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That the meaning of “ESG” no longer needs to be explained, illustrating how important these issues have become to investors, public companies, international capital markets and, correspondingly, the U.S. Securities and Exchange Commission (the “SEC”). Institutional investors remain focused on corporate governance and other policies related to long-term value creation, with an increased focused on Environmental, Social and Governance factors including sustainability. ESG-oriented funds have recorded unprecedented inflows and outperformed in many respects in 2020 during the COVID-19 pandemic. For example, in the midst of the COVID-19 pandemic, global inflows into sustainable funds were up 88% in the fourth quarter of 2020, and a record 196 sustainable fund products launched in the period, according to researcher Morningstar.1 In the United States, mutual funds claiming to be dedicated to sustainable investing outperformed their traditional peer funds by 4.3 percentage points on a median total return basis in the case of equity funds, and 0.9 points for bond funds, according to Morgan Stanley.2
At the same time, the pandemic exposed significant social, economic, and reputational costs that can occur if companies do not address ESG issues, including climate change, systemic racism, employee safety, health and well-being, and supply chain resilience, among other issues responding to these developments. For these reasons, the SEC has highlighted ESG-related issues in several recent announcements, speeches and other public statements, as have other regulatory organizations, as described in this update.
The SEC’s Recent Pronouncements on ESG
As part of a renewed focus on ESG issues, the SEC in 2021 has been issuing various statements and press releases focused on improving ESG disclosures in public companies’ SEC filings. On 24 February 2021, then-Acting Chair Allison Herren Lee issued a statement directing the SEC’s Division of Corporation Finance (“CorpFin”) to increase its focus on climate-related disclosures in public company filings.3 In her statement, Acting Chair Lee indicated that CorpFin will, among other things, (i) review the extent to which public companies are addressing the guidance published by the SEC in 2010 for public companies regarding existing disclosures related to climate change (the “2010 Guidance”),4 (ii) assess compliance with disclosure obligations under federal securities laws, (iii) engage with public companies on these issues, and (iv) absorb critical lessons on how the market is currently managing climate-related risks. In her statement, Acting Chair Lee indicated that the SEC would use insights from CorpFin’s review to update the 2010 Guidance to take into account developments in the last decade.
Similarly, on 3 March 2021, the SEC Division of Examinations, which conducts examinations in order to review the activities of various market participants, including investment advisors, broker-dealers, clearing agencies, and others, announced its 2021 examinations priorities, which include a greater focus on climate and ESG-related risks and disclosures than in the past.5 In the announcement, the Division of Examinations highlighted recent statements made by Acting Chair Lee on how the SEC plans to approach its focus on climate and ESG-related risks, such as the following: “[t]his year, the Division [of Examinations] is enhancing its focus on climate and ESG-related risks by examining proxy voting policies, and practices to ensure voting aligns with investors’ best interests and expectations, as well as firms’ business continuity plans in light of intensifying physical risks associated with climate change, [and] [t]hrough these and other efforts, [the Division of Examinations is] integrating climate and ESG considerations into the [SEC’s] broader regulatory framework.”
On 4 March 2021, the SEC announced the creation of a Climate and ESG Task Force in the SEC’s Division of Enforcement (the “ESG Task Force”).6 The ESG Task Force is being led by Kelly L. Gibson, the Acting Deputy Director of Enforcement, who will oversee a Division-wide effort, with 22 members drawn from the SEC’s headquarters, regional offices, and Enforcement specialized units. The mission of the ESG Task Force is to develop initiatives to proactively identify ESG-related misconduct and to coordinate the effective use of the Division of Enforcement’s resources, including through the use of sophisticated data analysis to mine and assess information across registrants, to identify potential violations of securities laws and regulations. The announcement stated that the ESG Task Force’s initial focus will be to identify any material gaps or misstatements in issuers’ disclosure of climate risks under existing rules, and that the ESG Task Force will also analyze disclosure and compliance issues relating to investment advisers’ and funds’ ESG strategies.
On 11 March 2021, the SEC issued a statement in connection with remarks given by Acting Director of CorpFin, John Coates, at the 33rd Annual Tulane Corporate Law Institute.7 In his remarks, Acting Director Coates highlighted the continuing debate over the precise contents and details of what ESG disclosures might or should encompass. Part of the difficulty, he said, is that ESG is on the one hand a very broad concept, touching every company in some matter, but at the same time quite company-specific in that the ESG issues companies face can vary significantly based on their industry, geographic location, and other factors. Consequently, there is no one set of metrics that can properly cover all ESG issues for all companies. Acting Director Coates noted that an effective ESG disclosure system would not be rigid, but instead would contain useful, reliable, and comparable disclosures under standards that are flexible enough to remain relevant over time.
