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This Advisory is the second in a series concerning environmental, social and governance (ESG) considerations for the financial services industry and other companies. Arnold & Porter's ESG advisories reflect the combined effort of the firm's Environmental Practice Group, Financial Services Group, and Securities Group, with insights from other practice areas at the firm. Arnold & Porter will be publishing additional ESG advisories over the next several months.

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Since the election, not a week has passed without news that ESG is an increasingly critical focus of the financial regulators, federal and state lawmakers, and investors. Last week may have been the most newsworthy yet. The topic came up at the nomination hearing of Gary Gensler for Chair of the US Securities and Exchange Commission (SEC), the SEC announced the creation of a Division of Enforcement task force to address ESG-related misconduct, and there was a lively debate during a hearing of the House Financial Services Subcommittee on Investor Protection, Entrepreneurship and Capital Markets on the proposed Climate Risk Disclosure Act, which would require public companies to disclose their exposure to climate-related risks.

This Advisory focuses on climate-related disclosures and the apparent growing focus among financial regulators and Congress aimed at making such disclosures mandatory for financial institutions and public companies. We address the issue primarily within the framework of SEC disclosure requirements. We also summarize the issue of climate-related disclosures from the perspective of the banking regulators.

Overview of the Current SEC Disclosure Framework

The SEC's anticipated focus on climate-related disclosures under the Biden-Harris Administration, including the question of whether additional regulations will be implemented, should be viewed in the context of the current disclosure framework under the federal securities laws. Regulation S-K provides a set of detailed disclosure requirements under both the Securities Act of 1933 (Securities Act) and the Securities Exchange Act of 1934 (Exchange Act) and is applicable to both public offerings and ongoing reporting obligations. Securities Act Rule 408 and Exchange Act Rule 12b-20 (17 CFR §§ 230.408, 240.12b-20) require a registrant to disclose in its registration statements and periodic filings, in addition to the information expressly required by SEC regulation, "such further material information, if any, as may be necessary to make the required statements, in light of the circumstances under which they are made, not misleading."

The US Supreme Court addressed the materiality standard in TSC Industries, Inc. v. Northway Inc., 426 U.S. 438 (1976), and concluded that a fact is material if there is "a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote . . . there must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the 'total mix' of information made available." Id. at 449. Later, in Basic Inc. vs. Levinson, 485 U.S. 224 (1988), the Supreme Court reiterated the standard for materiality, stating that materiality exists if there is "a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the 'total mix' of information made available." Id. at 231-32. Generally, materiality "will depend at any given time upon a balancing of both the indicated probability that the event will occur and the anticipated magnitude of the event in light of the totality of the [entity's] activity." Id. at 238.

Over the years, the SEC has provided guidance on materiality. For example, in a Staff Accounting Bulletin issued in 1999, the SEC stated that "[a] matter is 'material' if there is a substantial likelihood that a reasonable person would consider it important . . . The omission or misstatement of an item . . . is material if, in the light of the surrounding circumstances, the magnitude of the item is such that it is probable that the judgment of a reasonable person relying upon the report would have been changed or influenced by the inclusion or correction of the item." U.S. Securities and Exchange Commission Staff Accounting Bulletin No. 99 – Materiality, 17 C.F.R. §211, subd. B (Aug. 12, 1999).

Accordingly, while this disclosure framework provides a basis for requiring various climate-related disclosures, there are no line-item requirements mandating such disclosures. Instead, approximately a decade ago, the SEC issued its Guidance Regarding Disclosure Related to Climate Change (2010 Guidance), which addressed four items of Regulation S-K that could require disclosure regarding the impact of climate change, consisting of a company's description of business, legal proceedings, risk factors, and management's discussion and analysis. In its 2010 Guidance, the SEC provided examples of climate change-related issues that registrants may need to consider for disclosure purposes in connection with (i) the impact of climate change legislation and regulation, (ii) the impact of international climate change accords, (iii) any indirect consequences of regulation or business trends, and (iv) the physical impacts of climate change. Although not released as an official regulation, over the past decade, the 2010 Guidance generally has been the primary clarifying guidepost for companies trying to discern which climate change risks require disclosure.

