ESG Regulatory Reform

Katie McShane is an associate at Cadwalader, Wickersham & Taft LLP. This post is based on her Cadwalader memorandum. Related research from the Program on Corporate Governance includes The Illusory Promise of Stakeholder Governance (discussed on the Forum here) and Will Corporations Deliver to All Stakeholders?, both by Lucian A. Bebchuk and Roberto Tallarita; For Whom Corporate Leaders Bargain by Lucian A. Bebchuk, Kobi Kastiel, and Roberto Tallarita (discussed on the Forum here); and Restoration: The Role Stakeholder Governance Must Play in Recreating a Fair and Sustainable American Economy—A Reply to Professor Rock by Leo E. Strine, Jr. (discussed on the Forum here).

With ESG (Environmental, Social and Governance) funds on a dramatic incline, an incline expected to continue going forward, it seems inevitable that regulatory reform is on the horizon. Europe has been leading the charge in the incorporation of ESG considerations into its regulatory framework. As we look to gauge what type of regulatory reform might be around the corner for us here in the U.S., specifically in the realm of fund finance, it is useful to look at the regulatory developments in the EU.

Regulatory Reform in the EU

The most relevant EU regulation in this space is the Sustainable Finance Disclosure Regulation (SFDR), which came into effect in March of this year. The SFDR imposes mandatory ESG disclosure obligations on asset managers and other financial markets participants, and is a major milestone in the EU’s efforts to ensure a systematic and transparent approach to sustainability within financial markets, thereby preventing greenwashing and ensuring comparability.

By way of background, the SFDR was introduced by the European Commission alongside the Low Carbon Benchmarks Regulation and the Taxonomy Regulation as part of a package of legislative measures stemming from the European Commission’s Action Plan on Sustainable Finance.

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Boards Increase Transparency and Pursue Growth

Amy Rojik is Director and Founder of the BDO Center for Corporate Governance. This post is based on her BDO memorandum.

Introduction

As an uncertain business environment persists, board directors face expanding roles and responsibilities in applying the lessons learned over the past 18 months while continuing to navigate new obstacles. In our last Board Pulse Survey, directors indicated they were challenged by an array of financial, operational and regulatory pressures as the wide range of stakeholders expanded their expectations of the board’s role. In addition to those issues, board members face new regulatory changes, issues related to globalization and digital acceleration, and the rise of environmental, social and governance (ESG) factors being linked to company performance. All of these elements will play a pivotal role as boards look to thrive in today’s shifting corporate climate.

While keeping these challenges top of mind, boards are optimistic and taking active steps toward growth. Our 2021 BDO Fall Board Pulse Survey explores the evolving corporate strategies for public company boards of directors, including how they plan to pursue growth and increase transparency around strategic shifts.

Key Findings

  • Coming out of the 2021 proxy season, engagement of shareholders and investors is priority #1.
  • M&A is the top-ranked corporate strategy.
  • Cybersecurity and data privacy continue to be significant governance issues for all companies.
  • Risk of supply chain disruption challenges boards to tackle sourcing diversification head-on.
  • Labor shortages and scrutiny around board composition encourage more thoughtful talent recruitment and refreshment processes.
  • ESG issues remain high on boards’ priority lists, as directors explore options on how best to comply with changing requirements and communicate their efforts publicly.
  • With annual reporting approaching, boards anticipate challenges around increasing disclosures and risks.

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​U.S. DOL Proposes ESG-Related Updates to the ERISA Investment Duties Regulation

Heather L. Coleman, Eric M. Diamond, and Marc Treviño are partners at Sullivan & Cromwell LLP. This post is based on a Sullivan & Cromwell memorandum by Ms. Coleman, Mr. Diamond, Mr. Treviño, Jonathan B. Beek, and Samuel E. Saunders. Related research from the Program On Corporate Governance includes The Illusory Promise of Stakeholder Governance by Lucian A. Bebchuk and Roberto Tallarita (discussed on the Forum here); Companies Should Maximize Shareholder Welfare Not Market Value by Oliver Hart and Luigi Zingales (discussed on the Forum here); Reconciling Fiduciary Duty and Social Conscience: The Law and Economics of ESG Investing by a Trustee by Max M. Schanzenbach and Robert H. Sitkoff (discussed on the Forum here); and Will Nasdaq’s Diversity Rules Harm Investors? by Jesse M. Fried (discussed on the Forum here).

