Source: Securities and Exchange Commission
Thank you, Christian. I appreciate the chance to be part of this event. I must first let you know that my views are my own as a Commissioner and not necessarily those of the U.S. Securities and Exchange Commission (“SEC”) or my fellow Commissioners. Speaking of my views, they may not overlap much with those of Theodor Adorno, the famed early 20th century intellectual whose legacy is so prominent at this university. But his assertion that “progress occurs where it ends”[1] aptly describes my views of much of the global environmental, social, and governance (“ESG”) movement.
The ESG era, though marketed as progress, has harmed investors, companies, regulators, and society. Nothing is new about companies and investors taking a wide range of factors into account in deciding how to allocate capital. The materiality framework of our U.S. securities regulatory regime elicits disclosure about issues determinative to a company’s long-term financial value, including, when applicable, ESG issues. Our framework distinguishes between what is material to an investment decision and what is not material even though some investors might care deeply about it. Only the former warrants mandatory disclosure.
The distinctive element that marks this new era is the presumptive categorization of anything bearing the ESG label as inherently material to long-term financial value. In doing so it departs from a near-century-old materiality-based disclosure regime. If ESG is treated as a short-hand for materiality, affixing the ESG label to something automatically justifies using it to drive capital allocation decisions. An ESG label substitutes for hard analysis by companies and investors about how something relates to long-term financial value. The thinking goes that if lots of people in society are talking about “fill-in-the-blank” issue, it needs to factor into all corporate and investor thinking and thus into regulatory mandates. That companies, investors, and their advisors may find certain ESG matters material to their decisions does not justify short-circuiting real analysis of what matters for the long-term financial value of a particular company or a particular investor’s portfolio. The current approach to ESG is harmful because it takes a one-size-fits-all approach to regulation. Instead of capital allocators performing individualized analysis of ESG criteria they are given a box-checking exercise composed of generic metrics and criteria concocted by a hodge-podge of interest groups. As a result, focused financial analysis is burdened by irrelevant and misleading red herrings which may lead to worse financial decisions.
Let’s start with societal harm. ESG initiatives—even when couched in terms of disclosure—attempt to shift capital flows to uses favored by politicians, regulators, and powerful interest groups as embodied in the taxonomies that drive corporate and investor activity. These favored industries and companies are more likely to correspond to lobbying prowess than to the ability to improve society. Capital diverted to pet projects of the politically powerful is not available for companies working hard to meet people’s genuine needs or to solve society’s most pernicious and pressing problems. As political power shifts, the nature of the favored projects does too. Regardless of whose ESG it is, something other than people’s genuine needs determines who gets capital.
Regulators, often driven by good intentions, have poured countless hours into devising and implementing ESG frameworks. Central banks, securities regulators, and insurance regulators scour their rule books for ways to inject ESG targets into their regulated entities’ decision-making so that money flows to ESG-positive projects. A sustainability standard setter now sits alongside the international accounting standard setter, which may lead to unwarranted confidence in the sustainability standards and unwanted degradation of the accounting standards.[2] International organizations of regulators have packed their agendas with ESG work streams. Regulators’ other responsibilities have suffered from the attention given to ESG. The climate rule, for example, consumed a tremendous amount of time and resources that could have been devoted to modernizing the disclosure rulebook. And bank regulators’ focus on climate risk may obscure other risks, such as interest rate risk.[3]
The time and money regulators spend on ESG pales in comparison to what companies have spent. ESG initiatives coming from every level of government and reinforced by grifting, silver-tongued sustainability sirens consume tremendous amounts of corporate resources. Employees across the organization spend time collecting and analyzing ESG data—time which otherwise would be directed toward corporate value maximization. A growing list of ESG issues—amplified by proxy advisors, shareholder proponents, and ESG rating organizations—also demand the time and attention of boards and managers. ESG considerations influence product and supplier choices to the detriment of a company’s long-term value.
Investors also have suffered from the ESG obsession. Most significantly, if ESG targets supplement financial goals for companies, holding company managers accountable for their performance may be difficult. Managers can claim success based on one of the company’s ESG metrics even if the company has failed to meet its goals related to maximizing the long-term value of the company. Further interfering with accountability, investors may find it hard to locate material information in disclosures brimming with mandated ESG items. So much for Plain English initiatives designed to make disclosure documents easier to read! As just one example in the decline of readability, from 1997 to 2017 the average length of an annual report has grown by almost 200%[4]. These lengthy disclosures are time-consuming and distracting to prepare and give ample fodder for costly shareholder class action litigation and SEC enforcement actions. In one recent case, a throwaway line about the recyclability of coffee capsules led to a $1.5 million penalty.[5] Increasing disclosure increases litigation risk. Shareholders foot the bill for non-litigation costs too. Besides aspiring plaintiffs, an ever growing outside industry of advisers, consultants, accountants, and attorneys who help companies prepare ESG disclosures and defend them in litigation are eager to take their cut. In addition, shareholders incur costs imposed by their fellow shareholders who submit proposals for inclusion on corporate proxies. These proposals increasingly focus on environmental and social issues rather than governance issues with a direct connection to financial returns, such as the presence of staggered boards and poison pills. Proponents, who come from both sides of the political spectrum and often own only a tiny percentage of company shares, impose large costs on companies. Even if the proposal never makes it to the proxy, it can serve as an express ticket to special backroom negotiations with company management. Companies, with the help of attorneys, process and analyze the requests and sometimes make quiet concessions to the proponents that may be wholly unrelated to—and might be directly deleterious to—the company’s long-term financial value. Even worse, shareholders often have no idea these deals are even taking place.
