SEC’s Increased Scrutiny of Climate Risk and Disclosures Likely to Lead to Agency Rulemaking
In fulfilling disclosure obligations under the Securities Act of 1933 and the Securities Exchange Act of 1934, public companies are required to disclose various potential environmental liabilities and potential risks in filings with the U.S. Securities and Exchange Commission (SEC or Commission). During the 1970s, SEC efforts in the area of environmental disclosure focused primarily on statutes such as the Clean Water Act and the Clean Air Act. Subsequently, disclosure requirements were expanded to also encompass liabilities and cleanup costs under the Comprehensive Environmental Response, Compensation and Liability Act (CERCLA). Over time, the SEC increasingly has emphasized broader disclosure of environmental matters, as the Commission further articulated the materiality standards for disclosure under the securities laws. These standards provide that information is material if there is a substantial likelihood that a reasonable investor would consider it important in deciding how to vote or in making an investment decision—in other words, “that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.’” See Basic, Inc. v. Levinson, 485 U.S. 224, 231 (1988) (quoting TSC Indus., Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976)).
SEC disclosure requirements for environmental liabilities are contained primarily in the uniform disclosure rules of Regulation S-K, 17 C.F.R. pt. 229. Regulation S-K sets forth instructions for preparing the required narrative or nonfinancial statement portions of registration statements, as well as annual reports, proxy statements, and other filings required of publicly traded companies. In particular, Items 101, 103, 303, and 105 of Regulation S-K affect environmental disclosure. Moreover, in addition to other guidance discussed below, an agency guidance document issued in February 2010 provides examples of material information in the context of disclosing climate-related business risks to investors. See Commission Guidance Regarding Disclosure Related to Climate Change, 17 C.F.R. pts. 211, 231, 241 (hereinafter “Climate Guidance”). These risks fit within two categories: physical risks and transition risks. Examples of physical risks include extreme weather events, sea level rise, the availability of farmland and water, and changes in climate patterns that can cause supply and distribution chain delays. Transition risks identified in the guidance include the cost of transitioning to a low-carbon economy, such as the costs to comply with regulatory limits on greenhouse gas (GHG) emissions, changes in demand for products based on carbon footprint, the impact of international treaties to address climate change, and the effect of public information on a company’s reputation. More recently, climate-related issues have taken on an enhanced level of concern with the Biden Administration’s rejoining the Paris Agreement in an effort to stem climate change impacts, and the Administration’s intensified focus on achieving significant nationwide reduction of GHG emissions. As discussed below, climate change can directly and indirectly impact a company’s present value and prospects for the future. Therefore, the SEC is pursuing courses of action that strongly signal an intention to require disclosure of a broader range of climate-related risks to the public.
This intensified agency activity to address climate change as a significant risk factor is in sharp contrast to the position taken in August 2020, when the SEC adopted two sets of amendments to modernize certain disclosure requirements in Regulation S-K. At that time, the SEC declined to incorporate any specific disclosures of climate change business risks in the Regulation S‑K amendments because a majority of the commissioners deemed such climate-related directives inconsistent with the agency’s “principles-based” approach to revising the regulations. Nonetheless, as discussed immediately below, climate impacts on a company’s business still may require disclosure under several of the amended items in Regulation S-K, and should continue to be evaluated in light of the Climate Guidance until the Commission promulgates climate-specific disclosure requirements.
Climate Disclosure Under Regulation S-K, Item by Item
In the Regulation S-K amendments, the agency updated, among other things, the provisions governing a company’s description of environmental proceedings in which the government is a party, as well as its business, legal proceedings and risk factors. These amendments, effective on November 9, 2020 (as to Items 101, 103, and 105) and on February 9, 2021 (with a compliance date of August 9, 2021 for Item 303), are the first substantial changes made to these regulations in thirty years.
Item 101: Description of Business
Item 101 requires a description of the company’s business. With respect to environmental matters, a narrative discussion is required of the material effect that compliance with federal, state, and local environmental laws and regulations may have on the capital expenditures, earnings, and competitive position of the company and its subsidiaries. The company must disclose any material estimated capital expenditures for environmental control facilities for the then current fiscal year and any other material subsequent period. See 17 C.F.R. § 229.101(c)(2)(i). Moreover, in Levine v. NL Industries, Inc., 926 F.2d 199, 203 (2d Cir. 1991), the court held that Item 101 requires disclosure of the cost of failure to comply with the law as well as the actual cost of compliance. In some instances, a company may have difficulty estimating future compliance costs because, for example, the EPA has delayed establishing substantive environmental standards. Hence, the technology and related costs needed to comply with environmental regulations may not be readily quantifiable.
Disclosure of the effects of compliance with government regulations concerning climate change, such as the reduction of GHG emissions, creates additional reporting requirements to be discussed in Item 101, if material. Under such circumstances, the SEC’s Climate Guidance should be consulted.
