Will It Float?: The Legitimacy of the SEC’s Authority for Climate Risk Disclosures

On March 21, 2022, the SEC formally launched one of the most significant initiatives ever taken in its nearly 90-year history: proposals for disclosure of climate-related risks. (SEC, The Enhancement and Standardization of Climate-Related Disclosures for Investors. Sec. Act. Rel. No. 11042 (March 21, 2022)). It is a masterpiece of understatement to observe that few firms, public or private, and certainly no investor, will be untouched by forces unleashed by climate change.  Among SEC registrants, the effects of climate change will be many, albeit the magnitude of their impacts on each will vary. Thus, the historical significance of this SEC initiative is justified by the breadth, and sheer enormity, of climate-related risks, but also the diversity of forces underlying those risks.  The SEC’s action is stunning for another reason: The commission has entered this maelstrom without Congress having its back.

As I pored through the bulky proposals, I thought repeatedly of a yearly television-advertising campaign by a nation-wide furniture retailer.  The ad announced the company’s annual “blowout sale.”  The ad did so with three salespersons standing inside the company’s showroom with a deep and excited crowd of shoppers waiting for the doors to be opened so they could begin to harvest the deep discounts that would accompany each purchase.  The sales personnel were trying to determine which one of them would open the door for the eager throng of shoppers. One salesperson stood with the aid of crutches, another had her arm in a sling, and each was heavily bandaged; they expressed misgivings at having been on the floor during the last such sale, when they had been pummeled by customers eager to snap up the great bargains.  I see the three SEC commissioners who voted for the climate risk proposals as similar to the three salespersons.  They are now the targets of fierce criticism over whether and how the SEC can interact with the existential threat of climate change. Already numerous op-ed pieces have chastised the SEC for overstepping its authority with its proposals.

Even though there is no observable disagreement that climate change is occurring and at an ever-accelerating rate (just as predicted years ago in the so-called hockey stick trajectory), I am struck by the sharp contrast with what happened 50 years ago, when our nation also believed it was at an environmental crossroads. Then, following revelations of the environmental disaster at  Love Canal, Congress distinguished itself by moving forward with a broad environmental agenda that ultimately included creating the Environmental Protection Agency as well as several major pieces of environmental legislation that reflected national recognition of a need to turn the corner.  In contrast, today, even though hardly a week passes without observable evidence of the catastrophic impact of climate change, Congress remains disengaged from the issue.  The resulting political vacuum has pulled the independent regulatory agencies into the fray; the SEC’s statutorily identified constituencies, e.g., investors, markets, capital-hungry issuers, etc., have manifest needs due to operating in a world that climate change has made increasingly uncertain. However, agencies like the SEC are having to respond to the challenge without the political salience that comes with an approving Congress.  Hence, the image of the bludgeoned sales staff.

Much to its credit, the SEC has thoughtfully framed how best to provide investors and shareholders of public companies information useful in assessing climate risk. The proposals set forth multiple disclosure requirements that reach deep into each registrant’s operations to capture not just the uncertainty of how climate change might affect the firm, but also to shine a light on management’s strategies to cope with the ensuing tsunami. The SEC proposes to add a subpart to Regulation S-K, Subpart 1500, as well as a new article to Regulation S-X that calls for certain climate-related financial statement metrics (involving reporting on disaggregated climate-related impacts on line items of the financial statements) and related disclosures  in the notes of a registrant’s audited financial statements.  The new disclosures are to appear in registration statements and annual reports.  Among the items required to be disclosed:

The board’s oversight and governance structure surrounding climate-related risks;

The material impact(s) any climate-related risks have had or likely will have on the registrant’s business and financial statements in the short-, medium- and long-term;

The registrant’s climate-related targets or goals and any transition plan necessary to achieve them;

The effect or likely effect of identified climate risks on the registrant’s strategy, business model, and outlook;

The registrant’s process for identifying, assessing, and managing climate-related risks and whether this process is integrated into its overall risk management system; and

The impact of climate-related events and transition activities on financial statement items as well as financial estimates (and related assumptions) that are affected by such climate-related events and transition activities.

Most likely to generate the greatest consternation among registrants is the requirement to disclose registrants’ Scope 1 and Scope 2 greenhouse gas (GHG) emissions.  An accelerated filer would have to provide attestation of these disclosures. Larger issuers, in addition to these disclosures, would be required to make disclosures related to their Scope 3 emissions (concern for Scope 3 disclosures is, however, moderated by the fact that many registrants already provide Scope 3 disclosures, and those disclosures are required in only limited instances and will be phased in).

If the climate risk disclosures are adopted, few of the regulated companies are likely to be docile. Expected challenges will claim that the proposals exceed the SEC’s legislative authority and will question whether there is sufficient evidence that the recommendations not only are “necessary or appropriate in the public interest” but also  “ will promote efficiency, competition, and capital formation,” as articulated in the statement of the SEC’s mission found in acts it superintends. See e.g., Securities Act Section 2(b).

To consider whether the proposals are within the scope of this mandate, consider an earlier time when the SEC was sued for its reluctance to expand its focus to include advancing the then-rising environmental concerns. In National Resources Defense Council, Inc. v. SEC, 389 F.Supp. 689 (D.D.C. 1974), the SEC was sued for failing to fully incorporate into its rules a greater focus on environmental concerns.  The requested environmental disclosures were premised on the National Environmental Policy Act of 1969’s (NEPA) mandate that every federal agency, “to the fullest extent possible,” interpret and administer federal laws “in accordance with the policies set forth” in NEPA. Responding to the court’s rebuke for not more forthrightly addressing the NRDC’s petition, the SEC explained that NEPA did not alter the historical mission of the U.S. securities laws; to wit, in formulating disclosure policy, the SEC’s focus is the disclosure of economically significant information.

