ESG Misrepresentations and Bond Investors

When the Securities and Exchange Commission (SEC) describes its mission as protecting investors, it mainly has stock investors in mind. The stock market crash of 1929 prompted Congress to pass the federal securities laws. It believed that ordinary investors needed protection from Wall Street insiders who exploited the speculative fervor in stock prices that preceded the crash to enrich themselves. In contrast, investors in corporate bond markets were viewed as needing less protection. The private placement exemption was meant in part to relieve issuers from the disclosure requirements of the Securities Act of 1933 when selling bonds to sophisticated investors such as insurance companies.

In the modern era, the SEC’s enforcement cases against public companies for misleading investors have most often emphasized stock investor losses. The agency’s accounting fraud cases routinely argue that a company issued materially misleading information to boost its stock price. The losses from the wave of securities fraud in the late 1990s and early 2000s prompted Congress to give the SEC the power to create funds to compensate investors for their losses. The SEC generally distributes fund recoveries to stock investors.

The SEC also occasionally brings enforcement actions against public companies for material misstatements that affect bondholders. One type of case involves misstatements that are contained in disclosure documents associated with a bond offering.

• In a 2014 case, the SEC required CVS Caremark to pay $20 million for failing to disclose material information about the loss of contract revenue in a Prospectus Supplement for a $1.5 billion senior note offering.
• In 2020, the SEC imposed an $18 million penalty against the German auto manufacturer BMW. The case alleged that BMW included false information about its retail sales in documents relating to Rule 144A bond offerings. BMW raised $18 billion through seven different offerings from 2016 to 2019. In its presentations to the bond investors, the company “emphasized BMW’s retail sales history and outlook.” The SEC created a fair fund to distribute BMW’s payment to bond investors.
• Also in 2020, the South Carolina Electric & Gas Company paid $112.5 million in disgorgement for misstatements relating to the status of a nuclear power plant project that were incorporated by reference into the registration statement for a $1 billion bond offering.
• In 2023, the SEC brought a case against a company that went public through a special purpose acquisition company. The company fabricated revenue and issued misleading financial statements in connection with the sale of $200 million in bonds issued pursuant to Rule 144A.

My article discusses some recent SEC enforcement cases that have highlighted the interests of bond investors in ESG disclosure. The most significant is a complaint the SEC filed against the German automobile manufacturer Volkswagen (VW). The SEC cited statements VW made to investors who purchased bonds issued pursuant to the Rule 144A exemption, which permits a company to sell securities without registration to qualified institutional buyers. It alleged that VW misled Rule 144A investors about risk associated with its lack of compliance with environmental regulation. VW deliberately and egregiously violated those laws, triggering billions of dollars in criminal penalties and civil penalties by the Environmental Protection Agency.

The VW case is notable not only because the SEC brought it to protect sophisticated bond investors but because it addressed qualitative misstatements about Environmental, Social, & Governance (ESG) risk. The case could be read as making the point that ESG disclosure is of particular concern to bond investors. Unlike stock investors, bond investors receive a fixed return and do not share in the gains from reckless strategies. They are thus generally more risk-averse than shareholders. To the extent that ESG disclosure assures investors that companies will not take on excessive risk, such disclosure is arguably more important to investors in bonds than investors in stocks.

The interests of bond investors in some ways are similar to the interests of corporate stakeholders such as employees, customers, and the community. Such stakeholders, who do not receive direct protection under corporate law, tend to be more risk-averse than shareholders. Like other stakeholders, bondholders only have rights that are contractually negotiated. By actively protecting bond investors, the SEC could create additional incentive for public companies to avoid excessive risk-taking that harms stakeholders. It could do so without re-writing corporate law, which only extends fiduciary duties to shareholders.

As investors have demanded more ESG disclosure, the SEC has brought some significant cases that highlight the impact of material misrepresentations on bond investors. In doing so, the SEC has emphasized that bond investors also rely on truthful disclosure by corporate issuers. While they are less likely to suffer losses than stock investors, bond investors can also be impacted by hidden risks that can substantially affect a company’s market value. By bringing enforcement on behalf of bondholders, the SEC is recognizing that securities law does more than further shareholder wealth maximization. It can also check the tendency of public companies to mislead investors about excessive risk that can injure stakeholders with fixed claims.