Can the SEC Make ESG Rules that are Sustainable?

Thank you Gary [LaBranche] and the National Investor Relations Institute for inviting me to speak at your 2021 Virtual Conference. Of course, I will clarify up front that the views I express are my own and do not necessarily reflect those of the Commission.

I. Introduction

I appreciate the unique and important role Investor Relations (“IR”) teams play in our capital markets, serving as a primary channel for communication between companies’ leaders and groups such as analysts, as well as asset managers and investors who hold ownership positions in those companies. It seems that an increasing amount of that communication involves environmental, social, and governance (or “ESG”) matters. Looking through this conference’s three-day agenda, eight of the forty scheduled sessions are devoted to ESG and related topics. It would not surprise me to hear that IR teams spent at least a similar proportion of their work days focusing on these issues.

You no doubt know that the Commission has increased its attention on ESG matters as well, and the Chair has expressed his intent to propose new disclosure requirements relating to climate change and human capital.[1] I recently shared my belief that the Commission will need to find answers to several questions before it is able to promulgate such rules that would stand the test of time and fit into our historic frameworks.[2] While the complete list is longer, there are three questions I will focus on today:

1. What precise items of “E,” “S,” and “G” information are investors not getting that are material to making informed investment decisions?
2. If we were able to identify the information investors need, how would the SEC come up with “E” and “S” disclosure requirements—now, and on an ongoing basis? What expertise do we need?
3. If the SEC were to incorporate the work of external standard-setters with respect to new ESG disclosure requirements: how would the agency oversee them—in terms of governance, funding, and substantive work product—on an ongoing basis? And what kind of new infrastructure would be required inside the SEC and at the standard-setters themselves?

II. What’s Missing?

The question of what ESG information is missing in our markets is first and foremost a question for investors. But it has been instructive to hear companies share perspectives about how they have engaged with investors on ESG issues. I have yet to hear a company tell me that ESG is not important, and that it ignores ESG information requests. Instead, I often hear from companies that they are constantly asked to provide ESG information; that they feel they must comply with all or a large majority of the requests; that the multitude of requests can be overwhelming; and that each request requires special attention because it is similar to, but different from, the last. To address the difficulties companies face in meeting these overlapping requests, it has been suggested to me that the Commission should act to standardize disclosures. In a similar vein, institutional investors and asset managers have advocated for the Commission to facilitate companies providing ESG information that is more comparable than that which is available from companies now.

A. Can the SEC Find It?

It is tempting to think that the Commission could provide one list of ESG disclosures for companies to make that would satisfy all demands for information. But I am not sure that is a role we can play at this time. First, I suspect there is a reason for the differences among ESG disclosure requests. This variation likely reflects the requestors’ different objectives and uses for the information.[3] Also, it is not clear to me that investors have yet settled on an agreed list of information that they want from companies. Instead, it sounds like there is evolution in this area and in companies’ practices for providing ESG information to investors.

I worry that by stepping in to promulgate a static list of ESG disclosure requirements, the SEC would displace a good amount of this private sector engagement and freeze disclosures in place prematurely. In the area of climate-related disclosures in particular, we have continuing development in scientists’ projections of what physical risks we can expect climate change to present to companies and their assets on various time horizons. There’s potentially even more rapid development in which benchmarks people believe companies should consider when they disclose their so-called “transition risk,” or their ability to compete in a low-carbon economy.[4]

SEC rule-writing is slow by design. When we enshrine new disclosure requirements in our rules, we want to feel confident that they will be appropriate and relevant for many years to come, since the Commission normally does not revisit them for some time. It is not clear to me that we have sufficient certainty about what is and, crucially, will continue to be material information for new line-item ESG disclosures.

As the Commission considers rule proposals in these areas, I hope we will look at how companies and investors have engaged on these issues over time and what solutions the market has come up with for devising and communicating ESG information. We should learn from these efforts and understand the motivations behind their development. In particular, we should be clear on what information, exactly, is missing from the many types of ESG disclosures companies are already providing. If the problem is one of standardization rather than content, we must similarly understand the contours of the disclosures investors need before we establish our own template from the many already in existence.

B. Remember the Bottom Line: Materiality

In developing any new disclosure requirements, including those related to ESG, I believe that the Commission should act consistently with our historic approach by focusing on what information is material to an investment decision.

