On Thursday, January 30, the SEC proposed amendments designed to simplify and modernize MD&A and the other financial disclosure requirements of Reg S-K. (See this PubCo post.) Although the SEC did not hold an open meeting to consider the proposal, several of the Commissioners issued statements that addressed, for the most part, not what was in the proposal, but rather, what wasn’t—standardized disclosure requirements related to climate change. These statements allow us a peek into an apparently heated debate among the Commissioners on the issue of climate disclosure.

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This debate should be considered against the backdrop of accelerating investor interest, particularly among large institutional investors, in sustainability disclosure. This year, sustainability—especially as viewed through the lens of economic impact—has become a central concern among investment managers and others. For example, in his annual letter to CEOs, BlackRock CEO Laurence Fink said that he believes climate change risk will now lead to “a profound reassessment of risk and asset values. And because capital markets pull future risk forward, we will see changes in capital allocation more quickly than we see changes to the climate itself. In the near future—and sooner than most anticipate—there will be a significant reallocation of capital.” Investors, he said, are now “recognizing that climate risk is investment risk,” making climate change the topic that clients raise most often with BlackRock. (See this PubCo post.)

That view was reinforced by this report from consultant Russell Reynolds Associates on 2020 corporate governance trends, observing that, “[f]or the first time, in 2020, we see the focus on the ‘E’ and the ‘S’ of environment, social and governance (ESG) as the leading trend globally, including in the United States, where it traditionally has not received as much attention by boards.” For example, State Street Global Advisors, one of the largest asset managers, has just announced that, in 2022, it plans to start voting against the boards of big companies that have underperformed relative to their peers on ESG standards, particularly financially material sustainability issues, and cannot explain how they plan to improve. (See this PubCo post.)

However, many investors find the proliferation of frameworks and resulting disclosure to be an impediment to consistency and comparability. For example, in a recent article, BlackRock has contended that, to facilitate its own goal of putting sustainability at the center of its investment strategy, corporate issuers must provide more clarity and comparability in their ESG reporting, which will require harmonization and convergence of reporting frameworks, metrics and scoring methodologies. According to the article, the need for alignment and consolidation of standards is particularly acute in the U.S., which “has stood somewhat apart from other jurisdictions, taking a less prescriptive approach to ESG disclosure, opting instead for a principles-based approach centered on the [SEC’s] traditional materiality standard.” BlackRock advocates that policy makers play a role in promoting better and more comparable ESG disclosure practices by aligning around common disclosure frameworks.

According to this recent study from consulting firm McKinsey, although there has been an increase in sustainability reporting, investors believe that “they cannot readily use companies’ sustainability disclosures to inform investment decisions and advice accurately.” Why not? Because, unlike regular SEC-mandated financial disclosures, ESG disclosures don’t conform to a common set of standards—in fact, they may well conform to any of a dozen major reporting frameworks and many more standards, selected at the discretion of the company. That leaves investors to try to sort things out before they can make any side-by-side comparisons—if that’s even possible. According to McKinsey, investors would really like to see some type of legal mandate around sustainability reporting. In the survey, an overwhelming 75% of investors said there should be only one standard, and 82% of investors said companies should be legally required to issue sustainability reports. Surprisingly, 66% of executives agreed. (See this PubCo post.)

Similarly, in comments at a recent meeting of the SEC’s Investor Advisory Committee, a number of institutional investors advocated for more standardization and disclosure of more decision-useful information. A State Street representative indicated that availability of high quality information that was financially material, consistently disclosed and comparable across companies was one of their biggest challenges. And, State Street observed, companies need guidance on how to measure and disclose ESG information in a standardized way. Another representative of a large asset manager, Neuberger Berman, noted at the same meeting that, with more standardized information and dialogue, they would be better able to perform analyses and reach more qualitative conclusions. Currently, he contended, evaluating the information is an imprecise task because of the “patchy” and inconsistent nature of the disclosure among companies. There is insufficient quality, decision-useful data, exacerbated by corporate greenwashing. In his view, companies are typically unwilling to share more information because their competitors are not disclosing it and it’s not legally required, which the SEC could address. Another participant observed that, even though there are a number of frameworks, they are not regularly used or, if used, companies may respond selectively or fail to include quantitative data. One panelist observed that there is insufficient transparency into how companies determine which ESG issues are material for their financial performance. (See this PubCo post.)

