Monthly Archives: May 2022

SEC Examination Division Focuses on ESG Investing

Posted by Kerry Berchem and Charles Smith, Akin Gump Strauss Hauer & Feld LLP, on
Wednesday, May 11, 2022
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Kerry Berchem is partner and Charles Smith is a consultant at Akin Gump Strauss Hauer & Feld LLP. This post is based on their Akin Gump memorandum.

On March 30, 2022, the U.S. Securities and Exchange Commission’s (SEC) Division of Examinations (the “Division”) released its 2022 examination priorities. The Division announced an enhanced focus on five “significant areas”: (i) private funds; (ii) environmental, social and governance (“ESG”) investing; (iii) standards of conduct, including Regulation Best Interest, fiduciary duty and Form CRS; (iv) information security and operational resiliency; and (v) emerging technologies and crypto-assets. In this post, we address the examinations related to ESG investing.

Relative to the Division’s 2021 priorities, which we wrote about here, the Division’s 2022 priorities clearly indicate that the Division is expanding its regulatory scrutiny of ESG-related investing, product development, product offerings and disclosures. The staff continues to examine whether registered investment advisors and registered funds accurately disclose their ESG investing approaches and adopt and implement policies, procedures and practices that are consistent with ESG-related disclosures.

With respect to the Division’s 2022 priorities, the Division notes that “there is a risk that [ESG-related] disclosures regarding portfolio management practices could involve materially false and misleading statements or omissions, which can result in misinformed investors.” The Division is clearly concerned that such risk may be exacerbated by non-standardized terminology (or taxonomy) in connection with ESG investing; variations (even within individual funds or firms) with respect to how ESG considerations impact investment decisions; and potentially deficient compliance policies and procedures governing product development and offerings, and noted that it “will continue to focus on ESG-related advisory services and investment products (e.g., mutual funds, exchange-traded funds (ETFs) and private fund offerings).” Generally, the Division expects to focus on whether funds are:

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How to Identify Top ESG Priorities

Posted by Steven Rothstein (Ceres), Olivia Tay (Semler Bross LLC), and Yamika Ketu (Ceres), on
Tuesday, May 10, 2022
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Steven Rothstein is managing director, Yamika Ketu is an associate, and Melissa Paschall is director of governance at Ceres; Olivia Tay is senior consultant, Kathryn Neel is managing director, and Blair Jones is managing director at Semler Brossy LLC. The post is based on a Ceres/Semler Brossy client memo and article in Corporate Board Member.

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); For Whom Corporate Leaders Bargain by Lucian A. Bebchuk, Kobi Kastiel, and Roberto Tallarita (discussed on the Forum here); Restoration: The Role Stakeholder Governance Must Play in Recreating a Fair and Sustainable American Economy – A Reply to Professor Rock by Leo Strine (discuss on the Forum here); Stakeholder Capitalism in the Time of COVID, by Lucian Bebchuk, Kobi Kastiel, and Roberto Tallarita (discussed on the Forum here).

As investors, regulators, and stakeholders increasingly recognize environmental, social and governance (ESG) risks and opportunities as financially material, companies are looking for ways to link management incentives with ESG performance on climate change, diversity and inclusion, and other key issues. Though integrating ESG goals into the existing compensation program may seem like the obvious next step, there are several processes that board members need to implement first—and critical questions that they need to address—to ensure the new compensation structure is appropriately tied to corporate strategy.

We have teamed up to provide guidance to companies that have begun to integrate ESG issues into their corporate strategies and may be considering ESG in incentives. This three-part series focuses on that process, including guidance to corporate boards on how they can: 1) effectively identify and oversee top ESG issues, 2) focus and clarify efforts around establishing a select set of critical performance goals for material ESG issues, and 3) consider whether and how to integrate ESG metrics into incentive compensation programs. In this first article, we will focus on how companies can implement the foundational steps of board-level ESG oversight.

The board’s role in ESG oversight

As stewards of long-term corporate performance, boards have a critical role to play in ensuring that companies are aware of, and able to navigate, an ever-evolving risk landscape—one that increasingly involves social and environmental impacts. It is the board’s responsibility to ensure that processes are in place to identify material risks and opportunities—including those that arise from ESG concerns. In doing so, directors should look beyond the information they receive from management and actively inquire about processes employed and issues identified. This is not only best practice, but a fulfillment of director fiduciary duty, which includes the “duty of care,” or responsibility to adequately inform oneself prior to making decisions.