More recently, the SEC had an opportunity to implement climate-related disclosure requirements, but did not do so. In August 2020, the SEC adopted amendments to Regulation S-K "to modernize the description of business (Item 101), legal proceedings (Item 103), and risk factor disclosures (Item 105)," but these amendments did not include any new climate disclosure requirements. In fact, the amendments were adopted by a 3-2 vote by the Commissioners, and one of the dissenters was Commissioner Allison Herren Lee (now Acting Chair of the SEC), who observed that the amendments were "silent on . . . climate risk disclosures."

In addition, there may be some internal resistance at the SEC premised on the notion that more robust climate disclosure requirements are not necessary because the existing materiality standard is sufficient. This is a sentiment that has been echoed over time by Commissioners Peirce and Roisman. Addressing an ESG disclosure framework, Commissioner Peirce has said that any new guidance should "not bow to demands for a new disclosure framework, but instead support the principles-based approach that has served us well for decades." Further, Commissioner Roisman took issue with mandating ESG disclosures and opined that "the issues under this enormous umbrella of a term are usually subjective and constantly evolving based on current events. Because of this evolution, requiring prescriptive disclosure would be difficult." Commissioner Roisman also has made it clear that "while the SEC's principles-based framework requires a public company to disclose all material information (ESG or otherwise), a company can tailor disclosures so that they are useful to investors."

That said, the recent focus on enhanced climate-related disclosure requirements has not subsided. For example, in May 2020, the SEC Investor Advisory Committee (IAC) recommended that the SEC "begin in earnest an effort to update the reporting requirements of Issuers to include material, decision-useful, ESG factors." This recommendation was based on work by the IAC's Investor-as-Owner Subcommittee, which was chaired by John Coates—who, in turn, was named Acting Director of the SEC's Division of Corporation Finance on February 1, 2021. Acting Director Coates has since stated that the SEC "should help lead" the creation of a disclosure system relating to ESG issues for corporations. Indeed, he commented that "to some extent what has traditionally been voluntary is becoming less voluntary, not through law but because of investor demand." Coates cautioned, however, against an overly-prescriptive climate disclosure framework that may soon become obsolete.

On March 2, 2021, Gary Gensler, President Biden's pick to lead the SEC, testified before the Senate Committee on Banking, Housing, and Urban Affairs as part of his nomination hearing. Gensler pledged that, if confirmed as the SEC Chairman (which we expect will happen in the near-term), he would examine the need for rules and guidance on climate-related disclosures. During his hearing, Gensler indicated his general support for such rules and guidance, reasoning that many investors "really want to see" such disclosures and consider them material in making investment decisions. Gensler explained: "In 2021, there's tens of trillions of dollars of invested assets that are looking for more information about climate risk," and, "the SEC has a role to play to bring some consistency and comparability to those guidelines." Gensler also stated that these types of disclosure regulations could be "pro-issuer, pro-corporation and pro-investor" and provide companies with "some consistency, comparability, and some clear rules."

Gensler's support for climate-related disclosures echoes recent comments by SEC Acting Chair Lee, whose pro-ESG disclosure position is well-documented. On February 24, 2021, Lee issued a statement on climate-related disclosures, which directed the "Division of Corporation Finance to enhance its focus on climate-related disclosure in public company filings." In her statement, Lee explained that the SEC Staff "would review the extent to which public companies address the topics identified in the 2010 guidance, assess compliance with disclosure obligations under the federal securities laws, engage with public companies on these issues, and absorb critical lessons on how the market is currently managing climate-related risks."

