The Securities and Exchange Commission has two basic types of rules relating to Environmental, Social, and Governance (ESG) disclosures. The first are “line item” requirements for particular subject matters. The second are antifraud rules generally requiring materially accurate and complete disclosures. The antifraud rules apply to voluntary ESG disclosures as well as mandatory disclosures.
A. Existing ESG Disclosure Requirements
1. General Line Item Requirements
Certain ESG-type disclosure requirements are required under existing SEC regulations. For example, Regulation S-K requires that public companies disclose (a) the terms and conditions of compensation for executive management and board members, and certain of their transactions with the company, (b) the ratio of the compensation of the company’s principal executive officer to the median of the annual total compensation of all other employees, and (c) ownership of and transactions in securities of the company by board members, executive management and certain large shareholders.
2. Specific ESG Line Item Requirements
SEC’s regulations also require disclosures in certain specific matters that fall within the scope of ESG. One is disclosure by an operator of a coal or other mine concerning mine safety. Another is the obligation of companies engaged in the extraction of natural resources to disclose payments made to governments for the purpose of the commercial development of oil, natural gas, or minerals. A third is a requirement for disclosure of information concerning the source of certain minerals, if used by the company, that may originate from the Democratic Republic of the Congo. The latter rule has been the subject of lengthy litigation that has been adverse to the SEC and its status is largely unresolved. The SEC is considering what to do with respect to the conflicts minerals rule.
B. Antifraud Rules
1. Prohibition of Lying Directly and Through Omission
When a company subject to the SEC’s jurisdiction makes any ESG disclosure whatsoever, in an SEC filing or anywhere else, voluntarily or pursuant to regulatory requirement, it must comply with the SEC’s antifraud rules.
SEC Rule 10b-5 prohibits materially untrue statements and lying through material omissions. This rule creates a potential source of legal liabilities for ESG disclosures, especially because it requires a company to include all material negative information necessary to make its statements completely truthful.
To establish a violation of Rule 10b-5, the SEC must prove that a person or company acted intentionally or recklessly. However, when a person or company was negligent, the SEC can apply Section 17(a) of the Securities Act of 1933. Subsection (2) of Section 17(a) also prohibits materially untrue and incomplete statements and applies when a company was merely negligent.
If a misstatement or omission is immaterial, there is no violation of the antifraud rules. A fact is material if there is “a substantial likelihood that the ... fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.” This is an objective standard, meaning that materiality is not defined by the subjective perceptions of particular investors, but by what the court considers to be material under this definition.
The test of materiality does not limit the type or breadth of information that may be considered by the reasonable shareholder. ESG matters have become increasingly important to investors and money managers. A company’s willingness to satisfy market demand for ESG engagement and disclosure can affect the financial performance of its stock. Thus, ESG has become a matter of dollars and cents, and that brings it within the realm of materiality.
3. Stock Exchange Rules Require Disclosure of All Material News and Information
The SEC antifraud rules do not mandate disclosure of all material information a company has, but only require that companies make complete and accurate statements when they do speak. However, stock exchange rules require disclosure of all material news and information relating to a listed company. These rules concern information that may move the market price of a company’s stock, and some ESG information could arguably not fall within this category. However, readers should appreciate that disclosure may be required under stock market rules even if the SEC would not require it.
4. All ESG Disclosures Are Subject to the Antifraud Rules
All disclosures that can reasonably be expected to reach investors and the securities markets are subject to the antifraud rules. This means that, ESG disclosures must comply with the antifraud rules even if they are primarily directed at consumers, employees, communities, or other constituencies besides investors.
5. Duty to Correct, Update and Make Specific Disclosures
When a company realizes that the statement previously made was materially incorrect, the company should disclose corrective information. It should update prior accurate disclosures when subsequent events render them materially inaccurate or misleading. A company should also disclose specific material information it has about a matter, even if it has warned of such a matter in general, “boilerplate” disclosure.
Mandatory ESG disclosures should be made as required by the SEC’s regulations and forms. However, the larger part of the ESG disclosures public companies are voluntarily made in separate sustainability reports. These reports are written in a positive, upbeat tone that paints a rosy picture of virtuous corporate citizenship, and projects an aura of public relations. Even though ESG disclosures offer an opportunity to burnish the company’s image, they are subject to the antifraud rules of the federal securities laws. Materially inaccurate or incomplete statements could result in legal liability.
Companies should not rely on disclosure of negative information elsewhere, such as in financial reports filed with the SEC. Each statement in ESG disclosures should be materially complete by itself.
A company may be able to deflect legal liability by claiming that its ESG statements were puffery or aspirational expressions too general to be subject to legal action. However, courts have sometimes found that ESG disclosures can result in securities law liability.
In addition, general, aspirational and approximate wording used to avoid securities law liability may have little or no value to ESG stakeholders. In seeking to avoid legal liability, the company may fail to serve the purposes of ESG disclosure. A company may well be better off making meaningful and informative ESG disclosures while accepting the responsibility to ensure that those disclosures are materially accurate and complete.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Readers seeking more detailed information should consult Bloomberg Tax & Accounting Portfolio 5506-3rd, Wang, Corporate Governance of the Financial Reporting Process and SEC Regulation of ESG Disclosures (Accounting Policy and Practice Series).
Mr. Wang is a former Assistant Director, Division of Enforcement, of the U.S. Securities and Exchange Commission. During a 22-year career at the SEC, Mr. Wang received the Chairman’s Award For Excellence, the Stanley Sporkin Award, the Capital Markets Award and the Division of Enforcement Director’s Award. Mr. Wang was also elected to Phi Beta Kappa, Phi Kappa Phi, the Order of the Coif and the editorial board of the Wisconsin Law Review, and is a member of the District of Columbia Bar and State Bar of Wisconsin.