On March 3, 2021, the SEC Division of Examinations released their 2021 Examination Priorities, prioritizing ESG factors. As stated by the SEC Acting Chair Allison Lee, 'the Division (formerly known as OCIE) is enhancing its focus on climate and ESG-related risks' and that by doing so 'we are integrating climate and ESG considerations into the agency's broader regulatory framework.'
On February 26, 2021, the SEC issued an Investor Bulletin on ESG (Environmental, Social and Governance) Funds, noting that 'ESG investing has grown in popularity in recent years.' Just two days prior, on February 24, 2021, the SEC acting chair announced that she had directed the SEC to enhance its focus on climate-related disclosures in public company filings and review the previous SEC guidance issued over a decade ago on climate disclosures. ESG was already a trending topic and heading into the Biden administration it is clear that it will only grow in importance for investors, companies and their boards, and regulatory agencies. As noted by the SEC acting chair, ESG disclosures are a 'significant driver in decision-making'.
ESG represents the environmental, social, and governance factors that are non-financial, criteria for companies. As neatly summarized by the SEC Investor Bulletin.
- The environmental component might focus on a company's impact on the environment for example, its energy use or pollution output. It also might focus on the risks and opportunities associated with the impacts of climate change on the company, its business and its industry.
- The social component might focus on the company's relationship with people and society for example, issues that impact diversity and inclusion, human rights, specific faith-based issues, the health and safety of employees, customers, and consumers locally and/or globally, or whether the company invests in its community, as well as how such issues are addressed by other companies in a supply chain.
- The governance component might focus on issues such as how the company is run for example, transparency and reporting, ethics, compliance, shareholder rights, and the composition and role of the board of directors.
These factors are becoming more important to shareholders and investors and also regulatory bodies as demonstrated by the move towards ESG investing but also event-driven litigation and increased regulatory scrutiny and fines. As such, prudent directors, officers and boards should ensure that they are apprised of these recent developments and are planning accordingly.
ESG's Impact on Companies
Before reviewing the three pillars of ESG, it is important to understand why ESG has become increasingly important to companies and their directors and officers, aside from their obvious direct impact on the environment and people. ESG can significantly impact and influence companies’ growth, litigation risk and exposure, and regulatory scrutiny. Prudent directors and officers will consider all of these ESG-related
issues as they plan the priorities and conduct of their business and ESG-related disclosures.
Impact on External and Internal Growth
ESG investing is on the rise. Aside from the tenets that drive socially responsible investing, ESG investors are also driven by the belief that companies that focus on ESG criteria in their operations will ultimately perform better thereby maximizing shareholder value while minimizing risk. From BlackRock to the creation of new socially conscious funds, investors are increasingly prioritizing investment in companies with an ESG-focus. In 2019, almost 25% of investments went to ESG companies. From 2016 to 2018, investments in such companies grew to total $12 trillion.
Investment firms, institutions lending on ESG investments, and individual investors are increasingly looking at ESG factors to identify material risks, growth opportunities, and sustainable investment options. Many banks now offer managed ESG investment options. Green bonds, social bonds, and sustainability bonds have all been issued. The following bonds have been issued just within the last year:
- Bank of America issued $1 billion in COVID-19 bonds in May 2020 with the specific purpose of funding nonprofit hospitals engaged in COVID-19 healthcare.
- The Ford Foundation issued $1 billion of social bonds in June 2020 to support nonprofits impacted by COVID-19.
- JPMorgan Chase issued $1 billion of social bonds in February 2021 to fund affordable housing projects.
- Goldman Sachs issued $800 million of sustainability bonds in February 2021 to accelerate climate transition and advance growth in other environmental issue areas.
Likewise, new funds have also been created that invest in ESG-focused companies.
Beyond external investments, companies that are focused on ESG-factors may benefit internally as well. Maintaining a positive corporate reputation and attracting and retaining talent are two internal ways that companies focused on ESG can improve financial performance. A Harvard Business Review article found that employees who find work meaningful have significantly greater job satisfaction, which correlates
with increased productivity. The article estimated that highly meaningful work will generate an additional $9,078 per worker, per year. For these reasons and others, companies focused on ESG-factors are viewed as worthwhile investments. In a recent McKinsey study, 83% of C-suite leaders and investment professionals expect ESG programs to contribute more shareholder value in five years than today.12 They also indicated they would be willing to pay about a 10% median premium to acquire a company with a positive record for ESG issues over one with a negative record.
Event-Driven Litigation
Aside from growth, companies and D&Os need to be aware of ESG as it has an increasing impact on litigation, including class litigation. Event driven litigation is essentially litigation based around an event, usually trending in the news, and a company’s downplaying of its risks related to that event. The company may make public statements downplaying the risk or alternatively touting its policies and procedures around the risk, which turns out not to be true and drives stock prices down. This is in comparison to more traditional securities litigation based on company’s internal accounting issues. We have historically seen the latter type of litigation as the more traditional derivate and securities class actions. However, that is starting to change.