Item 103: Pending Legal Proceedings
In accordance with Item 103, a public company must report any material pending legal proceedings, besides ordinary routine litigation incidental to the business, to which the company or any of its subsidiaries is a party, or to which any of their properties is subject. 17 C.F.R. § 229.103. Under 17 C.F.R. § 229.103(c)(3), a proceeding involving environmental claims is not “ordinary routine litigation incidental to the business” and must be disclosed if
- it is material to the business or financial condition of the company;
- it involves primarily a claim for damages or potential monetary sanctions, capital expenditures, deferred charges, or charges to income, exclusive of interest and costs of more than 10 percent of the current consolidated assets of the company and its subsidiaries; or
- it involves a governmental authority as a party, unless the company reasonably believes that monetary sanctions will be less than $300,000, or, at the election of the company, such other threshold that (1) the company determines is reasonably designed to result in disclosure of any such proceeding that is material to the business or financial condition; (2) the company discloses (including any change thereto) in each annual and quarterly report; and (3) does not exceed the lesser of $1 million or 1 percent of the current assets of the company and its subsidiaries on a consolidated basis; provided, however, that such proceedings that are similar in nature may be grouped and described generically.
Thus, environmental claims brought by the government, whether in a judicial or administrative forum, are automatically deemed to be material if the agency demands penalties of at least $300,000, unless the company has chosen a higher threshold, as explained above. In addition to administrative orders, notices of violation also can trigger the disclosure requirement. Menaldi v. Och-Ziff Capital Mgmt. Grp. LLC, 164 F. Supp. 3d 568, 584 n.11 (S.D.N.Y. 2016) (holding that failure to disclose investigations by SEC and U.S. Department of Justice constituted potential material misstatement or omission). However, at least two federal courts have held that issuers are not required to disclose receipt of a Wells notice, a document which indicates the commencement of an investigation, because the Wells notice did not “indicate[ ] that litigation was ‘substantially certain to occur[ ].’” In re Lions Gate Entm’t Corp. Sec. Litig., 165 F. Supp. 3d 1, 12 (S.D.N.Y. 2016); Richman v. Goldman Sachs Grp., Inc., 868 F. Supp. 2d 261, 274 (S.D.N.Y. 2012).
Furthermore, pursuant to a 1989 No-Action Letter, the SEC has taken the position that “costs incurred pursuant to a remedial agreement entered into in the normal course of negotiation with the EPA will not be viewed as a sanction,” but that these costs may be reportable under Items 101 and 103 if it is reasonably likely the costs will be material. See Peter N. Ching & Brian M. Diglio, Staff Accounting Bulletin 92: A Paradigm Shift in Disclosure Standards, 7 Fordham Envtl. Law Rev. 73, 89 (2011).
Item 303: Management’s Discussion and Analysis
Item 303 requires a discussion called management’s discussion and analysis of financial condition and results of operations (often referred to as MD&A) in narrative format. 17 C.F.R. § 229.303. The preparation of MD&A calls for both a historical and prospective analysis of the company’s financial condition. Under Item 303, disclosure is required where a trend, demand, commitment, event, or uncertainty both is presently known to management and reasonably likely to have a material impact (favorable or unfavorable) on the company’s financial condition, including its liquidity and capital resources. Also, if the company knows of events that are reasonably likely to cause a material change in the relationship between costs and revenues, the change in the relationship must be disclosed.
Whether a matter is reasonably likely to have a material impact on future operations is to be based on a two-step test for assessing when a forward-looking disclosure is required. The test, which must be applied where a trend, demand, commitment, event, or uncertainty is known to management, considers the following questions. First, is the known trend, demand, commitment, event, or uncertainty likely to come to fruition? If management determines that it is not reasonably likely to occur, no disclosure is required. Second, if management cannot make that determination, it must evaluate objectively the consequences of the known trend, demand, commitment, event, or uncertainty, on the assumption that it will come to fruition. Disclosure is required unless management determines that a material effect on the company’s financial condition or results of operations is not reasonably likely to occur. See https://www.sec.gov/rules/final/2020/33-10890.pdf at 4343. Thus, in the context of an environmental matter, management must apply the two-step test, and make the “forward looking” disclosure unless it determines that the known trend, demand, commitment, event, or uncertainty is not reasonably likely to occur or that a material effect on the company’s financial condition or results of operations is not reasonably likely to occur (e.g., that the disclosure is not reasonably likely to be considered important by a reasonable investor in making a voting or investment decision). See https://www.sec.gov/rules/final/2020/33-10890.pdf at 46, 48.
A company’s designation as a potentially responsible party (PRP) under CERCLA can be troublesome in this regard. Although the SEC recognizes that such designation in and of itself does not automatically result in a governmental proceeding, the agency also maintains that specific circumstances may provide a company with knowledge that a proceeding is in fact contemplated. Particularly at the early stages of Superfund proceedings, it may be especially difficult for a company to evaluate its ultimate liability. That being said, where material cleanup costs are a certainty and there are no viable defenses, companies must disclose their PRP designation, quantified to the extent reasonably practicable according to SEC guidance. See https://www.sec.gov/rules/interp/33-6835.htm.
