Earlier this year, the U.S. Securities and Exchange Commission (SEC) issued proposed rules for publicly traded companies governing the disclosure of climate-related risks. Given investor demands for such data and the growing prevalence of ESG-related claims from companies, many executives fully expected the SEC to take such action. However, the magnitude of the proposed requirements was surprising.
In its present form, the SEC’s 500-page proposal would require senior management at publicly traded companies to disclose their organization’s greenhouse gas (GHG) emissions (Scope 1) and the GHG emissions related to the energy and electricity they purchase (Scope 2). They would also have to disclose GHG emissions produced across their upstream and downstream value chain (Scope 3), assuming these emissions are “material,” meaning reasonably likely to affect investors’ decision-making.
Formally titled “The Enhancement and Standardization of Climate-Related Disclosures for Investors,” the proposal would require publicly traded companies and large accelerated filers (companies with at least $700 million worth of shares in the hands of public investors) to disclose Scope 1 and Scope 2 emissions for 2023, then disclose emissions across all three scopes for 2024.
Scope 3 disclosures may be particularly challenging. The proposal defines upstream activities as purchased goods and services, capital goods, waste generated from operations, and employee business travel and commuting. Scope 3 downstream activities include the transportation and distribution of products, a third-party’s use of those products, and its investments.
In effect, a company would need to gather and verify the GHG emissions data of their business-to-business customers, suppliers and other vendors, and the companies these third-parties invest in. If the Scope 3 emissions data is considered material, it would need to be disclosed to the SEC along with the Scope 1 and Scope 2 emissions data in its 10-K and 10-Q reports.
“Providing adequate and accurate disclosures is probably not going to be easy,” said Natalie Douglass, chief legal director of the management liability practice at Gallagher. “Since Scope 1 and Scope 2 disclosures do not have a safe harbor in the proposal [for directors and officers], D&O liability is a concern. Potential climate-related misstatements provide a roadmap for plaintiff attorneys to file more securities class actions and more derivative claims. Companies also will see more SEC enforcement actions.”
D&O attorneys have a similar perspective. “Creative lawyers are interested in bringing claims, particularly for something involving climate change that many people feel strongly about,” said Doug Raymond, senior partner in the corporate practice of Faegre Drinker Biddle and Reath LLP. “In my mind, things haven’t been identified with sufficient specificity in the proposal to allow companies to satisfy the Scope 3 obligations, which can possibly result in D&O litigation.”
Douglass agreed that the Scope 3 disclosures are a potential litigation minefield. “The proposal’s requirement to disclose GHG emissions across a company’s value chain is controversial and challenging, given the murkiness in the proposal around materiality,” she said. “Although the proposal does provide a safe harbor for inaccurate statements provided by third parties, this is only the case if the statements are affirmed to be reasonable.”
On June 17, the public comment period ended and the SEC is now making modifications based on that feedback, but few securities litigation experts anticipate major changes. Since investors have long demanded more transparency into a public company’s climate-related risks, the SEC is likely to adopt a final climate risk disclosure regulation before the end of the year.
“Assuming the final proposal differs little from the current proposal, it’s a game-changer in many respects, as it imposes much greater oversight by board members and senior management,” said Dan Bailey, a partner at law firm Bailey Cavalieri LLC, which often represents insurers in D&O liability litigation.
For board members, the proposal would add a new Subpart 1500 to Regulation S-K in the U.S. Securities Act of 1933 to create a climate change reporting framework within existing SEC filing forms. Senior management would be required to disclose climate-related risks that have had, or are reasonably likely to have, material impacts on the company’s business or consolidated financial statements. They would also be required to disclose how these risks may affect the company’s strategy, business model and outlook, as well as the relevant risk management processes for identifying, assessing and managing the climate-related risks.
The proposal’s new reporting framework specifically requires companies to describe the board’s oversight of climate-related risks. The proposal further requires that boards disclose the names of members and specific board committees responsible for this oversight, the process by which the board is informed about climate risks, and the frequency of discussion on such matters. Additionally, boards must identify members with expertise in climate-related risks and describe the nature of this expertise.
The prospect of enhanced liability for board members identified as having climate-related expertise presents another concern. “Given possible work experiences or certifications involving climate science or risk mitigation, will these members have a heightened duty of care compared to other board members?” Douglass said. “If this is the case—and we don’t know if it is—why is there no safe harbor for these individuals?”
Other board-related responsibilities include how they consider climate-related exposures in relation to the registrant’s business strategy, risk management and financial oversight. Boards would also be required to disclose their monitoring of climate-related targets or goals and how they oversee progress towards attaining the targets or goals.
These are just a few of the comprehensive disclosure requirements for senior management and boards, as the proposal’s extreme length and complex language require in-depth examination and interpretation. Essentially, directors and officers are effectively being tasked with ensuring lower GHG emissions.
“This is not entirely about providing information to investors for investment purposes,” Bailey said. “The SEC’s broader goal here is to try to influence corporate behavior. As we have learned over the last two or three decades in any number of examples, the best way for the government to influence corporate behavior is to focus on the gatekeepers—the directors and officers. The best way to influence the behavior of the gatekeepers is to get them to focus on investor disclosures, as this is their biggest liability exposure. Push that button and the government knows it has a better chance of getting what it wants.”
By requiring publicly traded companies to disclose their own emissions and the emissions produced across their value chain, businesses are likely compelled to reduce or at least control these emissions. Otherwise, their investors may invest elsewhere, their customers may buy goods and services from their competitors and, particularly during this period of significant labor shortages, some employees may explore other options that align with their values.
“These very detailed rules will be very difficult to comply with,” Bailey said. “Consequently, the adverse publicity that results from a climate change carbon-based issue is a field day for plaintiff lawyers converting it into a securities class action lawsuit alleging recklessness.”
In its current form, the proposal could also increase the risk of D&O lawsuits, particularly among publicly traded companies that “overpromise and under-deliver on ESG goals,” said Jonathon Fanti, senior vice president and D&O underwriting leader at QBE North America. Soon, honoring ESG commitments will become not only a reputation issue but a regulatory one, as companies that fail to back up their lofty ESG pledges will face regulatory scrutiny.
Scope 3 emissions may pose the greatest exposure for directors and officers. “How do you get your arms around the emissions disclosures up and down the value chain?” he said. “And assuming you gather this intelligence, how do you assess materiality?”
He provided the example of a retailer that sources products or supplies from tiers of suppliers. “Not only would you have to disclose the GHG emissions of these upstream activities, you would need to also disclose the emissions data on the downstream activities like distribution and transportation, which are likely to involve airplanes and trucks that produce significant emissions,” Fanti said. “Many companies could be put in a position to have to change their supply chains to be in compliance—at a time when their supply chains are under duress from the pandemic, the conflict in Ukraine and COVID lockdowns in China.”
As for the D&O insurance market, which has seen several years of rising premiums and tighter coverage terms and conditions, there is some optimism. “I’d say we’re in a ‘wait and see’ situation, but I don’t expect a knee-jerk reaction; the short-term trajectory is for the stable market conditions to hold firm,” Douglass said.
She cautioned, however, that if there is a pronounced shift in claims frequency or severity as a result of the SEC disclosures, “the market will respond in kind.”