K, the “central repository for its non-financial statement disclosure requirements.” C.R. p. 6. The SEC noted that in 1975, it concluded that “it generally is not authorized to consider the promotion of goals unrelated to the objectives of the federal securities laws when promulgating disclosure requirements….” C.R. p. 209. Consequently, the SEC decided to require disclosure relating to social and environmental performance “only if such information…is important to the reasonable investor – material information.” Id., emphasis added. Some forty years later, the SEC notes that “the role of sustainability and public policy information in investors’ voting and investment decisions may be evolving as some investors are increasingly engaging on certain ESG matters.” C.R. p. 210. Consequently, the SEC is interested in receiving feedback on the importance of sustainability and public policy matters to informed investment and voting decisions. C.R. p. 205.
The U.S. Supreme Court has held that facts about a company are “material” if there is a substantial likelihood that a reasonable investor would consider the information important in making an investment decision. Basic Inc. v. Levinson, 485 U.S. 224 (1988). Commenters from all viewpoints generally acknowledged that the disclosure requirements under the securities laws are governed by this concept of materiality. The commenters differed widely, however, in their views on whether particular ESG topics are material to an investor’s understanding of a company’s business and financial condition and performance. Industry commenters argued that ESG matters are generally not material – but to the extent they are material, disclosure is already required under the existing regulations, and additional regulations would be unnecessary and inappropriate. Supporters of additional ESG reporting requirements argued that a sizeable portion of the investing community considers ESG reporting to be important, but the current mix of required and voluntary ESG reporting produces incomplete, inconsistent, and often unusable reports.
Whether specific information about any particular company is material to investors is a fact‑specific inquiry. In deciding whether to require all companies to report any particular category of ESG information, the SEC will need to decide whether that information likely will be valuable to the majority of investors across a significant number of companies. This article will review existing SEC requirements for ESG reporting and potential alternatives for future mandatory reporting, and summarize the arguments of commenters on the Concept Release.
Existing SEC Disclosure Requirements Relating To Sustainability
The SEC has previously issued guidance relating to one sustainability issue: climate change. Guidance Regarding Disclosures Related to Climate Change (Feb. 8, 2010) (“Climate Change Guidance”). The Climate Change Guidance describes several disclosure requirements in Regulation S-K which potentially relate to climate change.
- Costs of environmental compliance. “Appropriate disclosure also shall be made as to the material effects that compliance with Federal, State and local provisions … 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 CFR §229.101(c)(1)(xii).
- Material legal proceedings. Administrative or judicial proceedings arising under environmental laws must be described if they are material to the business or financial condition of the registrant. Disclosure is required if “A governmental authority is a party to such proceeding and such proceeding involves potential monetary sanctions, unless the registrant reasonably believes that such proceeding will result in no monetary sanctions, or in monetary sanctions, exclusive of interest and costs, of less than $100,000.” 17 CFR §229.103(5)(C).
- Risk factors. A prospectus must “provide where appropriate, under the heading ‘Risk Factors,’ a discussion of the most significant factors that make an investment in the registrant speculative or risky.” 7 CFR §503(c). These should not include generic risk factors applicable to any company, but could, for example, include risks for companies that are particularly sensitive to greenhouse gas regulation, such as those in the energy or transportation sectors. Id. at 22.
- Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”). MD&A disclosure, required by 17 CFR §303, should encompass known trends and uncertainties, and an assessment of whether they may have a material impact on the registrant’s liquidity, capital resources, or results of operations. Climate Change Guidance, p. 17. Disclosure topics could include pending or enacted climate change regulation that would be reasonably likely to have a material effect, negative or positive, on the company. Id. at 23. The guidance also points out that legal, technological, political, and scientific developments regarding climate change may indirectly create new opportunities or risks. Examples include: decreased demand for goods that produce significant greenhouse gas emissions and for services relating to carbon‑based energy sources, and increased demand for goods that result in lower emissions. Id. at 25. Another indirect risk might be impact on a company’s reputation from public disclosure of its greenhouse gas emissions. Id. at 26.
- Physical Impacts of Climate Change. SEC points out that significant effects of climate change on severity of weather (such as floods or hurricanes), sea levels, arability of farmland, and water availability and quality, may potentially affect a company’s operations and results.
Thus, even under the existing SEC disclosure regulations, a company has an obligation to consider the consequences of climate change, resource scarcity, water availability and quality, and other sustainability issues, and to make appropriate disclosures of their potential material effects on the company.
The Potential Scope Of Mandatory Sustainability Reporting.
Current voluntary ESG reporting practices, pending European Union legislation, and the reporting frameworks of various sustainability reporting, standards, and rating organizations reveal the extremely broad scope of sustainability topics and metrics.
