November 16, 2021

Should the Securities and Exchange Commission Adopt a Mandatory ESG-Disclosure Framework?

  • Amanda Rose

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This policy brief addresses recent proposals calling for the Securities and Exchange Commission (SEC) to adopt a mandatory environmental, social, and governance (ESG) disclosure framework. It illustrates how the breadth and vagueness of these proposals obscures the important—and controversial—policy questions that would need to be addressed before the SEC could move forward on ESG disclosure in a principled way.

What Is ESG?

The abbreviation “ESG” is used as shorthand for a dizzyingly broad array of environmental, social, and governance topics affecting businesses, including climate change, human capital management, supply chain management, human rights, cybersecurity, diversity and inclusion, corporate tax policy, corporate political spending, executive compensation practices, and more.

Members of the ESG movement are similarly diverse, in both identity and motivation. They include financially motivated investors and traditional asset managers who believe companies’ approach to (at least certain) ESG topics will bear on companies’ long-term performance or the long-term performance of the investors’ or asset managers’ broader investment portfolios. They also include values-based investors who care about whether and how corporations address (at least certain) ESG topics because of religious or sociopolitical commitments. The ESG umbrella also shelters various noninvestor corporate stakeholders and third parties who care about whether and how corporations address (at least certain) ESG topics because they are personally affected (e.g., employees vis-à-vis labor practices) or because of religious or sociopolitical commitments (e.g., environmentalists vis-à-vis environmental impact). ESG proponents also include members of an emerging corps of people and institutions who profit from the movement, including corporate sustainability officers, providers of ESG ratings and indices, accounting firms that offer ESG-related services, and managers of specialized ESG-investment vehicles.

Even the Business Roundtable seemingly embraced ESG in 2019 in its Statement on the Purpose of the Corporation, though some suspect its motivations have more to do with public relations or a desire to protect executives from shareholder discipline than a true commitment to ESG. The stated motivations of others involved in the movement are also questionable. Traditional asset managers claim that their commitment to ESG is motivated by a desire to improve long-term fund performance for the benefit of investors. But agency costs offer an alternative potential explanation: embracing the ESG movement may help asset managers curry political favor, enabling them to fend off greater regulation of the industry; it may advance the personal sociopolitical commitments of those who run them; or it may offer a way to attract investors to fund offerings without imposing any meaningful limitations on how a fund is managed.

The ESG Fuzziness Problem

The breadth of topics embraced by ESG and the breadth of motivations spurring the ESG movement have created a big tent that has undoubtedly served a purpose by helping the various causes of those involved to gain momentum. But it has also created problems. For example, ESG performance ratings are inconsistent and difficult to decipher. Which of the myriad ESG issues are factored into a rating, how performance on those issues is measured, and the weight each issue is given are subjective, usually nontransparent determinations that vary across ratings providers.

The breadth of ESG topics also makes studies that purport to show a positive link between ESG performance and financial performance difficult to interpret. There is no a priori reason to believe that a company’s approach to climate change and a company’s approach to diversity or any other ESG issue will each have the same sort of impact on a company’s financial performance; yet these studies often bundle ESG issues together to measure ESG performance or rely on ESG performance ratings that themselves bundle the issues together. They therefore leave unanswered which, if any, discrete corporate policies related to ESG actually affect financial performance.

Regulators have also pointed out problems with use of the term “ESG.” SEC officials have expressed concerns regarding its use in mutual fund advertising because its vagueness can leave fund investors with misimpressions about what exactly they are buying into. The US Department of Labor has found fault with the term in part because, “by conflating unrelated environmental, social, and corporate governance factors into a single term, ESG invites a less than appropriately rigorous analytical approach in evaluating whether any given E, S, or G consideration presents a material business risk or opportunity to a company that corporate officers and directors should manage as part of the company’s business plan and that qualified investment professionals would treat as economic considerations in evaluating an investment in that company.”

The Difficult Questions Raised by Calls for SEC Adoption of a Mandatory ESG Disclosure Regime

Many are urging the SEC to create a comprehensive, mandatory, ESG disclosure regime, and title I of H.R. 1187, a bill recently passed by the House of Representatives, would require the SEC to do so. Proponents contend that although a large percentage of public companies voluntarily disclose ESG-related information in stand-alone sustainability reports, these companies utilize divergent frameworks developed by private standard setters, and the disclosures may not be produced in the same careful manner as disclosures in SEC filings. They argue that an SEC-mandated ESG disclosure regime would enhance investors’ ability to compare companies on ESG dimensions, combat the problem of selective ESG disclosure (also known as “greenwashing”), and improve the quality of ESG disclosures.