Summary

On October 13, 2021, the U.S. Department of Labor (“DOL”) announced a proposed rulemaking to amend the Investment Duties regulation under Title I of the Employee Retirement Income Security Act of 1974 (“ERISA”) that would clarify the application of ERISA’s plan fiduciary duties of prudence and loyalty to selecting investments and investment courses of action, including selecting qualified default investment alternatives (“QDIAs”), and to exercising shareholder rights, including proxy voting. [1] While the proposal retains the core principle that the duties of prudence and loyalty require ERISA fiduciaries to focus on material risk-return factors, the proposal is intended to remove barriers implemented by the prior administration that the DOL believes limited fiduciaries’ ability to consider climate change and other ESG matters as factors when selecting investments and exercising shareholder rights. Title I governs private pension plans.

As described in greater detail below, significant points from the proposed rule include changes to:

  • Clarify the permissibility of consideration of climate change and other ESG factors, including governance and workforce factors, on particular investments or investment courses of action;
  • Apply the same investment standards to QDIAs, such that otherwise qualified QDIAs may include consideration of ESG factors;
  • Improve and clarify application of the “tie-breaker” test, which permits fiduciaries to consider collateral benefits as tie-breakers in some circumstances; [2] and
  • Increase the likelihood of fiduciaries exercising voting and other shareholder rights while reducing associated administrative burdens.

The proposal has been anticipated since President Biden took office and follows a range of measures in the E.U. (the Sustainable Finance Disclosure Regulation, among others), the U.K. (the Occupational Pension Schemes (Climate Change Governance and Reporting) Regulations 2021, among others) and elsewhere aimed at enhancing (or mandating) pension plan consideration of climate change and other ESG factors.

Comments on the proposed rule are due by December 13, 2021.

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First Legal Challenge to California’s Board Gender Diversity Statute Heads to Trial

Cydney S. Posner is special counsel at Cooley LLP. This post is based on her Cooley memorandum. Related research from the Program on Corporate Governance includes Politics and Gender in the Executive Suite by Alma Cohen, Moshe Hazan, and David Weiss (discussed on the Forum here); and Will Nasdaq’s Diversity Rules Harm Investors? by Jesse M. Fried (discussed on the Forum here).

You might remember that the first legal challenge to California’s board gender diversity statute, Crest v. Alex Padilla, was a complaint filed in 2019 in California state court by three California taxpayers seeking to prevent implementation and enforcement of the law. Framed as a “taxpayer suit,” the litigation sought to enjoin Alex Padilla, the then-California Secretary of State (now U.S. Senator), from expending taxpayer funds and taxpayer-financed resources to enforce or implement the law, SB 826, alleging that the law’s mandate is an unconstitutional gender-based quota and violates the California constitution. The court in that case has just denied each side’s motion for summary judgment after concluding that there were triable issues of material fact. The case will now be going to trial, which is currently set for October 25. Stay tuned.

Even proponents of the California law recognized the possibility of “equal protection” claims and other legal challenges—when Governor Jerry Brown signed the bill into law, he acknowledged that “serious legal concerns” had been raised. (See this PubCo post.) And many expected a flood of legal challenges to frustrate efforts to implement the bill. Nevertheless, California’s businesses appear to have accepted the requirements of the legal mandate—perhaps also feeling the pressure from large asset managers such as BlackRock and State Street—and have not filed suit.

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Weekly Roundup: October 15–21, 2021


More from:

This roundup contains a collection of the posts published on the Forum during the week of October 15–21, 2021.

Delaware Decision Deals with Director Independence



A Guide for Boards and Companies Facing Ransomware Demands


Board Refreshment and Succession Planning in the New Normal


SEC Enforcement Order Highlights Risks of Data-Based Market Intelligence


SEC Comments on Climate Change Disclosure


2021 Corporate Governance Trends in the Retail Industry


Are Star Law Firms Also Better Law Firms?



How to Translate ESG Imperatives into Executive Compensation


Expanding Proxy Voting Choice


Statement by Commissioners Peirce and Roisman on Staff Report on Equity and Options Market Conditions in Early 2021


Court of Chancery Upholds Enforcement of Advance Notice Bylaw


The Capital Structure Puzzle: What are We Missing?