The SEC also appears ready to address the dearth of enforcement activity involving climate disclosures. On March 4, 2021, the SEC announced the creation of a Climate and ESG Task Force in its Division of Enforcement. This division-wide effort will bring together a group of 22 enforcement specialists and attorneys and will be led by Acting Deputy Director of Enforcement Kelly Gibson. The task force will develop initiatives to identify "ESG-related misconduct," with an initial focus of identifying "any material gaps or misstatements in issuers' disclosure of climate risks under existing rules." In addition to reviewing public company disclosures, the task force will analyze disclosure and compliance issues relating to "investment advisers' and funds' ESG strategies." In carrying out its mission, the task force will work closely with other SEC Divisions and Offices, including Corporation Finance, Investment Management, and Examinations, and will use "sophisticated data analysis to mine and assess" registrant information for potential violations. The task force will complement the SEC's other initiatives in this sphere, including the recent appointment of Satyam Khanna as the agency's first-ever Senior Policy Advisor for Climate and ESG.

Finally, while the SEC Commissioners may have differing views on the necessity for public company climate-related disclosure requirements, the Commissioners appear to be in agreement that ESG funds (those that make investment decisions based, at least in part, on ESG principles) must disclose material ESG-related investment criteria. Commissioner Roisman has expressed concern that some ESG fund managers convey a false impression to investors that a given product is climate-friendly—a practice known as "greenwashing"—and has called for additional ESG disclosures for funds that market themselves as ESG-focused. Last week, the SEC issued an Investor Alert advising potential investors to carefully consider an ESG fund's disclosures in order to ensure the fund's ESG approach is aligned with the investors' objectives.

Voluntary Climate Disclosure Frameworks

Even in the absence of specific regulations or extensive enforcement efforts, a significant number of public companies already undertake voluntary disclosures based on a variety of well-established frameworks. One of the most prominent is the Task Force on Climate-related Financial Disclosures (TCFD) established by the Financial Stability Board. In 2017, the TCFD issued recommendations following a long consultation process between business and financial leaders on how to effectively communicate climate-related information. The TCFD's principal recommendations fall into four categories: (i) governance, including disclosure of an organization's governance structure around climate-related risks and opportunities; (ii) strategy, including disclosure of the actual and potential material impacts of climate-related risks and opportunities on an organization's businesses, strategy, and financial planning; (iii) risk management, including disclosure of how an organization identifies, assesses, and manages such risks; and (iv) metrics and targets, including disclosure of the specific metrics and targets an organization uses to characterize and mitigate climate-related risks, including, disclosure of Scope 1, 2, and potentially 3 emissions.1 These recommendations are widely viewed as a comprehensive and thoughtful high-level approach to climate disclosures, and they are embraced by more than 1,000 global organizations in the private and public sectors as well as by progressive associations like the Center for American Progress, which recently advocated for use of the TCFD recommendations as a floor for mandatory climate disclosures.

In some respects, the TCFD framework builds upon—and is generally complementary to—the approach developed by the Sustainability Accounting Standards Board and Global Reporting Initiative ESG frameworks. In addition to these frameworks, there are industry-specific initiatives, such as the Partnership for Carbon Accounting Financials (specific to financial institutions), which articulates a goal of establishing a "a clear and transparent set of rules to measure their financed emissions to assess risk, manage impact, meet the disclosure expectations of important stakeholders, and assess progress to global climate goals." There are differences in the lexicons and approaches to climate reporting among these different frameworks and initiatives, which may warrant close consideration to the extent regulators move forward with facets of these voluntary regimes as part of new mandatory disclosure requirements.

Could Investor Pressure Yield More Comprehensive Results?

