On Friday, the SEC’s Asset Management Advisory Committee met to discuss various matters, including possible recommendations to the SEC regarding—what else?—ESG. The latest version of subcommittee draft recommendations do not advocate a change from the current materiality disclosure requirements. Rather, they support adoption of mandatory standards to guide those materiality requirements, standards that take a “parsimonious” approach with a limited number of material metrics by industry—not exactly the “comprehensive” direction that the SEC appears to be headed, at least at the moment. Although the recommendations address investment product disclosure, the focus at the meeting was primarily on company ESG disclosure as the necessary predicate to investment product disclosure. Accordingly, the Committee heard from a panel of issuer representatives, who expressed a variety of views, but on the whole, appeared to advocate a cautious approach.
Acting SEC Chair Allison Lee made a brief statement at the meeting emphasizing the need for disclosure that is consistent, comparable and reliable. Of course, she has previously made clear her intent that the SEC go beyond existing principles-based materiality requirements and indicated that the SEC has “begun to take critical steps toward a comprehensive ESG disclosure framework.” (See this PubCo post.)
Commissioner Hester Peirce questioned the Committee’s focus on ESG and diversity to the exclusion of other issues she considered important, such as managing clients’ portfolios in a zero-rate environment, new technology and cybersecurity risks. With regard to ESG, she maintained that to arrive at
“broad ESG disclosure mandates for issuers, we have to reimagine materiality. But reimagining materiality is the same as tossing it in favor of a more malleable new edition. Materiality has served us well, and undermining it to accommodate ESG will harm investors. I reiterate a point I have made before—I am happy to consider new SEC mandates for specific metrics that are likely to be material to every issuer in every industry. ESG standards, however, continue to be talked of in broad strokes that obfuscate the immaterial nature of many of the specific underlying disclosures. Although I certainly understand the impetus for asking for mandated issuer disclosures, I urge the Committee to rethink the wisdom of recommending that we embark on a program to write standards for a set of issues nobody can define. They are not akin to accounting standards, which serve a clear, time-tested, universally understood objective. Having the SEC build a GAAP-like edifice around ESG standards would give investors a false sense of confidence in standards that are subjective, shifting, and sometimes even senseless.”
Note that Lee has previously floated the idea of creating a standard setter for ESG (similar to the FASB), and has remarked that symmetry around ESG and financial reporting, such as through attestation, should be the “ultimate goal.” (See this PubCo post.)
The concept of “materiality” has been subject to debate recently. This PubCo post reports on the colloquy among nominee for SEC Chair, Gary Gensler, and various members of the Senate Committee on Banking, Housing and Urban Affairs during his nomination hearing. In his questioning, Senator Pat Toomey introduced the topic of the meaning of “materiality” by reminding Gensler that in their prior conversation, Gensler had committed to basing SEC disclosure requirements on the concept of materiality. But how would Gensler apply that concept in practice? For example, if a big public company spent an insignificant amount on, say, electricity, is it material whether that electricity came from renewable sources? Gensler replied that, according to SCOTUS, the test is whether it’s material to a reasonable investor in the context of the total mix of information. So, in the hypothetical, the information about renewable sources may or may not be material, depending on the total mix of information. Often a financially insignificant amount may be immaterial, but it must be viewed in the broader context of the mix of information. Toomey responded that, if the amount was financially insignificant, he did not see how it could be material.
Similarly, Toomey asked, if a large public company reported revenues of hundreds of billions of dollars and it spent a million dollars on political issue ads, should disclosure be required? Gensler responded that the question is what information reasonable investors are seeking to make voting or investment decisions, and last year, based on their proxy votes on shareholder proposals, about 40% of shareholders said that political spending information would be material. So, even though the amount of spending is completely insignificant, Toomey asked, did he think it could be appropriate to mandate that disclosure? Gensler replied that he would be grounded in economic analysis and the courts’ views of materiality as the information reasonable investors want to see as part of the total mix of information. Why not leave it up to the companies to decide, Toomey asked? Gensler repeated that it’s a really a question of investors making the choice about the information they want.
Picking up on Toomey’s line of questioning, Senator Richard Shelby asked Gensler to discuss the difference between “economic materiality” and what he called “political materiality.” Gensler said that, although he was aware of the political ebb and flow, he would be grounded in the economic side together with the courts’ definition of materiality as based on the type of information reasonable investors want among the total mix to make voting and investment decisions. Senator Bill Hagerty also urged Gensler not to allow regulations to be used to backdoor social policy.
