On Monday, in a keynote address before the Society for Corporate Governance 2021 National Conference, SEC Commissioner Allison Herren Lee discussed the challenges boards face in oversight of ESG matters, including "climate change, racial injustice, economic inequality, and numerous other issues that are fundamental to the success and sustainability of companies, financial markets, and our economy." Shareholders, employees, customers and other stakeholders are now all looking to corporations to adopt policies that "support growth and address the environmental and social impacts these companies have." Why is that? Because actions or inactions by our largest corporations can have a tremendous impact. According to Lee, a 2018 study showed that, of the top 100 revenue generators across the globe, only 29 were countries—the rest were corporations, that is, corporations "often operate on a level or higher economic footing than some of the largest governments in the world."
No longer on the periphery. Environmental and social issues are no longer considered peripheral but are now viewed as more central to businesses. As a result, boards are more engaged on ESG risks and opportunities, Lee explains, citing a survey showing that almost 80% of "directors reported that their boards are focused on some aspect of ESG. An analysis of a selection of S&P 100 proxy statements found that 78 percent of companies had at least one board committee charged with overseeing environmental sustainability matters. And 42 percent of companies reviewed in that analysis associated at least one director with expertise in environmental policy, sustainability, corporate responsibility, or ESG." Nevertheless, other analysis suggests boards may lack specific sustainability mandates" and may be lacking board expertise on ESG.
Lee points to the results of the recent proxy season to underline the increasing significance of ESG. Shareholder proposals on climate received "record support," including 98% support in one instance at a large company and several proposals achieving significant majority votes. Not to mention that climate activists conducted a surprisingly successful proxy contest. Proposals on racial equity audits almost achieved majority votes and several proposals for political spending disclosure did achieve majorities. (See this PubCo post.) Notably, Lee observes, this proxy season occurred against the backdrop of "ever-more powerful signals from major institutional investors of their commitment to sustainability. Finally, it occurs as the SEC considers potential rulemaking to improve climate and other ESG disclosures for investors. These developments place ever greater responsibility on companies, and therefore boards, to integrate climate and ESG into their decision-making, risk management, compensation, and corporate transparency initiatives."
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For example, in his 2020 annual letter to CEOs, Laurence Fink, CEO and Chair of BlackRock, the world's largest asset manager, announced a number of initiatives designed to put "sustainability at the center of [BlackRock's] investment approach." According to Fink's letter, "[c]limate change has become a defining factor in companies' long-term prospects." What's more, he made it clear that companies needed to step up their games when it came to sustainability disclosure. (See this PubCo post.) Similarly, Fink's 2021 letter to CEOs asked companies to disclose a "plan for how their business model will be compatible with a net zero economy." Fink continues to believe that climate risk is investment risk and that we are now looking at an accelerating transition to sustainable investment, making climate transition "a historic investment opportunity." In his view, to achieve a net zero economy—"one that emits no more carbon dioxide than it removes from the atmosphere by 2050, the scientifically-established threshold necessary to keep global warming well below 2ºC"—the entire economy must be transformed. Every company will be "profoundly affected by the transition," but those companies that have articulated strategies and plans to achieve that transition "will distinguish themselves with their stakeholders." To that end, investors need "consistent, high-quality, and material public information" and analysis to assess how well companies are prepared for the risks and the transition. (See this PubCo post.)
Board obligations. Lee begins this part of her presentation by observing that, historically, many ESG issues were dismissed as only a component of "corporate social responsibility" and not really considered part of the board's principle responsibility—to "maximize shareholder value." Perhaps ESG issues might "bear on the public good, but were not relevant to maximizing value for shareholders." However, Lee concludes, "[t]hose days are over." We don't need to reach the debate over shareholder primacy versus stakeholder capitalism in this context because "the connection between ESG and the interests of shareholders has become evident. Our understanding of the significance of ESG and its short-, medium- and long-term relationship to financial performance has evolved to the point that the principal debates are about when, not if, these issues are material. Thus, regardless of whether one agrees with the Business Roundtable's position on corporate purpose and service to stakeholders and the broader economy, it is clear that the board has a role with respect to ESG." (Of course, Commissioner Elad Roisman might take issue with that conclusion. See this PubCo post.)