Statement by Allison Lee. Let’s start with Commissioner Allison Lee, who dissented from the proposal, primarily as a result of the failure of the proposal to tackle climate risk disclosure. In her statement, “Modernizing” Regulation S-K: Ignoring the Elephant in the Room,” she observed that, although the SEC’s 2010 guidance on climate highlighted four items in Reg S-K—business, legal proceedings, risk factors and MD&A—that could elicit climate disclosure, the SEC had “now proposed to ‘modernize’ every one of these four items without mentioning climate change or even asking a single question about its relevance to these disclosures.” Since 2010, she noted, there have been a number of significant changes in perspectives on climate change from scientists, economists, investors, companies and regulators around the world—all viewing the effects of climate as increasingly dire and the demand for disclosure more insistent. In particular, she remarked,

“investors are overwhelmingly telling us, through comment letters and petitions for rulemaking, that they need consistent, reliable, and comparable disclosures of the risks and opportunities related to sustainability measures, particularly climate risk. Investors have been clear that this information is material to their decision-making process, and a growing body of research confirms that. And MD&A is uniquely suited to disclosures related to climate risk; it provides a lens through which investors can assess the perspective of the stewards of their investment capital on this complex and critical issue.”

What’s more, she contended, the “broad, principles-based ‘materiality’ standard” has not elicited the type of standardized disclosure that investors crave, nor has the SEC’s disclosure review process been regularly employed to produce improved climate disclosure under the materiality standard: indeed, “in recent years there’s been minimal comment on climate disclosure.” Instead, in response to the investors’ pressure campaigns, companies have provided some sustainability disclosure, often in separate reports, but, “these voluntary disclosures, while a welcome development, are no substitute for Commission action”: in the absence of a mandatory standardized framework, the disclosures are variable and not comparable; the proliferation of frameworks and demands for various information puts undue pressure on companies; and the disclosures may not be reliable, lack independent verification and may not provide adequate remedies to investors.

Lee disclaims any suggestion that determining the best regulatory approach is a simple matter; there are lots of challenging issues about matters such as metrics, location, frameworks, and prescriptive v. principles-based disclosure. Rather, she is lamenting the failure to take up the challenge: “[w]e purport to modernize, without mentioning what may be the single most momentous risk to face markets since the financial crisis. Where we should be showing leadership, we are conspicuously silent. In so doing, we risk falling behind international efforts and putting US companies at a competitive disadvantage globally.”

(In the notes to Commissioner Lee’s statement, she advises that the staff is considering a roundtable on climate, so stay tuned for that.)

Statement by Jay Clayton. I’ll speculate that the commitment by SEC Chair Jay Clayton of well over half of his statement on the MD&A proposal to a discussion of climate-related disclosure issues was triggered by Lee’s strenuous objection above. Clayton has long taken the position that the SEC’s approach “has been, and in my view, should remain, disclosure-based and rooted in materiality, including providing investors with insight regarding the issuer’s assessment of, and plans for addressing, material risks to its business and operations.”

After making his position plain, Clayton then identified five interrelated threshold issues in crafting and evaluating climate-related disclosure mandates and guidance that underpin his conclusion above and can be expected to guide his thinking in the future:

  • the complex, uncertain, multi-national/jurisdictional and dynamic landscape that surrounds climate issues;
  • for “both issuers and investors, capital allocation decisions based on, or materially influenced by, climate-related factors are substantially forward-looking and likely involve estimates and assumptions regarding, again, complex and uncertain matters that are both issuer- and industry-specific, as well as regional, national and multi-national/jurisdictional, in nature”;
  • under the disclosure system, issuers generally provide verifiable and largely historic issuer-specific information, and forward-looking disclosure that is required or provided voluntarily is typically afforded safe-harbor protection;
  • as a standard setter, Clayton is mindful that he should not substitute his “operational and capital allocation judgments for those of issuers and investors” and that he (and other standard setters) must “stay within the bounds of their regulatory mandate”; and
  • in coordinating with other domestic or international regulators, the need to keep in mind that the U.S. regulatory regime “stands apart” from the perspectives of investor protection, liability and enforcement and that “facially analogous disclosure mandates should not be expected to equate to uniform effects across jurisdictions.”