Looking at the issue of materiality from a different perspective, Senator Chris Van Hollen noted that the determination of materiality changes over time. For example, 20 years ago, investors may not have seen climate change risks as essential to the success of a particular company, but they do now. Gensler confirmed that it was important for the SEC to keep an eye open to changing investor demands for information; as the courts have defined it, Gensler reiterated, reasonable investors are the ones who decide what is important, not the government. Gensler said that he would be guided by that. In 2021, Gensler agreed that investors with tens of trillions of invested assets are seeking information about climate risk, and the SEC has a role to play to bring comparability and consistency. Van Hollen also raised the issue of whether reasonable investors might not view political spending disclosure as material in light of the possibility of corporate reputational risk that could arise out of political spending. Gensler agreed that that could factor into a reasonable investor’s voting and investment decisions. The SEC could work to provide guidance to issuers about how to provide that information.
According to Commissioner Elad Roisman, it is “entirely reasonable for a person to feel that climate change deserves immediate attention from lawmakers and still question whether the SEC mandating new disclosures from U.S. public companies is an appropriate step for the agency. In this forum, I feel confident that we all recognize the fundamental questions here are about the SEC’s authority as a regulator and whether this agency’s intervention is appropriate to address the problems people have identified in our markets.” He posed a number of questions for the panelists, including asking asset managers whether they understand the objectives of the investors in sustainable funds ($2 trillion), “which (as the subcommittee’s preliminary recommendation states) may fall outside risk/return alone” and what ESG information is needed to value potential targets for investment and portfolio companies. He asked the Committee how the SEC should oversee a third-party standard-setter that, as recommended, would identify information that is material. He asked company representatives how they thought the burden on issuers could be mitigated, whether any mandated disclosures should be furnished rather filed and whether the SEC should provide a safe harbor. He also later asked what type of ESG information would cut across all industries that would help the investor analysis.
Draft potential recommendations from ESG subcommittee
The subcommittee recommendations started with a number of “areas of concern” to be considered, among them:
- “How can we avoid ‘greenwashing,’ that is, investment products bearing the name ESG but not actually engaging in meaningful ESG investment?”
- “Does ESG, or any substyle of ESG investment, contribute to performance, or are performance claims being made without basis in data?”
- “What guidance should be given to U.S. securities issuers with respect to ESG risks?”
Notably, issuer disclosure was the only area where the subcommittee recommended mandating specific actions. The subcommittee found that standardized, consistent issuer disclosure would facilitate verification by investors and their third-party service providers of “whether investment products met their objectives, and would make performance attribution to ESG factors more consistent and reliable.” However, the subcommittee concluded that
“significant disclosure requirements for material risks already exist and we do not see the need to change the disclosure laws to improve the quality and comparability of ESG for investors. What we do recommend is the adoption of standards for those disclosures; we propose that mandatory, rather than voluntary, standards be established, as the current, unguided approach has not resulted in consistent, comparable, complete and meaningful disclosure. The impact of the current approach could be poor transparency with the potential to mislead investors in investment products, as well as poor disclosure of material risks to investors in issuers’ securities.”
The subcommittee expressly rejected “the highly prescriptive approach that is used, for example, in Europe, as that may result in the production of metrics that are not needed to assess an issuer’s material risks, and unnecessary cost. Instead, we see a parsimonious approach being sufficient to meet the needs of investor transparency, with a focus on a limited number of material metrics, tailored by industry, overseen by an independent standard setting entity such as SASB, or other similar approaches so long as they are limited to material metrics by industry.”
More specifically, with regard to company disclosure, the subcommittee recommended that:
- “The SEC should require the adoption of standards by which corporate issuers disclose material ESG risks.” These standards should be mandatory (like GAAP), apply to disclosure of material ESG risks (including helping companies determine risk materiality), differentiated by industry (like SASB), ensure comprehensive disclosure of all material ESG risks and the extent of company exposure to ESG risk, and allow comparability across and within industries.
- “The SEC should utilize standard setters’ frameworks to require disclosure of material ESG risks.”
- “The SEC should require that material ESG risks be disclosed in a manner consistent with the presentation of other financial disclosures.”
These recommendations predate the recent crush of ESG plans and developments emanating from the SEC under Lee. According to Lee, the current voluntary ESG disclosure is not adequately satisfying investor demand and, as a result, the SEC has “begun to take critical steps toward a comprehensive ESG disclosure framework aimed at producing the consistent, comparable, and reliable data that investors need.” Another issue Lee has been considering is whether there should be a requirement for verification of climate and ESG disclosures, including potentially auditor attestation of sustainability reporting. In her view, symmetry around ESG and financial reporting, such as through attestation, needs to be the “ultimate goal.” And, as noted above, Lee is considering whether the SEC should establish a standard-setter for ESG under SEC oversight dedicated to devising an ESG reporting framework that would complement the SEC’s financial reporting framework. The goal would be to “devise a climate and ESG disclosure framework that is flexible and can efficiently evolve as needed.” Another approach might be to recognize another existing set of standards, much like the COSO framework is recognized with respect to internal control, an approach that seems more compatible with the subcommittee recommendation. (See this PubCo post.)
