Investor Relations

Will Public Company ESG Disclosures Come From Shareholders or Regulators?

“The question of what ESG information is missing in our markets is first and foremost a question for investors,” says one SEC commissioner.

Creighton Meland owns shares in a California-based company that markets airport security systems and metal detectors. Like all public company shareholders, Meland periodically has the opportunity to vote for or against nominees to the company’s board of directors, who will presumably steer the company in one direction or another. However, according to a recent federal appellate court decision, a California law may have improperly coerced Meland to vote for directors who otherwise wouldn’t have received his vote.

The 2018 California law at issue requires certain companies to have a specified number of women directors or be fined anywhere from $100,000 to $300,000. Meland filed a lawsuit objecting to the requirement, but a lower court dismissed the case saying Meland suffered no injury.  

Earlier this month, the appellate court disagreed and permitted the case to go forward, finding that California “enacted coercive legislation to achieve gender parity” and Meland could pursue his case alleging that the law improperly seeks to “compel shareholders to act” and “require (or at least encourage) shareholders to vote in a manner that would achieve” the government’s goal of board gender makeup. The decision clears the way for the case to proceed to trial.

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Ironically, while California legislators have been pursuing one environmental, social, and governance (ESG) goal (gender parity on boards) by disenfranchising shareholders, shareholders themselves are using their voting power to pursue other ESG objectives in remarkable ways. 

As widely reported in May, a small activist hedge fund investor in Exxon Mobil Corp waged a successful proxy fight to replace members of Exxon’s board with directors more supportive of committing the company to carbon neutrality by 2050. The hedge fund persuaded other Exxon shareholders to support the effort, resulting in dramatic changes to the make-up of Exxon’s board. The hedge fund has since launched two exchange-traded funds that will use proxy voting guidelines to affect corporate behavior.

Meanwhile, these same two approaches to pursuing ESG objectives are playing out at the federal level, each differing in what role investors’ interests should play in determining which ESG information public companies disclose. On the one hand, is a top-down approach best exemplified by a package recently passed by the House.

Under this approach, the government simply declares certain ESG topics must be disclosed. Specifically, the House bill would enable the SEC to require disclosure of ESG metrics and to define those ESG metrics. The bill goes on to say, “It is the sense of Congress that ESG metrics, as such term is defined by the Commission . . . are de facto material for the purposes of disclosures . . .” In other words, shareholders play no role in determining which ESG metrics are important to them under this approach. Rather, Congress would declare in advance that any ESG metrics defined by the SEC would be de facto material.

The competing, bottom-up approach relies on investors to determine what ESG information is important.

In a recent speech, SEC Commissioner Elad Roisman articulated this view. Roisman pointed out that “the question of what ESG information is missing in our markets is first and foremost a question for investors.”  

If ESG metrics come from the SEC rather than from investors, such metrics may ignore the fact that different investors have “different objectives and uses for the information” and those objectives and uses may change over time. Conversely, regulator-generated disclosure lists tend to be “static” and risk displacing “a good amount of this private sector engagement and freeze disclosures in place prematurely.”

Roisman closed his speech by referring his audience back to Supreme Court Justice Thurgood Marshall’s opinion in a seminal securities law case describing information as material “if there is a substantial likelihood that a reasonable investor would consider the information important in deciding how to vote or make an investment decision.” Investors rather than regulators are best positioned to make those determinations, according to Roisman.

As the Exxon experience demonstrates, empowered shareholders can generate bottom-up, groundswell changes on ESG matters. Of course, shareholder activist groups are also free to wage proxy battles for matters such as installing more conservative board members or pushing companies to disclose involvement in abortion issues.   

But the success of any of these efforts will depend on shareholders persuading other shareholders these topics are important to their investing or voting decisions. Conversely, “coercively” declaring certain topics material by regulatory decree may or may not bear any relationship to what investors care about.

Nicolas Morgan is a partner at the global defense firm Paul Hastings. He focuses his practice on complex securities litigation in state and federal courts and representations involving government investigations and white-collar crime allegations levied against individuals and businesses. He routinely represents CFOs in connection with SEC and DOJ investigations, litigation, and arbitration. He also counsels public companies on securities compliance and corporate governance, conducts internal investigations, and assists in regulatory examinations initiated by the SEC’s division of corporate finance and office of compliance inspections and examinations.