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In 2019, the Business Roundtable announced the adoption of a new Statement on the Purpose of a Corporation, signed by 181 well-known, high-powered CEOs. What was newsworthy was that the Statement moved "away from shareholder primacy" as a guiding principle and outlined in its place a "modern standard for corporate responsibility" that made a commitment to all stakeholders. According to the press release, the Business Roundtable has had a long-standing practice of issuing Principles of Corporate Governance. Since 1997, those Principles have advocated the theory of "shareholder primacy—that corporations exist principally to serve shareholders"—and relegated the interests of any other stakeholders to positions that were strictly "derivative of the duty to stockholders." The new Statement superseded previous statements and "more accurately reflects [the Business Roundtable's] commitment to a free market economy that serves all Americans. This statement represents only one element of Business Roundtable's work to ensure more inclusive prosperity, and we are continuing to challenge ourselves to do more." (See this PubCo post.)
Shareholder primacy was not always the prevalent theory, argues Professor William Lazonick in "Profits without Prosperity," published in the September 2014 Harvard Business Review: "From the end of World War II until the late 1970s, a retain-and-reinvest approach to resource allocation prevailed at major U.S. corporations. They retained earnings and reinvested them in increasing their capabilities, first and foremost in the employees who helped make firms more competitive. They provided workers with higher incomes and greater job security, thus contributing to equitable, stable economic growth—what [he calls] 'sustainable prosperity.' This pattern began to break down in the late 1970s, giving way to a downsize-and-distribute regime of reducing costs and then distributing the freed-up cash to financial interests, particularly shareholders. By favoring value extraction over value creation, this approach has contributed to employment instability and income inequality." (See this PubCo post.)
The shift to shareholder primacy has been widely attributed to the development of the "shareholder preeminence theory" by the Chicago school of economists, beginning in the 1970s, with economist Milton Friedman famously arguing that the only "social responsibility of business is to increase its profits." Subsequently, two other economists published a paper characterizing shareholders as "'principals' who hired executives and board members as 'agents.' In other words, when you are an executive or corporate director, you work for the shareholders." (See this PubCo post, this Cooley News Brief, this Cooley News Brief and this Cooley News Brief.)
For example, she suggests, there is "broad consensus regarding the physical and transition risks associated with climate." Many standard setters, such as SASB (now called the Value Reporting Foundation following a merger with the International Integrated Reporting Council), have identified ESG risks and standards that are financially material. Because the largest asset managers and other institutional investors view ESG to be "material to their decision-making," they have demanded ESG disclosure. Regardless of whether the SEC steps in to mandate specific ESG disclosure regulations, she contends, "directors must reckon with this growing consensus and growing demand from the shareholders who elect them. Accordingly, boards increasingly have oversight obligations related to climate and ESG risks—identification, assessment, decision-making, and disclosure of such risks."
Board's oversight obligations "flow from both the federal securities laws and fiduciary duties rooted in state law." The board plays a "critical and mandatory role" under the federal securities laws in connection with oversight of the financial statements, which is evident from SOX requirements, as well as Exchange rules and PCAOB requirements. Climate change, Lee asserts, "may bear on the valuation of assets, inventory, supply chain, and future cash flows," making engagement on those issues increasingly a part of board oversight of audits. Similarly, in light of the SEC's 2010 climate guidance, boards are increasingly required to consider ESG matters in the context of other corporate disclosures, such as MD&A. She also highlighted the SEC's recent update to Reg S-K, Item 101, regarding human capital, as well as the Item 407(h) requirement for disclosure of the board's role in the risk oversight, all of which could involve climate and other ESG issues.