Recently, institutional investors have led calls for enhanced climate-related disclosures. For example, in a 2020 letter to fellow CEOs, BlackRock Chairman and CEO, Larry Fink, called for "greater transparency on questions of sustainability" and urged that "[c]ompanies . . . be deliberate and committed to embracing purpose and serving all stakeholders." In his letter, Fink also stated that "[w]hile government must lead the way in this transition, companies and investors also have a meaningful role to play." He observed that clear disclosure standards are essential to further achieve net zero-aligned investing in the future by helping "investors assess which companies are serving their stakeholders effectively, reshaping the flow of capital accordingly." In a separate letter to its clients in 2021, BlackRock went a step further: "Where we do not see progress in this area, and in particular where we see a lack of alignment combined with a lack of engagement, we will not only use our vote against management for our index portfolio-held shares, we will also flag these holdings for potential exit in our discretionary active portfolios because we believe they would present a risk to our clients' returns."

As the Biden-Harris Administration focuses more on climate-related initiatives, other institutional investors and financial institutions may likewise take steps to support or lead climate-related disclosures and initiatives.

Proposed Federal Legislation on Climate Disclosures

In addition to keeping an eye on the SEC's focus on climate-related disclosures, public companies should be aware that legislation in the US Congress could mandate such disclosures. In 2019, Rep. Sean Casten (D-IL) and Sen. Elizabeth Warren (D-MA) introduced H.R. 3623, the Climate Risk Disclosure Act of 2019. This bill would "require public companies to disclose critical information about their exposure to climate-related risks," and direct the SEC to mandate "annual disclosure information regarding climate change-related risks posed to the issuer, as well as the issuer's strategies and actions to mitigate these risks."

Although this legislation has yet to be passed, it may find more support given the current composition of Congress. In this regard, on February 25, 2021, the House Financial Services Subcommittee on Investor Protection, Entrepreneurship and Capital Markets held a hearing and engaged on the issue of climate change and ESG disclosure requirements, including those related to the Climate Risk Disclosure Act. During the hearing, Republican members critiqued the bill, arguing that the SEC should not stray from its primary mandate to protect investors and should avoid wading into politically and morally charged climate debates.

Additionally, the CLEAN Future Act, the House's major climate legislation, includes provisions that would require the SEC to promulgate a rule on mandatory climate disclosures within two years. This rule would include a disclosure requirement related to potential financial impacts and risk management strategies associated with the physical and transition risks of climate change. The legislation also would require regulated parties to disclose risk mitigation activities to address these risks.2

State Disclosure Requirements

In addition to potential federal legislation, stakeholders should also be mindful of state legislation and regulation regarding climate-related disclosures. In this regard, there is proposed legislation in California that would require both climate-related disclosures and tracking against greenhouse gas (GHG) reduction targets established by the California Air Resources Board. To that end, the Climate Corporate Accountability Act (SB-260), introduced in the California legislature in late January 2021, proposes a two-prong approach. First, all publicly-traded domestic and foreign companies with annual revenues greater than $1 billion that do business in California would be required to broadly disclose GHG emissions. (The bill would require disclosure of Scope 1, 2, and 3 emissions.) Second, in addition to broad disclosure requirements, the bill would require the California Air Resources Board to develop "science-based emissions targets" to reduce GHG emissions by January 1, 2024, against which regulated companies' progress would be tracked.

Climate Disclosures From the Perspective of the US Banking Regulators

As we detailed in the first Advisory of our ESG series, since the election, federal and state banking regulators have noted with increasing frequency that climate-related risk must be considered as part of an institution's overall risk assessment and risk management. Many financial institutions already are taking specific measures to identify and mitigate climate-related risk, including by voluntarily providing climate risk disclosures. Notwithstanding these voluntary measures, the banking regulators, similar to the SEC, appear to be seriously considering making such disclosures mandatory.

At the state level, the New York State Department of Financial Services (DFS) issued industry guidance in October 2020 announcing that it is developing a strategy for integrating climate-related risks in its supervisory mandate. In the meantime, DFS expects its regulated financial institutions to "start developing their approach to climate-related financial risk disclosure and consider engaging with the Task Force for Climate-related Financial Disclosures framework and other established initiatives when doing so."

