SEC Commissioner Allison Lee has been speaking up quite a bit recently about diversity and inclusion and about climate change—and not just at SEC open meetings. In her recent dissents in voting on proposals regarding amendments to Reg S-K disclosure requirements related to the descriptions of business, legal proceedings and risk factors (see this PubCo post) and amendments to the SEC's shareholder proposal rules (see this PubCo post), Lee did not hesitate to express her misgivings about the failure of the first proposal to mandate disclosure regarding diversity and climate change and the anticipated adverse impact of the second proposal on shareholder proposals related to ESG. In recent remarks to the Council of Institutional Investors Fall 2020 Conference, Diversity Matters, Disclosure Works, and the SEC Can Do More, and in this NYT op-ed, Lee reinforces her view that the SEC needs to do more in terms of a specific mandate for diversity and climate disclosure.
SideBar
At the open meeting to consider adoption of the amendments to Reg S-K, Lee dissented, principally on the basis that the rules should have included more prescriptive requirements that would have more certainly elicited disclosure regarding diversity and climate risk. Instead, Lee objected, the rule is completely silent on those two critical topics. Lee explained that she had voted to publish the proposal, notwithstanding her misgivings about proposal's substantial shift toward a principles-based approach, because she hoped that
"investors—the consumers of this information—would weigh in regarding specific disclosures on human capital and climate risk, and help us get the balance right between principles-based and line-item disclosures. And that they did, in large numbers. We received thousands of comments seeking disclosure on workforce development, diversity, and climate risk. There were letters explaining why principles-based disclosure requirements, without at least some specifics, would not produce the disclosures investors need. Letters explaining what metrics were most important in terms of building long-term value for investors. Letters explaining what metrics cut across industries and what companies were already tracking."
What's more, she added, "recent events have provided a real-time case study on the need for many of these disclosures."
However, the final rules address neither diversity nor climate risk—the adopting release is "even silent on the very fact that there was a vast outpouring of comment letters on these subjects." To her dismay, the final rules "look largely like the proposal, ignoring both overwhelming investor comment and intervening events. We have declined to include even a discussion of climate risk in the release despite significant comment on this subject. And we have declined to go beyond merely introducing the topic of human capital generally, despite investors' views that this is not nearly enough." She would have supported the final rule, she reflected, had it included "even minimal expansion on the topic of human capital to include simple, commonly kept metrics such as part time vs. full time workers, workforce expenses, turnover, and diversity. But we have declined to take even these modest steps." The SEC, she observed, "takes the position that it does not need to require or specify these types of disclosures because our principles-based disclosure regime is on the job and will produce any disclosures on these topics that are material. Investors are asked to trust that each individual company has gauged materiality on these complex issues with flawless precision and objectivity." But hundreds of companies don't include disclosure on diversity—should we assume that it is therefore not material, she asks? Similarly, she argues, by "some estimates, over 90% of U.S. equities by market capitalization are exposed to material financial impact from climate change. 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."
Lee also dissented on the vote to adopt changes to the shareholder proposals rules, highlighting, in particular, the expected negative impact on ESG proposals and small shareholders. She contended that the "changes will be most keenly felt in connection with ESG issues, which comprise the main subject matter of shareholder proposals, at a time when such proposals are garnering increasing levels of support." Although the rationale given for the changes is the cost, in her view, that seemed at odds with the fact that the number of shareholder proposals is trending down: an "analysis of Russell 3000 companies reveals that, on average, only 13 percent of companies received a shareholder proposal in a particular year between 2004 and 2017. That translates to approximately one proposal every 7.7 years for the average company." However, the number of social and environmental proposals—including climate change, workforce diversity and corporate political spending—has been rising, as has the level of support for these proposals, "with average support reaching 24 percent in 2018 up from single digits just after the financial crisis....Shareholder proposals related to climate change continued to increase in number and in support last season, garnering an average of 31 percent support, with four such proposals passing."
Remarks to CII. Lee opens her speech to CII by noting that, in light of recent events, the issue of diversity and inclusion has been top of mind recently, but that the notion of its being "timely" is one that she "balks" at "because it suggests that somehow its importance is new or trendy. Unfortunately, it is almost an evergreen topic." Although, as she goes on to discuss later in her remarks, there are plenty of good economic reasons to promote diversity, as a
"threshold matter, it has often been argued that advocating for corporate diversity is about equality for equality's sake, and that corporate decision-making by contrast has to be about maximizing shareholder value. In other words, don't inject social ideals into the boardroom or the management suite. I could never quite buy in to the view that some 40 percent of the population in our country (if we're talking about minorities) or over half the country (if we're talking about women) must rationalize their inclusion in corporate boardrooms and elsewhere in economic terms instead of the reverse."