With regard to investment product ESG disclosure, because of the inconsistent and unreliable quality of issuer ESG data, the subcommittee concluded that “it does not make sense to have prescriptive additional requirements for ESG investment product disclosure or performance measurement and attribution practices. We do recommend as a suggested best practice that ESG investment products describe their objectives, how they prioritize these objectives (e.g., are the risk/return objectives a higher or lower priority than any non-risk/return objectives, such as religious rule adherence or social benefits).” The subcommittee did not find a “clear picture of the impact of ESG on performance,” nor did it conclude “that ESG should be treated any differently than other fund objectives or strategies with respect to disclosing performance. While performance standards might emerge if issuer ESG data improves, at this early state of evolution of ESG investing we did not find that particular standards for metrics and attribution were achievable or desirable.”
As initially reported in thecorporatecounsel.net blog, this opinion piece in USA Today is not so reticent to reach a conclusion about the impact of ESG on fund performance. It’s not quite what it’s cracked up to be, according to the author, who is—wait for it—the former chief investment officer for Sustainable Investing at BlackRock:
“The financial services industry is duping the American public with its pro-environment, sustainable investing practices. This multitrillion dollar arena of socially conscious investing is being presented as something it’s not. In essence, Wall Street is greenwashing the economic system and, in the process, creating a deadly distraction. I should know; I was at the heart of it.
“As the former chief investment officer of Sustainable Investing at BlackRock, the largest asset manager in the world with $8.7 trillion in assets, I led the charge to incorporate environmental, social and governance (ESG) into our global investments. In fact, our messaging helped mainstream the concept that pursuing social good was also good for the bottom line. Sadly, that’s all it is, a hopeful idea. In truth, sustainable investing boils down to little more than marketing hype, PR spin and disingenuous promises from the investment community.
“In many instances across the industry, existing mutual funds are cynically rebranded as “green”—with no discernible change to the fund itself or its underlying strategies—simply for the sake of appearances and marketing purposes…. Risk managers are focused on protecting their investment portfolios from potential damages done by a worsening climate rather than helping prevent that damage from occurring in the first place.
“As disheartening as this reality is, claiming to be environmentally responsible is profitable. Last year alone, ESG mutual funds and exchange-traded funds nearly doubled. The investment community understandably reacted to this with cheers. But those cheers were only for fund managers and their bottom lines. No matter what they tout as green investing, portfolio managers are legally bound (as well as financially incentivized) to do nothing that compromises profits.”
Contrary to what seems to be foundational these days, he concludes that to “advance real change in the environment simply doesn’t yield the same return.”
He goes on to note that the SEC seems to be somewhat of the same mind in creating a Climate and ESG Task Force in the Enforcement Division to “proactively identify ESG-related misconduct,” suggesting that “there might be abuses that have gone unaddressed.” (See this PubCo post.) He concludes that “stalling and greenwashing” is causing “irreversible harm” ….all in the name of profits,” and calls on the government to “fix the rules.”
[Based on my notes, so standard caveats apply.]
The first panelist, from an investment bank, maintained that the existing voluntary frameworks, such as TCFD, provide a great foundation. She advocated that any new mandate be focused on investment decision-making and cautioned against the use of any mandate for broader public policy purposes. She supported a balanced principles-based system with some prescriptive elements as wells as specific metrics with some qualitative aspects that could be tailored to provide the information that is relevant to individual companies. However, investors are not homogeneous and it would be tough to come up with one framework that would please all. Over time, she said, there has been a growing convergence around some voluntary frameworks such as SASB, TCFD and GRI. She raised the question of how to approach disclosure regarding the substantial uncertainty inherent in some of these topics, such as climate—both physical and transition risks. Some companies, she said, are reluctant to provide this disclosure because of that uncertainty.
The next panelist, from an airline, explained that her company had previously provided a variety of disclosure, including verified greenhouse gas emissions, but, after BlackRock expressly advocated use of TCFD and SASB, the company began to align its disclosure with those frameworks. To begin with, they provided the qualitative TCFD disclosure, concerned about the potential that the quantitative data could convey false precision. She found TCFD to be a useful tool in leading the company to start to prepare and think more deeply about the impact of climate issues. The company also complied with SASB for airlines, which they appreciated for its tailored questions, such as its effort to address airline safety management systems. She noted that ESG compliance was very different from financial disclosure; for example, they needed to engage experts for help on some issues, such as climate scenarios. She agreed that a balance of qualitative and quantitative information would be preferable. She also observed that one unexpected benefit of compliance was the need and opportunity to engage on these issues with leaders across the company.