Although the federal banking regulators have not yet issued specific guidance on climate risk disclosures (let alone any such regulations), at least some senior officials have endorsed the idea making them mandatory. In December 2020, Martin J. Gruenberg, a member of the FDIC Board of Directors, stated in a speech titled "The Financial Stability Risks of Climate Change" that "regulators need to provide direction now to financial institutions to develop plans to identify, monitor, and manage the risks posed by climate change." He further stated that "[f]or larger institutions, these plans should be comprehensive and require the measurement and disclosure of climate change risks, including through the use of stress tests."3

Most recently, in February 2021, Federal Reserve Governor Lael Brainard made headlines when she stated that, "[c]urrent voluntary disclosure practices are an important first step, but they are prone to variable quality, incompleteness, and a lack of actionable data. Ultimately, moving toward standardized, reliable, and mandatory disclosures could provide better access to the data required to appropriately manage risks."

It is unknown whether other senior banking agency officials share the views of Mr. Gruenberg and Governor Brainard on climate risk disclosures, and therefore the industry is in a "wait and see" mode on what to expect in terms of guidance or regulation. Given that the Biden-Harris Administration plans to make addressing climate change a priority, and Treasury Secretary Yellen has indicated that one of her priorities is understanding and monitoring the effects of climate change on the financial stability of the economy, there very likely is more to come on this issue. Financial institutions are therefore advised, if they have not already, to consider what potential disclosure-related requirements or regulator guidance might entail.

Unfortunately, there currently is little to discern on this topic from the banking regulators themselves. The regulators have acknowledged that they first must continue their work in identifying the specific impacts and magnitude of climate change on financial services activities as well as consider the appropriate application of disclosures to an industry comprised of financial institutions that vary widely in size, geography, business models, and other risk factors.4 To the extent the banking regulators give further consideration to mandatory disclosures, they likely will consider the TCFD's recommendations discussed above.

International Disclosure Requirements

Looking outside the United States, the European Union (EU) has confirmed that its regulation, the Sustainable Finance Disclosure Regulation (SFDR), will become effective on March 10, 2021. Touted as promoting transparency in the financial industry, this regulation requires that certain financial firms disclose information on ESG considerations to potential investors on their websites. The regulation will require firms to consider how sustainability risks and ESG factors are incorporated into their investment processes and reporting. Specifically, under the SFDR, financial market participants will be required to include (i) disclosures at the product level, which may be made to investors, (ii) disclosures at the entity level, in the form of public disclosures on the entity's website, and (iii) periodic reporting to investors. The SFDR applies to any EU-regulated firm that manages money, such as banks, investment firms, asset managers, pension providers, or insurance‐based investment products. The SFDR also applies to financial market participants that advise on investments or investment strategy.

As this new regulation is implemented across the EU, it raises a question of whether and how US companies with overseas activity (including marketing of funds) will be required to make detailed ESG disclosures beyond what US federal and state regulators may require. Although it is not clear at this point how the SFDR will be applied to non-EU asset managers, it appears that SFDR disclosure requirements will likely apply to non-EU investment managers in two general capacities: (i) non-EU investment managers that market into the EU, and (ii) non-EU investment managers providing portfolio management and/or investment advice services to EU firms that are themselves subject to the new rules. As the SFDR goes into effect, we may see additional guidance from regulators on the SFDR's application to non-EU firms. It also will be instructive to review how disclosures are employed and whether they generate new market norms, including in markets that are not currently as heavily-regulated in this area.