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The SEC's 2010 guidance points to a number of topics that could have an impact on climate disclosure. For example, regulatory, legislative, business and market changes "could have a significant effect on operating and financial decisions, including those involving capital expenditures to reduce emissions and, for companies subject to 'cap and trade' laws, expenses related to purchasing allowances where reduction targets cannot be met. Companies that may not be directly affected by such developments could nonetheless be indirectly affected by changing prices for goods or services provided by companies that are directly affected and that seek to reflect some or all of their changes in costs of goods in the prices they charge." Likewise, the guidance highlights the potential physical effects of climate change that could have a material impact on a company's business and operations, including its "personnel, physical assets, supply chain and distribution chain." In addition, the impact of climate change can have an indirect financial impact through physical risks to entities other than the company. The guidance observes that various provisions of existing rules have the potential to require climate-related disclosure, such as the Reg S-K requirements for business narrative, legal proceedings, risk factors and MD&A, and addresses in some detail how then-current disclosure obligations could apply to climate change. (See this PubCo post.)
Lee also observes that ESG-related risks and opportunities may be implicated under state law, as directors seek to fulfill fiduciary duties of loyalty and care. And, under the duty of good faith, she contends, "directors may need to investigate 'red flags' that suggest legal violations or other harm to the corporation. This may require directors to do a deeper dive on climate change and other ESG issues as the regulatory landscape evolves. Unaddressed red flags relating to a violation of emissions regulations, for instance, could implicate the duty of good faith." Accordingly, Lee advises, "climate change and other ESG matters should be regular and robust topics for the board."
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In Marchand v. Barnhill (June 18, 2019), a shareholder had sued derivatively, alleging that "management turned a blind eye to red and yellow flags that were waved in front of it." The case, authored by former Delaware Chief Justice Leo Strine, provides a warning that directors need to be proactive in conducting risk oversight and could face liability if they fail to "make a good faith effort to implement an oversight system and then monitor it." Marchand, a Caremark case that can survive a motion to dismiss, showed that a board can face liability if it simply leaves compliance and risk oversight entirely to the prerogatives of management. As the Court made clear, boards need to oversee compliance and monitor risks. (See this PubCo post.) See also Hughes v. Hu, where the complaint alleged that the audit committee consciously failed "to establish a board-level system of oversight for the Company's financial statements and related-party transactions, choosing instead to rely blindly on management while devoting patently inadequate time to the necessary tasks." (See this PubCo post.)
Risks and Opportunities. Climate and other ESG, Lee explains, involve both opportunities and risks—physical risk, transition risk, regulatory risk and reputational risk. There is even risk in connection with human capital, she maintains, "as younger workers increasingly place a premium on whether a company's values align with their own." Boards are expected to oversee and manage these risk and opportunities, she argues, citing the TCFD framework, as well as a World Economic Forum white paper advocating that boards "integrate ESG into corporate governance out of a recognition that 'business value creation' is increasingly dependent on understanding and managing these risks and opportunities." Large asset managers also have expectations for board oversight of ESG. For example, BlackRock has urged "boards to shape and monitor management's approach to material sustainability factors in a company's business model," indicating that it "will hold directors accountable where they fall short. Proxy advisory firms ISS and Glass Lewis have announced new voting policies that include director accountability for ESG governance failures." Shareholders can also hold boards accountable for failures to include climate and ESG as part risk management and governance —through shareholder proposals, proxy contests and even selling their shares. And boards that are proactive, she maintains, can not only mitigate risk, but also "better position their companies and business models to compete for capital based on good ESG governance."
Key steps for boards. Lee then suggests several steps that boards can take to "maximize ESG opportunities, message their commitment on these issues, and position themselves as ESG leaders."
- Enhance Board Diversity. Lee suggests that there are still some laggards on boards that have failed to fully appreciate the need to integrate climate and ESG into governance practices, citing a 2019 report in which 56% of directors "thought investor attention on sustainability issues was overblown." One way to address this problem, she suggests, is to refresh and diversify boards to introduce new perspectives.
