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Portfolio > Portfolio Construction > ESG

SEC's ESG Plans for Public Companies May Get Frosty Reception in Court

By Nicolas Morgan

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What You Need to Know

  • Courts have not looked favorably on requiring public companies to disclose information not necessary for preventing deception in investing decisions.
  • The changing views of investors on the importance of ESG disclosures may be more impactful than new SEC regulation.
  • Gary Gensler told Senators that any new ESG disclosure rules would be based on what is “material to reasonable investors.”

Investors rightly demand that public companies disclose lots of information important for making investment decisions. As a result, public companies are often a useful target for disclosure of all sorts of information of general social interest even if that information is not important for making investment decisions.

The current calls for the Securities and Exchange Commission to compel disclosures of certain environmental, social and governance information may become a case in point. To the extent proposals suggest disclosure of information that a reasonable investor would not find significant to a trading decision, such proposals are on dubious legal footing.

Courts have not looked favorably on requiring public companies to disclose immaterial information not necessary for preventing deception in investing decisions even if the information may be of general public interest.

But as investors (rather than regulators) place greater importance on obtaining ESG information from public companies, existing laws will support greater disclosures.

Sea Change at SEC on ESG

What a difference a year makes — particularly for public companies trying to determine what sorts of disclosures to make about ESG issues.

This time last year, the SEC confirmed the long-standing requirement that companies were required to disclose all material information — on whatever topic — that would be necessary to avoid making management’s discussion and analysis of a company’s operations misleading.

This year, there are calls from Congress, the acting SEC chair and senior SEC staff suggesting that something more should be required — particularly regarding climate change issues.

Today’s calls for ESG disclosures stem in part from recommendations made by the Task Force on Climate Related Financial Disclosures, established in 2015 by a global group of regulators.

The TCFD “believes climate-related issues are or could be material for many organizations, and its recommendations should be useful to organizations, and its recommendations should be useful to organizations in complying more effectively with existing disclosure obligations.”

The TCFD’s recommendations appear to recognize the importance of aligning disclosures with what is important to investors.

This tension over climate change disclosures beyond what is material came to a head during the March 2 Senate Banking Committee hearing on Gary Gensler’s nomination to become chair of the SEC.

Sen. Pat Toomey, R-Pa., followed up on Gensler’s statement that investors “really want to see climate risk disclosures,” and that any new disclosure requirements would be based on what is “material to reasonable investors.”

Toomey asked Gensler whether, hypothetically, he would consider a company spending a “financially insignificant amount of money on electricity” to be material, and Mr. Gensler suggested the answer would be nuanced and based on the total “mix of information” rather than an isolated expenditure.

Gensler’s answer suggests that he would not support requiring public companies to make disclosures beyond the material information that is already required to be disclosed. But, assuming his nomination is confirmed, the political pressure on Gensler to approve broader disclosures will be immense.

Courts Filter Out Insignificant Info, Protect First Amendment Rights

For decades, courts have recognized the benefit of using materiality as a guiding principle for disclosure (rather than imposing a laundry list of items that must be disclosed whether or not material).

For one thing, multiple judges have concluded the materiality principle weeds out insignificant information of “dubious significance” that could result in “an avalanche of trivial information.”

Similarly, going back to at least the 1970s, the Commission recognized that requiring disclosure of all non-material information about “social matters in which investors may be interested … would in the aggregate make disclosure documents wholly unmanageable and would significantly increase the costs to all involved without, in our view, corresponding benefits to investors generally.”

Despite the long history and current support behind requiring disclosure of information only if it is material to investment decisions, some advocates would require disclosure of ESG information regardless of whether it is material or not. We have been down this road before.

The Dodd-Frank Act, passed after the financial crisis of 2008-2009, required public companies to disclose whether their products contain “minerals that directly or indirectly finance or benefit armed groups in the Democratic Republic of Congo or an adjoining country” and describe its products as not “DRC conflict free.”

Unlike most securities disclosure laws, Congress imposed the conflict mineral disclosure requirement for a humanitarian purpose: to reduce trade in minerals from the DRC.

In the absence of public companies deceptively using the “conflict free” label to sell securities, a federal appellate court concluded that compelling such disclosure — even for a laudable humanitarian purpose — violated the First Amendment’s right to free speech.

Where Next for ESG?

Federal securities laws already require public companies to disclose material information, including ESG information, to ensure companies’ disclosures are not misleading.

Beyond preventing deception in securities transactions, the federal securities laws make a poor tool to compel disclosure of information that is not material to investors — even if the disclosure achieves some other laudable social purpose.

But information that may be immaterial to shareholders at one point in time may become material at a later point in time. Many large institutional investors have been vocal about the importance to them of public company disclosure on ESG issues.

Ultimately, the changing views of investors on the importance of ESG disclosures may be more impactful than any new SEC regulation.

Nicolas Morgan

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