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Board Practices in the Digital Era: Maximizing the Benefit-to-Cost Ratio of Information Technology

Posted by Leo E. Strine Jr., and Laura A. McIntosh, Wachtell, Lipton, Rosen & Katz, on
Tuesday, May 10, 2022
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Leo E. Strine, Jr. is Michael L. Wachter Distinguished Fellow at the University of Pennsylvania Carey Law School; Senior Fellow, Harvard Program on Corporate Governance; Of Counsel, Wachtell, Lipton, Rosen & Katz; and former Chief Justice and Chancellor, the State of Delaware. Laura A. McIntosh is consulting attorney at Wachtell, Lipton, Rosen & Katz. This post is based on their article in Directors and Boards Magazine.

Virtual capabilities and electronic documents are double-edged swords.

Modern information technology can markedly improve the efficiency and quality of the deliberative processes of corporate boards of directors. Yet, if used imprudently, the same technological capabilities can reduce the quality and integrity of corporate decision-making, potentially exposing a company and its directors not only to greater litigation costs and risks, but also to serious reputational harm.

Regrettably, rather than evolving to keep pace with technological developments, corporate governance practices often involve an admixture of obsolete past approaches and ad hoc new ones, a combination that underutilizes the potential benefits of technology and increases its potential risks. In this article, we look in particular at two types of board-level practices that should evolve to take into account technological developments:

  1. Board information policies involving (a) the transmission to and use of information by the board of directors and (b) the documentation of action taken by the board and board committees; and
  2. Board meeting practices in the wake of the COVID-19 pandemic and the ubiquitous use of virtual web-conferencing platforms to conduct director meetings remotely, rather than in person.

These two topics are related. A regular diet of virtual meetings puts pressure on board information policies and requires directors and managers to be highly self-disciplined in their focus and engagement. The efficiency advantage can be undermined by director and manager inattention and unproductive online interaction. An overreliance on virtual meetings can also lead to insufficient in-person time for the board and key managers to meet and develop the chemistry and expectations for information flow that are vital to a successful company’s governance. The vulnerabilities in these less-than-ideal scenarios are eagerly exploited by activist investors and plaintiffs’ lawyers.

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SEC’s Climate Risk Disclosure Proposal Likely to Face Legal Challenges

Posted by Jacqueline M. Vallette and Kathryne M. Gray, Mayer Brown LLP, on
Tuesday, May 10, 2022
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Jacqueline M. Vallette is partner and Kathryne M. Gray is an associate at Mayer Brown LLP. This post is based on their Mayer Brown memorandum.

On March 21, 2022, the US Securities and Exchange Commission (SEC) voted 3:1 to propose new rules that, if adopted, would require public companies to, among other things, provide audited financial statements containing climate-related financial impact and expenditure metrics, report their greenhouse gas emissions, and disclose details of how climate change is affecting their businesses (the “Proposal”). Though some companies voluntarily report climate-related information, currently there are not any standardized requirements imposed by the SEC. In a statement of support, SEC Chair Gary Gensler said that the Proposal responds to demand from investors and companies given the increased push for information on the risks climate change-related events pose to businesses.

The Proposal signifies a substantial change to existing law and, if adopted, would have wide-ranging implications for companies’ disclosure requirements and internal procedures. Given the significant additional expense the proposed rules would impose on public companies, the Proposal will likely face legal challenges. Dissenting and supporting statements from, and in response to, SEC commissioners have previewed the wide range of debate. SEC Commissioner Hester Peirce issued a lengthy dissenting statement sharply rebuking the Proposal, including on the basis that the SEC lacks authority to issue climate-related disclosure rules. As Commissioner Peirce described it, the Proposal “turns the disclosure regime on its head.”

Summary of the Proposal

A summary of the Proposal’s key disclosure requirements and resulting concerns is necessary for context before examining the potential legal challenges in detail. (A comprehensive description of the Proposal was previously discussed in the March 24 Mayer Brown Legal Update “SEC Proposes Climate Change Disclosure Rules Applicable to Public Companies.”) At a high level, the approximately 500-page Proposal would require a public company to disclose the following information in registration statements and periodic reports:

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Does Enlightened Shareholder Value Add Value?

