US SEC: Do ESG obligations exist within existing federal regulations?

We have frequently said over the last few months that environmental, social and governance (ESG) factors are top of the financial regulatory agenda. At first ESG was just a murmuring, then came word from the FCA that, despite Covid-19 we “cannot lose sight of the climate crisis”.

If you were to take a glance at the recent publications of any financial regulator, from Singapore’s MAS, to the FCA, to the SEC – ESG, sustainability and climate-related policies form the central thread. In fact, these factors are no longer regulatory considerations but seem to be dominating current regulatory rhetoric.

At the end of June, Securities and Exchange Commission (SEC) Commissioner, Allison Herren Lee, gave a Keynote Address at the 2021 Society for Corporate Governance National Conference. Unsurprisingly, the theme of the speech was “Climate, ESG, and the Board of Directors”, inspired by the rather poetic vision that “you cannot direct the wind, but you can adjust your sails.” The title may be poetic, but Herren Lee took the opportunity to advocate for corporate boards to “integrate climate and ESG into governance practices”. She also set out key statistics and tackled two areas of current regulatory focus: the ESG obligations that boards must currently meet, and the practical steps boards can take to better manage ESG.

What ESG obligations must US boards currently meet?

As her colleague, Elad Roisman, pointed out in his recent speech, myriad ESG obligations exist within the current regulatory regime. Herren Lee goes one step further than Roisman to highlight where existing regulatory requirements already oblige the board to engage with ESG matters. These obligations stem from both federal securities laws and state-rooted fiduciary duties, including:

• The SEC’s 2010 climate guidance, which sets out a number of existing disclosure requirements, in particular the Management’s Discussion & Analysis, that may give rise to climate disclosure obligations.
  
  
• The SEC’s latest update to Regulation S-K’s item 101, which identifies human capital as a potentially material disclosure topic.
  
  
• Regulation S-K’s item 407(h), which requires disclosure of the board’s role in the risk oversight of a company, which can include climate change risks.
  
  
• Under US state law, directors have fiduciary duties of loyalty and care. Herren Lee points out that a director’s duty of care requires that a board must be well-informed when making corporate decisions, which extend to ensuring it has relevant information regarding ESG and climate-related risks and opportunities.

How can boards position themselves as ESG leaders?

Commissioner Herren Lee points out that ESG presents “both risks and opportunities for companies and their boards”. The risk presented by such challenges may take many forms, including physical risk, regulatory risk, and transition risk – as well as reputational risk where companies fall short of the expectations of investors and consumers.

The expectation is that corporate boards will play an essential role in managing and mitigating these risks, a prospect that may seem bewildering – or even overwhelming – for some. With that in mind, Herren Lee offers three practical steps that boards could take to “maximise ESG opportunities, message their commitment on these issues and position themselves as ESG leaders”:

1. Enhance board diversity

While progress has been made with regards to ESG, Herren Lee points to evidence that suggests that board directors have been slow to understand the need to integrate climate and ESG into their governance practices, with only 6% of corporate directors highlighting climate change as a focus in 2019.

Boards “need to refresh and diversify perspectives”, including putting new directors on boards and placing a focus on diversity, which will inevitably lead to new ways of thinking, new ideas and “could facilitate more current and proactive approaches to climate and ESG governance.”

2. Increase board expertise

While ESG isn’t new, it poses new challenges for financial institutions. These are challenges that few existing boards will have the in-depth expertise to tackle effectively. In order to address climate and ESG risks, “boards need adequate expertise on these subjects”.

As such, Herren Lee suggests that boards should look to make ESG expertise a priority when recruiting to the board, or at least provide training and education to the existing board via third-party experts.

3. Inspire management success

Financial services is an industry with deep roots in financial incentives. Herren Lee notes that decisions made by the board about compensation could be used as a “powerful tool” to drive progress on corporate strategies and approaches to address the risks associated with ESG.

Herren Lee draws on research from 2019 to support her point; academic research found that airlines that offered their executives bonuses for on-time flight arrivals, led to more on-time flight arrivals. If executive compensation were tied to ESG metrics, there could be comparable shift – and a considerable incentive – to drive ESG factors forward.

CUBE comment

Commissioner Allison Herren Lee’s speech serves to demonstrate the breadth of understanding and approach to ESG within the SEC. Herren Lee fervently argues that the principal debate around ESG should be “about when, not if, these issues are material”.

Avid readers of SEC speeches (of which I am one) will note that this bears a degree of contrast, when compared with a recent speech by her colleague, Commissioner Roisman, in which he set out a much more sceptical view.

The tone of the speeches may be at odds, but the messaging is broadly similar: ESG is important, it is not being effectively tackled (by firms or regulators) and more work needs to be done. In fact, it is refreshing to see a regulator that is exploring ESG from a variety of lenses, not simply pushing a pre-determined party message.

Both Roisman and Herren Lee point out that ESG obligations of sorts exist within the current regulatory regime. They are not necessarily comprehensive or specific, but they do require boards to commit to ESG principles.  

Against the backdrop of the US re-entering the Paris Agreement, and pledging to cut CO2 emissions in half by 2030, the SEC’s latest grappling with ESG and climate change marks a stark shift from their regulatory stance in 2020. If it continues at this velocity, US regulated institutions will need to be on their toes to keep up with the pace of change.

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