Recognizing the dangers of an unthinking embrace of everything ESG, the United States at multiple levels, has paused to assess its approach. States have raised questions about how asset managers are taking ESG objectives into consideration in managing state investment portfolios. A knee-jerk prohibition on considering anything that might be categorized as ESG could impede legitimate investment analysis. But asking asset managers to be clear about what is driving their investment decisions can help to ensure that asset managers are fulfilling their fiduciary responsibility to their clients.
Change also is happening at the federal level. The U.S. Department of Labor will engage in new rulemaking to rescind ESG rules adopted under the prior administration.[6] The SEC’s signature ESG rulemaking faces a court challenge against which the current SEC has decided not to defend,[7] and other ESG initiatives, such as an ESG proposal for investment advisers, have lost steam. Earlier this year, Commission staff rescinded guidance that had made it easier for certain investors and their representatives to inundate companies with proposals that had nothing to do with the company receiving them. In rescinding this guidance, the staff returned to an analysis that considers the “policy issue raised by the proposal and its significance in relation to the company.”[8] This change should help prevent shareholder proponents from forcing companies to focus on ESG issues that are wholly unrelated to their business. To help prevent a shift back to ESG as an excuse for a disclosure mandate, I recommend embedding in the SEC rulebook an explicit commitment to materiality as the governor of disclosure mandates. This commitment is consistent with statute.[9] To complement such a rulemaking, the Commission could undertake a project, as appropriate, to remove from the SEC rulebook or modify any disclosure mandates that are not rooted in materiality.
Europe too seems to be looking at its ESG regulatory framework with an eye toward streamlining it. Absent such streamlining, Europe could suffer economically. Also worthy of reconsideration is the direct and indirect imposition of Europe’s ESG mandates and regulations on American companies either because they have some European presence or have as investors European asset managers seeking to satisfy their own ESG mandates. These extraterritorial efforts threaten to spread economic malaise globally. International organizations would do well to work as hard to dismantle the ESG regulatory edifice as they have in building it.
I look forward to a lively upcoming conversation. In this exchange of ideas, I hope that we can honor the legacy of Doktor Adorno in terms that are accessible to people like me who are not steeped in the erudite political, artistic, and philosophical discourse that flowed so readily from his pen.
[1] Theodor W. Adorno, Progress, in Critical Models: Interventions and Catchwords 150, 143-60 (Henry W. Pickford trans., Columbia Univ. Press 2005).
[3] See e.g. Governor Michelle W. Bowman, Statement on Principles for Climate-Related Financial Risk Management for Large Financial Institutions (Oct. 24, 2023), https://federalreserve.gov/newsevents/pressreleases/bowman-statement-20231024b.htm (“The lessons learned from supervisory failures during the bank stress in the spring clearly illustrate that bank examiners and bank management should focus on core issues, like credit risk, interest rate risk, and liquidity risk. Today’s guidance could ultimately distract attention and resources from these core risks.”).
[4] Danny Lesmy, Lev Muchnik and Yevgeny Mugerman, Doyoureadme? Temporal Trends in the Language Complexity of Financial Reporting, SSRN Elec. J. 4 (Sept. 2019), https://ssrn.com/abstract=3469073.
[9] See, e.g., Andrew Vollmer, Part 1: Reasons a Court Should Find that the SEC Lacked Legal Authority for the Climate-Change Disclosure Rules (Apr. 29, 2024), https://www.finregrag.com/p/reasons-a-court-should-find-that (“The statutory context of the Securities Act and the Securities Exchange Act limits the SEC’s power to issue disclosure rules to specific types of information about the disclosing company’s business, finances, and securities that bear on investment returns.”); Sean J. Griffith, What’s “Controversial” About ESG? A Theory of Compelled Commercial Speech under the First Amendment, 101 Neb. L. Rev. 876, 923 (2023), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4118755# (“The disclosure of financial material under an investor protection rationale must therefore be bounded by a baseline principle of relevance. Fortunately, securities law contains such a principle in the concept of materiality. . . . Using the concept of materiality as a guide to relevance suggests that in order to be justified under the investor protection rationale, mandatory disclosures must have a clear and plausible relationship to the financial return of the investment. Speculative or uncertain information would not meet this standard. Information that is immaterial . . . imposes a cost on investors.”).