Earlier this week, SEC Commissioner Allison Lee delivered keynote remarks at the 2021 ESG Disclosure Priorities Event hosted by the AICPA, the Chartered Institute of Management Accountants, SASB and the Center for Audit Quality. Her topic: “Myths and Misconceptions about ‘Materiality.’” In the context of the discussion about potential mandatory ESG disclosures, Lee observed, there has been a lot of attention to the concept of materiality, which is fundamental to our securities laws. The public company disclosure system “is generally oriented around providing information that is important to reasonable investors,” and “the viewpoint of the reasonable investor is the lens through which we all are meant to operate.” Since investors are the ones who make the investment choices, “investors are also the ones who decide what information they need to make those choices.” But, in the course of the ongoing discourse about ESG, Lee has found that a number of myths have proliferated about the role and meaning of materiality; her purpose in these remarks is to dissect and dispel those myths, which she believes have hampered the “important debate on how best to craft a rule proposal on climate and ESG risks and opportunities.”
“Myth #1: ESG matters (indeed all matters) material to investors are already required to be disclosed under the securities laws.” The most prevalent myth, Lee contends, is the myth that the securities disclosure system already imposes an affirmative duty to disclose all material information, but she reminds us, that “is simply not true, and reflects a fundamental misunderstanding of the securities laws….Rather, disclosure is only required when a specific duty to disclose exists.” And, she observes, an affirmative duty arises only under specific circumstances, among them, an SEC regulatory requirement, a sale or purchase by the issuer of its own stock, when leaks or rumors in the marketplace are attributable to the issuer or when the issuer is already speaking on an issue and information is necessary to make the issuer’s statements accurate or not misleading. For example, in Basic v. Levinson, Lee notes, the duty to disclose pre-merger negotiations arose out of public statements the company made asserting that it was unaware of any developments that might explain high trading volumes and price fluctuations in its shares.
Her prime example is political spending, an issue that can be extremely important to reasonable investors, particularly because shareholders want to be able to assess the use by companies of shareholder funds for political influence. But, despite rulemaking petitions and other efforts, there are no SEC requirements to disclose political spending and, as a result, it’s rarely disclosed in SEC reports. (As she notes, the SEC is currently prohibited by Congress from spending funds to finalize a rule on this subject.) Arguably, she continued, companies’ public statements after the events of January 6 regarding their political spending could “give rise to a duty to disclose their actual political contributions—not unlike the duty to disclose merger negotiations in Basic—to ensure that such statements are not misleading, especially if actual contributions run contrary to these pledges. But such a duty would arise only based on discretionary statements made by management, not solely on the basis that information regarding political contributions is material to investors.” In the end, she said, “absent a duty to disclose, the importance or materiality of information alone simply does not mandate its disclosure.”
Noting the 2010 staff guidance, which identifies four requirements in Reg S-K that could give rise to obligations to make disclosures regarding climate (for a summary, see this PubCo post), Lee explained that the securities laws “currently include little in the way of explicit climate or other sustainability disclosure requirements. In many instances, therefore, disclosure may be required only when a particular discussion of climate is collateral to something else disclosed by the company. The same is true for many ESG matters that lack express disclosure requirements. Thus, climate and ESG information important to a reasonable investor is not necessarily required to be disclosed simply because it is material.”
“Myth #2: Where there is a duty to disclose climate and ESG matters, we can rest assured that such disclosures are being made.”
One of the problems associated with principles-based rulemaking that elicits disclosures based simply on materiality is that it “presupposes that managers, including their lawyers, accountants, and auditors, will get the materiality determination right. In fact, they often do not.” This point is reinforced, she suggests, by the many SEC enforcement cases that “reveal infirmities in materiality determinations, as year after year the SEC brings scores of cases for negligence in making these assessments.” Even though materiality determinations are supposed to be based on the “reasonable investor standard,” they are, at least initially, made by management, who can be, some might say, almost preternaturally optimistic about their businesses: “Management may view matters with an enthusiasm that reflects a belief in the nature and direction of their business. Developments that investors may see as negative and in need of disclosure may be viewed by management as a temporary aberration or even a positive development. That is, in part, why the system builds in checks and balances.” But lawyers and auditors who perform these checks “can also get the decision wrong,” and may see materiality differently than do investors. Moreover, she contends, both lawyers and auditors may have incentives or implicit biases “to agree with management, particularly on close cases.They have an economic and psychological incentive to want to retain positive relations with management,” which, she maintains, can cause them “to often expend efforts to support, rather than independently analyze, management’s decisions.” Lee concludes that a “disclosure system that lacks sufficient specificity and relies too heavily on a broad-based concept of materiality will fall short of eliciting information material to reasonable investors.”
“Myth #3: SEC disclosure requirements must be strictly limited to material information.”