The concept of materiality is used throughout the federal securities laws, and the Commission itself has used a definition of materiality since at least 1937.[5] Supreme Court Justice Thurgood Marshall is often credited with articulating the concept of materiality, when his opinion in the case TSC Industries v. Northway described an item of information as material if there is a substantial likelihood that a reasonable investor would consider the information important in deciding how to vote or make an investment decision.[6] But in fact, the Commission itself informed the Supreme Court’s confidence in the materiality principle, advocating for it as an amicus in this same case.[7] Justice Marshall’s opinion described how the SEC has broad statutory authority to promote “the public interest” and “the protection of investors,” and gave due consideration to the SEC’s view of how to strike the “proper balance between the need to insure adequate disclosure and the need to avoid the adverse consequences of setting too low a threshold for civil liability.”[8]

The Commission has held fast to the materiality principle throughout its efforts to design our corporate disclosure regime under the federal securities laws. Indeed, even disclosure requirements that, on their face, do not appear to have materiality qualifiers were crafted by the Commission with materiality as a guiding principle.[9] I believe, as the Commission continues to consider new potential disclosure requirements, we should continue to use materiality as our touchstone.[10]

In describing the materiality standard, it is important to note whose perspective Justice Marshall focused on: that of a reasonable investor.[11] While neither he nor our regulations or statutes define the term “investor,” it is relevant that the basic test we use to determine whether something is a security includes as an element an “expectation of profit,”[12] a characteristic that aligns with the dictionary definition of “investor.”[13] So, while any given shareholder may have bought securities for reasons other than or in addition to making money, it seems clear that a “reasonable investor” is someone whose interest is in a financial return on an investment.[14] In carrying out its role as a federal securities regulator, that is where the Commission must continue to focus: it should assess the merits of any potential disclosure requirements against the question of whether a reasonable investor would consider them material—that is, to a company’s financial value.

C. The Unique Role and Authority of the SEC

This is an important point to clarify. Legislative bodies in other countries have taken different approaches, intentionally motivating asset managers or businesses operating there to pursue explicitly societal goals, including environmental sustainability.[15] These actions have contributed to the creation of international ESG disclosure frameworks that many U.S. financial market participants are now following. But, we must remember that the SEC has no legislative mandate to make rules for the U.S. financial markets to further these same societal objectives.[16] If our Congress wishes to follow suit, it certainly can; in fact just last week, the U.S. House of Representatives voted on a measure addressing ESG issues.[17] But as of now, when the Commission considers what to require in its own ESG rules, we should not merely copy the requirements of the international standards, given the different mandates.

We have to look at the issue through our own three-part mission and assess how the types of information other standards require companies to report, such as greenhouse gas emissions, are material to investors. If such information is relevant primarily for purposes of a climate-focused goal, then I question how the SEC is the appropriate agency to undertake requiring its disclosure. The U.S. has other federal regulators (e.g., Environmental Protection Agency) with mandates and expertise to address these issues. In some instances, the appropriate body may not be a regulatory agency at all. To the extent that there are issues included within the ESG umbrella that remain contested among American voters, I believe that such debates are properly and appropriately held amongst Americans’ elected officials, either at the state or federal level. Unelected federal regulators should be careful to avoid circumventing the will of the people or undermining state sovereignty.

D. Who Represents “Investors?”

Assessing what ESG information investors deem important is no easy task. The interests of actual investors—that is, individuals who beneficially own investments (let’s call them “true investors”)—often are conflated with those of institutional investors and asset managers. To be sure, these groups offer important perspectives in policy-making; some of the most helpful information I have seen on ESG is from asset managers explaining how, specifically, they have used particular items of ESG information to inform their investment allocation decisions. But, in general, we have to be mindful that asset managers’ interests are not necessarily the same as those of true investors.

In the context of advocating for SEC-mandated ESG disclosures, asset managers in particular have certain conflicts of interest.[18] For example, many are subject to European requirements to report on how securities they hold in their investment portfolios impact certain ESG factors, including climate-related issues and others.[19] Of course increased comparability in U.S. companies’ ESG reporting would make it easier for asset managers to fulfill those regulatory obligations. But, I’m not sure that this benefit to asset managers would be relevant to the true investors in our markets; and the costs of imposing prescriptive disclosure requirements on U.S. companies, in order to yield the kind of comparable information asset managers are searching for, would be borne by all U.S. companies and their true investors (not just asset managers themselves).

This is all to say that, to the extent that the Commission is, properly, looking to gauge investors’ interest in ESG information as an indicator of materiality, we must be careful we are actually looking at the interests of true investors and remaining cognizant that others, who might claim to represent them, can have different concerns.[20] Many have pointed to the increasing amounts of money that retail investors are allocating to funds labeled “ESG,” “green,” and the like as an indication that retail investors consider ESG issues important in investing.[21] But, it is not clear to me that we understand these investors’ objectives, which (as the SEC’s Asset Management Advisory Committee has noted) may “fall outside risk/return alone.”[22] To the extent that investors’ objectives are unrelated to risk/return, it is hard to see how the information relevant to those strategies could be considered material, per the SEC’s historical understanding of the term. With regard to products that have stated objectives outside of profit-seeking, the SEC’s regulatory role should be limited to making sure that those products comply with our existing rules.[23]

III. Adding New “E” and “S” Resources at the SEC

Beyond the challenge of keeping focused on materiality, the Commission must consider how it will acquire and maintain the expertise to develop and oversee a disclosure regime that includes specifically “E” and “S” information. Our agency’s staff is predominately composed of lawyers, accountants, and economists, all of whose principal expertise is in financial markets. We do not have, for example, climate scientists on staff. It is fair to question how our staff is equipped to determine which climate or environmental information—such as various measures of companies’ greenhouse gas emissions, or strategies for adapting to future climate scenarios—is material to an investment decision today. Given how quickly research in these areas is developing, it raises additional questions on how, and how often, the Commission would update these standards over time.