Posted by Lucian Bebchuk (Harvard Law School), Kobi Kastiel (Tel Aviv University), and Roberto Tallarita (Harvard Law School), on
Monday, May 9, 2022
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Lucian Bebchuk is the James Barr Ames Professor of Law, Economics, and Finance and Director of the Program on Corporate Governance at Harvard Law School; Kobi Kastiel is Associate Professor of Law at Tel Aviv University, and Senior Fellow of the Harvard Law School Program on Corporate Governance; and Roberto Tallarita is a Lecturer on Law and Associate Director of the Program on Corporate Governance at Harvard Law School. This post is based on their 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); For Whom Corporate Leaders Bargain by Lucian A. Bebchuk, Kobi Kastiel, and Roberto Tallarita (discussed on the Forum here); Will Corporations Deliver Value to All Stakeholders? by Lucian A. Bebchuk and Roberto Tallarita; and The Perils and Questionable Promise of ESG-Based Compensation by Lucian A. Bebchuk and Roberto Tallarita (discussed on the Forum here).

Unlike shareholder value maximization (SV), which calls on corporate leaders to maximize shareholder value, enlightened shareholder value (ESV) combines this prescription with guidance to consider stakeholder interests in the pursuit of long-term shareholder value maximization. In a forthcoming article we recently placed on SSRN, Does Enlightened Shareholder Value Add Value?, we show that replacing SV with ESV should not be expected to benefit stakeholders or society.

We begin by explaining that the appeal of ESV and the enthusiasm for it among supporters seems to be grounded in a misperception about how frequent “win-win situations” are. In the real world, corporate leaders often face significant trade-offs between shareholder and stakeholder interests, and such situations are exactly those for which the specification of corporate purpose is important.

Furthermore, we explain that, under certain standard assumptions, SV and ESV are always operationally equivalent and prescribe exactly the same corporate choices. We then relax these assumptions and consider arguments that using ESV is beneficial in order to:

  • counter the tendency of corporate leaders to be excessively focused on short-term effects;
  • educate corporate leaders to give appropriate weight to stakeholder effects;
  • provide cover to corporate leaders who wish to serve stakeholders; and/or
  • protect capitalism from a backlash and deflect pressures to adopt stakeholder-protecting regulation. We show that each of these arguments is flawed.

We conclude that replacing SV with ESV would fail to deliver any material benefits to stakeholders or society. At best, such replacement would be neutral, creating neither value nor harm. However, to the extent that the switch to ESV would introduce the illusory perception that corporate leaders can be relied upon to protect stakeholders, such a switch would be detrimental for stakeholders and society.

Below is a more detailed account of our analysis:

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Performance Bounced Back—CEO Pay Up

Posted by Joanna Czyzewski and Lauren Peek, Compensation Advisory Partners, on
Monday, May 9, 2022
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Joanna Czyzewski and Lauren Peek are principals at Compensation Advisory Partners. This post is based on a CAP memorandum by Ms. Czyzewski, Ms. Peek, Jared Sorhaindo, and Kristine Stanners. Related research from the Program on Corporate Governance includes The Perils and Questionable Promise of ESG-Based Compensation by Lucian A. Bebchuk and Roberto Tallarita (discussed on the Forum here); The CEO Pay Slice by Lucian Bebchuk, Martijn Cremers and Urs Peyer (discussed on the Forum here); Paying for Long-Term Performance by Lucian Bebchuk and Jesse Fried (discussed on the Forum here).

CAP reviewed chief executive officer (CEO) pay levels among 50 companies with fiscal years ending between August and October 2021 (defined as the Early Filers). 2021 was a bounce back year. Median financial performance in all measures reviewed was up double digits over 2020 and median CEO total pay was up +19%. Higher bonus payouts, up nearly +75% year over year, drove the increase in CEO pay. This post covers 2021 financial performance, CEO actual pay levels and annual incentive payouts for the Early Filers.

Key Findings

Performance: 2021 median performance—as measured by revenue, pre-tax income, and earnings per share (EPS)—was higher than 2020. Revenue (+17.1%), pre-tax income (+62.5%), EPS (+71.0%), and one-year total shareholder return, or TSR, (+35.8%) were all up substantially.

CEO Pay: Median CEO pay increased by +19%. CEO pay is up largely because of a dramatic year over year increase (+73%) in the annual incentive payout. Base salaries were flat at median and the grant-date value of long-term incentives (LTI) increased +11%.

