Enhanced Focus by SEC and Investors on Climate-Related Disclosures
As part of President Biden’s whole-of-government approach to confronting climate change, the U.S. Securities and Exchange Commission (“SEC”) has prioritized ESG -related matters. SEC Chair Gary Gensler recently remarked that investors increasingly want to understand the climate risks and workforces of the companies in which they invest. Gensler has asked the SEC staff to propose new disclosure rules related to climate risk and human capital, including workforce and corporate board diversity, by the end of 2021. A prescriptive disclosure framework will likely lead to increased litigation and enforcement.
Existing Principles-Based Disclosure Framework
Any examination of the SEC’s forthcoming ESG disclosure rules must start with existing regulations that affect US issuers.
Item 303 of Regulation S-K requires that registrants disclose known trends and other material information in securities filings. In doing so, it follows the principles-based “materiality” disclosure regime that generally governs disclosure matters for US issuers.
In February 2010, the SEC published interpretative guidance to Regulation S-K to advise when a registrant might be required to disclose the impact of climate change (the “2010 Guidance”). The SEC noted that climate change disclosures could factor into, among other areas, the registrant’s description of its business, legal proceedings, risk factors, and management’s discussion and analysis sections of securities filings. The SEC also provided the following specific examples of climate change-related topics that a registrant should consider disclosing: (1) the impact of legislation and regulation regarding climate change; (2) the impact of treaties or international accords relating to climate change on its business; (3) the indirect consequences of regulation or business trends, including legal, technological, political and scientific developments regarding climate change that may create new opportunities or risks for registrants; and (4) the significant physical effects of climate change that may have the potential to affect a registrant’s operations and results.
On February 24, 2021, then-Acting SEC Chair Allison Herren Lee requested that the SEC’s Division of Corporation Finance scrutinize companies’ climate disclosures for adherence to the 2010 Guidance. To that end, on September 22, 2021, the SEC’s Division of Corporation Finance published an “illustrative” Sample Letter containing questions for companies to consider regarding the 2010 Guidance. In releasing the Sample Letter, the SEC reminded companies that the 2010 Guidance may require disclosure related to climate change and stated it might send the Sample Letter to companies regarding their climate-related disclosure or the absence of such disclosure.
The Sample Letter is broken down into three topical sections with respect to climate-related matters:
General
The SEC asks for explanations as to why expansive disclosures in the company’s corporate social responsibility report are not included in the company’s SEC filings.
Risk Factors
The SEC first asks the company to disclose the material effects of transition risks related to climate change that may affect its business, financial condition, and results of operations, such as policy and regulatory changes that could impose operational and compliance burdens, market trends that may alter business opportunities, credit risks, or technological changes. The SEC then requests the company to disclose any material litigation risks related to climate change and explain the potential impact to the company.
Management’s discussion and analysis of financial condition and results of operations
The SEC outlines several topic areas that may require further disclosure, including, if material:
* Pending or existing climate change-related legislation, regulations, and international accords, with a description of any material effect on the company’s business, financial condition, and results of operations;
* Past and/or future capital expenditures for climate-related projects and a quantification of those expenditures;
* A discussion of the indirect consequences of climate-related regulation or business trends, such as:
* The physical effects of climate change on operations and results, which may include the severity of weather, quantification of weather-related damages, the impacts on major customers or suppliers, decreased agricultural production capacity due to drought or other weather-related changes, and weather-related impacts on the cost or availability of insurance;
* Quantification of any increased compliance costs related to climate change; and
* The purchase or sale of carbon credits or offsets and effects therefrom.
The SEC’s Sample Letter serves as yet another reminder that climate change is a priority for the SEC. Companies can expect continued scrutiny and questions from the SEC concerning their existing disclosures while awaiting the SEC’s forthcoming ESG disclosure rules.
The Evolving Regulatory Landscape
In March 2021, the SEC invited public comments on prescriptive climate disclosures. The request for comments set out 15 multipart questions on climate and ESG disclosures, including the following areas that would require additional disclosure:
* How should companies consider disclosing internal governance of climate issues and the impact of climate risk or impact and executive compensation?
* Should climate disclosures be subject to an audit or assessment process or attestation requirement comparable to assurance requirements for financial disclosures?
* Should climate disclosures be subject to specific executive officer certifications?
* Should there be a management sustainability analysis section that is similar to the management discussion and analysis or compensation discussion and analysis?
* How should the SEC address disclosure by private companies in exempt offerings?
