Wachtell, Lipton, Rosen & Katz
With ESG investments soaring to new record levels the U.S. Securities and Exchange Commission (SEC) is now heeding investor calls to review current ESG disclosure standards and strengthen enforcement efforts on ESG-related matters. The shifting tide at the SEC has been reflected in several public announcements this year. In March, the SEC announced that its priorities for 2021 include “enhancing its focus on climate and ESG-related risks by examining proxy voting policies and practices . . . as well as firms’ business continuity plans in light of intensifying physical risks associated with climate change.” Shortly thereafter, the SEC announced the formation of a Climate and ESG Task Force in the Division of Enforcement tasked with “proactively” identifying ESG-related misconduct. The step up in enforcement was followed by an SEC Risk Alert issued in April in which the SEC noted a litany of disclosure and compliance issues affecting investment advisors and funds engaged in ESG investing.
On the international front, the SEC recently agreed to co-lead a technical expert group of the International Organization of Securities Commission to consider the IFRS Foundation’s recommendation to form an international Sustainability Standards Board (which would work alongside the IFRS’s International Accounting Standards Board) and to refine the IFRS’s prototype climate-related disclosure standard. The expert group will, among other things, consider whether the IFRS’s climate-related disclosure standard could 1) be a basis for developing an international reporting standard that serves as a baseline for consistent and comparable approaches to mandatory cross-jurisdictional sustainability disclosure; 2) be compatible with existing accounting standards; and 3) form the basis for developing an audit and assurance framework.
The SEC’s latest moves are consistent with President Biden’s recent executive order recognizing the threat to America’s financial security from climate-related risks. The executive order calls for a government-wide risk strategy no later than September of this year to identify and disclose climate-related risks. The order also encourages agency members of the financial security oversight council, including the SEC and the banking regulatory agencies, to report on actions taken by those agencies to improve climate-related disclosures and to incorporate climate-related financial risk into regulatory and supervisory practices. While it remains to be seen how the SEC will revise and reshape disclosure practices on climate change risks and other ESG issues, the uptick in enforcement of existing rules and guidance should caution companies and investors to remain alert to more sweeping changes to come.
The flurry of ESG-oriented activity from the SEC this year marks a notable turnaround from its policy approach under the Trump Administration, where the SEC appeared content to let private actors take the lead in developing ESG disclosure standards. For much of 2020, the SEC resisted investor calls for the SEC to establish an ESG disclosure framework for issuers to disclose material, decision-useful, comparable and consistent information necessary for investors to make informed investment and voting decisions. Former SEC Commissioner Jay Clayton took the view that any “attempt to impose rigid standards or metrics for ESG disclosures . . .would be a departure from our long-standing commitment to a materiality-based disclosure regime.” Instead, the SEC continued to largely rely on its materiality standard to guide ESG disclosures in public company filings. The most notable steps the SEC took in 2020 on ESG disclosures were amending Regulation S-K to require the broad disclosure of an issuer’s human capital resources and any human capital measures or objectives used by the issuer in managing its business (but without mandating any metrics) and describing the circumstances under which inclusion of certain ESG-type key performance metrics would be appropriate in MD&A disclosures.
In the absence of the SEC’s involvement in ESG disclosure and enforcement, last year saw several private-led ESG disclosure regimes make significant strides. The International Business Council of the World Economic Forum published in September a set of industry-agnostic, universal ESG disclosure metrics. That same month, several established ESG disclosure frameworks, including the Sustainability Accounting Standards Board (SASB), CDP, the Climate Disclosure Standards Board, the Global Reporting Initiative, and the International Integrated Reporting Council, pledged to work together toward a comprehensive ESG reporting system. In the meantime, major investors, including BlackRock and State Street, have called on companies to publish disclosures in line with SASB guidelines and the recommendations of the Task Force on Climate-related Financial Disclosures. By the end of last year, it appeared that a private market led effort was poised to succeed in creating a universal, standardized ESG reporting regime.
