SEC issues proposed regulations on climate-related disclosures and D&O implications
Across Europe and the United States there has been a growing focus on Environmental Social and Governance (“ESG”) regulations for corporations. While the regulatory landscape in Europe has led to conduct-based directives on ESG, the landscape in the United States is developing and still in its early stages as US regulators begin to issue proposed ESG-related regulations. One such proposed regulation was published by the Securities and Exchange Commission (“SEC”) on 21 March 2022. The proposed regulation entitled “The Enhancement and Standardization of Climate-Related Disclosures for Investors” requires SEC registered issuers (“Registered Issuers”) to provide certain climate-related information in their registration statements and annual reports. If enacted, Registered Issuers may face substantial new risks from regulators and private litigants. D&O related implications require close attention as the proposed regulation develops and comes under scrutiny.
The proposed disclosure requirements
The proposed regulation was prompted by the SEC’s concern that Registered Issuers’ disclosures of climate-related risks do not protect investors despite the requirements to disclose “material” risks to investors. As a result, the SEC seeks to implement additional disclosure requirements that it believes are necessary to prompt consistent, comparable, and reliable climate-related disclosures for investors. To achieve these goals, the proposed regulation requires additional disclosures from Registered Issuers in their annual filings and registration statements.
Under the proposed regulation, Registered Issuers would be required to provide: (i) climate-related disclosures in their registration statements and Securities and Exchange Act of 1934 (“Exchange Act”) reports; (ii) the Regulation S-K mandated climate-related disclosure in a separate, appropriate captioned section of its registration statement or annual report or alternatively to incorporate that information in the separate appropriately captioned section by reference from another section such as Risk Factors, Description of Business, or Management’s Discussion and Analysis; and (iii) the Regulation S-X mandated climate-related financial statement metrics and related disclosure in a note to the registrant’s audited financial statements. Additionally, reporting issuers would be required to electronically tag both the narrative and quantitative climate-related disclosures in Inline XBRL and file the disclosures rather than furnish them.
A key part of the proposed regulation is the greenhouse gas protocol. The greenhouse gas protocol was created in partnership between the World Resources Institute and the World Business Council for Sustainable Development. This protocol introduces the concept of scopes of emissions to help differentiate those emissions that are directly attributable to the reporting issuer and those emissions that are indirectly attributable to Registered Issuers’ activities through the use of three different scopes to categorize and report their emissions.
Scope 1 emissions are generated from sources owned or controlled by the company. For example, a manufacturing company’s machinery or delivery vehicles may be included in Scope 1 if they directly cause greenhouse gas emissions. Scope 2 emissions are generated from the generation of electricity purchased and consumed by the reporting issuer. Scope 3 emission are all other indirect emissions not accounted for in Scope 2 emissions. A Scope 3 emission might include those emissions that result from the production and transportation of goods that a reporting issuer purchases from third parties.
Takeaways for underwriters and claims professionals
Regulators, investors, and plaintiff’s attorney are clearly focusing on ESG disclosures. As a result, the SEC’s proposed rule is an attempt to address some of these climate related and corporate governance issues. It is probable that the proposed rule will be subject to scrutiny and change as an overreach, including through legislative or judicial challenge. As ESG-related enforcement, regulation, and legislation evolve, the risk faced by corporations will likely change. This is especially true if the SEC adopts similar disclosure requirements regarding cybersecurity risk governance, human capital management, and corporate board disclosures. If the SEC continues to enhance disclosure requirements, it could lead to surges in enforcement actions by government regulators and private plaintiffs.
To address the new risk commensurate with this proposed rule, Underwriters may want to consider the climate impact of any potential policyholder’s business and strategies to comply with the proposed climate-related disclosure requirements going forward even if such rules are challenged.
From a claims perspective, there may be possible shareholder or derivative actions if adequate internal processes or controls are not used to comply with the disclosure requirements of the new rule. Additionally claims professionals may see heightened claims activity as Registered Issuers begin reporting this information as the disclosures could cause a wave of litigation brought by private litigants in connection with a variety of state laws.