Enforcement escalation: SEC eyes ESG compliance

December 2023  |  FEATURE | RISK MANAGEMENT

Financier Worldwide Magazine

December 2023 Issue

Environmental, social and governance (ESG) issues are of increasing concern to consumers, investors and government agencies. They will continue to pose greater challenges in the years to come, not least due to the urgency caused by climate change and other ecological disasters.

ESG issues are broad in scope. Environmental considerations include a company’s impact on the natural environment, such as carbon emissions, resource use and waste management. Social considerations include a company’s impact on its employees, customers and communities, such as labour practices, human rights and product safety. And governance considerations include a company’s management structure and decision-making processes, such as board diversity, executive compensation and shareholder rights.

Given shifting stakeholder attitudes, the importance of corporates adopting sound ESG practices cannot be overstated. ESG has become an essential consideration for businesses as customers, employees, shareholders and other interested parties demand greater transparency and accountability from organisations. As such, organisations need to adopt ESG practices that align with the values and expectations of their stakeholders.

Economic case for ESG

Embedding good ESG practices within a company has many advantages. It can increase profitability and prevent costly missteps. Myriad studies espouse the benefits of adopting a proactive approach toward ESG. According to McKinsey & Company, based on 2000 academic studies on companies’ investment in mitigating ESG risks, around 70 percent revealed a positive correlation between ESG scores on the one hand and financial returns on the other, whether measured by equity returns, profitability or valuation multiples.

Companies with strong ESG reputations enjoy higher customer satisfaction and better access to markets, investment capital and talent, according to the Boston Consulting Group. Additionally, Moore Global looked at companies across eight major economies and discovered that those which adopted ESG as part of their strategic planning sustained faster profit growth and better customer retention and brand impact while encountering fewer hiring issues than non-ESG adopters.

On the flip side, failure to prioritise ESG concerns may leave organisations exposed to a variety of financial and legal consequences. Companies failing to act not only risk losing investors but also suffering fines.

Regulatory bodies are increasingly concerned about ESG. In the US, for instance, companies face an escalation of enforcement activity by the Securities and Exchange Commission (SEC) related to ESG issues. The consequences of failing to comply with the SEC’s climate-disclosure requirements carries the risk of substantial administrative sanctions that can restrict a company’s trading capabilities. Violations may also lead to potential liability for a company and its leaders, exposing them to legal and financial risks.

Furthermore, a qualified audit report resulting from non-compliance could leave the company vulnerable to shareholder actions questioning the accuracy and reliability of its financial or non-financial information. Additionally, there is a reputational cost to non-compliance which companies must consider. Misstatements and omissions leading to penalties can weaken a brand, particularly for repeat occurrences.

SEC enforcement trends

The SEC’s approach to ESG enforcement has evolved in recent years, with 2022 a notable year for actions and proposals. In March, it proposed amendments to existing rules requiring additional climate-related disclosures for publicly traded companies. That same month, the SEC released its 2022 exam priorities, in which ESG was listed as its second-highest priority. Its enforcement actions also demonstrated the agency’s desire to hold firms accountable for ESG-related statements that do not accurately reflect their investment process.

Although the SEC’s enforcement approach to ESG investment remains a work in progress, it is taking shape, according to Lynn Bergeson, managing partner at Bergeson & Campbell, PC. “The SEC created the Climate and ESG Task Force within the Department of Enforcement in March 2021,” she notes. “Announced with much fanfare, the Task Force committed to ‘develop initiatives to proactively identify ESG-related misconduct’ with an initial focus on material misstatements or gaps in issuer disclosure.

“It would seem the ‘G’ factor is first among equals and the element that drives most of the SEC’s decision to initiate enforcement,” she continues. “Review of the SEC’s actions and decisions seems to suggest governance is central to ESG and reflects the reality that corporate implementing procedures and internal controls are critical to preventing ESG misconduct. More guidance will almost certainly be found in the final climate disclosure rules, and perhaps other guidance that the SEC may issue.”

The Climate and ESG Task Force will utilise a variety of methods and potential sources to proactively identify “material gaps or misstatements in issuers’ disclosure of climate risks under existing rules, and disclosure and compliance issues relating to investment advisers’ and funds’ ESG strategies”. It also works closely with other SEC divisions and offices, including those covering corporation finance, investment management, and examinations.

Recent enforcement activity, as well as establishment of the Task Force, certainly reinforces the fact that the SEC will be proactively pursuing companies for ESG-related reporting misconduct. In March 2023, the SEC announced a $55m settlement in ongoing litigation with Vale S.A., a Brazilian mining company whose American depository shares and notes are registered with the SEC and publicly traded on the New York Stock Exchange. It was the first case brought by the SEC’s Climate and ESG Task Force.