IV. Third-Party Standard-Setters

Some have advocated that the Commission rely on the work of one or more external third parties to devise and maintain updated ESG disclosure standards and then incorporate those standards into our regulatory regime. While this approach seems expedient and responsive to concerns about expertise, we have to acknowledge that this is not a “plug and play” solution.

A. Not So Fast With FAF and FASB

Looking at the SEC’s historical reliance on the Financial Accounting Foundation (“FAF”) and the Financial Accounting Standards Board (“FASB”) to devise accounting standards, we can foresee some of the challenges the Commission would face in taking this approach. The Commission largely deferred to the private accounting industry to set standards for financial statements since the Commission’s creation in 1934.[24] But the 1960s saw a period of heightened public participation in the capital markets and increasing amounts of company information flowing to investors, straining the existing standards-setting system.[25] The Wheat Report, commissioned by the SEC, provided recommendations to re-design the system of accounting standards-setting, and these recommendations eventually gave rise to FASB, an independent regulatory body overseen by the Commission.[26]

The SEC’s relationship with FASB developed over the ensuing decades,[27] but it is telling that concerns raised in the Wheat Report have continued to surround FASB since its inception. For one, there was a fear about the standard-setter’s independence and credibility being compromised by its funding sources and proximity to the industry it regulates.[28] While FASB’s funding issues were mostly resolved after the Sarbanes-Oxley Act (“SOX”) required public companies to pay “accounting support fees,”[29] questions persist about FASB’s independence from market participants and how much influence other groups, including investors, should have inside the organization.[30] Also, though the SEC has long maintained that the Commission and FASB work independently but towards common goals,[31] critics have questioned whether the level of control the Commission has over FASB compromises FASB’s independence from the political process.[32]

Setting aside policy debates over whether the Commission has struck the right balance in overseeing FASB, the practical reality is that the SEC uses significant resources in carrying out this work. Former SEC Chair Mary Jo White put it well when she said: “[T]he work is not done when [FASB’s] standards are set.”[33] She went on to describe how the setting of a new standard leads to much more work for FASB and the SEC, when one considers the level of monitoring and guidance needed to promote consistent application of the standard over time. The SEC’s Office of the Chief Accountant (“OCA”), a group of nearly 50 people,[34] spends much of its time serving as the primary liaison with FASB, FAF, and the Public Company Accounting Oversight Board and monitoring these entities’ work. Beyond OCA, the Commission has accountants throughout the agency, particularly in the Division of Corporation Finance, who provide expertise necessary to review filings to monitor and enhance compliance with accounting requirements. The Commission also has accountants in our Division of Enforcement, who pursue accounting-related enforcement actions.

Overall, I think the FAF and FASB have done excellent work, and the Commission’s relationship with these organizations has benefited the agency, as well as investors and our markets. But, this did not happen overnight, and we have worked through many issues along the way to get to this point. So, if the Commission were to consider incorporating a third party’s ESG standards into SEC rules, we should certainly learn from our experience with FASB. That would mean thinking through how such an entity should be governed, funded, and staffed; how the representation of investors, industry participants, and other experts in the organization should be calibrated to best serve the Commission’s objectives; and how the Commission’s need to oversee the entity’s operations should be balanced with the standard-setter’s need to remain independent from political pressures. The Commission would also need to make sure that its own staff had adequate resources to carry out its monitoring and enforcement responsibilities. Since the world of ESG involves many more stakeholders and more potential areas of expertise than the world of accounting—including in environmental science and others—I fear that the challenges we have grappled with over the course of our history with FASB will be even more difficult to mitigate and manage in this new context.

B. Who and How Many?

Aside from all of these concerns, the Commission would have to choose the standard-setter or setters to rely on and explain how its choice serves its objectives in promulgating new disclosure rules. As I have noted above, the proliferation of ESG disclosure frameworks suggests that the standards have not yet settled. In recent years, however, there have been movements amongst existing standard-setters to work together toward harmonizing their standards and frameworks, where possible.[35] Such harmonization efforts are still in their early days.[36] If the Commission were to pick one third party to set standards that would be recognized in its rules, we would risk cutting short these efforts and artificially constraining the development of true consensus in this area. If the Commission instead were to pick several different entities, we would likely exacerbate the challenge of conducting effective oversight.

V. Conclusion

Let me conclude by saying that I have presented all of these questions and concerns for consideration because I believe that doing so will help the Commission in the challenging task ahead. These questions, while not necessarily insurmountable, are nonetheless essential to the process of crafting rules that are sustainable. While I have expressed reservation, my mind is not made up on any of these issues. Indeed, I am eager to learn more and invite anyone who is willing to engage with me.[37] My door is open.