Item 105: Risk Factors
Item 105 of Regulation S-K (17 C.F.R. § 229.105) requires disclosure of the material factors that make an investment in a company’s securities speculative or risky. Additionally, Item 105 directs companies to explain how each identified risk affects the company or its securities being offered; but, the item discourages the disclosure of risks that could apply generally to any company. This disclosure must appear in registration statements and annual reports and be updated quarterly for material changes.
For some companies, the regulatory and legislative, as well as the business and market, impacts of climate change could have a significant effect on their operating and financial decisions. These impacts can include changes in weather patterns such as sea-level rise, increases in storm intensity, and temperature extremes that potentially could affect a company’s personnel, physical assets, and supply and distribution chains. Thus, such factors may require disclosure under Item 105 in accordance with the SEC’s Climate Guidance. For example, an energy technology company disclosed that: "Compliance with, and rulings and litigation in connection with, environmental and climate change regulations and the environmental and climate change impacts of our customers’ operations may adversely affect our business and operating results." See https://investors.bakerhughes.com/node/23176/html. The company also acknowledged that the risk is not solely regulatory, but may include such “risks to our operations and those of our customers” as ““extreme variability in weather patterns such as increased frequency of severe weather, rising mean temperature and sea levels, and long-term changes in precipitation patterns.” See https://investors.bakerhughes.com/node/23176/html.
Under the Biden Administration’s leadership and appointments that changed the majority of the commissioners, the SEC has turned its attention to the disclosures by public companies of climate-related risks. For example, in an agency release on February 24, 2021, the then acting chair of the SEC stated that she had directed the Division of Corporation Finance to “enhance its focus on climate-related disclosure in public company filings” in order to determine the extent of public companies’ compliance with the Climate Guidance and to begin updating that guidance based on its findings.
Moreover, on March 4, 2021, the SEC announced the formation of an Enforcement Division Task Force focused on climate and environmental, social, and governance (ESG) issues. The announcement stated that “[t]he initial focus will be to identify any material gaps or misstatements in issuers’ disclosure of climate risks under existing rules.” See https://www.sec.gov/news/press-release/2021-42. Efforts to promote climate disclosures have become part of a broader movement to enable investors to incorporate ESG considerations into investment decisions. In addition to climate concerns, ESG issues include nonclimate environmental impacts, working conditions, diversity, executive compensation, and corruption, although climate change has become the most prominent ESG issue from the investors’ perspective.
Further, on March 15, 2021, the SEC published a statement that requested staff to evaluate current disclosure rules “with an eye toward facilitating the disclosure of consistent, comparable, and reliable information on climate change,” and requested public input on a series of questions, including whether to require disclosures of climate and other ESG risks. See https://www.sec.gov/news/public-statement/lee-climate-change-disclosures. The comment window closed on June 13, 2021, and a majority of commenters supported the agency requiring increased disclosure of climate-related risks.
Several institutional shareholder and management firms and nongovernmental organizations (NGOs) have urged the SEC to issue enforceable rules that apply uniform terminology and metrics already included in various industry standards requiring that material climate change disclosures be included in SEC filings.
Examples of the types of “material” disclosures that some investment managers and investor groups would like the SEC to require are seen in an August 2007 settlement between the New York Attorney General’s Office and Xcel Energy Inc., which addressed the risks associated with powerplants generating GHG emissions. Xcel agreed to provide greater disclosure in its future annual reports about its GHG emissions, trends in climate change regulation, the physical impacts of climate change (including impacts on sea level and weather), corporate governance actions regarding climate change, and related litigation, financial exposure, and associated risks.
The SEC’s regulatory agenda announced on June 11, 2021, stated that rulemaking concerning climate-related disclosure would be a top agency priority. Accordingly, more prescriptive climate-related as well as ESG-related disclosure rules are expected to be considered by the SEC in the coming year.
In the meantime, heightened concerns regarding climate change–related business risks have led to increased SEC scrutiny of 10-Q and 10-K reporting practices. As a preview of the types of disclosures that may be sought in the anticipated rulemaking proceeding, on September 22, 2021, the Division of Corporation Finance staff posted a sample letter with examples of comments or questions it planned to send to issuers inquiring about the specific climate-related risk disclosures made in their recent filings. These sample comments address the various “materiality” requirements in Regulation S-K as they relate to climate-related matters and the examples provided in the Climate Guidance, as discussed above.
In light of the foregoing, public companies must be able to demonstrate compliance with current SEC disclosure requirements. Also, companies should be preparing proactively to address the climate change disclosure rules and ESG requirements that are expected to be promulgated shortly by the SEC.