EU Directive. Pending legislation in the European Union exemplifies the broad extent of possible ESG reporting not necessarily related to investors’ financial concerns. Directive 2014/95/EU of the European Parliament and Council, Oct. 22, 2014 (“Directive”) requires companies to prepare non-financial disclosure statements on a wide range of corporate social responsibility topics. These include:
- Environmental matters: Impacts of the company’s operations on the environment and health and safety, use of renewable and/or non-renewable energy, greenhouse gas emissions, water use and air pollution.
- Social and employee-related matters: actions taken to ensure gender equality, working conditions, social dialogue, respect for the rights of workers to be informed and consulted, respect for union rights, health and safety at work, and dialogue with local communities and actions taken to ensure the protection and development of those communities.
- Human rights, anti-corruption, and bribery: information on prevention of human rights abuses and instruments in place to fight corruption and bribery.
Directive, ¶¶ 6 and 7. E.U. member states have two years to incorporate this legislation into their national law. This directive will impact many U.S. companies doing business in the E.U., and will require nonfinancial disclosures to be made available on the company’s website. At least some of the reporting topics mandated by the Directive arguably do not satisfy the investor‑oriented materiality requirement necessary to justify U.S. SEC-mandated reporting.
Global Reporting Institute (GRI). The Global Reporting Initiative is a global, multi‑stakeholder organization founded in 1997, now operating in the Netherlands as a United Nations affiliate. Its latest generation of sustainability reporting guidelines, “G4,” has become the leading standard globally for companies issuing voluntary sustainability reports. G4 has the benefits of familiarity and a reporting track record for participating companies. G4 is encyclopedic, enabling a company to make disclosures on over 100 ESG indicators. Disclosure categories include Economic, Environmental, and Social, with Social sub-categories of Labor Practices and Decent Work, Human Rights, Society, and Product Responsibility. G4 Sustainability Reporting Guidelines, p. 43. G4 includes a materiality concept under which relevant topics are those which “reflect the organization’s significant economic, environmental, and social impacts; or substantively influence the assessments and decisions of shareholders.” G4 Sustainability Reporting Guidelines, p. 14 (emphasis added). Because ESG topics covered in a G4 report need not be assessed from an investor viewpoint, many of the reporting topics arguably would not satisfy the SEC’s materiality requirement. It thus seems unlikely that the SEC would require disclosures on all of the G4 indicators.
Sustainability Accounting Standards Board (SASB). SASB is a U.S.-based not‑for‑profit standards-setting organization founded in 2011. The SASB system for voluntary ESG reporting has been modeled after the financial reporting and disclosure standards issued by the Financial Accounting Standards Board (FASB). The SASB system is designed to enable U.S. publicly traded companies to make disclosures in their SEC filings on ESG issues that are financially material to their business. It is the only ESG reporting system designed with SEC-regulated reporting in mind; SASB explicitly applies the U.S. Supreme Court’s definition of materiality in developing its standards. SASB has issued industry sector guidance documents to establish industry‑specific ESG metrics. For example, material sustainability topics for the Chemicals Industry include Greenhouse Gas Emissions, Air Quality, Energy and Feedstock Management, Water Management, Hazardous Waste Management, Safety and Environmental Stewardship of Chemicals and Genetically Modified Organisms, Product Design for Use-phase Efficiency, Political Spending, and Health, Safety, and Emergency Management. If the SEC adopts requirements for ESG reporting, the SASB standards may be a favored vehicle because they have been intentionally tailored for materiality‑based disclosures.
International Integrated Reporting Council (IIRC). The IIRC is a global coalition of regulators, investors, companies, standards organizations, accounting firms, and NGOs. The focus of the IIRC is integrated reporting, defined as “a process founded on integrated thinking that results in a periodic integrated report by an organization about value creation over time and related communication regarding aspects of value creation.” Id. IIRC supports preparation of annual reports that integrate both financial and non-financial information. IIRC has signed memoranda of understanding with GRI and SASB as “partner” organizations. Id. IIRC integrated reporting could be consistent with SEC-mandated ESG reporting, but it seems unlikely that the SEC would mandate an integrated reporting process and format.
Climate Disclosure Standards Board (CDSB). The CDSB is an international consortium of companies and environmental non-governmental organizations (NGOs) founded in 2000. The CDSB has developed two frameworks for reporting environmental/natural capital and climate change-related information. Id. The CDSP is affiliated with the GRI and IIRC, and its reporting frameworks provide a method for incorporating GRI and IIRC topics into mainstream corporate financial reports. Id. It appears to be competing with SASB to provide a vehicle for sustainability reporting in financial reports.