Acting Director Coates also highlighted the importance of structuring a disclosure system for ESG issues. For example, one question that he said he believes should be considered is whether such disclosures should be the subject of mandatory versus voluntary disclosure provisions. According to Acting Director Coates, the SEC’s current disclosure regime is nuanced in that it is not binary between mandatory compliance or voluntary compliance, and he stated his belief that there is no reason an ESG disclosure system would need to be less nuanced. Indeed, the current system already contains mandatory ESG disclosure requirements, such as how a company’s board considers diversity in identifying director nominees. However, the existing system permits significant differences in how companies respond to these “mandatory” requirements, including disclosing items only if they are material to the registrant. Moreover, there are “comply or explain” requirements, where the ability to explain (e.g., why a company does not have an audit committee financial expert) makes the requirement less than mandatory, and, for some companies, more informative to the reader.
On 15 March 2021, Acting Chair Lee delivered a speech at the Center for American Progress entitled “A Climate for Change: Meeting Investor Demand for Climate and ESG Information at the SEC”.8 During her speech, Acting Chair Lee highlighted corporate accountability to investors concerning ESG matters through enhanced transparency and supporting the exercise of shareholder rights as a central issue. Acting Chair Lee also discussed how climate change, workforce diversity, independent board leadership, and corporate political spending, as well as other ESG-related issues, are becoming more common in shareholder proposals, reflecting investor interest in corporate accountability around these issues. She highlighted how 2020 has in her view helped to clarify why the perceived barrier between social value and market value is breaking down. For example, COVID-19 has driven focus on worker safety, while social justice protests have driven focus on racial equality. Acting Chair Lee further noted that, last year, the same issues dominating our national conversation were also dominating decision-making in the boardroom. Such issues include human capital, human rights, and climate change, all of which are fundamental to our markets. As a result, investors want to (and can) help drive sustainable solutions in these areas through ESG investing and demanding improved ESG disclosures on these issues.
That same day, Acting Chair Lee issued a statement requesting public input on whether current climate change disclosures adequately inform investors about known material risks, uncertainties, impacts, and opportunities.9 Acting Chair Lee indicated that she has asked the SEC staff to evaluate current disclosure rules, including the 2010 Guidance, with an eye toward facilitating the disclosure of consistent, comparable, and reliable information on climate change. To that end, her statement included a list of questions for consideration to solicit public feedback, including how the SEC can best regulate, monitor, review, and guide climate change disclosures, what information related to climate risks can be quantified and measured, and what the advantages and disadvantages are for establishing different climate change reporting standards for different industries, such as the financial section, oil and gas, transportation, and other industries. The comment period for this initiative began on 15 March 2021 and expired 90 days thereafter on 13 June 2021.
More recently, on 9 April 2021, the SEC’s Division of Examination published a Risk Alert on ESG investing in order to highlight observations from recent examinations of investment advisers, registered investment companies, and private funds offering ESG products and services.10 Over the course of its recent examinations of these asset managers, the Division of Examinations observed that some advisers and funds considered ESG factors alongside many other factors (e.g., macroeconomic trends of certain company-specific factors), whereas others focus on ESG practices because they believe investments with favorable ESG profiles may provide higher returns or result in better ESG-related outcomes (e.g., some ESG funds select companies that have demonstrated a commitment to a particular ESG factor, such as companies with policies aimed at minimizing their environmental impact). Some advisers and funds consider ESG factors by applying negative, positive, or norms-based screens to investments, while others focus on a range or subset of ESG themes, including sustainability, climate, and faith-based investing. Still others invest with a goal of generating measurable ESG-related benefits, known as impact investing. According to the Risk Alert, the Division of Examinations believes that “this rapid growth in demand, increasing number of ESG products and services, and lack of standardized and precise ESG definitions present certain risks.”
The Risk Alert provides observations of certain of those risks and specifically describes both (i) deficiencies and internal control weaknesses from examinations of investment advisers and funds regarding ESG investing and (ii) effective practices from such examinations. For example, the Division of Examinations observed some instances of potentially misleading statements regarding ESG investing processes and representations regarding the adherence to global ESG frameworks. Other firms, however, had clear disclosures that were precise and tailored to their specific approaches to ESG investing, and which aligned with the firms’ actual practices. For further discussion of the Risk Alert, see the Dechert Financial Services Group’s recently published OnPoint.
On 7 May 2021, new SEC Chair Gary Gensler informed the House of Representatives Financial Services Committee that he expects the SEC to propose new rules on corporate climate risk disclosures in the second half of 2021.11 One week later, on 13 May 2021, at the annual Conference on Financial Market Regulation, hosted jointly by the SEC’s Division of Economic and Risk Analysis, Lehigh University and the University of Maryland, SEC Chair Gensler further explained that rulemaking around climate risk and human capital disclosures will be “an early focus of his tenure in light of investors, interest in the areas,” and “is one of [his] top priorities” since he believes that “investor demand should guide our thinking on this work.”12
Most recently, on 26 May 2021 during his testimony before the Financial Services and General Government Subcommittee of the U.S. House Appropriations Committee, SEC Chair Gensler said that the SEC is considering diversity reporting requirements as part of a corporate workforce disclosure proposal that the SEC is crafting.13 SEC Chair Gensler also stated during his testimony that the SEC’s proposal has the potential to include new disclosures about the diversity of a company’s senior management, among other reporting obligations.