- Increase Board Expertise. Addressing climate and other ESG issues requires that boards have "adequate expertise on these subjects." But some research suggests that boards may not have the appropriate level of competence in these areas. To enhance the ESG competence of boards, boards should consider "integrating ESG considerations into their nominating processes in order to recruit directors that will bring ESG expertise to the board; training and education efforts to enhance board members' expertise on ESG matters; and considering engagement with outside experts to provide advice and guidance to boards."
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This study from the NYU Stern Center for Sustainable Business, U.S. Corporate Boards Suffer From Inadequate Expertise in Financially Material ESG Matters, analyzed the credentials of the 1,188 Fortune 100 board directors, based on company bios and Bloomberg bios. The study "found that very few sectors and very few companies were adequately prepared at the board level for issues that were already affecting their performance." While on an initial examination, the study found that 29% of those directors had relevant ESG credentials, on a deeper dive, the Center found that 21% of the directors' experience was in the "social" category—clustered around health and diversity issues—but in each of "environment" and "governance," only 6% of directors had relevant credentials. As it turned out, the absence of board expertise was often in an area of ESG that could be considered critical to that business; for example, the study cited a property and casualty insurance company that had "no environmental expertise on the board in a year experiencing $100 billion in damage caused by climate change-heightened extreme weather events." According to the study, "without board members who have a strategic understanding of the issues, the board will not know the questions to ask or even understand that the potential risks might exist." In the "environmental" category, the study found "very little director expertise." Only 1.2% of directors had expertise in energy and land/conservation—the highest showings in this category—with backgrounds in renewables, nuclear power and utilities (energy) and service on conservation boards (land/conservation), as well as some public policy and/or regulatory experience. The study observed that, although energy is an important issue for most companies, generally only energy companies had directors with energy expertise. Notably, the study found that, in general, a number of industry sectors that faced material environmental challenges "did not reflect that materiality on their boards." (See this PubCo post.)
- Inspire Management Success. Finally, Lee suggests that boards use financial incentives to "spur progress" to achieve strategic company goals associated with ESG: in "addition to helping achieve strategic goals related to issues such as reduced carbon emissions or increased diversity of the workforce, tying executive compensation to ESG metrics can offer an important way to deliver on a company's commitment to issues that matter to investors and consumers." To illustrate, she observes that some companies that made commitments to racial diversity also tied executive comp to diversity metrics, employing "one of the most powerful tools they have to make real progress on ESG goals, and at the same time signaling the strength of their commitment to these issues."
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In this article from comp consultant Semler Brossy, the authors agree that "[l]inking ESG metrics to executive pay is a powerful way to drive change." However, they advise that "compensation is a sensitive instrument, so we urge caution. As with any other new metric, a board should craft it to reflect the company's context and ESG priorities—and to complement the existing pay incentives. The board should also test a metric before including it in compensation, to reveal unintended consequences or the possibility of gaming. Rather than a single decision, new pay metrics involve a journey that begins with elevating certain issues internally and externally." As described by the authors, the journey undertaken by some early adopters began with "asking pointed questions, customizing ESG goals and metrics for their company, and measuring them. They began holding themselves accountable, and the board oversaw the process to make sure it happened. Eventually, where it made sense, they linked compensation to some of those metrics, along with other reward and recognition practices." In determining whether to include ESG metrics, the authors advise that board buy-in is critical: the commitment must be to a serious, multi-year effort; while inclusion of ESG metrics will likely be viewed positively by the public, subsequent dilution of those metrics probably will not. And given the number of performance metrics that companies employ, it is important to prioritize and balance all of these metrics for optimal effect. (See this PubCo post.)
Key to Lee's message is that "substantive consideration of ESG should be meaningfully integrated into board oversight." Lee acknowledges, however, that there is "no one right answer for each individual company on how to mitigate risks and maximize opportunities with respect to climate and ESG issues. They are complex, evolving and, in some cases, highly charged issues." The public needs to to able to test whether "public pledges on ESG issues are actually backed up by corporate action"—that's one reason why Lee believes that the disclosure regime must provide investors with adequate information. "The more we can have open, thoughtful, and well-researched dialogue on the specifics of these issues," she concludes, "the more companies, investors, and all stakeholders will benefit."
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