Another panelist, from an insurance company, laid out her five guiding principles:
- Focus on value rather than values. She thought that ESG had been usurped by interest groups concerned with broad societal issues rather than increasing shareholder value over time. She argued that politicizing ESG would ultimately alienate some customers and employees, but employees should be able to “bring their whole selves” to work. She advocated that the SEC concentrate on shareholder value and not stray into politics and social goals. (A Committee member later observed that some investors don’t want to segregate value from values.) Companies understand that they need to consider other stakeholders, such as communities and employees, but that doesn’t make all of that information material, she contended. She also argued that giving a small unelected group, such as the leaders of corporate America, the power to make policy decisions (outside of shareholder value) would weaken democracy.
- Any disclosure requirement should be based on materiality. In her view, the fact that some investors want to see certain information doesn’t by itself make the information material. In addition, she raised the risk of information overload. For example, in her experience, when an investor asked for EEO1 information, they couldn’t explain why they wanted it and what they would do with it.
- Any requirements should be principles-based and not prescriptive. A single blueprint for everyone, she said, is enticing, but it wouldn’t provide companies the flexibility to disclose the most appropriate information for each company. Management is best able to determine materiality, and any mandate the SEC adopts should allow management the discretion to make that determination. This is a new field, and the SEC should proceed with caution and humility.
- The SEC should provide a safe harbor to mitigate the risk of liability.
- Any disclosure requirements must go through the regulatory approval process of the APA. If instead, the SEC mandated the use of a framework from an unregulated body, her fear was that changes could be made in that framework outside of the regulatory process.
The final issuer panelist, from an association representing electric companies, described his association’s role in developing the industry ESG template. The template was developed with input of various stakeholders, especially investors, and is regularly reassessed and refined. He shared some of the lessons learned:
- ESG is evolving. Issues such as cybersecurity, privacy and diversity have grown in importance over time. He advocated a principles-based standard that would allow companies to apply different weights to various issues, depending on the industry. For example, while child labor might be an important issue in the clothing industry, it might not be relevant at all in the tech space.
- Not all ESG is financially material and not all is appropriate for disclosure where there is no impact on investment decision-making. He recognized, however, that some ESG issues that are not financially material initially may become so over time.
- More ESG information is not necessarily better. He learned from investor feedback that they wanted the disclosure to be clear and concise, such as in a dashboard format. Some companies may provide voluntary 90-page sustainability reports, but investors have told him that they aren’t able to use all that information. The industry template provides for disclosure about two qualitative and four quantitative factors aligned with TCFD. He also thought there should be some description of the forward trajectory.
- He advocated adoption of a safe harbor. For example, Scope 3 information is difficult to ascertain and could be inaccurate. He also advocated that, because of the potential for liability, any disclosure mandate not require disclosure to be included in SEC filings.
- He hoped that the SEC would take the costs into account (such as the need for engagement of specialists, as noted above.) The template asks for information about direct emissions only, but global Scope 3 emissions are very hard to determine and costly to compute.
There was also some discussion of ESG raters and rankers, which request all kinds of information from issuers, and those requests are often bespoke. The SEC, it was suggested, might be able to provide some relief there.
Asset manager panel
Representatives of two asset managers also spoke. The first representative (from BlackRock) emphasized her company’s view that climate risk is investment risk and has significant impact on returns. She advocated that the SEC impose mandatory standards, but recognized that the materiality of information can change. Investors need clarity and struggle with the different standards. She also saw problems with greenwashing. They would like to see full implementation of TCFD, including disclosure of Scope 1 and 2 and, for heavy carbon emitters, Scope 3, along with information about short-, medium- and long-term targets. Investors want to see information about GHG emissions and other information to help them build net-zero portfolios. She also thought that sustainability needed to be embedded in governance. She hoped the SEC would work with international regulators to help shape the outcomes of international efforts. She agreed that the SEC should balance principles and metrics, and suggested that, at the early stages, a “best efforts” approach may be appropriate. She also asked about disclosure for private companies; the absence of some requirements for private companies could lead all carbon-intensive companies to remain private.
The second representative (from Wellington) advocated adoption of an industry-specific mandates that provide clear standards for disclosing information material for each industry. Currently, there is a lack of standardization, and requests are fragmented and require costly responses. She also agreed that some ESG disclosure should be required of private companies. In addition, she observed that there is a misperception that, if information is not in an SEC filing, it’s not subject to any disclosure standards. She advocated leveraging the work of existing standard setters, even if not adopted wholesale, and harmonizing standards.