Sustainability Reporting: A Gap Between Words and Action


Boeing: Rejecting Early Dismissal of Claims Against Directors for Inadequate Risk Oversight


Team Production Revisited


Speech by Commissioner Lee on Action on Climate

Speech by Commissioner Lee on Action on Climate

Allison Herren Lee is a Commissioner at the U.S. Securities and Exchange Commission. This post is based on her recent remarks at the PRI/LSEG Investor Action on Climate Webinar. The views expressed in the post are those of Commissioner Lee, and do not necessarily reflect those of the Securities and Exchange Commission or the Staff.

Good morning or good afternoon depending on where you are. I want to start by thanking Principles for Responsible Investment and the London Stock Exchange Group for inviting me to speak today, and for holding this event. I also need to share the standard, but important, disclaimer that the views I express are my own and not those of the Commission or its staff.

This type of dialogue among market participants is a critical component of the larger global effort to come together to address the risk that climate change poses to capital markets and the global economy.

As we move forward on climate initiatives, we must take an approach that is both collaborative and comprehensive. Investors, issuers, standard setters, academics, regulators—we all have a role. At the SEC, our focus is on capital markets—protecting investors, maintaining fair, orderly, and efficient markets, and promoting capital formation. We don’t set emissions standards or net zero targets, we don’t implement carbon pricing, or otherwise shape energy or environmental policy. But we must work hand-in-hand with our colleagues all across government and in the private sector as we fulfill our mission.

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Team Production Revisited

William W. Bratton is Nicholas F. Gallicchio Professor of Law Emeritus at the University of Pennsylvania Carey Law School. This post is based on his recent paper, forthcoming in the Vanderbilt Law Review.

My article, Team Production Revisited, forthcoming in the Vanderbilt Law Review, reviews and reconsiders Margaret Blair and Lynn Stout’s team production model of corporate law (TPM), offering a favorable evaluation.

With the TPM, Blair and Stout set themselves the task of articulating a model of the public corporation that does three things simultaneously. First, the model must be grounded in a microeconomic theory of the firm. Second, the model must be consonant with the provisions and structure of corporate law. Third, the model must situate the accomplishment of productivity outside of the tent of shareholder primacy and market control. Blair and Stout succeeded at the task described, achieving closure for their theory. Indeed, they did something that no one thought could be done.

The model first appeared in the Virginia Law Review in 1999, just as shareholder primacy emerged as corporate law’s consensus view. The TPM challenged the consensus and the agency model on which it centered by widening the descriptive lens. Where the agency model looks only at the shareholder-management contract, the TPM looks at the contracts between the corporation and all capital providers, both financial and human. Where agency model looks for value enhancement only through agency cost reduction, the TPM looks to the production side to encourage firm-specific investment. The TPM also deemphasizes market control, reviving the Coasian stress on hierarchical relationships independent of markets.

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Boeing: Rejecting Early Dismissal of Claims Against Directors for Inadequate Risk Oversight

Gail Weinstein is senior counsel and Steven Epstein and Mark H. Lucas are partners at Fried, Frank, Harris, Shriver & Jacobson LLP. This post is based on a Fried Frank memorandum by Ms. Weinstein, Mr. Epstein, Mr. Lucas, Erica Jaffe, Shant P. Manoukian, and Roy Tannenbaum, and is part of the Delaware law series; links to other posts in the series are available here. Related research from the Program on Corporate Governance includes Monetary Liability for Breach of the Duty of Care? by Holger Spamann (discussed on the Forum here).

The Boeing Company Derivative Litigation (Sept. 7, 2021) is another in a series of cases in recent years in which the Delaware Court of Chancery has found, in the wake of a “corporate trauma” relating to product safety issues, that the company’s independent directors may have personal liability to the stockholders, under the “Caremark doctrine,” for a failure to have overseen management of the corporation’s core risks. In the Boeing opinion, Vice Chancellor Zurn echoes a number of themes from other recent cases involving so-called “Caremark claims,” and thus provides important guidance with respect to best practices for directors in fulfilling their oversight responsibilities (as discussed in “Practice Points” below).

