Let's just say that the SEC's Investor Advocate, Rick Fleming, was none too pleased with the work of the SEC this year. Although, in his Annual Report on Activities, he complimented the SEC for its prompt and flexible response to COVID-19, that's about where the accolades stopped. For the most part, Fleming found the SEC's rulemaking agenda “disappointing.” While cloaked in language about modernization and streamlining, he lamented, the rulemakings that were adopted were too deregulatory in nature, with the effect of diminishing investor protections. But issues that definitely called for modernization—such as the antiquated proxy plumbing system—despite all good intentions, were not addressed, nor did the SEC establish a “coherent framework” for ESG disclosure. And the SEC “also selectively abandoned its deregulatory posture by erecting higher barriers for shareholders' exercise of independent oversight over the management of public companies” through the use of shareholder proposals and by imposing regulation on proxy advisory firms. That regulation could allow management to interfere in the advice investors pay to receive from proxy advisory firms and was widely opposed by investors. What's your bet that he'll be a lot happier next year?
The report makes a number of recommendations, including the following:
- Reversal of the shareholder proposal rule. Among other things, the new rules modified the eligibility criteria for submission of proposals and raised the resubmission thresholds; provide that a person may submit only one proposal per meeting, whether as a shareholder or acting as a representative; and prohibit aggregation of holdings for purposes of satisfying the ownership thresholds. (See 2020/10/02/amendments-to-shareholder-proposal-rules-updated/">this PubCo post.) Fleming opposed the rulemaking because the “new ownership thresholds significantly diminish the ability of shareholders with smaller investments to submit proposals,” and many of these holders have played an important role in the process. In addition, he believed the economic analysis was fundamentally flawed, particularly failure to take into account “the most important and obvious question in the economic analysis of a rulemaking that changed eligibility thresholds: specifically, how many shareholders that were eligible under the prior rules would become ineligible under the amended rules.” Staff analysis estimated that number to be between one-half and three-quarters of the retail investor accounts; however, he indicated, that analysis was withheld from public view and from the Advocate's office until 40 days prior to the SEC vote and months after the public comment period had formally closed.
- Reversal of the proxy advisory firm rules. These rules made proxy voting advice subject to the proxy solicitation rules and conditioned exemptions from those rules for proxy advisory firms, such as ISS and Glass Lewis, on disclosure of conflicts of interest and adoption of principles-based policies to make proxy voting advice available to the subject companies and to notify clients of company responses. In addition, the changes modified Rule 14a-9 to include examples of when material omissions in proxy voting advice could be considered misleading within the meaning of the rule. (See 2020/07/24/sec-amendments-proxy-advisors-updated/">this PubCo post.) Fleming characterized the changes as requiring proxy advisory firms, which are engaged by institutional investors to provide advice, “to act as conduit[s] for company management to rebut the advice given.” Fleming was troubled by the absence of empirical evidence supporting claims of select market participants that “proxy voting advice historically had not been transparent, accurate, and complete.” In addition, Fleming believed that investors should be able to seek this advice without have to “pay for feedback mechanisms that subject them to further lobbying by corporate management….We worry that the newly mandated feedback mechanism enables undue interference in the voting process and will likely result in the suppression of dissenting views.” He also contended that the economic analysis for this rulemaking was inadequate.
- Reversal of the rulemaking to “harmonize” various Securities Act exemptions. As summarized in the report, the amendments address “in one broadly applicable new rule, the ability of issuers to move from one exemption to another, as well as to a registered offering; [raise] offering limits for Regulation A, Regulation Crowdfunding, and Regulation D Rule 504 offerings, and rais[e] individual investment limits; [relax] restrictions on general solicitation; and [adjust] certain disclosure and eligibility requirements and bad actor disqualification provisions in order to reduce differences between exemptions.” (See 2020/11/03/final-amendments-private-offering-exemptions/">this PubCo post.) Fleming expressed concern about the continued shift of capital-raising from public markets—and the protections to the public that it provides—to private markets, facilitated by the “ever-expanding exemptions that allow companies to raise increasing amounts of capital with less and less public disclosure. As a practical matter, a company can now raise as much money as it wants from as many people as it wants for as long as it wants, without ever having to go through the registration process. We view the ‘harmonization' rulemaking…as a further step toward making registration entirely voluntary.” In particular, the report contends that the integration doctrine was “nearly eviscerate[d]” and points to the failure of the SEC “to provide a balanced analysis of the potential ramifications for investors who are being given greater access to private offerings,” such as information limitations and illiquidity of shares.