The trouble with these proposals, however, is that they speak in generalities about the importance of ESG to investors without specifying which, if any, specific ESG topics are financially material, and they invite the SEC to model a mandatory ESG-disclosure framework after frameworks developed by private standard setters without strict regard for notions of financial materiality. For example, title I of H.R. 1187 would require public companies to provide in their annual proxy statements a description of the company’s views “about the link between ESG metrics and the long-term business strategy” of the company and any process the company “uses to determine the impact of ESG metrics on the long-term business strategy.” The bill would also require the SEC to require public companies to disclose ESG metrics in any filing that requires audited financial statements. But the bill does not define “ESG metrics.” Instead, it requires the SEC to do so through rulemaking, explicitly authorizing the SEC to, as it may deem appropriate, “incorporate any internationally recognized, independent, multi-stakeholder environmental, social, and governance disclosure standards” (emphasis added) when it promulgates a definition of ESG metrics.

As discussed at greater length in my recently published article “A Response to Calls for SEC-Mandated ESG Disclosure,” this feature of the bill raises numerous difficult policy questions. I outline several in the following subsections.

Does the SEC Have the Requisite Institutional Competence and Democratic Accountability?

When the SEC mandates disclosure of information because of the information’s demonstrable importance to companies’ financial performance, it clearly acts within the scope of both its expertise and authority. Asking the SEC to choose an ESG disclosure framework on the basis of considerations that extend into the realm of politics thrusts the SEC into a less familiar and more controversial role, one that threatens to undermine its reputation as a nonpartisan regulator of the capital markets.

Questions of institutional competence and democratic accountability are particularly significant because advocates for ESG disclosure clearly see ESG disclosure as a mechanism for promoting certain types of corporate behavior and discouraging others. Mandating that such disclosures appear in SEC filings would amplify this effect by involving the board and executives who certify SEC filings in the ESG disclosure process. Advocates view this as a benefit of SEC-mandated ESG disclosure. But the SEC lacks the expertise and authority to broadly regulate corporate behavior. As one scholar has observed, if the goal is to drive changes in firm behavior for social ends, an ESG-standard-setting process requires “a broader democratic legitimization than what financial reporting standard setting usually has; it needs to be more akin to what we require for other major regulatory interventions into firm behavior (e.g., taxes or emission limits).”

Is This How the SEC Should Allocate Its Scarce Resources?

Placing responsibility for developing an ESG disclosure framework on the SEC also raises questions about resource allocation. If the SEC mandates disclosure on a topic, it assumes a responsibility for ensuring compliance, either through its screening of SEC filings or through enforcement. Proponents view this as a benefit, given that it promises to promote the integrity, uniformity, and completeness of companies’ ESG disclosures, combating the problem of greenwashing that many believe is prevalent in sustainability reporting today. But unless the SEC’s budget is increased, this added responsibility will necessarily divert resources from other pressing SEC priorities. That diversion may be warranted, but it is a cost that must be explicitly weighed in the discussion.

How Burdensome Would This Be for Public Companies?

An SEC-mandated ESG disclosure regime would impose new information-gathering and reporting obligations on companies that today do not prepare sustainability reports pursuant to whatever framework the SEC could adopt. Even companies that do currently use that framework when preparing sustainability reports would bear additional costs, because the process for preparing SEC filings is much more rigorous and involved. As Jill Fisch, professor at the University of Pennsylvania Law School, has observed, the leading ESG disclosure frameworks created by private standard setters identify “dozens of disclosure items, and current sustainability reports commonly exceed one hundred pages in length.” She notes that the “cost of developing and complying with comparable mandatory disclosure requirements would place a heavy burden on issuers.”

Is Vastly Expanding Public Companies’ Exposure to Securities Class Actions a Good Idea?