Annual Incentive Payouts: Approximately 90% of companies in this study had a payout that was at or above target. Median payout in 2021 was 145% of target which is significantly higher than median in both 2020 and 2019 (81% and 90%, respectively). A little over 40% of Early Filers had a payout that was 150% of target or higher (compared to 21% in 2020 and 7% in 2019).

Say on Pay Results: Median say on pay vote outcome was 95% in 2021 for Early Filers. However, nearly 40% of companies saw a shift of +/- five percentage points year over year. Despite this volatility, less than 5% of companies in our study failed the say on pay vote this year.

ESG Disclosure: Nearly all Early Filers include a discussion on the ESG strategy and/or compensation-related actions in the proxy statement. Around 50% of these companies include ESG as a metric in the incentive plan design (up from 30% in 2019).

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Recent Ruling on Board Diversification

Posted by Virginia Milstead, Skadden, Arps, Slate, Meagher & Flom LLP, on
Sunday, May 8, 2022
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Virginia Milstead is partner at Skadden, Arps, Slate, Meagher & Flom LLP. This post is based on her Skadden 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); Will Nasdaq’s Diversity Rules Harm Investors? by Jesse M. Fried (discussed on the Forum here); and Duty and Diversity by Chris Brummer and Leo E. Strine, Jr. (discussed on the Forum here).

In the first test of a state’s board-diversity requirement, a Los Angeles County Superior Court judge has entered summary judgment in favor of the plaintiff in Crest v. Padilla, who challenged the constitutionality of California’s law requiring California-based public companies to have at least one director on their boards from an “underrepresented community”—defined as “an individual who self-identifies as Black, African American, Hispanic, Latino, Asian, Pacific Islander, Native American, Native Hawaiian, or Alaska Native, or who self-identifies as gay, lesbian, bisexual, or transgender.”

In its April 1, 2022, decision, the court concluded that the law, known as Assembly Bill 979 and codified at California Corporations Code §301.4, violated the equal protection clause in California’s constitution. In particular, the court reasoned that the law utilized race, sexual orientation and gender-based classifications because “it impose[d] a duty on corporations to use such categories in the selection of their board members” and to “have a specific number of directors who are members of certain listed races, or else have certain listed sexual orientations or gender identities.” Use of these classifications required the defendant, California’s Secretary of State, to prove that the law was justified by a compelling state interest and narrowly tailored to accomplish its goal.

While remedying past discrimination in board selection could potentially constitute a compelling state interest, the court concluded that the defendant had “not properly defined a sufficiently specific arena in which discrimination is to be remediated.” Instead, the law applied across all industries in California. The defendant also failed to present sufficient evidence of past discrimination, the court said. While it presented evidence that straight, cisgender, white males are overrepresented on public company boards relative to the population as a whole, it failed to show a “disparity between the demographic make-up of the qualified talent pool and those who hold positions in the targeted arena.” As for the argument that businesses benefit from having a diverse board, the court concluded that “this sort of generic interest in healthy business [cannot] constitute a compelling state interest.”

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Remarks by Chair Gensler at the Annual Conference on Financial Market Regulation

Posted by Gary Gensler, U.S. Securities and Exchange Commission, on
Saturday, May 7, 2022
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Gary Gensler is Chair of the U.S. Securities and Exchange Commission. This post is based on his recent remarks before the Annual Conference on Financial Market Regulation. The views expressed in the post are those of Chair Gensler, and do not necessarily reflect those of the Securities and Exchange Commission or the Staff.

Thank you. It’s good to join the Annual Conference on Financial Market Regulation once again alongside my SEC colleagues, including Chief Economist Jessica Wachter and Commissioner Allison Herren Lee.

The field of economic research is central to our work at the SEC. It helps shape every aspect of our policymaking, from the early design phase to the proposing releases to the consideration of public comments to the adopting releases. It helps us determine the size of fines for enforcement actions. It provides important context for every one of our meetings. I look forward to hearing more about the presentations from today’s conference.

As is customary, I’d like to note that my views are my own, and I’m not speaking on behalf of the Commission or SEC staff.

I want to begin by noting a big birthday. Tomorrow happens to be the 100th anniversary of my dad’s birth.

