Attorneys see rocky road for SEC climate initiative

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While questions abound as to their final form, attorneys are confident that the Securities and Exchange Commission will adopt some version of ambitious climate disclosure rules proposed last month.

And whatever their final form, securities experts say the forthcoming regulatory regime promises legal challenges by the business community, sleepless nights for compliance officers, and fertile ground for plaintiffs’ attorneys eager to pounce on corporate missteps.

On March 21, the SEC proposed rule changes that would require issuers of securities subject to registration under the Securities Exchange Act of 1934 to include certain climate-related disclosures in their registration statements and periodic reports.

The disclosures required of publicly traded companies would include information about climate-related risks that are “reasonably likely to have a material impact” on a company’s business, operations or financial condition. Moreover, required disclosures would include estimates of a registrant’s greenhouse gas emissions.

Matthew E. Miller, a defense-side securities litigator in Boston, says he has no doubt the litigation risk for companies will increase if the rules are adopted.

“It’s a simple equation: If you require public companies to make additional disclosures, then additional litigation is likely to follow,” Miller says. “While sometimes those claims are meritorious, oftentimes you have a very aggressive plaintiffs’ bar who will seize upon a disclosure and try to make [a case] out of it.”

The SEC‘s climate initiative marks a “radical departure” from the current climate change related disclosure requirements for public companies, according to Andrew C. Spacone, a retired corporate attorney who teaches securities regulation at Roger Williams University School of Law in Rhode Island.

“To put it bluntly, it is a bad rule if only because the increased costs and adverse impact on capital formation will far outweigh the benefits,” Spacone says.

But Owen P. Lynch, a corporate attorney in Providence, says he doesn’t think the SEC’s proposal is as radical as some claim.

“In many respects, it’s in line with a broader movement of investor interest in [greenhouse gas] sensitivity,” Lynch says. “It also builds on frameworks that are already in place as far as reporting requirements.”

Joseph Franco says while companies will face challenging regulatory burdens under the proposed rules, the SEC’s climate initiative responds to the demands of today’s investors.

“There is no doubt that in the marketplace today there is much greater appetite among investors to evaluate the [Environmental, Social and Governance] profile of companies,” the Suffolk University Law School professor says. “And just as it is very difficult to manage what you don’t measure, it’s very difficult to actually implement these investment desires unless you somehow have some transparency and culpability about how companies are performing in the ESG space.”

Bureaucrats’ delight?

The 506 pages of proposed rule changes are subject to a comment period that ends 30 days from the date of their publication in the Federal Register or on May 20, whichever is later. (As of press time, the SEC’s proposal had not been published in the Federal Register.)

Lynch views the short comment period as problematic.

“It really doesn’t give companies a ton of time to determine the burden these rules will place on them and to present what better alternatives there may be,” he says.

Meanwhile, Franco says he fully expects the SEC to adopt rules along the lines of the current proposal.

“The momentum at the agency level is very strong in that direction,” he says.

According to Spacone, the SEC is following the lead of the White House.

“This is part of the administration’s climate change agenda, and the SEC — [Chair Gary] Gensler, in particular — is hell bent to follow the lead,” Spacone says. “The rule will probably undergo some modification. They’ll probably ratchet it down a bit — but not much.”

The SEC voted 3-1 in favor of proposing the revisions.

“Today, investors representing literally tens of trillions of dollars support climate-related disclosures because they recognize that climate risks can pose significant financial risks to companies, and investors need reliable information about climate risks to make informed investment decisions,” Gensler said in announcing the agency’s action.

Miller agrees that there is investor demand for climate-related disclosures, but he questions whether the SEC should respond to that demand.

“The fundamental question is who should be responding to this need? Is it the SEC? Or should it be Congress? A lot of people would argue it should be Congress,” Miller says.

“It’s a simple equation: If you require public companies to make additional disclosures, then additional litigation is likely to follow.”

— Matthew E. Miller, Boston

The rule changes would require a publicly traded company to disclose information detailing: (1) the business’s governance of climate-related risks and relevant risk management processes; (2) how any climate-related risks identified by the registrant have had or are likely to have a material impact on its business; (3) how any climate-related risks have affected or are likely to affect the registrant’s business strategy and outlook; and (4) the impact of climate-related events, such as severe weather, on the line items of a registrant’s consolidated financial statements.

The rules also would require a registrant to disclose information about its direct greenhouse gas emissions (Scope 1) and indirect emissions from purchased electricity or other forms of energy (Scope 2).

In addition, a registrant would be required to disclose material GHG emissions from “upstream and downstream activities in its value chain” (Scope 3).