Current and Proposed ESG Disclosure Frameworks
Any new SEC disclosure rules on climate change or other ESG topics will be built upon the existing disclosure framework and the way market practices regarding ESG disclosures in the United States and globally have evolved in the past several years. As described in the 2010 Guidance, climate change and other ESG-related risks can be relevant under a variety of existing rules and regulations, such as the itemized requirements for business narrative, legal proceedings, risk factors, and management discussion and analysis (MD&A) requirements of Regulation S-K. However, many past and current ESG disclosures have been descriptive and historical, and there has recently been a call for greater accountability through the use of targets and other metrics in order to demonstrate a company’s progress towards achieving its ESG-related goals. For example, the Task Force on Climate-Related Financial Disclosure (TCFD), which was created in 2015 by the Financial Stability Board (FSB) to develop consistent climate-related financial risk disclosures for use by companies, banks, and investors in providing information to stakeholders, published an overview earlier this year which recommends that companies, among other things, (i) disclose the metrics and targets used to assess and manage relevant climate-related risks and opportunities where such information is material and (ii) describe the targets used by the organization to manage climate-related risks and opportunities and performance against targets.14 A growing number of public companies in the United States have already publicly disclosed forward-looking initiatives on climate change and diversity that include targets and other metrics, often on a dedicated page on their corporate website, and occasionally to a limited extent in their SEC reports.
There has also been a move towards creating a comprehensive disclosure and reporting framework for reporting ESG issues and sustainability. Last year, five of the major ESG disclosure frameworks, including CDP, the Climate Disclosure Standards Board (CDSB), the Global Reporting Initiative (GRI), the International Integrated Reporting Council (IIRC) and the Sustainability Accounting Standards Board (SASB) issued a joint statement committing to work together to create a comprehensive corporate reporting system for sustainability disclosure, including climate-related reporting, along with the recommendations of the TCFD.15 With ESG reporting being a central focus of regulators and disclosure frameworks, and reporting standards becoming more uniform, regardless of pending SEC action in the area, companies are likely to continue to face increased investor pressure to publish more comprehensive ESG disclosures.
Regulators, investors, and other stakeholders are also increasingly focusing on racial and ethnic diversity in the workplace – part of the “S” in ESG – largely due to the racial injustices caused by systemic issues brought to the forefront during the COVID-19 pandemic. While the COVID-19 pandemic raised awareness with respect to these issues, unfortunately the pandemic and job losses continue to disproportionately affect minorities and women. In an effort to address diversity and racial inequality, in December 2020, the Nasdaq Stock Market filed a proposal with the SEC to adopt new listing rules related to board diversity and disclosure.16 If approved by the SEC, the new listing rules would require all companies listed on Nasdaq’s U.S. exchange to publicly disclose consistent, transparent diversity statistics regarding their board of directors. Additionally, the rules would require most Nasdaq-listed companies to have, or explain why they do not have, at least two diverse directors, including one who self-identifies as female and one who self-identifies as either an underrepresented minority or LGBTQ+. Institutional Shareholder Services (ISS), Glass Lewis and other proxy advisers have amended their 2021 proxy voting guidelines to increase scrutiny of gender and racial diversity on boards. On 10 March 2021, the SEC issued a release indicating that the SEC received a mix of comment letters on the proposal and that it is taking additional time to rule on the Nasdaq proposal, while also seeking further public comment.17 The SEC has not set a new deadline for it to act on the proposal. As a result of the delay, a final decision on whether to approve or reject the proposal will likely come out this summer. Nasdaq’s plan needs SEC approval to take effect.
Boards of directors should continue to consider how to formulate an ESG strategy whose progress can be measured by concrete, reportable targets, goals, and forecasts, and decide how best to publicly communicate long-term initiatives that are capable of adapting and changing over time. While existing SEC rules may require companies to make certain ESG-related disclosures only if material, the SEC has indicated that, in the near future, it will likely issue updated climate change disclosure requirements. These updated disclosure requirements could come in various forms, including amendments to current disclosure requirements, including Regulation S-K and Regulation S-X, potential new SEC disclosure requirements or frameworks that the SEC might adopt or incorporate in its disclosure rules, or both. It is important for issuers to continue to monitor these changes, since new developments relating to ESG will continue to occur at a rapid pace.
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