A Distracted — But Fixable — Mission at the SEC
Both businesses and regulators must stay true to their core missions instead of being drawn to the cause of the day.
Over the past two years, the SEC has proposed a bevy of new rules on ESG issues. These rules — while largely couched in terms of “disclosures” — not only will create new burdens on corporate America, but also will direct the flow of money to particular favored causes.
Take the proposed climate disclosure rule. The proposal — a staggering 534 pages long — would require publicly traded companies to disclose information on greenhouse-gas emissions and risks related to climate change. Companies now do financial accounting; soon, they will have to do climate accounting too. The Wall Street Journal called it “one of the Biden administration’s potentially most significant environmental actions to date.”
There’s a lot in there. Every company must disclose its own greenhouse gas (GHG) emissions and the amount of energy it consumes. But many companies also have to disclose Scope 3 emissions — that is, the emissions of every supplier, vendor, employee and worker across its “value chain” — even if the company does not believe such emissions are financially material. More specifically, the proposed rule would require any company that has pledged net-zero goals to now disclose its Scope 3 emissions and report on them in SEC filings like its annual report.
It’s true that many companies were pressured in recent years to make high-level commitments to reducing their carbon footprint, reaching net zero 25 years from now, setting GHG targets, etc. But they viewed these commitments as voluntary, and, in some instances, as little more than feel-good affirmations of socially accepted norms. Now, however, any company that issued such a PR statement will be required to make a detailed accounting of every source of emissions connected in any way to its business. When companies were making these pledges, they had no idea they were signing up for this level of scrutiny or potential liability. The lone dissenting SEC Commissioner, Hester Peirce, explained that companies are in for a “rude awakening” once they learn “they are going to be playing an entirely different game, at far higher stakes.”
The rule also requires companies to disclose whether climate change may affect more than 1% of any line item — like revenue or debt — and explain the impact. Such requirements are not just burdensome, but impossible to determine. It requires speculation piled on top of speculation to guess what the climate trajectory will be, what the resulting regulatory landscape will look like in the United States and abroad, how third-party customers and suppliers are likely to react to such changes, and what the impact on any individual line item to a company’s business might hypothetically be. Are 1% of our customers in coastal areas and therefore likely to cut back on discretionary spending if insurance premiums rise? Will a property management company be forced to increase its costs by 1% for more frequent lawn mowing to help prevent wildfires? Will the EPA pass a regulation that increases fuel costs, therefore increasing my delivery costs? The resulting disclosures will appear to be reliable, quantitative, data-driven figures but will really be little more than guesswork.
And that’s not the only regulation the Commission has been working on. There’s also the newly enacted rule requiring mutual funds to categorize their proxy votes into buckets including “environment or climate,” “diversity, equity and inclusion” and “other social matters.” While proponents of the rule claimed it would help investors, Commissioner Peirce was doubtful. She explained that “[t]he real interest in this kind of detailed voting information seems to come from activists and the ever-expanding population of ‘stakeholders,’ for whom proxy voting seems to be the fund’s highest purpose.” Commissioner Peirce noted that until 2003, proxy voting was by secret ballot; mutual funds did not have to disclose how they voted at all. While there are pros and cons to this approach, at the time the original disclosure rule was pending, the heads of the two largest asset managers, Fidelity and Vanguard, penned a Wall Street Journal piece raising at least one legitimate concern:
“Requiring mutual-fund managers to disclose their votes on corporate proxies would politicize proxy voting, In case after case, it would open mutual-fund voting decisions to thinly veiled intimidation from activist groups whose agendas may have nothing to do with maximizing our clients’ returns.”
Commissioner Peirce called this prediction “prescient,” explaining that since the original disclosure rule was enacted, “activists of every stripe can use the fact that funds have to publish their votes to increase their leverage through intimidation and negative publicity.” These additional disclosures will likely serve only to give these activists more ammunition to further politicize the corporate ballot box.
Last year, the SEC also proposed a pair of new rules imposing new disclosure and naming requirements for ESG funds. The rules are meant to combat “greenwashing” and make sure that funds that are capitalizing on the coveted ESG marketing moniker are doing enough to push ESG goals. They require any sustainable fund to disclose the GHG emissions of its portfolio, and any impact fund to detail its progress toward achieving its goals. The rules also contain what Commissioner Peirce termed the “nag rule,” requiring funds that want to use the ESG label but do not screen investments to engage in a sufficient amount of “nagging” of corporate America. Such funds would be required to advocate for “one or more specific ESG goals to be accomplished over a given time period,” ensure these goals are “measurable” and engage in an “ongoing dialogue with the issuer regarding this goal.”
All of these new rules will do more than require disclosures; they will drive behaviors. Take the climate disclosure rules. Businesses must identify specific board members or committees responsible for overseeing climate issues, detail board members’ expertise, describe the process and frequency of discussions about climate risk, reveal whether it considers climate issues as part of its business strategy, and on and on. There are similar “disclosure” requirements for management. As Commissioner Peirce explained, these disclosure requirements will “almost certainly . . . affect the substance of what companies do,” shifting companies’ focus away from their business and toward climate-related goals.
The same is true of the rules requiring asset managers to categorize votes by ESG issue, make fund-level GHG disclosures and make detailed disclosures about corporate engagements. No fund will want to end up on the “wrong” side of history and expose itself to activists, so they will vote in favor of ESG proposals knowing they will have to be disclosed. No ESG fund will want to check the “no” box when stating whether it has a specific engagement strategy, so it will create one. It’s all part of a “troubling trend of not-so-subtle coercion through disclosure mandates.”
The Commission has also acted in more informal ways. Shortly after President Biden took office, the Commission launched a task force “focused on climate and ESG issues.” It also issued a bulletin for investors, highlighting the popularity of ESG funds and offering advice on how to invest in them. And it issued a legal bulletin making it easier for activist shareholders to get proposals on the ballot. The existing rules did not allow shareholders to propose resolutions related to “ordinary business operations”; the new one allows shareholders to dictate such operations if the proposal focuses on a “significant social policy.” All of these developments have made it easier for ESG activists and asset managers to accrue funds and then use them to impose their worldview on corporate America.
These efforts have also taken a toll on the agency itself. If this sounds like a lot of rulemaking, that’s because it is. As of October 2022, the SEC had more than 50 proposed rules on its agenda. It proposed 26 new rules in the first eight months of 2022 alone, more than twice the previous year as a whole. As a result, an SEC office of the inspector general report warned that SEC staff were having trouble keeping up with this breakneck pace and raised “concerns” about their capacity to juggle other “mission-related work.”
This is exactly how ESG works: Just as American businesses are unable to focus on their core missions of making great products or serving hungry patrons or developing lifesaving medications when they are forced to focus on social issues instead, the SEC is unable to focus on its core mission of protecting investors when it is asked to protect the environment and racial equity and other social causes too. But fortunately, the solution is the same: American businesses and regulators should each stay true to their central missions rather than allow themselves to be distracted by the partisan causes du jour. “We are not the Securities and Environment Commission,” Commissioner Peirce titled one of her recent remarks, “At least not yet.”
Vivek Ramaswamy is cofounder and executive chairman of Strive Asset Management.