Nevertheless, she contends, if we are looking for "economic support for diversity and inclusion (instead of requiring economic support for the lack of diversity and exclusion), the evidence is in." For example, there is substantial research showing that "board diversity corresponds to lower stock volatility due to the adoption of less risky financial policies, and firms with more diverse boards invest more in research and development and therefore are better at fostering innovation." Similarly, McKinsey
"found that companies with the greatest ethnic diversity on executive teams outperformed those with the least by 36 percent in profitability. The same report found that companies with more than 30 percent women on their executive teams are significantly more likely to outperform those with fewer or no women executives. Fortune 500 firms with the highest proportion of women on their boards outperform those with the lowest. Companies with higher than average diversity on management teams report higher revenue from new products and services. More women in senior positions is associated with higher return on assets. The list of tangible performance benefits goes on."
That explains why investors now consider diversity in their voting decisions—even quant firms incorporate it into their algorithms, she said. It is also widely acknowledged that a lack of diversity may represent "a significant reputational risk for companies and may hamper their ability to recruit and retain top talent." Companies are also aware, with regard to the recent flood of public statements expressing commitments to racial justice, that "it may matter to their bottom line whether we as consumers perceive them to have a sincere commitment to racial justice."
The recent economic downturn has also served to highlight issues regarding diversity. This past proxy season saw "diversity-related proposals garnering significant support," which may reflect, in part, "a growing understanding that a commitment to diversity makes good business sense as a strategy for weathering a difficult economy. Evidence shows, for instance, that banks with more women on their boards were more stable during the 2008-09 financial crisis. I note also some commentary and data suggesting that women leaders are better guiding their countries through the current COVID crisis."
Clearly, she says, there is much work to be done: the question is how best to do it? There are a variety of approaches, including national and state legislation mandating diversity (see, for example, this PubCo post, this PubCo post, and this PubCo post), disclosure regarding diversity or consideration of diverse candidates (such as the Rooney rule), as well as changes to board refreshment practices. For the SEC, the "most obvious tool in the SEC's toolkit is disclosure." Disclosure not only provides decision-useful information to investors, it also "can also drive corporate behavior. For one thing, when companies have to formulate disclosure on topics it can influence their treatment of them, something known as the 'what gets measured, gets managed' phenomenon. Moreover, when companies have to be transparent, it creates external pressure from investors and others who can draw comparisons company to company." (Sometimes referred to as "regulation by humiliation."
Although the SEC "has long-recognized that influencing corporate behavior is an appropriate aim of our regulations," it has thus far been reluctant to require diversity-related disclosure. A 2009 amendment requires companies to "disclose if and how diversity is considered as a factor in the process for considering candidates for board positions," and subsequent staff guidance has encouraged "disclosure of self-identified characteristics of board candidates." While these measures are welcome, Lee acknowledged, nevertheless, "given that women of color hold just 4.6% of Fortune 500 board seats and less than one percent of Fortune 500 CEOs are Black, it's time to consider how to get investors the diversity information they need to allocate their capital wisely."
SideBar
SEC staff guidance was provided in CDIs Question 116.11 and Question 133.13. The question asks what type of disclosure is required under Item 401 and Item 407 of Reg S-K where directors or nominees have voluntarily provided "self-identified specific diversity characteristics, such as their race, gender, ethnicity, religion, nationality, disability, sexual orientation, or cultural background," consenting to disclosure of these diversity characteristics. Item 401(e) requires the company to "briefly discuss the specific experience, qualifications, attributes or skills that led to the conclusion that the person should serve as a director for the registrant at the time that the disclosure is made, in light of the registrant's business and structure." According to Corp Fin, to the extent those self-identified diversity characteristics were considered by the board or nominating committee in assessing whether the person's "experience, qualifications, attributes or skills" were the right fit for the board, Corp Fin expects the discussion required by Item 401 to include, among other things, "identifying those characteristics and how they were considered." (See this PubCo post.)
Item 407(c)(2)(vi) requires disclosure of "whether, and if so how, the nominating committee (or the board) considers diversity in identifying nominees for director. If the nominating committee (or the board) has a policy with regard to the consideration of diversity in identifying director nominees, describe how this policy is implemented." As above, Corp Fin expects the description of diversity policies under Item 407 to "include a discussion of how the company considers the self-identified diversity attributes of nominees as well as any other qualifications its diversity policy takes into account, such as diverse work experiences, military service, or socio-economic or demographic characteristics."
