United States: How Will An Increased Focus On ESG By The SEC And Investors Impact Transactions?

ESG Overview and Use in Investments

Environmental, Social and Governance or ESG has become a hot topic for investors in recent years. For those not familiar, ESG proposes a set of non-traditional factors to identify risks and opportunities related to a given business. Each of the three main categories include numerous subcategories, so any given company must tailor its focus on the ESG factors most relevant to its business. Environmental considerations range from physical risks due to rising sea levels to carbon emissions. Social factors can mean anything from diversity and inclusion to the sourcing of materials. The governance factors look to how ethically a company operates and how it incorporates environmental and social considerations into the business. Advocates argue that boards incorporating ESG into business decisions and investors using ESG to evaluate potential investments increase financial returns and reduce liabilities.¹ For example, a company with robust anti-harassment practices is less likely to encounter costly litigation. On the environmental side, an investment fund considering the physical risks of its assets is likely to suffer fewer costly damages from hurricanes or flooding.

Consequently, there has been a vast increase in ESG-related funds and a focus on ESG in the M&A world.² According to one study, 65% of M&A executive say that their company's focus on ESG will increase over the next three years.³ Incorporating ESG into due diligence involves broadening the considerations of traditional diligence but is still geared toward evaluating potential litigation risks or future financial performance. In fact, many ESG factors, like safety and diversity, are already accounted for through reviewing measures such as EEO-1 and OSHA-related reporting. Buyers are asking more ESG questions in the due diligence process, and sellers need to be prepared.

As investors seek ESG investments, companies are looking to review their internal ESG metrics and provide reports to their shareholders and potential investors. However, the US currently lacks a standardized ESG reporting standard. Companies attempting to incorporate ESG have wide latitude to choose a reporting standard (or not) in compiling any investor reports or public relations materials. The most commonly used reporting standards include the Global Reporting Initiative (GRI), the Sustainability Accounting Standards Board (SASB) and the Task Force on Climate-Related Financial Disclosures (TCFD). Even after selecting a given framework, companies have further discretion on how to use the framework. For example, SASB includes 77 identified industries, each with different standards for evaluation.⁴ Thus, a company must select the most applicable industry (or combination) prior to evaluating its ESG metrics. Similarly, the TCFD includes eleven different categories of disclosure. For the fiscal year 2021, only 4% of companies using TCFD disclosed according to all 11 recommended disclosures and only 40% included at least five of eleven disclosures.⁵ While ESG reporting may provide investors and shareholders with more information, the lack of standardization leads to difficulty in comparisons between companies, or even a full understanding of any individual company or fund. These reports may even be misleading due to a lack of scrutiny of climate-related methodologies.

SEC takes an Interest in ESG

Companies are increasing their ESG reporting, and regulators are taking note. To rectify some of the issues associated with this new plethora of ESG reports, the Securities and Exchange Commission (SEC) launched a Climate and ESG Task Force in March of 2021. ⁶ The Task Force is working to identify material gaps or misleading statements in issuers' reports.⁷ As summarized below, the SEC is stepping up enforcement related to ESG reporting and is proposing new rules related to this reporting.

Investment Company Act "Names Rule"

In 2022, the SEC proposed changes to the Names Rule, including changes designed to reduce greenwashing in investment funds. Greenwashing refers to exaggerated claims made with regards to ESG, especially for sustainability. ⁸ The current rule requires investments with names suggesting a focus on a particular type of investment to have 80% of the assets invested in accordance with the suggestion of the name. The proposed rule extends this 80% requirement to funds with names suggesting a focus on investments with "particular characteristics." The SEC did not define the term "particular characteristics," but used ESG as an example of a term that would trigger the new requirement. Funds with names such as "ESG" or "sustainable" need to consistently invest in appropriate assets or risk being found materially deceptive or misleading under the new requirements.

Climate-Related Risk Rule

In March 2022, the SEC published a proposed a rule requiring publicly traded companies to report on climate-related risks.⁹ While many people agree that there is broad need for standardization, there has been considerable discussion and commentary surrounding the proposed rule. It has been hotly contested and drew over 15,000 comments. The rule would require registrants to include climate-related disclosures in their registration statements and periodic reports. In particular, companies would be required to disclose climate-related risks which are reasonably likely to have a material impact on the business, results of operations or financial condition. The proposed rule requires companies to analyze the climate-related costs and risks for each item of their financial statements and report costs that are 1% or higher of a given line item. It was expected that the rule would be finalized in April 2023, but as of this article, the rule has not been finalized. Given the broad reach of the proposed rule, legal challenges are sure to follow.

SEC Enforcement

While the SEC is still increasing the regulations around ESG, current regulations give the SEC power to prosecute issuers who make misleading statements in their reports. In the past few years, the SEC has been cracking down on issuers' and investors' statements regarding ESG.¹⁰ In 2022, the SEC charged BNY Mellon Investment Advisor, Inc. (BNY) for misstatements and omissions about ESG considerations in making investment decisions for certain mutual funds that it managed.¹¹ BNY agreed to settle the charges with a $1.5 million penalty. The SEC's order found that for three years, BNY had failed to use the ESG criteria as promised in evaluating investments. The order found that numerous investments held by BNY did not have ESG quality review scores at the time of the investment. Adam S. Aderton, Co-Chief of the SEC Enforcement Division's Asset Management Unit and a member of the Climate and ESG Task Force, stated, "[a]s this action illustrates, the Commission will hold investment advisers accountable when they do not accurately describe their incorporation of ESG factors into their investment selection process." While this is just one example, as ESG reporting and related regulations increase, we expect similar enforcement actions to increase in tandem.

Going Forward

As investors become increasingly focused on ESG, they will demand more accurate and reliable information from companies. The SEC's proposed rule points to a significant shift towards standardization and accountability in ESG reporting. SEC enforcement poses a serious potential liability, so buyers of public companies will need to closely review past reporting for potential greenwashing. There has been and will likely continue to be some ESG pushback as well, such as states withdrawing investments from funds they view as too heavily focused on ESG-related investing. Still, it seems fair to say that the overall emphasis on ESG will continue, with a corresponding increase in ESG due diligence in connection with investment decisions and acquisitions.