Placing ESG disclosures in SEC filings also heightens the private liability risk faced by companies, directors, and officers. Whereas ESG disclosures in stand-alone sustainability reports can theoretically give rise to private securities fraud liability, mandating that such disclosures be included in SEC filings heightens that risk considerably for a few reasons. First, stand-alone sustainability reports are not subject to the certification requirements imposed by the Sarbanes-Oxley Act that operate to heighten the liability exposure of CEOs and CFOs. Disclosures in stand-alone sustainability reports also avoid exposure to liability under section 11 of the Securities Act of 1933 and under rule 14a-9, promulgated under the Securities Exchange Act of 1934, because section 11 applies only to misrepresentations and omissions in a company’s registration statement filed with the SEC in connection with a public offering and rule 14a-9 applies only to misrepresentations and omissions in a company’s proxy solicitation materials. Such disclosures are also less exposed to litigation under rule 10b-5, promulgated under the Securities Exchange Act of 1934. This is because sustainability reports have multiple audiences, so it remains possible for a company to argue that a topic covered in such a report was not material within the meaning of the securities laws and did not affect its stock price. Companies also have freedom to couch statements in sustainability reports in aspirational or vague terms, which can help to reduce liability risk. Indeed, some law firms recommend that companies phrase ESG disclosures in these terms for precisely this reason. SEC-mandated disclosure would likely reduce this flexibility. As a consequence, it would be more difficult for a company to argue against the materiality of ESG information, at least in a manner that might support a motion to dismiss. Indeed, title I of H.R. 1187 would render ESG disclosures de facto material.

Some may perceive this as a benefit, but others would view it as a major cost. The debate over the social value of fraud on the market securities fraud class actions is long-standing and passionate. Fraud on the market class actions threaten to impose massive damages on defendants and thus may have settlement value out of proportion to their merits, inviting strike suit litigation that taxes companies—and ultimately shareholders—and threatens to affect corporate disclosure practices in socially undesirable ways. Concerns over strike suit litigation led to the adoption of the Private Securities Litigation Reform Act (PSLRA) in 1995, which makes it more difficult for a securities fraud class action to get past a motion to dismiss. Most important, the PSLRA requires plaintiffs to plead particularized facts giving rise to a strong inference of scienter and imposes a discovery stay until after a motion to dismiss has been decided. It also contains a safe harbor for forward-looking statements accompanied by meaningful cautionary language or made without actual knowledge of their falsity. The predictable form lawsuits related to ESG disclosures will take are of a sort, however, that are often immune from the PSLRA’s protections against abusive litigation.

Imagine a company that has an industrial accident, finds itself embroiled in a sexual harassment scandal, or experiences a cybersecurity breach. These are events that even the most prudently managed corporation cannot completely protect against, at least not at acceptable cost. They are also events that, when made public, can result in a meaningful stock price decline. Imagine also that the company has in the past made representations in its SEC filings that speak to the company’s management of workplace safety, human relations, or cybersecurity risks, as the case may be. Imagine further that a rule 10b-5 class action is filed alleging that the relevant disclosures were misleading half-truths that helped the company maintain an artificially inflated stock price, because the company did not disclose facts available to the board which, at least in hindsight, appear to have suggested that the unfortunate event was likely to occur or that the risk management strategies the company was undertaking were inadequate.

Cases like this—commonly referred to as event-driven securities litigation—have increased in prevalence in recent years, and SEC-mandated ESG disclosure would only accelerate this trend. Event-driven securities class actions can be difficult to get dismissed on the pleadings, even when of dubious merit. Although it may be highly doubtful that the alleged omissions were material to investors or that the defendant corporation acted with the requisite scienter, courts may (and often do) allow cases like this to proceed past a motion to dismiss. Unless the statement alleged to be misleading was so vague as to be considered puffery, questions of materiality are often treated by courts as raising factual questions inappropriate for resolution on a motion to dismiss. And whereas the PLSRA’s heightened scienter pleading requirement creates a real barrier to frivolous claims alleging that defendants knew, or were reckless in not knowing, the falsity of an affirmative misstatement, scienter may not be rigorously examined in half-truth cases. This is because scienter will turn on whether the defendants knew, or were reckless in not knowing, that a reasonable investor would have viewed the challenged statement as misleading in light of the omission of some allegedly material fact. Whether a statement is misleading, and whether an omitted fact is material, turns on the perspective of a reasonable investor, raising factual questions that courts may be reluctant to examine on a motion to dismiss.

The difficulties associated with terminating event-driven securities litigation at the motion to dismiss stage, coupled with the costs of discovery and extremely large potential damage awards typical in this sort of litigation, means that the risk of vexatious litigation is high. This has led many to voice concerns about event-driven litigation. These critics include not just groups such as the US Chamber Institute for Legal Reform that have a vested interest in reducing corporate liability exposure, but also respected scholars, and even shareholder-oriented groups such as Institutional Shareholder Services. Any serious discussion regarding the adoption of a broad SEC-mandated ESG disclosure regime cannot ignore these concerns.

Is There a Private Ordering Solution?

