Proposed Amendments to Issuer Disclosure: To ESG or Not to ESG

Proposed Amendments to Issuer Disclosure: to ESG or not to ESG

In connection with the SEC’s January 30 proposed amendments to certain of the financial disclosure requirements applicable to public companies under Regulation S-K, as well as accompanying guidance thereon, the separate public statements of Chairman Jay Clayton, Commissioner Hester Peirce, and Commissioner Allison Herren Lee underscore the continuing divide over the role of the SEC in disclosure related to ESG factors–and particularly climate-related disclosure–and its materiality to investors.

John P. Hamilton

Commissioner Peirce applauds the proposed amendments and guidance for “not bow[ing] to demands for a new [ESG-related] disclosure framework, but instead support[ing] the principles-based approach that has served us well for decades.” Citing the lack of sustainability-focused metrics disclosed in a recent sample of public disclosure filings, Peirce suggests that, “[t]here is reason to question the materiality of ESG and sustainability disclosure based on existing practices.” Further, Peirce highlights her skepticism of “calls to expand our disclosure framework to require ESG and sustainability disclosures regardless of materiality.”

Commissioner Lee, on the other hand, notes that she cannot support the proposal because the Commission has chosen to “ignore the challenge of disclosure around climate change risk rather than to begin the difficult process of confronting it.” Lee posits that investors have “overwhelmingly” made clear to the SEC, “through comment letters and petitions for rulemaking, that they need consistent, reliable, and comparable disclosures of the risks and opportunities related to sustainability measures, particularly climate risk …[and] that this information is material to their decision-making process, and a growing body of research confirms that.”  In Lee’s view, the “principles-based ‘materiality’ standard has not produced sufficient disclosure to ensure that investors are getting the information they need—that is, disclosures that are consistent, reliable, and comparable.”

Chairman Clayton, in his comments, took the opportunity to summarize steps that the SEC has taken over the last several years involving climate-related disclosure, framing the SEC’s commitment as “rooted in materiality,” and citing efforts such as the Commission’s 2010 guidance on climate change disclosure, as well as continuing engagement, both formally and informally, with market participants and non-U.S. regulators. In addition, Chairman Clayton noted certain of the challenges involved, including the “complex, uncertain, multi-national/jurisdictional and dynamic” landscape as well as the forward-looking nature of much of such disclosure, which “likely involve[s] estimates and assumptions regarding, again, complex and uncertain matters that are both issuer- and industry-specific…”

Looking ahead, Chairman Clayton highlighted two “avenues of engagement that currently are of particular interest” to him:

  1. Discussing with issuers, such as property and casualty insurers, the extent to which they use, and their experience with, environmental and climate-related models and metrics in their operations and planning, including price, risk and capital allocation decisions; and,
  2. Discussing with asset managers that have been using environmental and climate-related models and metrics to allocate capital on an industry or issuer specific basis their experience with that process.  

 De Facto Materiality – A Proposal in the ESG Disclosure Simplification Act

While several ESG-related bills have been filtering through Congress, and each will likely continue to face an uphill battle, one such bill, the ESG Disclosure Simplification Act of 2019 would address the materiality question raised in the Commissioners’ public comments referenced above by deeming ESG metrics “de facto material.” As such, the draft law would task public companies with mandatory reporting, while the SEC would be responsible for defining the relevant ESG metrics based on recommendations from the permanent Sustainable Finance Advisory Committee to be established pursuant to the law.

It’s true, ESG is a ‘compliance minefield’

Sometimes, our friends in the press come up with a headline that simply cannot be topped. Yesterday, Ignites published an article called, “Going Green: Shops Work to Navigate ESG Compliance Minefield.” The article opens appropriately, noting that while ESG funds “may be all the rage with investors […] shops that fail to think carefully about their investment methodologies and related disclosures could end up in the SEC’s hot seat.” Indeed, though, the SEC is certainly not the only regulator to keep a close eye on ESG products and mandates. In the United States, the Department of Labor also has ESG on its radar. ESG is also a hot topic for numerous regulators and legislatures globally. What are some of they important compliance challenges?

