Though ESG has been around for a while, with roots that extend back to the environmental sustainability movement, the script for current ESG litigation and investigations is still being written. ESG efforts have expanded to include diversity within companies and an increased focus on compliance and governance within organizations. Regulatory oversight, especially from the SEC, has swiftly come to the fore to monitor those compliance efforts. As with many areas where the precise regulatory and enforcement regime is still coming into focus, it is crucial to recognize the importance of being both proactive and pragmatic.
The SEC Takes Aim
As we have discussed elsewhere, ESG has been an enforcement and regulatory priority at the Commission for several years. In March 2021, right in the middle of the pandemic, the SEC created a task force within its Division of Enforcement to focus exclusively on climate and ESG issues. While the SEC occasionally creates task forces and specialized units to convey a message to the markets, but this one has seemed different from its inception for several reasons:
- The task force is highly resourced. There are, at a minimum, 21 staff members from across the country, which includes not only attorneys but also data analysts, economists, and industry experts.
- It is multidisciplinary. The SEC is leading a multidisciplinary effort to tackle its ESG-related agenda. The unit works collaboratively with other units within the commission, including those that regulate public companies, broker-dealers, and investment advisors. This is an area where every market participant has some form of exposure. The SEC is referring to this as its “all-agency approach” in an effort to send a meaningful message to the market.
Among the various enforcement priorities at the SEC in general, it is a safe bet to consider ESG as one of the top, if not the top, priority. That said, it is worth taking a moment to examine exactly what the SEC is doing in this space. After all, the SEC is not the climate police or the EPA, so that raises the question, “What’s their source of authority?”
Focus on Disclosures
Securities regulation in the U.S. is primarily a regime of disclosure. A company can get away with a lot of what we might consider to be “bad conduct” if they are willing to tell the markets and investors that they are doing it. Most ESG enforcement actions coming down the pike are likely going to be disclosure cases. For example, if a company tells the market that it will achieve a certain reduction in greenhouse gases or that its board is going to meet XY criteria for diversity, and those statements prove false or misleading, those companies will face enforcement scrutiny. In the private litigation context, there may be available defenses based on arguments that statements were forward-looking, but the SEC has more tools than shareholders do and can bring claims based on negligence and, under Section 13(a), against issuers under essentially a strict liability standard. It is not just disclosures: Public companies in particular need to think about various types of internal controls, including disclosure controls and procedures, which focus on processes through which information flows up to officers and the board, allowing for an evaluating of whether there is a disclosure obligation. The SEC is going to look at cases where ESG-related information didn’t percolate up the chain to allow such an evaluation to occur. The same is true with internal accounting controls. It may sound like “internal accounting” would only cover controls related to accounting, but the current commission construes it much more broadly. If there are improper procedures related to ESG that can impact financial reporting, the SEC may determine that a company has deficient accounting controls.
On March 21, the agency voted 3-1 to propose rules mandating the inclusion of climate-related disclosures in annual reports and registration statements, as well as certain climate-related financial metrics in audited financial statements.
Starting Early and Keeping It Real
In any discussion of risk mitigation, it is worth reiterating just how much of a priority ESG is for the agency. In March, SEC Chair Genzler tweeted, “If it’s easy to tell if milk is fat-free by just looking at the nutrition label, it might be time to make it easier to tell if ‘green’ or sustainable funds are really what they say they are.” To mitigate against the risk of an enforcement action, companies should consider the following:
- While the regulations are coming, the SEC is not going to wait for those regulations to start bringing cases. The SEC’s policy making and regulatory divisions are focused on ESG, which will lead to enforcement referrals in the very near future. In terms of specific risk mitigation measures, obviously you want to carefully review disclosures for accuracy and completeness. We suspect that many ESG disclosure violations are going to be more in the vein of material omissions, so companies should focus on whether to add additional information so that representations are not misleading.
- Avoid aspirational ESG disclosures. When considering misleading disclosures, it is important to focus on “aspirational disclosures” because those types of disclosures contain the implicit representation that they are realistic at the time when made. If you say that you plan to cut greenhouse gases emissions by 50% (even if you really believe that and the plan is sincere), you can get into trouble if there are reasons why that might not have been realistic and you do not disclose them to the market.
- Show your work. It is important to contemporaneously document the basis for disclosures, particularly for the “E” part of ESG or any time that you provide a specific metric to the market on ESG issues. If enforcement staff later questions those presentations, you have got a whole file that you can point to that supports why your disclosure was reasonable.
- Materiality defenses may be difficult to mount. There is plenty of research indicating that shareholders really do care about ESG issues—a 2021 PWC study indicated that ESG was actually the top issue for shareholders. That is another strong plug for the accuracy and completeness of disclosures, because it increases the risk that misrepresentations and omissions are likely to be material.
- Don’t count on proposals being excluded. SEC rule 14-8(a) allows shareholders to submit proposals to be included in an issuer’s proxy materials. Last year saw many ESG-related proposals, particularly in the area of civil rights audits. While those initial initiatives generally did not pass, the momentum is growing. (Apple shareholders recently approved two ESG-related measures.) Companies have attempted to exclude them under various “no action” letters under rule 14-8(a), which the SEC has rejected providing a strong signal that the agency does not intend to allow companies to exclude these types of proposals from their proxy statements.
Ultimately, the key to withstanding SEC scrutiny related to ESG matters is much the same with any regulatory scrutiny: Be proactive in your strategy. Be precise in your disclosures. And when choosing between aspirational and realistic, choose the latter.