The period for public comment closed in June 2021 and the SEC received more than 550 comment letters, three-fourths of which support prescriptive disclosures. Three emerging themes addressed in comments supporting mandatory disclosures include (1) what specific disclosures the SEC should require, such as whether the SEC should require disclosure of Scope 1, 2, and 3 greenhouse gas emissions; (2) where and how issuers should make disclosures, including whether the SEC should require disclosures in a Form 8-K or other SEC report, or in the 10-K annual report; and (3) to what extent the SEC should leverage existing frameworks and standards concerning ESG disclosures, such as those issued by the Task Force on Climate-related Financial Disclosures (“TCFD”) or Sustainability Accounting Standards Board (“SASB”).
In July 2021, the SEC’s Asset Management Advisory Committee (“AMAC”) recommended that the SEC encourage registrants to adopt a disclosure framework for material ESG matters or provide an explanation as to why they have not. The AMAC advised that disclosure frameworks could include (1) those developed by third-party standard setting organizations (like the TCFD); or (2) those developed by an industry group dedicated to ensuring consistent, comparable disclosure of material ESG matters.
It is clear the SEC is determined to develop a comprehensive climate disclosure framework, though it remains unclear exactly what form that framework might take. Companies can expect the disclosure framework to include qualitative and possibly quantitative components. Qualitative components could require companies to explain how they manage climate-related risks and opportunities and how those factors feed into the company’s strategy. Quantitative components could include metrics related to greenhouse gas emissions, financial impacts of climate change, and progress towards climate-related goals.
Litigation and Regulatory Risks
Companies should be aware of their legal and regulatory risks for climate-related disclosures. For one, statements in offering documents are subject to Sections 11 and 12(a)(2) of the Securities Act of 1933, which impose civil liability for material misstatements and omissions in certain offering documents. In addition, Section 10(b) of the Exchange Act of 1934 (“Exchange Act”) and Rule 10b-5 prohibit material misstatements and omissions in securities filings and other public statements, including less formal statements like press releases, investor calls and websites. Section 14(a) of the Exchange Act and Rule 14a-9 prohibit material misstatements and omissions in connection with proxy solicitations, under which courts and the SEC have generally applied a negligence standard. Climate-related disclosures may also give rise to liability under state laws, including consumer protection laws.
To date, although litigation relating to climate disclosures is sparse, it is likely to increase given the increasing prevalence and focus on climate disclosures. Companies might find themselves subject to suit for alleged failures to disclose material risks stemming from climate change, such as environmental risks to key assets or supply chain disruptions caused by flooding or wildfires. Or, companies might face allegations of “greenwashing” their disclosures, meaning the company is alleged to have represented its business practices as environmentally friendly when they were not.
Companies might also be subject to enhanced enforcement, as indicated by the September 2021 Sample Letter. Relatedly, in March 2021, the SEC formed a 22-member task force in its Division of Enforcement (the Climate and ESG Task Force) charged with identifying ESG-related misconduct. And in April 2021, the Division of Examinations announced that its 2021 examination priorities would enhance focus on climate-related risks, issuing a Risk Alert noting that “[d]uring examinations of investment advisers, registered investment companies, and private funds engaged in ESG investing, the staff observed some instances of potentially misleading statements regarding ESG investing processes and representations regarding the adherence to global ESG frameworks.”
Best Practices to Reduce Litigation and Enforcement Risks
Companies should consider the following best practices to reduce their litigation and enforcement risks:
Develop internal controls for climate-related disclosures. Companies should develop internal controls, similar to controls over financial reporting, to ensure that climate-related statements are supported by facts and data. Companies should also disclose the basis of projections and explain assumptions with reasonable detail, and utilize estimates, ranges, and aspirational statements when appropriate, that are accompanied by meaningful cautionary language. Further, companies should compare their ESG disclosures made in sustainability or other reports, with those made in SEC filings, and if different, investigate the reason.
Specifically tailor disclaimers to climate-related risks. Companies should consider the specific climate-related risks applicable to their particular circumstances and prepare individualized and detailed cautionary statements tailored to those risks. Cautionary language should be reviewed and updated regularly, warn of specific risks and discuss actual developments relevant to those risks.
Disclose all known material information in voluntary disclosures. Safe harbors for forward looking statements do not protect against false or misleading statements made with actual knowledge that the statement was false or misleading. In April 2021, John Coates, then-Acting Director of the SEC’s Division of Corporation Finance, stated in another context that “[a] company in possession of multiple sets of projections that are based on reasonable assumptions, reflecting different scenarios of how the company’s future may unfold, would be on shaky ground if it only disclosed favorable projections and omitted disclosure of equally reliable but unfavorable projections, regardless of the liability framework later used by courts to assess the disclosures.” Thus, if a company speaks on climate-related issues voluntarily, it must ensure that its statements are neither materially false nor misleading and that such statements do not omit material information.
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