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In a 2019 published interview in Directors & Boards (see this PubCo post), Clayton made clear that when it comes to mounting calls for rulemaking that standardizes ESG disclosure, Clayton was less than enthusiastic: “My view is that in many areas we should not attempt to impose rigid standards or metrics for ESG disclosures on all public companies. Such a step would be inconsistent with our mandate, would be a departure from our long-standing commitment to a materiality-based disclosure regime, and could effectively substitute the SEC’s judgment for the company’s judgment on operational matters.” In terms of marketwide metrics, he identified U.S. GAAP as an example of a system that effectively allows a reasonable level of comparability across all companies, but, in his view, the development of non-GAAP financial measures in some ways illustrates the point that across-the-board metrics can be tricky–sometimes even GAAP works only at a company level.

As noted above, instead of imposing marketwide ESG regulation, Clayton favored the application of “the ‘materiality’ based approach to disclosure regulation. This has been the commission’s perspective for 84 years and it has served our investors and markets very well. Keeping that perspective in mind is critical to our mission.” What that meant to Clayton was that if a matter was “going to affect the company’s bottom line or presents a significant risk to the business, I would expect them to do something about it. If the matter is material, I also would expect the company to disclose the matter and what they are doing about it. This is consistent with general fiduciary obligations of directors and officers, as well as our disclosure rules.” In particular, he adverted to a recent speech by Corp Fin Director Bill Hinman, which addressed the application of principles-based disclosure requirements to complex and evolving disclosure questions. (See this PubCo post.)

Currently, Clayton pointed out, companies can continue to look to the SEC’s 2010 interpretive release for guidance regarding climate disclosure (with regard to which the “staff has generally found robust efforts to comply”), as well as staff comments that are part of the disclosure review process. (You might recall the interpretive release was approved on a split vote at the SEC, with two commissioners voting against it for a variety of reasons, one of which was that the science was “unsettled.”) The staff also engages with investors and others, focusing on

“(1) better understanding the environmental and climate-related information investors currently use and how they analyze that information to make investment decisions on both an issuer- and industry-specific basis and more generally; (2) better understanding the extent to which (and how) issuers identify, assess and manage environmental and climate-related risks in their particular business and industry; and (3) reminding issuers and other market participants of how the Commission’s principles-based disclosure requirements apply to environmental or climate-related matters and, as circumstances change (for example, as a result of changes in environmental regulation or changes in costs of operations) prior disclosures may require modification.”

Clayton identified the first two points above as especially important. The SEC also received substantial feedback on the issue in connection with the Reg S-K Concept Release, which was part of its Disclosure Effectiveness Initiative and solicited public comment on modernizing certain business and financial disclosure requirements in Reg S-K.

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The Concept Release noted that some investors and interest groups have requested more disclosure of a variety of public policy and sustainability matters, including climate change, resource scarcity, corporate social responsibility and good corporate citizenship, contending that this information is significant to their voting and investment decisions. The release asked which disclosures, if any, are important to informed voting and investment decisions. The question was whether this disclosure is important to the general population of “reasonable investors” or only to a narrow segment of investors. he release cited one study showing that “investors are more likely to engage registrants on sustainability issues than on financial results or transactions and corporate strategy.” However, some commenters expressed concern “that adopting sustainability or policy-driven disclosure requirements may have the goal of altering corporate behavior, rather than producing information that is important to voting and investment decisions.” According to BNA, at a 2016 conference, then-Corp Fin Director Keith Higgins reported that the highest proportion of comments received at that point on the Reg S-K Concept Release related to better environmental and social responsibility disclosure. He observed that, of the 360 “unique” comment letters (i.e., non-form letters) received on the Concept Release, about 80% “were looking for improved sustainability disclosure.” According to Higgins, “[c]limate change tops the list of issues….” (See this PubCo post.)

