A Response to Calls for SEC-Mandated ESG Disclosure

Amanda M. Rose is Professor of Law at Vanderbilt University Law School and Professor of Management at Vanderbilt University Owen Graduate School of Management. This post is based on her recent paper. 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) and 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).

The acronym “ESG” is used as shorthand for a dizzyingly broad array of “environmental,” “social,” and “governance” topics affecting businesses. The topics spanned include 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 the 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 due to religious or sociopolitical commitments. The ESG umbrella also shelters various non-investor 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 due to 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, an association of chief executive officers of leading U.S. corporations, seemingly embraced ESG in its 2019 Statement on the Purpose of the Corporation, though some suspect its motivations had 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 can also be questioned. Traditional asset managers claim 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 breadth of topics embraced by ESG, and the breadth of motivations spurring the ESG movement, has created a big tent that has undoubtedly served a purpose in terms of 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 non-transparent 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 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 them together. They therefore leave unanswered which, if any, discrete corporate policies related to ESG actually impact 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 regarding what exactly they are buying into. Rule changes may follow. The Department of Labor (DOL) cited a lack of clarity regarding the goals of ESG investment funds as a basis for a recent rule proposal that would have clarified that ERISA plan fiduciaries cannot offer or invest in a fund if the fund’s strategy allows it to prioritize non-economic ESG benefits or risks at the expense of financial returns. The final rule removed any specific references to “ESG.” The DOL explained that “‘ESG’ terminology, although used in common parlance when discussing investments and investment strategies, is not a clear or helpful lexicon for a regulatory standard.” The DOL 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.”

In A Response to Calls for SEC-Mandated ESG Disclosure, I address one manifestation of what we might call the “ESG fuzziness problem.” Many are urging the SEC to create a comprehensive, mandatory, ESG disclosure regime, and a recent House Bill would require it do so. Proponents contend that while a large percentage of public companies voluntarily disclose ESG-related information in stand-alone sustainability reports, they 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 difficulty with these proposals 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 on frameworks developed by private standard setters without strict regard for notions of financial materiality. My Article discusses the many difficult policy questions the SEC would need to confront if takes up this invitation, as Acting Chair Allison Lee has signalled it will. The questions extend beyond the mundane (though not unimportant) question of the costs associated with expanding public company reporting obligations. Indeed, they include some of the most contested in the field of corporate and securities law, such as the value of interjurisdictional competition for corporate charters, the right way to conceptualize the purpose of the corporation, the proper allocation of managerial power as between the board and shareholders, and the social desirability of fraud-on-the-market class actions.

The complete paper is available for download here.

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