Key Points

  • In recent years, the Delaware courts, at the pleading stage of litigation, have more frequently rejected dismissal of Caremark claims against directors. The express articulation of the standard for pleading a valid Caremark claim has not changed and the courts continue to characterize these claims as among the most difficult upon which a plaintiff might hope to succeed. Also, importantly, each of the recent cases has presented a particularly egregious factual context. Nonetheless, directors should be mindful that, unlike in the past, there is now a trend of decisions in which the court has rejected early dismissal of Caremark
  • Plaintiffs’ increased success in Caremark claims surviving the pleading stage is attributable to their more frequent use of books and records demands. With the courts more often granting stockholders’ demands under DGCL Section 220 for inspection of the corporate books and records, and the courts more often granting expansive access to the corporate books and records, stockholder-plaintiffs have been able to uncover information that has helped them craft more particularized pleadings substantiating their claims of lack of board oversight.
  • Recent Delaware decisions provide specific guidance for directors in fulfilling their Caremark duties.  Most critically, directors should understand that there is a board-level responsibility to oversee legal and regulatory compliance and other risks relating to the company’s “mission-critical” operations. It is not sufficient to delegate management of these critical risks to senior officers of the company. The oversight process with respect to these types of risks should be formally established and the board’s monitoring of the process should be well documented.

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Sustainability Reporting: A Gap Between Words and Action

Maureen McCarthy is an ESG Analyst at ISS ESG, Institutional Shareholder Services, Inc. This post is based on her ISS memorandum. Related research from the Program on Corporate Governance includes The Illusory Promise of Stakeholder Governance (discussed on the Forum here) and Will Corporations Deliver to All Stakeholders?, both by Lucian A. Bebchuk and Roberto Tallarita; For Whom Corporate Leaders Bargain by Lucian A. Bebchuk, Kobi Kastiel, and Roberto Tallarita (discussed on the Forum here); and Restoration: The Role Stakeholder Governance Must Play in Recreating a Fair and Sustainable American Economy—A Reply to Professor Rock by Leo E. Strine, Jr. (discussed on the Forum here).

Key Takeaways

  • Investor attention on sustainability issues has increased in recent years and shows no sign of abating.
  • While the demand for ESG information is increasing, variation in the quality of data is a major headwind.
  • Of over 7,000 ISS ESG-rated corporate entities, data indicates that the quality of most Sustainability Reporting is suboptimal, leaving stakeholders with opaque views of company performance.
  • Sustainability Reporting will continue to improve, and should evolve to be standard business practice.

ESG and the New Normal

A common misconception about Environmental, Social and Governance (ESG) investment practice is that, along with the many other sustainability acronyms, it is a hot topic driven by the media. The terminology might be trending and evolving, but the fundamental convictions behind sustainable value, transparency, and accountability to stakeholders are the new business as usual.

Demand for ESG Disclosure and the related ecosystem has grown exponentially in recent years. The COVID-19 pandemic exacerbated social issues such as occupational health and safety and supply chain labor, and now urgent global disruptions are giving way to investors finding solutions to understand and catalyze corporate responsibility. Extra-financial measures are increasingly integrated into investor decision making; the number of investor PRI signatories has increased by 29% in the last year alone.

Since 2006, ISS ESG has seen an increase in shareholder proposals requesting that companies report their climate change performance. Institutional investors are seeing the connection between long- term business health and systematic management of ESG issues such as climate.

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The Capital Structure Puzzle: What are We Missing?

Harry DeAngelo is Professor Emeritus of Finance and Business Economics & Kenneth King Stonier Chair in Business Administration at the University of Southern California Marshall School of Business. This post is based on his recent paper.

The Holy Grail of corporate finance is a theory that explains the capital structure behavior of real-world firms. It’s been 63 years since Modigliani and Miller’s (1958, MM) landmark paper and we still do not have a model that explains even the broad-brush features of observed capital structures.

In this paper, I identify the conceptual sources of the empirical failures of the leading models of capital structure, and delineate model features that would repair those failures. In the process, I explain why we should largely ignore Miller’s (1977) “horse-and-rabbit-stew” view of the tax incentive to lever up and Jensen’s (1986) view of the disciplinary role of debt. The analysis yields a compact set of foundational principles for building an empirically credible theory of capital structure.

I argue that our failure to solve the capital structure puzzle reflects a major Catch-22: The formal analytical (optimization) approach that is used in our leading models inherently ignores—and therefore implicitly rules out—the key to explaining real-world capital structure behavior. By insisting that our models be framed in a way that implicitly precludes a key element of the solution, we have inadvertently ensured that the literature has stagnated far short of a solution to the capital structure puzzle.

What we have mistakenly ruled out is the role of imperfect managerial knowledge: Managers do not have sufficient knowledge to optimize capital structure with any real precision.

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