United Nations Global Compact. “The Global Compact is the world’s largest global corporate sustainability initiative, with over 8,000 companies and 4,000 non-business participants, based in over 160 countries.” Guide To Corporate Sustainability, United Nations Global Compact, https://www.unglobalcompact.org. The Compact outlines ten principles of responsible businesses, spanning human rights, labor issues, environmental issues, and anti-corruption. The Compact requires participating companies to issue an annual Communication on Progress (“COP”), which must contain a statement of commitment to the initiative and its principles, a description of practical actions taken to implement the principles, and a measurement of outcomes. Although the Compact coordinates with the GRI, there are no prescriptive requirements for the format or content of a COP, and it is unlikely to be a source of SEC‑mandated reporting topics.
ISO Standard 26000. The International Standards Organization (ISO) is worldwide organization of national standards bodies which has promulgated thousands of internationally-recognized standards. ISO 26000 is its Guidance on Social Responsibility for organizations. Subjects of the Guidance include organizational governance, human rights, labor practices, the environment (including pollution prevention, sustainable resource use, and climate change), fair operating practices, consumer issues, and community involvement and development. The Guidance “helps clarify what social responsibility is, helps businesses and organizations translate principles into effective actions and shares best practices relating to social responsibility, globally.” ISO states that ISO 26000 is not a management systems standard, and provides guidance rather than requirements, so it is not appropriate for certification purposes. Id. Consequently, ISO 26000 is not likely to be directly relevant to any SEC-mandated ESG reporting requirements.
Sustainability Rating Organizations. In addition to the organizations discussed above, which provide ESG principles and reporting formats, there are several organizations which provide subscribers with ESG ratings of companies. EcoVadis provides CSR ratings for global supply chains, marketing its CSR scorecards to both buyers and suppliers. CSR Hub purports to offer the world’s largest CSR database, covering over 16,500 companies. The Dow Jones Sustainability Indices provide sustainability assessments of nearly 2,000 companies, with around 40% of them based on company questionnaire responses and the remainder based on public information. There is no consistent rating system among these organizations.
SEC’s Requests For Comments And Responses Received
The following discussion summarizes the SEC’s Concept Release requests for comments on ESG matters, and highlights key responses from commenters.
Requests for comments Nos. 216, 218, and 223 (paraphrased): What sustainability or public policy issues are important to informed voting and investment decisions, and how could SEC rules elicit meaningful disclosure on such issues? Is information about ESG matters in registrants’ websites or sustainability/ corporate social responsibility reports sufficient to address investor needs?
Industry Comments. Industry commenters typically asserted that ESG issues are generally not material for the majority of investors, and to the extent they are material, they are adequately addressed by the SEC’s existing disclosure requirements. They argued that SEC‑mandated disclosures should not be used to further social cultural, or political motivations that the securities laws were not designed to advance. Discussion of ESG issues, in their view, is more appropriate for corporate sustainability reports or webpages. See, e.g., National Association of Manufacturers (NAM), 7/21/16; U.S. Chamber of Commerce Center for Capital Markets Competitiveness, 7/21/16; American Fuel & Petrochemical Manufacturers, 7/21/16; American Petroleum Institute, 7/21/16.
Investment Manager Comments. Several investment management firms commented that ESG factors are important to shareholders’ investment decisions. They asserted that companies with strong positive ESG policies can increase profitability, develop a competitive edge, and position themselves to deliver strong long-term performance. Despite the materiality of ESC information, however, the commenters believe that ESG information in voluntary sustainability reports or company websites is not adequate to address investor needs, because it is not universal or uniform and does not facilitate company‑to‑company comparisons. The absence of quantifiable and comparable data on ESG indicators limits investors’ ability to consider these factors on a systematic basis. See, e.g., Trillium Asset Management, 7/21/16; State Street Global Advisers, 7/21/16.
Environmental Organization Comments. Environmental organizations, many of which filed joint comments, built the case for materiality of ESG factors for investors. They reported that “socially-responsible impact investment (SRI)” represents close to 18% of money under professional management. SRI investors actively consider ESG risk factors of investments, which they consider to be material beyond their immediate financial implications. SRI investors’ needs for ESG data, however, are arguably not being met by the current combination of mandatory disclosures and companies’ voluntary sustainability reports. The environmental organizations also argued that sustainability factors present economically material risks and/or opportunities for companies in almost every industry and every part of the world:
- Companies managing ESG factors well can outperform other companies, including operational and stock price performance.
- Physical and regulatory changes associated with climate change present material financial risks.
- Resource pressures on global ecosystems present material financial risks in many industries.
- Changing environmental and social justice norms are creating acute pressures on many companies.
Consequently, the environmental organizations argued, better sustainability disclosure is required to meet the needs of reasonable investors. See, e.g., Center for International Environmental Law, Center of Concern, Environmental Investigation Agency – Global, Foundation Earth, Friends of the Earth, Greenpeace – U.S., Rainforest Action Network, Sierra Club, (“Environmental Organizations”), 7/21/16.