  1. Are fund descriptions, registration statements and disclosures accurate? If ESG factors are considered as part of the fund’s strategy, do such documents reflect that reality correctly?
  2. If the firm has publicly committed to engage in certain conduct (e.g., shareholder engagement, etc.) by reason of membership in a particular group or alliance (e.g., UN PRI, Climate Action 100+, etc.), is the firm following through on its promises?
  3. Are global legal developments considered, recognizing that Europe, North America and Asia are at different stages of ESG statutory and regulatory promulgation?
  4. Have proxy voting policies been considered in light of SEC and DOL guidance?
  5. Does the investment management agreement explicitly require (or prohibit) the investment manager to vote proxies or exercise other shareholder rights on behalf of an ERISA plan?
  6. Are the investment manager and asset owner on the same page in terms of which ESG strategy will be pursued?
  7. Does the investment policy statement or investment guidelines specify which E, S or G factor is part of the investment mandate?
  8. Has the investment manager considered potential conflicts of interest of proxy adviser firms?
  9. If the client is a governmental plan, has the investment manager diligenced the applicable state statutes and constitutional provisions to confirm that implementation of the mandate complies with applicable law?
  10. Is disclosure in due diligence questionnaires accurate and factually supportable?


ERISA fiduciaries, take note of new ISS study on ESG

Brian Croce of Pensions & Investments recently reported on a new ISS study. As reported, the study establishes a link between a high/favorable ISS ESG rating and profitability. Similarly, companies with higher ESG ratings are less volatile.  The Department of Labor, rather rightly, in Field Assistance Bulletin 2018-01, cautioned fiduciaries against making too many assumptions or wishful thinking in establishing a nexus between an ESG risk factor and investment performance. The ISS study is worthwhile because it helps build a case for fiduciaries that use integration as an ESG strategy. As a reminder, integration is when one “incorporates ESG-related data and/or information in respect of an ESG factor into the usual process when making an investment decision where such data or information is material to investment performance and where the exclusive purpose is to enhance portfolio return or reduce portfolio risk.” See this glossary for more information and context.

Larry Fink discusses ESG and ERISA’s fiduciary duties with Squawk Box

ESG, Proxy Voting & ERISA Today

As we prepare for upcoming proxy voting rules from the Department of Labor (DOL), it is important to consider their context. A registered investment adviser (RIA) can indeed satisfy its fiduciary duties under the Employee Retirement Income Security Act of 1974 (ERISA) to plan clients when taking environmental, social and governance (ESG) risks into account as part of investment decisions and voting proxies. Some will cheer the preceding sentence, while others remain skeptical. The fact is, with proper structuring, a fiduciary to an ERISA plan, or a governmental plan, for that matter, can favorably respond to client requests for ESG issues to be part of the investment mandate without losing much sleep over fiduciary duty risk.

For all the headline-grabbing that ESG garners, there remains considerable uncertainty over what exactly it means. This is unfortunate, not least because it is hard to comply with fiduciary duties if the conduct at issue is a moving target. ESG issues are various environmental (e.g., climate change), social (e.g., child labor) and governance (e.g., board structure) risk areas. RIAs can zoom in slightly and focus just on environmental, social or governance risks. Zoom in even further and focus on a single risk area, such as climate change.

From here, there are four primary techniques for addressing ESG risk. First, one can screen out from investment consideration those portfolio companies that fail to satisfy one more ESG risk-related criteria, known as negative screening. For convenience, divestment, can be included in this category because it is effectively screening out existing holdings. The second technique is to limit the investible universe to those best-in-class portfolio companies that satisfy ESG risk-related criteria, known as positive screening. Third, treating an ESG risk like any other material risk to investment performance, no more and no less. This is known as integration. The fourth technique is to address ESG risk through proxy voting and other forms of shareholder engagement.

At this stage, we now recognize that ESG is an umbrella term that encompasses myriad environmental, social and governance risks. We appreciate that ESG can be boiled down to discrete risk areas, such as cybersecurity or board diversity, and that RIAs can focus on only one of these risks as part of their mandate with a plan client. We also understand that there are basically four main ways of taking these risks into account in a similar plug-and-play fashion. Our final threshold question for fully appreciating ESG investing, and, ultimately, how an RIA can satisfy its fiduciary duties under ERISA, is the reason for addressing the ESG risk.

ERISA’s fiduciary duties can most directly be satisfied if the reason for addressing an ESG risk is to mitigate material investment risk or seek material investment return (i.e., alpha). At least for now, a less direct, though entirely attainable, path toward satisfying ERISA’s fiduciary duties exist when investment risk/return is at most a secondary reason for taking ESG into account.