- Adoption of a framework for ESG disclosure. The report notes that numerous investors have long been calling for the adoption of ESG disclosure requirements, pointing to a 2018 rulemaking petition (see 2018/10/04/climate-change-disclosure-petition/">this PubCo post) and recommendations from the SEC Investor Advocacy Committee (see 2020/05/27/investor-advisory-committee-disclosure-recommendations/">this PubCo post). Recognizing that some favor the SEC's principles-based approach to ESG disclosure, Fleming nevertheless agrees “with the many investors who assert that the principles-based disclosure requirements have failed to deliver important, decision-useful information. The information provided by companies tends to vary in quality, and it is not presented in a standard format that enables comparisons between companies.” He also expressed concern that the lack of substantive ESG disclosure standards contributed to the proliferation of greenwashing. He viewed as “sensible” the recommendation of Commissioners Allison Lee and Caroline Crenshaw to create a special ESG advisory committee to make recommendations to the SEC, as well as an internal SEC task force to consider and implement policies for ESG disclosure requirements. (See 2020/11/20/sec-amends-mda-requirements/">this PubCo post.)
According to this 2019 study from consulting firm McKinsey, investors want to see standardized sustainability reporting. The authors observe that, in light of mounting evidence “that the financial performance of companies corresponds to how well they contend with environmental, social, governance (ESG), and other non-financial matters, more investors are seeking to determine whether executives are running their businesses with such issues in mind.” Although there has been an increase in sustainability reporting, McKinsey's survey revealed that investors believe that “they cannot readily use companies' sustainability disclosures to inform investment decisions and advice accurately.” Why not? Because, unlike regular SEC-mandated financial disclosures, ESG disclosures don't conform to a common set of standards—in fact, they may well conform to any of a dozen major reporting frameworks and many more standards, selected at the discretion of the company. That leaves investors to try to sort things out before they can make any side-by-side comparisons—if that's even possible. In response to a question from McKinsey about sustainability standards, 14% of investors said there should just be fewer standards, but an overwhelming 75% of investors said there should be only one standard. Executives had a similar perspective: 28% said there should be fewer standards, and 58% said there should be only one standard. In addition, the vast majority of investors agreed or strongly agreed that more standardization would help with effective capital allocation (85%) and with more effective risk management (83%). A similar majority of executives agreed or strongly agreed that more standardization would help their companies benchmark against their peers (80%) and enhance their companies' ability to create value or mitigate risk (68%). What's more, 82% of investors said companies should be legally required to issue sustainability reports and, surprisingly, 66% of executives agreed. (See 2019/08/19/investors-standardized-sustainability-disclosures/">this PubCo post.)
The lack of reporting consistency has been confirmed in a recent GAO report. The GAO found substantial inconsistencies—in definitions, in metrics and methodologies—that would limit comparability. The GAO found “instances where companies defined terms differently or calculated similar information in different ways,” most often in connection with climate change, personnel management, resource management and workforce diversity. For example, companies used different groupings for employee demographics or reported greenhouse gas emissions data differently, combining carbon dioxide and other greenhouse gases in some cases, while reporting carbon dioxide emissions alone in other cases. Companies also used different calculation methods or units of measure, with some reporting reductions year-over-year, while many others “reported reductions over multiple years with no consistency within or across industries.” Even when companies used the same ESG framework, they did not always provide disclosure consistently. For example, among companies using the GRI framework, the GAO identified four different methods for reporting workforce diversity. (See 2020/08/10/gao-inconsistent-esg-disclosure/">this PubCo post.)
Even a recent CFTC subcommittee report has advocated that the SEC create a “mandatory, standardized disclosure framework for material climate risks, including guidance about what should be disclosed that is closely aligned with developing international consensus, [which] would improve the utility and cost-effectiveness of disclosures.” The subcommittee report concluded that “[t]he quality of climate disclosure in the United States by issuers largely remains inadequate for the needs of investors.” In part, the report attributes the inadequacy to current interpretations of the concept of “materiality,” which often limits “required disclosure to short- and medium-term risks, and firms may have assumed that climate risks are relevant only over longer time horizons.” Primarily because of the “significant ambiguity about when climate change rises to the threshold of materiality, particularly for medium- and long-term risks,” the existing disclosure regime cannot fill “the reporting gaps.” To achieve comparability in disclosure, the report advises, companies must have “clear rules about what metrics companies should consider.” (See 2020/09/10/cftc-report-climate-change/">this PubCo post.)
Notwithstanding strenuous objections from the Democratic SEC commissioners, the SEC as a whole has regularly elected not to mandate any prescriptive disclosure requirements regarding climate change. Former SEC Chair Jay Clayton persisted in his long-held view that the SEC's approach to climate risk disclosure should be principles-based. In a 2019 interview in Directors & Boards (see 2019/07/25/clayton-discusses-short-termism-and-esg-disclosure/">this PubCo post), Clayton made clear that when it comes to mounting calls for rulemaking that standardizes ESG disclosure, Clayton was less than enthusiastic: “My view is that in many areas we should not attempt to impose rigid standards or metrics for ESG disclosures on all public companies.”
