Rise of the Shadow ESG Regulators

Paul Rissman is Co-Founder of Rights CoLab and Diana Kearney is Legal and Shareholder Advocacy Advisor at Oxfam America Inc. This post is based on their article, recently published in the Environmental Law Reporter.

Federal securities law is grounded in the principle of disclosure; however, many have found wanting the prevailing disclosure requirements for the social and environmental impacts of public corporations. The sustainability practices of business might be better regulated if companies reported about them with greater care. But U.S. public companies spend less time communicating with investors about ESG issues than their global peers. They also disclose less. This aversion to transparency isn’t surprising, if viewed in relation to the treatment of “materiality” within federal securities law. The Supreme Court grappled with the definition of materiality in 1976 and again in 1988, and determined that, for disclosure relevant to the trading of securities, materiality should be defined through the lens of what is important solely to investors. The Court restricted the concept to what would be considered in a decision to buy, sell, or hold a stock, or to vote a proxy. This is known as “financial materiality.” The SEC has always considered certain ESG impacts to be financially material, but not to such a general degree that it has required robust reporting on the subject. Business is therefore free to avoid disclosure of “immaterial” ESG impacts.

We predict that corporations are on the cusp of dramatic improvement in their disclosure practices, however. We don’t attribute this to the SEC; we doubt that a deregulatory SEC will institute mandatory ESG reporting anytime soon. Nor will this result from a sudden change of heart on the part of a company’s directors and officers. Rather, it is the attitude of a critical subset of stockholders that has begun to change: the largest professional asset managers. While more than one cause will foment this, the factor that will seal the shift in stockholder attitude, and in turn emphasize ESG reporting as a corporate priority, is last November’s finalization of a set of material disclosure standards for sustainability topics. The Sustainability Accounting Standards Board (SASB), an organization conceived explicitly to formulate standards that comply with the Supreme Court’s definition of materiality, can soon be instrumentalized to improve the monitoring of corporate behavior, and thus corporate behavior itself.

The futility of regulating social and environmental externalities in the U.S. prompted the formation of the SASB in 2011. The Board brought investors, corporate staff and industry representatives together and divided them into working groups, organized by industry, to investigate the financial impact of various social and environmental externalities upon the companies that create them. Its exclusive focus on financial materiality distinguishes this standards body from all other sustainability reporting regimes and creates the basis for a binding obligation to demand disclosure according to the standards. The SASB working groups explored the ways that good and bad practices regarding environmental and social impact affected revenue and profits. When 75% of working group participants agreed that a particular business behavior could create material financial impact, a disclosure standard was written so that companies would report about the practice and how it affected them. The SASB also recruited institutional investors into an Investor Advisory Group (IAG) to review, approve and support the standards. The IAG members subscribe to various statements appearing on its web page, including public commitments to participate in ongoing standards development, encouragement of companies to disclose material social and environmental information, and affirmations that the SASB’s “materiality-focused” approach will help provide investors with financially “decision-useful” information. Through their participation in writing, approving and supporting the standards, members of the IAG would find it very difficult to plead that they did not themselves believe that the standards were material. Among this group are a significant set of investment advisers, including six of the ten largest asset managers globally.

Reporting on the SASB standards is intended to be voluntary. Nevertheless, we argue that members of the SASB IAG, and all fiduciaries who agree with them, have created for themselves a binding duty to press for disclosure according to all of the SASB standards, among all of their global stock holdings. The law is clear that a fiduciary’s duty of care to its beneficiaries includes the duty to investigate topics material to a decision to buy, hold, or sell a security. The Staff of the SEC has affirmed that an investment adviser must “make a reasonable investigation to determine that it is not basing its recommendations on materially inaccurate or incomplete information (emphasis added).” An investment adviser that recognizes a topic to be financially material to a given investment, yet neglects to make a reasonable investigation of that topic, throws itself open to accusations of fiduciary breach and the attendant threat of litigation.

Until a few years ago this fiduciary pressure would not have been enough to foster behavior change in the corporate sector, but it has become so. Previously, the common response to a company with excessive risk from social or environmental externalities would be to sell the stock, leaving the bad actor unperturbed. This is no longer an option for the largest asset managers due to their size. Institutional investors control an estimated 70% of stock holdings in the U.S. Concomitant with the growth of institutional investing is growth in its degree of concentration; market share is dominated by a handful of fund families. The three largest, BlackRock, Vanguard and State Street, all IAG members, have been estimated to control up to 18% of 1700 U.S. companies. Globally, the big five (adding in the holdings of Capital Group, another IAG member, and Fidelity) controlled over 14% of the world’s market capitalization at the end of 2017. These firms are too large to move in and out of stocks with facility. In addition, among the largest firms are passive investors, who must own every stock in a broad index whether or not it is desired as a holding. Nowadays the largest asset management firms, recognizing their immense influence, most often approach problematic companies through persuasive engagement with company officers and directors, rather than exiting the stock. When engagement fails, these firms may vote contrary to management recommendations for non-binding shareholder resolutions, or even vote against the election of board directors. For all 43 countries for which this information is accessible, directors cannot join a board without a shareholder vote, and in every instance the vote is binding.

Large asset managers tend not to rock the corporate boat. Some may not want to develop a reputation for opposing poor disclosure because they seek business from corporate pension funds. Others value easy communication with officers and directors of their holdings, and fear that the quality of that communication could be impaired if company managements are put off by a perceived adversarial relationship. There are documented instances of investment advisers supporting enhanced disclosure only after pressure by customers or their own shareholders. The SASB standards add the duty of care to the avenues by which many of our largest asset managers can be forced to act as more responsible stewards of customer assets, using their broad reach to improve ESG disclosure, and hence corporate behavior, among public companies across the globe. Otherwise, socially responsible customers and beneficiaries may see increased opportunities for litigation surrounding fiduciary breach.

The complete article is available for download here.

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