Environmental, social and corporate governance (ESG) concerns have become an increasingly important metric in the corporate world
Increasingly, corporate responses to public events are splashed all over the news and social media, allowing customers, counterparties, investors and employees to follow corporate ESG developments closely.
However, these are not the only constituencies about which companies, and their general counsel, should be concerned. Lately, the US Securities and Exchange Commission has intensified efforts to address ESG concerns, emphasizing the environmental component especially.
Until very recently, sustainability issues were mostly not seen as central to financial performance or material to investors – or government regulators, for that matter. Then, with the changing of the guard at the SEC after the 2020 election, along with an intensification of interest by investors, US regulators radically altered course. In the first few weeks of the Biden administration, the SEC created a nationwide Climate & ESG Task Force in its Division of Enforcement, signaling its intent to make this a priority in its enforcement agenda.
This was coupled by a directive to the Division of Corporate Finance “to enhance its focus on climate-related disclosure in public company filings” as well as additional ESG-related appointments. Even more recently, the SEC announced it will consider proposing additional new rules to “enhance and standardize” climate-related disclosures.
The temptation to highlight a company’s commitment to sustainable ideals, when not coupled with measurable achievements, can be an invitation to government investigators.
This shift is motivated by two recognitions: first, that climate risk is material to investors; and second, that climate risk represents systemic financial risk. The rapidly increasing number of shareholder proxy proposals on sustainability matters demonstrates the former; multiple statements by SEC commissioners and various departments highlight the latter.
As a former SEC prosecutor, I have watched with interest as the SEC has imposed additional ESG-related requirements and ratcheted up its ESG enforcement infrastructure. But what does this mean in a practical sense for public companies?
While potentially more detailed ESG rules are expected later this year, they will probably face significant legal challenges. In the interim, however, we can predict likely enforcement priorities based on the existing disclosure regime. Thus, it would be wise to look at probable enforcement targets, collateral impacts of increased enforcement and potential avenues for minimizing those exposures.
The sources of increased exposure
Like Chekhov’s gun – destined to go off in the third act – government enforcement task forces often become self-fulfilling prophecies. So, what kind of cases are they likely to bring?
The temptation to highlight a company’s commitment to sustainable ideals, when not coupled with measurable achievements, can be an invitation to government investigators. Vague statements about emissions reductions or sustainability initiatives are inherently susceptible to multiple interpretations – as well as to the inference that a company is misleading investors into thinking it is taking actionable steps when it has not. This is especially true if the company’s environmental disclosures in one part of its business – such as its sustainability reporting – fail to match up to its SEC disclosures.
Companies can be prosecuted for misleading accounting activity arising out of environmental issues. Enforcement action can be brought based on the way that companies account for the potential economic impacts of climate change, including potential impairments to assets, both physical and not. The latter might include additional limits to the useful life of assets, along with potential risks to counterparties, as well as potential contingent liabilities arising from climate change.
What steps has the company taken to adapt to a range of potentially material changes associated with climate change? Has the company considered what it will do with physical plants in potential flood zones? Or more extreme weather events? What disclosures, if any, are made about these plans? These disclosures would include a range of scenario planning, including for “black swan” events.
Compliance with the legal and regulatory landscape
In addition to rapidly changing federal laws and regulations, individual states present a hodgepodge of legal obligations, as do overseas jurisdictions. How is the company satisfying all these obligations? How is it disclosing its compliance status? A failure to comply with all the relevant legal regimes regarding environmental obligations can be prosecuted as a failure to disclose – and that has happened in the past. If these compliance failures are material, SEC action is likely to follow other governmental action.
Counterparty and supply chain risk
In addition to responsibility for its own conduct, a company might be prosecuted for failing to disclose the environmental risks associated with its counterparties and supply chain participants. Is the company including that supply chain in its sustainability disclosures? What is the company doing to ensure that its supply chain complies with stated environmental goals?
How to limit potential liability risks
While the potential exposures for companies can be substantial, there are many ways in which they can reduce them, including:
- Focus on accountability – Puffery and vague aspirational statements will not suffice. Companies must recognize potential issues early and ensure that private behavior matches up with public statements. They should also establish effective avenues of internal reporting of any concerns and develop a culture of accountability, both on the corporate level as well as on the individual level.
- Internal education – All internal stakeholders must understand that we have entered a new era of environmental focus, and that sustainability issues are not only essential to long-term viability, but also to staying out of the crosshairs of regulators.
- Working across departments – Minimizing ESG exposures is not the work of only one department. The strategic planning of general counsel should encompass not only compliance staff but also personnel in the sustainability, reporting and investor relations departments, among others. Leadership with sufficient gravitas must be included in these efforts to ensure everyone understands how central these issues are to the company.
- Accounting – Because the SEC likely will focus on accounting issues as a lever into enforcement in this area, there needs to be a heightened awareness of the intersection of these matters with environmental concerns.
The onset of a new age of regulatory enforcement actions is here, where perceived environmental failures are prosecuted as securities violations. While we can expect to see a flurry of cases over the next year or so, savvy companies can – and should – prepare themselves to limit potential exposures.