SEC Commissioner Allison Herren Lee, a big supporter of environmental, social, and governance (ESG) reporting, described what she believes are myths surrounding the concept of materiality that public companies use in deciding what to disclose to investors. In her view, materiality is not a static concept, and she believes that information about corporate political spending, for example, can be material today.
In general, materiality means companies should disclose information that a reasonable person would find important in the total mix of information to make an investing or voting decision. And the definition in the securities laws are based on such Supreme Court decisions as TSC Industries v. Northway and Basic v. Levinson.
She shared her views as the SEC is considering ESG disclosure rulemaking.
“As debates around climate and ESG disclosure have intensified, I have found through dozens if not hundreds of conversations that a number of misconceptions about materiality— what it is and what it is not—have proliferated,” Lee said in a speech during the 2021 ESG Disclosure Priorities Event hosted virtually by the AICPA & the Chartered Institute of Management Accountants, Sustainability Accounting Standards Board (SASB), and the Center for Audit Quality (CAQ) on May 24.
“For example, many appear to believe that materiality currently works almost preternaturally, on its own with no need for regulatory involvement, to produce all important information from all public companies at all times,” Lee said. “Many have also come to believe incorrectly that the SEC is legally prohibited from requiring specific disclosures unless it can demonstrate that each such disclosure is individually material to the bottom line of every public company.”
Thus, she came to the most prevalent myth: All matters, including ESG, that are material to investors are already required to be disclosed under the securities laws. Business groups have been using this argument as well as the two Republicans on the commission who have been skeptical of standardized ESG rules.
“This is simply not true, and reflects a fundamental misunderstanding of the securities laws,” Lee said. “Public company disclosure is not automatically triggered by the occurrence or existence of a material fact. There is no general requirement under the securities laws to reveal all material information. Rather, disclosure is only required when a specific duty to disclose exists.”
She pointed to the court’s decision on Basic that said preliminary merger negotiations may be material. It affirmed that materiality should be gauged by what the reasonable investor finds material.
“But Basic also acknowledged the fundamental principle that, under the securities laws, an omission of information – even material information – is not actionable absent a duty to disclose,” Lee said. “In Basic, the duty to disclose the pre-merger negotiations arose out of public statements the company made asserting that it was unaware of any developments that might explain high trading volumes and price fluctuations in its shares.”
Lee explained that a duty to disclose could arise with explicit SEC disclosure requirement, such as the rules in Regulation S-K, the repository of public company disclosure requirements outside the financial statements. A duty to disclose may also arise to make sure that a company’s other statements are not misleading.
Political Spending Disclosure
Lee said political spending illustrates the principles behind both types of possible duties.
First, this information, she said, can be “extremely important” to reasonable investors.
The SEC has gotten over 1.2 million individuals supporting a rulemaking petition by 10 academics in August 2011 following a 2010 Supreme Court decision that allowed corporations to spend freely on political activities. But the measure was opposed by business groups who said the disclosure requirement is outside the SEC’s legal authority and call it an arbitrary attempt to interfere with company First Amendment rights. The rule would also impose costs without justification.
“As the late founder of Vanguard, John Bogle, once said ‘corporate managers are likely to try to shape government policy in a way that serves their own interests over the interests of their shareholders,’” Lee said. “When companies use shareholder funds for political influence, it stands to reason that shareholders would want to be able to assess for themselves whether such spending is in their interests.”
However, Lee said companies rarely disclose this information in reports filed with the SEC because there are no explicit requirements in the commission’s rule books.
On the second duty, she pointed to the January 6th attack on the Capitol. Some companies at the time made public pledges about their political spending.
“One might argue that these public pledges give rise to a duty to disclose their actual political contributions – not unlike the duty to disclose merger negotiations in Basic – to ensure that such statements are not misleading, especially if actual contributions run contrary to these pledges,” Lee said. “But such a duty would arise only based on discretionary statements made by management, not solely on the basis that information regarding political contributions is material to investors. The bottom line is that absent a duty to disclose, the importance or materiality of information alone simply does not mandate its disclosure.”
Securities laws today include little explicit climate or other sustainability disclosure requirements.
“In many instances, therefore, disclosure may be required only when a particular discussion of climate is collateral to something else disclosed by the company,” she said. “The same is true for many ESG matters that lack express disclosure requirements. Thus, climate and ESG information important to a reasonable investor is not necessarily required to be disclosed simply because it is material.”
Possibility of Rulemaking
Political spending disclosure has increasingly become a partisan issue over the years.
Democratic lawmakers want it; Republicans do not. And a former SEC official said the agency has been in a difficult position when Congress passes laws that can be interpreted as outside the commission’s mandate.
“I know from personal experience that SEC staff by-and-large—at least during my time— did not appreciate Congress dictating to the SEC what companies should and should not be required to disclose. Mine safety disclosures were always a tidy example of what staff considered overreaching ‘politicization’ of the disclosure rules,” said Will Dorton, Of Counsel with Dickinson Wright PLLC, who worked at the SEC from 2015 to 2017.
“I would not be surprised if the SEC is now—like the rest of the country—a bit more divided along partisan lines, and I would not be surprised if [SEC Chair Gary] Gensler and the Democratic commissioners move on something in this area.” Dorton said.
While business groups have been traditionally opposed to this, Dorton added that they “are starting to be more receptive across the ESG gamut than I would have expected.”
He said the Business Roundtable, for example, has been pretty open about supporting various ESG measures.
In the meantime, Steven Lofchie, a partner with Cadwalader, Wickersham & Taft LLP, in a client memo wrote that Lee “is working to establish a legal basis to require companies to disclose a greater amount of information as to ESG issues. Essentially, her argument is that the SEC should regard information as material if investors want the information, even if the information may not be relevant to the issuer’s financial performance.”
This article originally appeared in the May 26, 2021 edition of Accounting & Compliance Alert, available on Checkpoint.
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