With the SEC now asserting a leadership role on ESG disclosures and enforcement, it appears that private efforts may need to make way for potential regulatory shifts and enforcement actions. Perhaps what is most notable about the SEC’s latest foray into ESG is the scope of its commitment to the issue. In announcing its 2021 examination priorities, the SEC noted that it is willing to “find innovative ways to enhance the effectiveness of examinations and our risk-based approach.” The fact that the SEC has chosen to focus its attention on compliance programs of investment advisers and investment companies, including the “consistency and adequacy of the disclosures” relating to ESG strategies and the “proxy voting policies and procedures” of such investment advisers, signals that the SEC expects to hold institutional investors—and potentially their portfolio companies as well—accountable for their ESG policies and practices.
Over the coming months, claims of greenwashing or double standards that have been leveled against institutional investors in connection with their voting policies may also attract SEC scrutiny. Meanwhile, issuers who have looked to their peers to determine the appropriate scope of their ESG disclosures are well-advised to check the adequacy of such disclosures as the SEC tightens its focus on inaccurate or incomplete disclosures. If the SEC’s Risk Alert issued in April on misleading statements made by investment advisers is any indication of the SEC’s expectations, issuers should review, and in some cases establish, compliance policies to track their ESG investment decision-making processes, clearly document internal policies and procedures and ensure the ESG competency of their compliance personnel. Third-party verification and assurance of ESG disclosures will also continue to become more common.
Two areas of particular interest to the SEC are climate change and human capital, with the SEC considering adopting new disclosure rules in both areas. Earlier this year, the SEC commenced a review of its 2010 guidance on climate-related disclosures, which reminded issuers of the need to consider certain climate change-related risks and opportunities in their public disclosures. In doing so, the SEC recognized the dramatic increase in investor demand for this type of information and noted that the issue now is “whether climate change disclosures adequately inform investors about known material risks, uncertainties, impacts and opportunities.” Picking up where the Trump-era SEC had declined to do so, the SEC has sought public input on approaches that would facilitate the disclosure of “consistent, comparable and reliable information on climate change.” The possible changes the SEC has mooted include new disclosure requirements and potential new disclosure frameworks that the SEC could incorporate or adopt—a move that could signal a shift away from the SEC’s principles-based reporting towards a metrics reporting currently found among the major ESG disclosure frameworks (or an amalgamation of principles and metrics-based reporting). Similarly, notwithstanding the SEC’s guidance in late 2020 related to “principles-based” disclosure concerning human capital, Commissioner Gary Gensler recently indicated that the SEC will propose new rules on human capital disclosures concerning company workforces.
Heading into the remainder of 2021, companies should be prepared for a continued shakeup of ESG guidance and rule-making and increased enforcement from the SEC. Compared to its peers in Europe and the U.K., who have already established extensive disclosure and enforcement regimes, the SEC is still playing catch-up. In the meantime, companies would be well served to continue refining their ESG disclosures, both in scope and accuracy; reviewing their internal policies and procedures to ensure compliance; and ensuring adequate board and management oversight of ESG risks and opportunities. While the SEC has begun asserting a leadership role on ESG, it may be some time before its position on various matters are crystallized. In the meantime, companies should be prepared to meet market-led practices on ESG disclosure, management and oversight.
David M. Silk is a partner of Wachtell, Lipton, Rosen & Katz where he focuses on merger and acquisition transactions, takeover defense, private equity transactions, corporate governance, ESG and sustainability issues, proxy contests, restructurings, joint ventures and securities laws. He represents public and private companies and private equity funds worldwide and in a wide variety of industries.
Carmen X. W. Lu is an associate in Wachtell, Lipton, Rosen & Katz’s Corporate Department. Carmen received a B.A. in Political Science from Yale University, where she received the Arthur Twining Hadley Prize as the highest-ranking graduate. She received her J.D. from Yale Law School, where she was articles and essays editor of the Yale Law Journal and executive editor of the Yale Journal on Regulation.
PLI Programs you may be interested in:
Disclaimer: The viewpoints expressed by the authors are their own and do not necessarily reflect the opinions, viewpoints and official policies of Practising Law Institute.
To submit an article for consideration, please contact the editor at: email@example.com
This article is published on PLI PLUS, the online research database of PLI. The entirety of the PLI Press print collection is available on PLI PLUS—including PLI's authoritative treatises, answer books, course handbooks and transcripts from our original and highly acclaimed CLE programs.
Sign up for a free trial of PLI PLUS at pli.edu/pliplustrial.