As for banking regulators outside the US, the European regulators have been at the forefront of climate-related financial regulatory issues, and their efforts are likely to be studied by the US banking regulators. The European Central Bank (ECB), for example, issued non-binding guidance in November 2020 regarding climate-related risk management for supervised institutions, including on climate risk disclosures. Included among those supervisory expectations are (i) disclosing material climate-related risks with respect to business models and due diligence procedures, among other areas, (ii) maintaining disclosure policies that state the key considerations that inform their assessment of the materiality of climate-related and environmental risks, as well as the frequency and means of disclosures, and (iii) when institutions disclose climate-related figures, metrics, and targets as material, referencing the methodologies, definitions, and criteria associated with them. The ECB also published more specific expectations, including the disclosure of an institution's Scope 3 GHG emissions. The ECB noted it would not prescribe specific measurements, but suggested that this could entail, for example, a property-by-property measurement of energy consumption for real estate portfolios.5 Whether to require this level of specificity—and the associated burden of compliance—of course would garner significant debate among US regulators.

Recommended Practices in Anticipation of Enhanced Climate Disclosure Requirements

The contours of any new SEC action on climate disclosure requirements remain to be seen, and the timing of new rulemaking and/or guidance is unclear. Nonetheless, stakeholders may wish to take steps now to be proactive on these issues. For example, public companies that currently disclose physical and transitional climate risks may consider revisiting the SEC's 2010 Guidance with fresh eyes in light of the current domestic and international regulatory and legislative climate. This step is particularly advisable given the SEC Enforcement Division's newly-minted Climate and ESG Task Force, which will likely be taking a closer and harder look at the sufficiency of these disclosures. As many major public companies have announced ambitions to be "net zero" by 2030 or 2050, those entities may wish to explore how potential disclosure requirements bear on communications related to steps to achieve such "net zero" goals. Prompt attention to these matters from public company boards of directors is advisable.

In addition, in anticipation of a new potentially mandatory and prescriptive disclosure framework around GHG emissions, stakeholders may wish to carefully consider the various existing voluntary frameworks and whether advocacy to the SEC (even in advance of a proposed rule or guidance) may be prudent. If, down the road, the SEC were to require a level of specificity beyond that established in existing frameworks, companies may wish to evaluate the pros and cons of various approaches. For example, a disclosure framework that requires detailed, mandatory reporting of Scope 3 emissions may be more or less feasible depending on the industry and the line-of-sight into supply chains.

Arnold & Porter's Financial Services and Securities Groups have partnered with our Environmental Practice Group to monitor climate and other ESG developments in the financial services sector and to develop best practices for the firm's financial institution clients. If financial institutions are seeking advice on how to incorporate ESG factors—including climate-related factors—into their business strategy, risk management, or disclosure processes, please contact any author of this Advisory, or your regular Arnold & Porter contact.

  1. Scope 1 emissions are direct emissions from sources a company owns or controls directly. Scope 2 emissions result from the generation of electricity, heat, or steam purchased from a utility provider. Scope 3 emissions are as emissions from activities a company does not own or directly control, like emissions associated with a company's supply chain and investments, e.g., financing a capital project.

  2. While it may be unlikely that federal legislation requiring mandatory climate disclosures could overcome a Republican filibuster, it is unclear whether the filibuster will remain a viable tool and whether Republicans would utilize it in this context.

  3.  See our prior Advisory for a discussion on climate-related stress tests and scenario analyses.

  4.  The financial services industry is keen to be heard on this latter point. The US Climate Finance Working Group, which is comprised of financial services trade associations (e.g., the American Bankers Association, Bank Policy Institute, Institute of International Bankers, International Swaps and Derivatives Association, and Securities Industry and Financial Markets Association), recently published a memo stating its support for more robust climate disclosure standards, as well as a general willingness to work with the Biden-Harris Administration and Congress to support pragmatic approaches to transitioning to a low-carbon economy. This working group noted, however, that disclosure frameworks should balance the value of consistency “with the need for a degree of flexibility to ensure that disclosures are relevant for individual business models, different sectors and varied operating environments.”

  5. The Bank of England (BoE) is pushing for the development of a global standard for mandatory disclosures that will provide consistent and comparable requirements. The BoE has stated that a global standard is necessary because adoption of the TCFD recommendations are voluntary and inconsistently followed by those institutions that have adopted them, which leads to fragmented standards globally.