However, that position is likely to change with a new administration and new SEC Chair. For example, Commissioners Allison Lee and Caroline Crenshaw have strenuously advocated a stronger mandate for ESG disclosure. According to Lee, we “are long past the point at which it can be credibly asserted that climate risk is not material. We also know today that investors are not getting this material information.” Crenshaw observed that the question of whether climate change risk is material is “no longer academic,” noting that the SEC's “steps to modernize the securities laws should facilitate the efficient comparison of long-term sustainability in the face of present-day risks to issuers. (See 2020/08/26/sec-modernize-business-legal-risk-factor-disclosures/">this PubCo post.) In this NYT op-ed, Lee reinforced her view that the SEC needs to do more in terms of a specific mandate for climate disclosure. It is a misconception, she writes, to conclude that SEC disclosure rules based on materiality already elicit sufficient information about climate; otherwise Enforcement would take action. However, she observes, as
“a former S.E.C. enforcement lawyer who spent over a decade spotting failed and misleading disclosures, I can attest that enforcement of broad-based materiality requirements does not work with this kind of near-magical efficiency. That's why securities laws sometimes require very specific data and metrics on certain important matters like executive compensation. But, so far, not for climate risk. There are no specific requirements, and without that clarity how can companies be sure what is expected of them? As of now, there is little for us to enforce. The voluntary disclosure that companies have increasingly provided in recent years is still largely regarded as insufficient. It's not standardized, it's not consistent, it's not comparable, and it's not reliable. Voluntary disclosure is not getting the job done. And without better disclosure of climate risks, it's not just investors who stand to lose, but the entire economy.”
And, a recent PLI annual securities regulation institute, Lee gave the keynote address, Playing the Long Game: The Intersection of Climate Change Risk and Financial Regulation. Recognizing that there is a “growing consensus that climate change may present a systemic risk to financial markets,” Lee emphasized the need for “clear-eyed analysis of accurate, reliable data” obtained through “uniform, consistent, and reliable disclosure.” Some disclosure has resulted from private ordering, but, as she has contended previously (see, e.g., 2020/02/06/sec-debate-climate-disclosure-regulation/">this PubCo post), “some level of regulatory involvement [is needed] to bring consensus, standardization, comparability, and reliability.” (See 2020/10/09/commissioner-lee-diversity-climate-disclosure/">this PubCo post and 2020/11/10/sec-commissioner-lee-sec-must-address-systemic-financial-risk-posed-by-climate-change/">this PubCo post.)
- Adoption of minimum listing standards for exchange. Although, the report indicates, the SEC has oversight responsibility over exchanges' proposed amendments to their listing standards to ensure consistency with the Exchange Act, corporate governance remains largely the province of state law. Beyond “the proxy voting process, only the exchanges themselves have broader authority to regulate other substantive aspects of corporate governance for their listed issuers.” Fleming advocates that this allocation of responsibility be revisited. Why? Because the “primary listing exchanges are now for-profit entities that, unlike their prior mutual ownership structure, have an inherent conflict of interest between protecting investors and generating business revenue from listed issuer fees,” creating a potential race to the bottom when it comes to qualitative corporate governance standards. Fleming advocates that Congress set, by statute—or give the SEC statutory authority to set—minimum listing standards to guarantee investor protections. Fleming views the Holding Foreign Companies Accountable Act as one example of Congressional action in this area. (See 2020/12/22/consolidate-rulemaking-holding-foreign-companies-accountable-act/">this PubCo post.) The report suggests that minimum standards should include a sunset provision for dual-class share structures and more complete board and management diversity disclosure.
- Adoption of rules to make disclosures machine-readable. Investors are increasingly using technological tools to analyze data and would benefit from improvements such as the use of legal entity identifiers and other uniform data standards. Fleming supports adoption of the Financial Transparency Act and implementation of the directives of the Open, Public, Electronic and Necessary Government Data Act, which “provides a sweeping, government-wide mandate for all federal agencies to publish government information in a machine-readable language by default.”
In this column on Bloomberg, former SEC Chair Arthur Levitt advocates that the new SEC Chair adopt some of the same priorities. In particular, he contended that the SEC has, for too long, “been seen as captive to the interests of audit firms, financial market leaders, public companies and other entities. But all those interests have their own dedicated representatives in Washington; the investing public does not, save for the SEC. That's why the agency's chair must ultimately represent the interests of public investors in every SEC action and discussion.” Characterizing the new rules harmonizing the private placement exemptions as a “rule permitting private placement of opaque investments with financially unsophisticated investors,” he urged that it be further reviewed and rescinded. He was also critical of the new rule proposal to allow “non-registered ‘finders' to collect transaction-based compensation when they steer investors into private offerings. Bottom line: If a proposal doesn't improve the information given to ordinary investors, reduce fees and friction for public investing activity, and reduce obfuscation and the risk of scams, then it should be dropped or rescinded as soon as possible.” Among other concerns were the stock-trading apps that entice investors into day trading, and dilution of auditor independence rules—including “a recent rule that would allow audit firms to determine for themselves whether their independence was compromised” (see 2020/10/20/sec-amends-auditor-independence-rules/">this PubCo post), which he advocated be rescinded. He also advocated continuation of the effort to subject audits of Chinese companies to PCAOB review and promotion through the bully pulpit of higher transparency standards for ESG funds to allow investors to be sure that “their socially responsible mutual funds aren't taking positions in companies with questionable policies and practices.”
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