The SEC's current principles-based approach to regulation allows companies to use their discretion to determine whether information with respect to diversity is material, and, if so, what needs to be disclosed. To Lee, however, this approach "has led to spotty information that is not standardized, not consistent period to period, not comparable across companies, and not necessarily reliable. In addition, I hear complaints about so-called 'woke-washing' where companies attempt to portray themselves in a light they believe will be advantageous for them on issues like diversity. A disclosure regime that allows companies to decide if or what to disclose in this area can certainly exacerbate that problem."
What's more, she argues, the "shortcomings of a principles-based materiality regime" are revealed in the data: "For example, 72 percent of companies in the Russell 1000 do not disclose any racial or ethnic data about their employees and only four percent disclose the complete information they are required to collect and maintain under EEOC rules. Less than half of all Fortune 100 companies disclose data on the ethnic and gender compositions of their boards. There is room for improvement."
What to do? First, Lee advocates that the SEC revisit the recent Reg S-K amendments to "require disclosure of workforce diversity data at all levels of seniority," and "strengthen" the staff guidance on board diversity disclosure. (That's likely to be an uphill battle in the absence of a change in the composition of the SEC itself.)
But, in the end, Lee thinks the question is larger than just disclosure. She believes that there is a "serious lack of diversity among financial regulators." For example, a recent analysis showed that only 3% of "top financial regulators in the past 106 years were Black." The SEC and other regulators should work toward opening up opportunities at financial regulators, such as the SEC, as well as among the regulated in the financial services industry, where there is "a noteworthy lack of diversity, most pointedly at senior levels," and dismal levels of improvement for women and minorities at the management level in data from 2007 through 2015. She also points to "substantial disparities in access to capital for women and minorities," as well as "disparities in lending practices that can hinder or discourage minority and women founders from seeking or obtaining loans, and unconscious bias in investment behavior, which may also contribute to disparities in capital raising."
She advocates that the SEC consider how these disparities could be considered more systematically in policymaking, whether through economic analysis from DERA on the impact of rules on underrepresented communities, better integration of the SEC's Office of Minority and Women Inclusion into SEC policymaking and encouraging more use of that office's voluntary diversity self-assessment tool, and otherwise working with other agencies to "combat discrimination and support women and minority-owned small businesses." With regard to DERA, for example, Lee observed that the economic analyses used as part of SEC rulemaking, especially related to capital-raising,
"often claim that our rules will benefit minority- and women-owned businesses simply because we are loosening restrictions that are equally applicable to all businesses. This mindset fails to recognize the unique reasons for disparity of opportunity. We could instead take a more rigorous approach to the question by isolating and analyzing whether and how a proposed rule addresses the particular challenges faced by minority- and women-owned business, or otherwise affects underrepresented communities. It is insufficient to expect changes in our rules to affect all businesses in the same way."
Diversity matters, she concluded, "for fairness, it matters to consumers, and it matters in realizing the full potential of our talent base. All of that translates to performance and matters to investors."
NYT Op-ed. In her NYT Op-ed, Lee forcefully makes her case for disclosure regarding climate change. Much of the private sector—businesses and investors—she maintains, understands and is preparing for a future low-carbon economy, aware that as much as 93% of the U.S. equity market is "already exposed to harms from climate change, with this year's intensified fire and hurricane seasons offering a devastating preview of more to come." Investors, as well as the general public, need better information "about how businesses are contributing to greenhouse gas emissions, and how they are managing—or not managing—climate risks internally." But, she contends, pointing to the recent CFTC report on climate risk (see this PubCo post), "[r]ealistically, that can happen only through mandatory public disclosure." According to Lee, that report "emphasized that greater public disclosure of companies' in-house risk calculations will be essential in helping governments (local and federal) as well as other businesses (large and small) measure and manage their climate risks." And, as the report notes, U.S. financial regulators are not fully utilizing the authority they already have to mandate financial climate-related risk.
"Outdated thinking," she suggests, has led some to view ESG disclosure as "merely about one's policy preferences or moral choice"—i.e., more about "values" than "value." But that's not really the case today when ESG is considered "a significant driver in capital allocation, pricing and value assessments. A major study recently found that a large number of powerful institutional investors rank 'climate risk disclosures' as being just as important in their decision-making processes as traditional financial statements and other metrics for an investment's performance — like return on equity or earnings volatility." Expected U.S. climate catastrophe, such as heat, seasonal fires, rising sea levels, hurricanes and flooding, "means we must price climate risk accurately and drive investment toward an orderly, sustainable transition to green portfolios—rather than panicked scrambles and stock sell-offs as we see more and more climate disasters."
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."
The SEC, she concludes, needs to act now.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