Under the terms of the agreement, Vale agreed to pay a $25m civil penalty and $30.9m in disgorgement and prejudgment interest, in addition to general injunctive relief. According to Mark Cave, associate director at the SEC, the settlement would “levy a significant financial penalty against Vale and demonstrate that public companies can and should be held accountable for material misrepresentations in their ESG-related disclosures, just as they would for any other material misrepresentations”.

In the view of Ms Bergeson, most observers would agree that the SEC has made good on its ESG promises, given its aggressive approach to initiating actions over the past two years or so. “But the number of cases the SEC has brought lately seems to reflect a ‘light touch’,” she contends. “This pattern likely telegraphs several messages. First, resource constraints as cryptocurrency investigations have taken their toll on bandwidth. Second, a strategic decision to relent on enforcement as the SEC seeks to issue in final its controversial climate disclosure rules this year. Third, a response to the 19 state attorneys generals’ opposition to ESG generally. And lastly, the fast-approaching general elections and the predictable anaesthetising effect elections tend to have on enforcement generally. Aggressive enforcement is expected to continue in 2024, but perhaps a bit less robustly for these reasons.”

The SEC’s ESG enforcement efforts will certainly remain a point of interest, particularly in terms of what guides them. “The answer is perhaps found in analysing the SEC’s enforcement choices rather than in explicit SEC guidance, which remains scant,” notes Ms Bergeson. “Clearly, SEC enforcement targets are driven by a desire to promote compliance, create precedent-setting impacts and demonstrate an ‘all of agency’ commitment to blunting bad behaviours.”

Rising scrutiny of asset management

In the financial services sector, the SEC has been monitoring firms’ practices when they offer services based on clients’ preferences around ESG and investing factors related to corporate responsibility, along with other factors that go beyond immediate bottom-line concerns.

ESG investing has exploded in recent years, reaching $3 trillion in global assets under management (AUM) in 2021, up from $1 trillion in 2019, according to Morningstar. The SEC’s enforcement division has sent document requests, including subpoenas, to several asset managers relating to their ESG investment marketing this year. Such moves suggest a looming crackdown on sustainable funds.

Previously, the agency cited the broad provisions of section 206 of the Advisers Act, which requires disclosure of material facts, to bring ESG-related actions. However, since November 2022 the SEC has gained broader authority under the newly implemented Marketing Rule to examine all of a firm’s compliance processes for advertising and marketing material, including ESG claims.

New rule proposal

The SEC also recently proposed a new rule – ‘Enhance and Standardize Climate-Related Disclosures for Investors’ – which aims to ensure that the US capital markets receive consistent, comparable and useful information regarding climate-related matters, and promotes standardised reporting practices among organisations. The proposed new rule would apply to all companies with registered securities, including foreign private issuers, which will be required to comply with the climate-related disclosures stated in the new regulation.

The proposed climate-disclosure rule incorporates both quantitative and qualitative metrics. Under the new rule, US companies and foreign private issuers would be required to disclose their climate-related risks and greenhouse gas emissions. They would need to include detailed information on their climate-related governance and plans for transitioning to a more sustainable future. This data would allow investors to make more informed assessments of a company’s enterprise value, taking into consideration the myriad climate-related risks that can affect various aspects such as business operations, value chains, financial condition and specific climate-related financial statement metrics.

How to respond?

In response to the direction of travel on ESG matters, companies must understand the impact of ESG factors and strategically harness them while ensuring their compliance frameworks are sound. They should carefully and regularly review their ESG-related disclosures for accuracy and completeness and maintain adequate controls and procedures. This includes compiling documentation to support their ESG and climate-related representations.

Going forward, with the SEC and other regulatory bodies increasing their focus on ESG, organisations will need to review and update their policies and procedures with respect to investor-facing disclosures. This would include, for example, responses to requests for proposals and information, due diligence questionnaires and investor presentation materials. It would also cover existing product descriptions to validate related ESG elements, including ensuring that materials are true and consistent. Additionally, firms should update their training and education sessions to ensure employees have a comprehensive understanding of the company’s ESG obligations.

While there will be no ‘one size fits all’ approach to ESG for organisations, regulators and investors will have relatively consistent demands which companies must be able to meet. Proving they can satisfy ESG-related disclosure requirements, issue them truthfully and consistently across the organisation and back them up with supporting documentation will put companies on solid footing. Robust processes and controls will allow companies to respond to rising regulatory and investor scrutiny in the years ahead, helping to mitigate liability and provide viable defences where required.

© Financier Worldwide

BY

Richard Summerfield