Clayton also remarked that SEC has participated in various international regulatory efforts related to climate disclosure, including, in 2015, as part of the Financial Stability Board, as well as with other international regulators, seeking “decision-useful” disclosures. The FSB convened private market participants to form the Task Force on Climate-Related Financial Disclosures (TCFD). the TCFD has developed Recommendations of the Task Force on Climate-related Financial Disclosures—and supporting materials, designed to provide a standardized framework and detailed guidance for voluntary, consistent climate-related financial risk disclosures. (See this PubCo post and this PubCo post.)

Clayton encouraged continued engagement with market participants, particularly on the threshold issues identified above and the use of climate-related information in capital allocation decisions, especially by issuers such as property and casualty insurers, and by asset managers.

Statement by Hester Peirce. Finally, we come to the statement from Commissioner Hester Peirce, who was pleased that, faced with “repeated calls to expand our disclosure framework to require ESG and sustainability disclosures regardless of materiality” from “an elite crowd pledging loudly to spend virtuously other people’s money,” the SEC did “not bow to demands for a new disclosure framework, but instead support[ed] the principles-based approach that has served us well for decades.” In her view, the

“concept of materiality has worked well over time because it considers disclosure through the prism of the reasonable investor, who is occupied with the long-term financial value of the enterprises in which she invests…. Materiality does not turn on what is important to non-investors or to a select group of investors motivated by objectives unrelated or only tangentially connected to their investment’s profitability. If materiality were so loosely defined, it would lead to information overload in disclosure documents, increased costs associated with being a public company, increased litigation risk for public companies, a decrease in the attractiveness of our public capital markets, reduced investment returns, and—most alarmingly—a misallocation of capital.”

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Some might question whether calls for sustainability disclosure are really calls for disclosure regardless of materiality or unrelated to profitability, as Peirce alleges. For example, the SASB framework is one of the most commonly used frameworks. By focusing on development of standards and associated metrics specific to 77 particular industries, SASB has sought to identify a “subset of sustainability factors most likely to have financially material impacts on the typical company in an industry.” The objective is to provide investors and companies “decision-useful” information that can help them make more informed decisions. (See this PubCo post. See also, for example, this PubCo post, this PubCo post, this PubCo post and this PubCo post.)

Existing practices, she argued, provide “reason to question the materiality of ESG and sustainability disclosure.” If these disclosures were material, why do they appear regularly in voluntary sustainability reports but rarely in Forms 10-K? While she did not question the “materiality determinations of companies that did report these metrics,” she was likewise not “ready to mandate that every other company make the same materiality determination.” She urged securities regulators not to “grow weak-kneed in defending the concept of materiality, which continues to play a central role in ensuring the vibrancy of our capital markets. We ought not step outside our lane and take on the role of environmental regulator or social engineer.”

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There seems to be increasing support for “mainstreaming” of sustainability disclosure. A new initiative, Toward Common Metrics and Consistent Reporting of Sustainable Value Creation, sponsored by the World Economic Forum International Business Council in collaboration with the Big Four accounting firms, advocates that, instead of discussing the various metrics in a separate sustainability report, as seems to be the more common practice, the discussion should be mainstreamed. Because sustainability is “increasingly material to business performance,” the report contends, the related disclosures should be

“addressed in the mainstream report and proxy statements and integrated into core business strategy and governance processes. By reporting on these factors on a consistent basis in its mainstream report—including a discussion of their implications for company strategy and governance—a company demonstrates to its shareholders and other stakeholders that it diligently weighs all pertinent risks and opportunities in running its business, conducting its governance processes and contributing to broader economic and social progress, including achievement of the SDGs [sustainable development goals].” (See this PubCo post.)