An RIA’s motivation for treating one or more E, S or G issues as material is possible because, depending on the issue, there is now data linking that issue with portfolio return. Climate change modeling, for example, can predict the sectors, industries and asset classes most vulnerable to climate change, whether it is because their source materials dry up, they face high regulatory uncertainty, or some of their key assets become stranded. The DOL, in Interpretive Bulletin 2015-01, acknowledged that ESG can present material risks and opportunities for a fiduciary. By doing so, the DOL put ESG risk on equal footing with more traditional material market risks.

The significance of the DOL’s acknowledgment that ESG issues may in fact present material risks to portfolio performance cannot be overstated. An RIA, acting as an ERISA fiduciary, effectively treats the ESG risk as if it were any other material risk factor. Historically, though, a fiduciary considering an ESG investment had to satisfy the “tie-breaker” test, a set of conditions fraught with risk and more understandable in the abstract than in practice. This test, which remains in effect for ESG investments that do not treat ESG as being material to investment performance, demands that an ERISA fiduciary serve up the potential ESG investment opportunity and a non-ESG investment alternative with similar risk and return characteristics; only when the RIA determines that the ESG opportunity does not create more risk relative to return (and vice versa) than the non-ESG opportunity, may the ESG investment be pursued.

It is worth noting at this point that the DOL’s most recent guidance on ESG, Field Assistance Bulletin 2018-01, expressly reaffirmed the notion that ESG issues can present material risks (and opportunities) for plans, and, consequently, could be treated the same way as any other factors a fiduciary would consider as part of a prudent process. The DOL cautioned fiduciaries against making too many assumptions and against not relying on the evolving data linking one or more ESG issues with investment performance. This makes sense and should not present too much of an operational nuisance, considering that more fine-tuned data is available reportedly showing one or more ESG issues as being material to performance.

Proxy voting and other forms of shareholder engagement (which usually precede voting decisions) are one of the most popular techniques used to account for ESG risks. The exercise of shareholder rights is a fiduciary function under ERISA. It is critical that an investment management agreement be crystal clear as to whether the RIA is responsible for proxy voting, and that the RIA review the plan’s proxy voting policies when managing a separate account. Commingled funds may develop their own proxy voting/shareholder engagement policies, to which the subscribing plans would be subject.

Indeed, proxy voting and engagement rarely cost much, and proxy advisor firms are often used to reduce costs even more. Where, however, the exercise of shareholder rights would be expensive, such as in cases where it would be unusually expensive to partake in a shareholder vote, or where the time and preparation to meet with a company board is more involved, RIAs, as ERISA fiduciaries, should analyze and document the cost of that activity and weigh it against the expected gain. This is easier said than done. If anything, costs should be monitored and recorded in the RIA’s files, and there should be some estimate or calculation of what benefits will flow back to the plan investor over the short, medium and long term resulting from one or more votes or engagements.

Proxy voting and shareholder engagement have become a flashpoint and is under scrutiny by the Securities and Exchange Commission, the DOL and even the White House. Just this past April, the President issued an Executive Order that required the DOL, in part, to determine whether additional guidance on proxy voting was necessary. The Executive Order’s aim was on energy independence, so it is fair to assume that the White House is interested in whether more onerous requirements are necessary for ERISA fiduciaries to vote proxies on ESG issues.

Whether the DOL will impose on fiduciaries a more exacting and granular cost-benefit analysis for proxy voting and shareholder engagement remains to be seen. With that said, the DOL must walk the tight rope: if new guidance contains so many trap doors, thereby introducing significantly greater fiduciary risk for voting proxies and engaging the boards of energy companies, for example, then RIAs may feel compelled to purge fossil fuel companies altogether from the portfolio to satisfy their fiduciary duties under an ESG mandate. A tilt toward divesting or negative screening, and away from engagement and voting, arguably undermines the very purpose of the Executive Order. The DOL could update this guidance any day now.

Finally, several influential individuals and institutions have publicly stated that one or more ESG issues are in fact material risks. While there is by no means a consensus on whether ESG is material to investment performance, ERISA fiduciaries, at a minimum, would be expected to kick the tires on these claims. A prudent process necessarily involves some knowledge of what others are fiduciaries are considering. An RIA could take the position that these materials are already reflected in the share price; ERISA fiduciaries, after all, are not required to second-guess the market price of a security absent extraordinary circumstances. A fiduciary could alternatively believe that the markets do not (yet) fully appreciate these risks, thereby presenting meaningful opportunities from a risk/return standpoint for the RIA. Following this latter path, the RIA has various techniques at its disposal to addressing one or more ESG risks and, as described above, can satisfy its fiduciary duties under ERISA in doing so.