The climate-risk proposing release hews closely to the position the SEC took in response to the National Resource Defense Council litigation.  The release carefully makes the case that disclosures of climate risk are well within the criteria the SEC draws upon when modeling mandatory disclosure requirements: information enabling investors and shareholders to assess the firm’s financial position, its operational performance, and management’s stewardship, provided in a manner that facilitates comparisons among registrants. These themes are not only set forth in the release’s lengthy introduction but also carefully woven into each of its explanations of the climate risk disclosure directives.  No fair reading of the release suggests that its objective is to rid the planet of GHGs, to stop sea levels from rising, or to return the rains to lands now arid.  Instead, it recognizes that climate risk is a broad concern among investors and that investors (and voting shareholders) are genuinely eager to learn how their portfolio companies might be or are being affected and how their management assesses these risks and plans to address them. Hence, the SEC’s proposals essentially ask registrants to identify how they might be affected by climate risks, risks such as whether the registrant’s key asset is in Miami Beach, whether that property floats, and, if as is likely it does not float, what management’s strategy is for addressing the risk the Miami Beach facility will be inundated.  This certainly seems sensible information for a regulator to mandate if the regulator is tasked, as is the SEC, with protecting investors and facilitating the allocation of capital among competing issuers. And, the release calls for such disclosures in a uniform manner so that the response can be compared with that of other registrants. This is very much within the SEC’s lane.

In considering whether the SEC’s climate risk disclosures are outside its remit, consider how they parallel existing disclosure demands related to risk.  Item 105 or Regulation S-K calls for registrants to discuss “the most significant factors that make an investment  . . . speculative or risky.”  A very recent decision, Jaroslawicz v. M&T Bank Corp., 962 F3d 701 (3d Cir. 2020), held this obligation was breached when the firm’s disclosures failed to include specific aspects regarding how it conducted its internal operations. The court concluded such disclosure was relevant to understanding the degree and gravity of the risk the firm faced of being sanctioned by banking regulators.  Similarly, non-disclosure of a key plant that does not float in the coastal floodplain would certainly meet the orthodox standard of materiality.

Consider further the operation of Item 303(b)(2)(ii) of Regulation S-K. The Management Discussion and Analysis requirement calls for registrants to “[d[escribe any known trends or uncertainties that have had or that are reasonably likely to have a material favorable or unfavorable impact . . . .” Climate risk disclosures fit within this requirement as they essentially focus issuers on addressing a risk of which all registrants are aware, climate change.  Indeed, the proposing release holds Item 303 as a guide for the level of discussion requested when identifying climate-related risks. Securities Act Release 11042 at 80. See also Proposed Item 1502(d).  Thus, the climate risk disclosure requirements, as an initial matter, focus management on a “known” condition, and seek responses to a series of questions important to investors arising from this risk.  The questions so posed accordingly assure both comparability and depth of analysis by the disclosing registrant.  This is the organizing principle of proposed Subpart 1500 in eliciting a series of items to include in the discussion.  Much like the SEC’s proposed cybersecurity disclosures, where another pervasive business risk is the focus, the disclosure treatment follows a series of guides that appear well-designed to assure sufficient coverage of the topic and in a format that enables comparability. See SEC Cybersecurity Risk Management, Strategy, Governance, and Incident Disclosures (March 9, 2022). This approach seems well grounded in the enabling criteria set forth for SEC rulemaking.

The range of information sought in the proposed climate risk disclosures is extensive, and highly detailed, both in content and  specificity regarding the format for its presentation.  It may well be that the most novel of the mandated disclosures are those for annual reporting of GHG emissions.  The impetus for their disclosure is that they are widely used by investors to assess climate risk, and they are presently quantifiable so that they enable important comparative assessments. Thus, the information has great utility, and there are tools available for their calculation. The usefulness of the information to investors may well be the source of the challenge to their disclosure being mandatory.  The proposal provides that Scope 1 and Scope 2 emission disclosure will be required for all issuers. This seems relatively non-controversial. More challenging is Scope 3, as it requires disclosures related to the GHG produced outside the registrant’s operational boundary, in other words, inputs flowing from the operations of another entity.  Of concern to issuers is that an issuer, even though not an accelerated filer, has a duty to disclose Scope 3 emissions if they are material.  Thus, registrants would appear to be required to monitor their Scope 3 emissions to comply with the need to disclose Scope 3 emissions when they rise to a material level.

This aspect of the Scope 3 emissions poses a challenge. To assess the burden of this monitoring, though, consider that this information is sought by scores of large institutional investors whose portfolio objectives include that their respective portfolio companies meet specified targets with respect to GHG. This part of the climate risk disclosures raise an important question: Is it appropriate to mandate disclosure of information about operations that are beyond the registrant’s governance boundaries?   There is no doctrine in the securities laws generally, or with respect to materiality specifically, that renders that kind of disclosure mandate beyond the scope of the SEC’s mandate.  The resolution of this question, and any other questions raised in the climate risk proposals, should depend on the role of the required disclosure in protecting investors and facilitating the aggregation of capital.  As to Scope 3 emissions, a focus on exposing risk and enabling sharp comparisons among investment opportunities should put a thumb on the scale for evaluating the rules that will ultimately guide the disclosure of climate risk.

This post comes to us from James D. Cox, the Brainerd Currie Professor of Law at Duke University School of Law.

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