Sustainability Reporting Organization Comments. Not surprisingly, the sustainability reporting organizations asserted the materiality of ESG information, and the inadequacy of current disclosures. SASB referenced a recent survey indicating that 73% of institutional investors take ESG issues into account in their investment analysis. In SASB’s view, current sustainability disclosures are not “investment grade,” largely not material, and not industry‑specific, comparable, complete, auditable, nor reliable. SASB, 7/1/16.
Governmental Agency Comments. The U.S. Environmental Protection Agency commented that sustainability concerns related to climate change, resource scarcity, and corporate social responsibility may have material impacts on a company’s financial performance. U.S. EPA, 7/21/16. SEC’s Investor Advisory Committee argued that ESG issues can be material based on quantitative measures such as expenditures required or the effect on earnings, and that a significant and growing number of investors utilize ESG disclosures to better understand a company’s long-term risk profile. SEC Investor Advisory Committee, 6/15/16.
Requests for comments 217 and 220 (paraphrased): Are there sustainability or public policy issues for which line-item disclosure requirements would be consistent with the SEC’s authority and mission “to protect investors, maintain fair, orderly, and efficient markets and facilitate capital formation?” Would line-item disclosure requirements on sustainability or public policy issues cause disclosure of non-material information, or obscure important information?
Industry Comments. Industry commenters generally opposed prescriptive line-item disclosure requirements for ESG information. They argued that such requirements would be a poor fit for many companies, resulting in disclosure of information having little financial significance. They further voiced the concern that prescriptive sustainability disclosure requirements would constrain voluntary ESG reports and website postings, due to risks from divergence of voluntary and mandated disclosures. See, e.g., American Fuel & Petrochemical Manufacturers, 7/21/16; American Petroleum Institute, 7/21/16.
Investment Manager Comments. Investment managers argued that line-item disclosures would enhance competition by allowing investors to measure a company’s performance over time and against its peers. They noted, however, that disclosure requirements not based on industry‑specific factors would not provide financially material information. See, e.g., BMO Global Asset Management, 7/18/16; AFL‑CIO, 7/21/16.
Environmental Organization Comments. The Environmental Organizations argued that mandatory sustainability disclosure regulations would result in ESG disclosure and data being clearer, more comparable, more complete, and more consistently presented. See, e.g., Environmental Organizations, 7/21/16.
Sustainability Reporting Organization Comments. The sustainability reporting organizations’ views on prescriptive line-item reporting reflected their own particular reporting philosophies. The CDSP supported line-item disclosure requirements, while the IIRC favored “a principles-based approach, emphasizing the … [company’s] assessment of materiality. SASB opposed line-item disclosure requirements, favoring instead industry-specific metrics. See, e.g., SASB, 7/1/16; IIRC, 7/20/16; CDSP, 6/22/16.
Request for comments 219 (paraphrased): Which, if any, of the available sustainability reporting frameworks should be considered by the SEC in developing additional disclosure requirements?
Industry Comments. Industry commenters, favoring voluntary ESG reporting, urged the SEC not to “pick a winner” by approving one of the existing reporting frameworks as a template for ESG disclosure. See. e.g., American Fuel & Petrochemical Manufacturers, 7/21/16.
Investment Manager Comments. Several investment managers favored the SASB framework. This is not surprising, given SASB’s consultation with the investor community and the resemblance of its framework to FASB reporting. See, e.g., Breckinridge Capital Advisors, 7/20/16; Rockefeller Brothers Fund, 7/14/16.
Environmental Organization Comments. The Environmental Organization commenters encouraged the SEC to evaluate the existing disclosure frameworks as useful starting points. See, e.g., Environmental Organizations, 7/21/16.
Sustainability Organization Comments. SASB recommended SEC acknowledgement of its standards, for 79 industries, as an acceptable disclosure framework. SASB, 7/1/16. CDSP recommended its “mainstream reporting” approach, which can accommodate the SASB or IIRC frameworks. CDP, 6/22/16.
Governmental Agency Comments. U.S. EPA supported the SASB reporting standards, or others that provide sector‑appropriate and market-specific information. U.S. EPA, 7/21/16.
Will The SEC Promote A Shift From Voluntary Sustainability Reports To Required Sustainability Disclosures?
The SEC has been afforded a wide range of viewpoints by the commenters on the Concept Release, and it is impossible to predict the details of possible new SEC guidance or regulations on ESG reporting. Nonetheless, there is an emerging understanding among investors that corporate ESG information can be important to their investing decisions, and that the current patchwork of ESG reporting methods does not make such information readily accessible. It appears likely that the SEC, by guidance or regulation, will expand ESG reporting beyond that covered by its current climate change guidance. It is also likely that the SEC will introduce some standardization of ESG reporting to increase the comparability of ESG reports.