Event-driven litigation hinges on allegations around misleading or fraudulent statements or the omission of materially relevant information that had the investor known the true or omitted information, the investor would have possibly made different investment decisions. The main theory in the event-driven cases is that the occurrence or event upon which the case is based was the materialization of an under-disclosed or downplayed risk. The bulk of the event-driven litigation rests on Section 10(b) of the Securities Exchange Act and Rule 10b-5 of the Code of Federal Rules.
Class action filings over the last few years demonstrate this shift from these traditional accounting fraud allegations to more event-driven litigation. During 2015 and 2016, the most common type of allegation related to accounting issues, accounting for more than 30% of cases. In 2018, this trend started to change as cases were increasingly filed regarding the #MeToo movement and the opioid crisis. In 2019 cases were
centered on cyber security breaches and environmental disasters. In 2020, filings and class actions were based on COVID-19 and its impact on certain economic industries, such as cruise lines and pharmaceutical companies.
Although event-driven securities class actions are still a smaller subset of overall securities class actions, it is certainly an emerging area of litigation. The large settlements related to event-driven litigation, including the $240,000,000 settlement by Signet Jewelers, certainly make it an area that D&Os and companies must plan for.
Regulatory Scrutiny
The Biden administration has signaled its strong interest in prioritizing ESG-related issues in the new administration. Among President Biden’s first-day executive orders was a presidential memo entitled “Modernizing Regulatory Review.”14 The memo reiterates President Biden’s previously announced major priorities: the COVID-19 pandemic, the economy, racial inequality and climate change – direct ESG factors. The memo states:
It is the policy of my Administration to mobilize the power of the Federal Government to rebuild our Nation and address these and other challenges. As we do so, it is important that we evaluate the processes and principles that govern regulatory review to ensure swift and effective Federal action.
The result of this memo is an anticipated set of new recommendations and regulations from the federal government in these areas.
Already we are seeing that regulatory impact, as evidenced in the recent SEC memo on climate change from the Acting Chair of the SEC, Allison Herren Lee. Lee herself has previously been critical about the SEC’s lack of clear guidance on ESG disclosures, while emphasizing the importance of ESG disclosures. Lee stated in August 2020 that many market participants use these disclosures as a “significant driver in decision-making.” It appears that the SEC – and other regulatory bodies – will be increasingly focused on these ESG disclosures.
ESG Liabilities and Exposures
Against this backdrop, analyzing how these issues play out against the three pillars of ESG is helpful as boards consider best practices moving forward.
Environmental
From being one of the Biden administration’s top priorities to extreme weather issues, climate-related issues have been pushed to the front of the news lately. Perhaps more than any other of ESG factors, climate demonstrates the myriad ways ESG can impact a boardroom.
First, investors have turned their focus to climate issues. In a much publicized move, BlackRock announced initiatives last year that it was placing sustainability at the center of our investment approach, including: making sustainability integral to portfolio construction and risk management; exiting investments that present a high sustainability-related risk, such as thermal coal producers; launching new investment products that screen fossil fuels; and strengthening our commitment to sustainability and transparency in our investment stewardship activities.
BlackRock followed-up with a recent letter stating that it was committed to net zero greenhouse gas emissions by 2050 or sooner. This includes “using investment stewardship to ensure the companies our clients invest in are mitigating climate risk and considering the opportunities presented by the net zero transition” and asking companies to disclose a business plan aligned with the goal of limiting global warming. This follows prior BlackRock requests that corporations disclose their climate-related actions, including but not limited to sustainability: “This data should extend beyond climate to questions around how each company serves its full set of stakeholders, such as the diversity of its workforce, the sustainability of its supply chain, or how well it protects its customers’ data.”
Environment issues have also been a major focus of event-driven litigation. For example, one of the most publicized securities class action litigation cases was the Deepwater Horizon oil spill by BP. Among other things, the complaint alleged that BP misled its investors regarding its Gulf of Mexico growth potential while internally reducing its spending on safety measures. The class action case ultimately settled for $175 million.
Other cases include the US shareholder suit filed against Volkswagen after it was revealed that its diesel cars were programmed to cheat emissions test. That case ultimately settled for $48 million. Volkswagon also paid $4.3 billion in criminal and civil penalties. It settled three other cases with US car owners, regulators and dealerships, totaling more than $17 billion, to settle similar claims.
The Deepwater Horizon spill serves as a cautionary example of regulatory scrutiny around ESG factors. At the time representing the third-largest settlement in SEC history, BP settled with the SEC for $525 million. The SEC charged it with “misleading investors while its Deepwater Horizon oil rig was gushing into the Gulf of Mexico by significantly understating the flow rate in multiple reports filed with the SEC.”18 In a statement
announcing the settlement, Robert Khuzami, Director of the SEC’s Division of Enforcement, stated:
The oil spill was catastrophic for the environment, but by hiding its severity BP also harmed another constituency — its own shareholders and the investing public who are entitled to transparency, accuracy, and completeness of company information, particularly in times of crisis. Good corporate citizenship and responsible crisis management means that a company can’t hide critical information simply because it fears the backlash.