Lee views this myth as a “widely held assumption. However, this is affirmatively not what the law requires, and thus not how the SEC has in fact approached disclosure rulemaking.”
Rather, the SEC has broad statutory rulemaking authority that is not qualified by “materiality.” Where materiality does come up is in connection with the anti-fraud rules, “such as Rules 10b-5 and 14a-9, where it plays a role in limiting how much information must be provided. In other words, materiality places limits on anti-fraud liability; it is not a legal limitation on disclosure rulemaking by the SEC.” Historically, she observes, Reg S-K has always required disclosure that is “important to investors but may or may not be material in every respect to every company making the disclosure. We have done this, for example, with respect to disclosures of related party transactions, environmental proceedings, share repurchases, and executive compensation.” For example, the requirement to disclose environmental proceedings has a bright-line threshold of $1 million—and, until recently, it was $100,000—without regard to materiality. Similarly, the prescriptive requirements for executive comp, such as the comp tables, include a number of metrics that may not be material to all companies, but are still required to be disclosed. (As noted above, Jackson and Coates used perk disclosure to illustrate the same point.) And without these types of broadly applicable requirements, “comparability would be sacrificed almost completely. Indeed such an approach would be at odds with modern capital markets which have become increasingly comparative in nature thus requiring at least some specific metrics in order to make appropriate comparisons. The idea that the SEC must establish the materiality of each specific piece of information required to be disclosed in our rules is legally incorrect, historically unsupported, and inconsistent with the needs of modern investors, especially when it comes to climate and ESG.”
“Myth #4: Climate and ESG are matters of social or ‘political’ concern, and not material to investment or voting decisions.”
Here, Lee argues that, rather than climate’s being just a political concern, the idea that “scientifically supported risks like those associated with climate change” should be ignored is what’s really questionable. And just because ESG has political or social significance does not preclude its being material; rather, “all manner of market participants embrace ESG factors as significant drivers of decision-making, risk assessment, and capital allocation precisely because of their relationship to firm value. Finally, investors, the arbiters of materiality, have been overwhelmingly clear in their views that climate risk and other ESG matters are material their investment and voting decisions.”
In conclusion, Lee hopes that dispelling these myths will help advance the debate about crafting a rule proposal on climate and ESG.
[The following is based on my notes, so standard caveats apply.]
At the end of Lee’s remarks, in response to questions from the moderator, Lee observed that the work on ESG standards being done by international standard setters holds promise, as she saw it, especially because global sustainability standards could provide baseline standards, while allowing each country to provide its own particular twist. She was also asked about the move in the EU to “double materiality” and “dynamic materiality.” In her view, it was not clear that these standards were all that different from our own concept of materiality. With regard to dynamic materiality, we also view materiality as flexible and changing over time. As for double materiality, in Lee’s view, external impacts will be internalized at some point, so even the concept of double materiality may not be all that different from our own perspective.
As part of the program, speakers from SASB and Travelers Insurance that followed Lee were asked to comment on her remarks. The CEO of SASB noted that the reasonable investor concept has served the markets well but is becoming harder to apply in practice in light of the current huge array of investors that employ different strategies. But that is why standards are beneficial in helping to build consensus. She also observed that SASB supported SEC action on climate, but advocated a broader ESG framework. The reality, she continued is that current sustainability disclosure is being used by investors, but is not on always on a solid foundation and needs standards. Investors need comparability to make investment decisions, so they end up buying ESG scores, which would benefit from standards.
The VP and Chief Sustainability Officer from Travelers made three points: she urged the SEC to ground any new ESG disclosure regime in materiality; she feared that a failure to do so could politicize the ’34 Act and the role of corporations, which could harm companies, employees and shareholders. She also encouraged the SEC to take into account the significant costs of ESG compliance, which can involve $1 million or more and thousands of employee hours. In that regard, she said, a prescriptive or one-size-fits-all approach not tied to materiality could be problematic. Finally she asked whether comparability should really be the desired goal and driver of ESG rulemaking? There are many differences among companies—in geographies, size, strategies and other characteristics—and the emphasis on comparability could lead to less meaningful disclosure and more costs. Companies, she said, are doing the best they can with disclosure, but would embrace more guidance. Investors have not coalesced around topics and have wildly divergent requests for information. We need to keep in mind, she said, that ESG is a really new field—as we approach it, we need some humility.
The moderator from the Center for Audit Quality observed that calls for ESG assurance seemed to be increasing. Looking at the S&P 100, 80% provided assurance for some metrics, such as GHG. The CEO of SASB agreed that there was an increasing pull for assurance, especially in the EU. In contrast, the Travelers VP asked why ESG disclosures should be treated differently from any other disclosures; auditors provide assurance only with respect to the financial statements, not the surrounding text.