Smaller companies are provided an exemption from the Scope 3 emissions disclosure mandate. Likewise, the proposed rules afford smaller companies a safe harbor from liability for Scope 3 disclosure violations.

Franco characterizes quantifying Scope 3 emissions as “truly uncharted territory” in terms of being able to reliably capture information among consumers and upstream partners and participants in the chain of production.

“I think everyone realizes that the Scope 3 emission [disclosure requirement] is a pretty open-ended enterprise,” Franco says. “It would be costly even if you knew how to do everything. But when you start with a new regime of disclosures, there are significant startup costs.”

The commission’s one “no” vote on the proposed rule changes came from Hester M. Peirce. In her dissenting statement, Peirce wrote that the new disclosure framework “will eventually rival our existing securities disclosure framework in magnitude and cost and probably outpace it in complexity. … The placard at the door of this hulking green structure will trumpet our revised mission: ‘protection of stakeholders, facilitating the growth of the climate-industrial complex, and fostering unfair, disorderly, and inefficient markets.'”

Legal challenges

The proposed rules will significantly increase the management time and capital expenditures required for companies to achieve compliance, according to Spacone.

Opponents of the rules will have several avenues to challenge them in court should they be adopted.

Spacone says there’s an argument to be made that the required disclosures amount to compelled speech in violation of the First Amendment. He also expects companies to argue that the SEC exceeded its rule-making authority by effectively making an “end run” around Congress to mandate climate change mitigation practices.

“How the courts will address the issue is uncertain, but there are several justices on the U.S. Supreme Court who have expressed concerns with executive agency overreach, and there are some notable decisions on the free speech issue that plaintiffs are sure to rely on,” Spacone says.

The commission’s greenhouse gas proposals would appear to be particularly vulnerable to the “agency overreach” argument, Miller says.

“Courts are going to look at the overall context of the statutes giving the SEC rulemaking authority,” he says. “Is it to make rules with the public welfare in mind, generally? No, it’s not. It’s really about requiring companies to make financial disclosures that investors would believe are important in making a decision to buy or sell a stock.”

But Lynch doesn’t believe the SEC is guilty of overreach.

“From a common-sense perspective, we can see the effects of climate change,” Lynch says. “What I believe the SEC is trying to do with this is make companies more proactive in considering the financial impact of climate change.”

Franco says one could argue that the proposed rules “come within the purview of the commission’s legitimate concerns about how climate-related risks will impact public companies and their financial results.” But on the other hand, the SEC’s rulemaking could be vulnerable to the argument that the agency did not meet its statutory obligation to adequately assess the potential costs of its proposals, he says.

“The commission also has to consider alternatives that are less costly,” Franco says. “I would imagine that businesses will advance a series of more manageable alternatives as a way to achieve some the goals reflected in the commission’s proposal.”

But Miller has less faith in a cost-based argument.

“The cost impact is not going to be that extensive because a lot of companies are doing [climate risk disclosures] already,” Miller says. “A lot of investors are clamoring for standardized disclosures in this area.”

More work for plaintiffs’ bar

Spacone says the sheer complexity of required climate disclosures would expose public companies and their management to increased liability under the anti-fraud provisions of the Securities Exchange Act of 1934 — Section 10(b) and Rule 10b-5 (b) — as well as the SEC’s Management Discussion & Analysis Rule.

“[The proposed rules require] standardized reporting in registration statements and periodic reports on estimated greenhouse gas emissions arising from the companies’ own operations, as well as from energy they consume, and requires independent certifications of the estimates,” he says.

Franco agrees that there’s an increased litigation risk for companies under the proposed rules.

“If you are on the corporate side, there is always the concern that the more detailed and specific the disclosures become about specific areas of a business, that becomes a greater litigation risk,” he says. “The more ‘granular’ the disclosure becomes, the greater the risk that there could be mistakes and that inaccuracies creep into the disclosure.”

“To put it bluntly, it is a bad rule if only because the increased costs and adverse impact on capital formation will far outweigh the benefits.”

— Andrew C. Spacone, Roger Williams University School of Law

Consequently, Franco says, there is little doubt that the proposed rules present an increased litigation risk for businesses.

“Companies will have to come up with disclosure strategies to try to minimize the risk and also litigation strategies that combat the attendant risk,” he says.

According to Miller, most securities cases based on alleged failure to make a required disclosure eventually settle.

“Often, the settlement has nothing to do with the merits,” Miller says. “[Cases settle] to confront the litigation costs and [the strain] of having to be involved in litigation. Those settlements are often multi-million-dollar affairs, so it’s a very significant and real risk.”