Drawing from these lessons, boards should be aware that climate and sustainability issues are paramount to investors and will likely only increase in importance moving forward. Board actions and disclosures should take this focus into account.
Social
The social factor of ESG has seen recent evolvement. In 2018, event-driven litigation centered on the #MeToo movement as seen in cases filed against Wynn Resorts Limited, CBS Corporation and Papa John’s International.
More recently, three separate shareholder derivate suits concern the diversity and inclusion actions and statements made by high-profile companies. In complaints filed against Facebook, Oracle and Qualcomm, plaintiffs separately allege that the companies made public statements, including in proxy materials, regarding their D&I efforts but the assertions were false as compared to the companies’ actual
diversity statistics and history.
For example, in the shareholder derivate suit filed against Oracle, allegations include that the company made false assertions regarding their commitment to diversity and equity within the company while in reality they were involved in a Department of Labor investigation that they have underpaid minorities and women by $400 million. The complaint alleges that despite “platitude in its proxy statement” Oracle has failed
to create any meaningful diversity at its board of directors, stating “[t]he Oracle Board has lacked diversity at all relevant times, and is one of the few remaining publicly‐traded companies without a single African American director.” The complaint further states that “Oracle’s Directors have deceived stockholders and the market by repeatedly making false assertions about the Company’s commitment to diversity.” The lawsuit alleges that by doing so, the directors have breached their duty of candor and violated federal proxy laws. The plaintiffs bring claims for breach of fiduciary duty, aiding and abetting breach of fiduciary duty, abuse of control, unjust enrichment, and violation of Section 14(a) of the Securities Exchange Act of 1934.
The Oracle plaintiffs seek a variety of relief, including resignation of directors and their replacement by two Black professionals and one of another minority group; removal and replacement of Larry Ellison as chairman; the return of 2020 Oracle compensation from the director defendants; publication of an annual diversity report that contains particularized information and the hiring, advancement, promotion and pay
equity of all minorities at Oracle; creation of a $700 million fund to hire Black and minority employees, promote them to more management positions, and establish and maintain a mentorship program for Black and minority employees that is committed to providing the skills and mentorship necessary to succeed in corporate America; requirement of annual diversity training of Oracle’s entire Board and all Section 16 executive officers; equitable and injunctive relief; restitution; and punitive damages.
Governance
The last of the ESG factors, governance, is likely the most developed and mature of the pillars. Strong governance has historically led to strong corporate returns and thus the historical emphasis on these practices among directors and officers. As stated by S&P Global:
There is increasing evidence of the link between ESG and financial outperformance as better data quality, standardized data, longer data history, and heightened interest in assessing the materiality of ESG drives continued research. However, there is already substantial empirical evidence to suggest that the “G” aspect of ESG ultimately yields better corporate returns.
Good governance includes ensuring that the directors and officers are managing the company in the interests of its shareholders, including minority shareholders, through board structure, executive compensation and management ownership requirements. It also includes well-developed codes of business conduct including codes of conduct, policies on corruption and bribery, reporting on breaches, and other systems and procedures. Strong governance also includes robust risk and crisis management, stress testing, risk governance and culture.
Actions and Planning for Directors & Officers
With so much at stake, companies and their directors and officers must plan for environmental, social and governance factors. Heading into 2021, these factors are anticipated to only increase in importance to both investors and regulators.
Drawing lessons from shareholder derivate suits, boards should be forthright in their disclosures and public statements, not just aspirational. Particularly in any disclosures filed with the SEC, boards should ensure that their statements are accurate and truthful regarding their diversity statistics and history. To do this, boards should ensure they know what public statements have been made about ESG and what is being done internally. Nominating and governance committees should evaluate these issues carefully. Outside counsel, and other experts, can be useful in ensuring accurate disclosures.
Boards should likewise ensure that their management, HR and risk teams are well aligned. Directors and officers should ensure that these internal teams are operating with fluid communication and clear prioritization of goals.
In this hardening insurance market, underwriters consider an insured’s exposure to ESG issues and liabilities when considering an insured’s risks, especially for Directors & Officers insurance. To the extent that companies can proactively demonstrate that they have decreased exposure to these risks – through strong corporate governance, accurate disclosures, and commitment to environmental and social factors in both word and action – they will best position themselves for best rates and coverages for their companies, directors and officers. Working with an experienced broker such as NFP, who understands these risks and how to best position an insured’s ESG factors, is crucial.
For more information, please contact Lauren Kim at lauren.kim@nfp.com.
Sources
SEC Division of Examinations Announces 2021 Examination Priorities
Environmental, Social and Governance (ESG) Funds – Investor Bulletin