Investors have alternative tools at their disposal to achieve greater consistency and credibility in corporate ESG disclosures, raising the question of why a mandatory regulatory solution should be favored over a market-based solution. Investors can submit precatory proposals under rule 14a-8 requesting greater board involvement in ESG disclosure practices or ESG risk oversight, for example. If investors can reach a consensus on which ESG disclosure framework they prefer, they can also use rule 14a-8 or informal engagement to promote its use. They could use similar techniques to encourage integrated ESG reporting in SEC filings, if they were to view that as independently important.

It appears that these techniques are already bearing considerable fruit. During the 2019 proxy season, Glass Lewis found that “approximately 43% of Russell 1000 companies had established some sort of board oversight of ESG issues.” Moreover, in Larry Fink’s 2020 letter to CEOs he asks the companies BlackRock invests in to (a) publish a disclosure in line with industry-specific Sustainability Accounting Standards Board (SASB) guidelines by year-end or disclose a similar set of data in a way that is relevant to the particular business and (b) disclose climate-related risks in line with the recommendations of the Task Force on Climate-Related Financial Disclosures (TCFD). In his 2021 letter, Fink reports encouraging progress over the past year, noting “a 363% increase in SASB disclosures and more than 1,700 organizations expressing support for the TCFD.” Other leading asset managers, such as State Street and Vanguard, have similarly called on companies to align their ESG disclosures with the SASB standards and TCFD recommendations. Moreover, calls for greater consistency and comparability in ESG disclosures have led major standard setters to begin efforts at harmonization. Though the proposals seeking an SEC-mandated ESG disclosure framework have emphasized the failure of market forces over the past several decades to produce “consistent, comparable, highly-reliable ESG information,” they may have spoken too soon.

Is This Actually Good for Stakeholders?

The concerns about mandatory ESG disclosure raised thus far are likely to resonate most strongly with those who possess a free-market orientation. But progressive scholars have also warned against the tendency to try to expand the scope of the federal securities laws in service of nonfinancial interests. In a recent article, Ann Lipton, associate dean for faculty research at Tulane University School of Law, warns of the “detrimental effects of relying on investor-oriented disclosure to serve the needs of the general public.” She argues that funneling demands for ESG disclosure through the SEC encourages advocates for information disclosure geared toward stakeholder audiences to conceal their true motives and that this prevarication comes at real cost, as the “need to emphasize financial risk and shareholder return inhibits a fuller discussion of the societal need for such information” and risks “contributing to a discourse that suggests that investors are the only members of society who matter.” She also points out that SEC-mandated ESG disclosure would fail to reach a growing number of large and socially impactful private companies that are not subject to SEC-imposed disclosure obligations. A better approach, in Lipton’s view, is to push for a generalized disclosure system designed in service of stakeholder as opposed to investor interests.

Furthermore, adoption of an SEC-mandated ESG disclosure regime would represent a symbolic embrace and entrenchment of “stakeholder capitalism”—the controversial notion that corporate managers should manage the corporation not for the primary benefit of shareholders but rather for a broader set of constituencies, including society at large. Though deviating from the so-called norm of shareholder primacy is often criticized on the basis that it serves to insulate corporate managers from accountability and thereby increases agency costs, stakeholder capitalism may also harm the very constituencies it purports to help. In a recent essay, Tariq Fancy—BlackRock’s first global chief investment officer for sustainable investing between 2018 and 2019—called the idea that corporate managers will drive the type of societal change ESG proponents hope a “fairy tale,” and an extremely dangerous one at that because it makes the necessity of government intervention to address systemic problems facing society seem less urgent. Others have similarly argued that direct regulation, rather than reliance on corporate fiduciary duties or SEC disclosure policies, is the proper way to deal with societal problems. Leaving it to corporate managers is not only likely to prove ineffective and counterproductive, but it also undermines democratic values. Elected officials, accountable to voters and subject to the checks and balances built into American constitutional design, should decide how the nation approaches important matters of societal concern.

Conclusion

Henry Kissinger is credited with coining the idea of “constructive ambiguity” as a negotiating tactic, one that employs the deliberate use of ambiguous language on sensitives topics to advance some political purpose. But ambiguity can be destructive as well, particularly if the end sought is sound public policy. Whether the SEC ought to mandate ESG disclosure and, if so, how it should do so can be approached and debated on a discrete, topic-by-topic basis, like any other item of arguably material information. If the call instead is for the SEC to adopt a broad ESG disclosure framework modeled after frameworks designed to meet the informational needs of stakeholder-inclusive audiences, then the significance of the request should be recognized and the difficult questions it raises openly addressed.