Sam Gensler was the first of his siblings to be born in the U.S. My grandmother was so proud to be in the U.S. that she decided to name her first American-born child after Uncle Sam (at least, that’s the family lore). During World War I, the U.S. government raised money from the public through “Liberty Bonds,” marketed on posters featuring Uncle Sam. Americans turned to our capital markets to support the war efforts.

The Roaring Twenties brought about the rise of the automobile, the electrification of factories, and the large migration of Americans to cities. The retail public started to invest, in part thanks to that Uncle Sam advertising. At the time, though, there were basically no federal protections for those investors, leading to a lot of pain in the Great Depression.

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Assessing ESG-Labeled Bonds

Posted by Salima Lamdouar, Patrick O'Connell, and Tiffanie Wong, AllianceBernstein, on
Friday, May 6, 2022
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Salima Lamdouar is Portfolio Manager of Sustainable Fixed Income, Patrick O’Connell is Director of Fixed Income Responsible Investing Research, and Tiffanie Wong, CFA is Director of Fixed Income Responsible Investing Portfolio Management at AllianceBernstein. This post is based on their AllianceBernstein memorandum.

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 Exit vs. Voice by Eleonora Broccardo, Oliver Hart and Luigi Zingales (discussed on the Forum here).

Increasingly, today’s fixed-income market presents unique opportunities for responsible investing in the form of environmental, social and governance (ESG) labeled bonds. These relative newcomers to the market can give their corporate, sovereign or securitized issuers a welcome ESG halo and could even lower their cost of debt by attracting new investors. In turn, investors are drawn to ESG-labeled bonds because they can deliver a measurable—and meaningful—social or environmental impact.

Unfortunately, as demand surges for responsible investing choices and the market for ESG-labeled bonds balloons, so too do the challenges. It’s tricky for investors to select bonds with the right structures and features that will meet their ESG promises as advertised. That’s why investors and their bond managers must have a disciplined framework for assessing ESG-labeled bonds.

Bigger, Broader, Better: The Rise of ESG-Labeled Bonds

Heightened demand for responsible investing has led to an explosion in issuance of ESG-labeled bonds such as green bonds, social bonds and sustainability-linked bonds. Nearly US$800 billion in ESG-labeled bonds were issued in 2021, accounting for about one in four investment-grade and high-yield new issues in Europe alone (Display). A wider variety of companies is embracing ESG-labeled bonds too, many within industries that are increasingly faced with challenges—and opportunities—to lower the carbon intensity of production processes and consumer goods, such as chemicals, auto, telecom and consumer products.

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SEC’s Climate Disclosure Rules: GHG Emissions Disclosure Requirements

Posted by Nick Grabar, Lillian Tsu and Helena Grannis, Cleary Gottlieb Steen & Hamilton LLP, on
Friday, May 6, 2022
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Nick Grabar and Lillian Tsu are partners and Helena Grannis is counsel at Cleary Gottlieb Steen & Hamilton LLP. This post is based on a Cleary Sustainability Working Group publication by Mr. Grabar, Ms. Tsu, Ms. Grannis, Jonathan Povilonis, and Yuan He.

On March 21, 2022, the U.S. Securities and Exchange Commission issued for public comment a rule proposal that, if adopted, would require reporting companies to provide certain climate-related information in their registration statements and annual reports filed with the SEC. Specifically, the proposed rules would require:

  1. A new section in annual reports and registration statements titled “Climate-Related Disclosure,” which would include climate-related governance, risk, business impacts, targets and goals and other related disclosures.
  2. Within that section, disclosure of the registrant’s Scope 1, Scope 2 and, if material, Scope 3 greenhouse gas (GHG) emissions, together with an attestation report from an independent GHG emissions expert covering the Scope 1 and Scope 2 emissions disclosures.
  3. A new note to a registrant’s audited financial statements that provides climate-related metrics and impacts on a line-item basis.

This post addresses the second point above—the GHG emissions disclosure and attestation report requirements—and provides takeaways and possible issues for inclusion in comment letters on the proposal. Please see the other two memoranda in this series for a discussion of the Regulation S-K governance, business, risk and targets disclosure requirements and the Regulation S-X financial statements note disclosure requirements described above.

The comment period for the proposed rule is quite short: comments will be due on May 20, 2022, or 30 days after the proposal is published in the Federal Register, whichever is later. We expect that the SEC will aim to release the final rules before the end of 2022.

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