Like many of you, I anxiously await the release of the new James Bond film No Time to Die. Sadly, this will be Daniel Craig’s final turn at the role, who in my opinion has been the finest Bond ever. It may also be the last time we see Bond’s stunning Aston Martin DB5. Although after the car’s total destruction in Skyfall, Q did rebuild it for the subsequent Spectre, so maybe there is hope.
One bond that isn’t going away is the sustainability-linked bond (SLB) – at least according to JPMorgan Chase. Last month, Marilyn Ceci, global head of the bank’s ESG developed capital markets (DCM) group offered this prediction:
The SLB market will grow from $6.9 billion (the volume for January-March 2021) to $100 – $130 billion before the end of 2021. She expects the global issuance of green bonds generally to grow almost 50% – to around $690 billion – in 2021 alone.
Shortly after Marilyn made that comment, BlackRock announced a $400 million expansion of a $4 billion revolving credit facility in which it pays slightly lower fees & interest if it meets targets for women in senior leadership and Black and Latino employees in its workforce. The filed amendment contains specifics. We don’t know whether it was BlackRock or its lenders who wanted to add these terms to the debt deal – it helps both sides show that they’re making commitments to ESG, and it could add momentum to the SLB trend.
The first SLB was issued in 2019, meaning SLBs are a newer subset of the broad category of green bonds. SLBs are an interesting animal, offering both carrots and a stick to issuers.
The carrots: SLB proceeds can be used for general corporate purposes rather than being limited to a specific green or social project, and the issuer gets a reputational bump for offering a sustainability instrument.
The stick: if the issuer misses the sustainability goals/performance metrics, they must pay bondholders a premium that is established at issuance. Some are saying this is a different shade of “say-on-climate” – with bondholders determining whether the metrics are appropriate and whether they’ve been satisfied.
Another unique aspect is the economic certainty of SLBs. When evaluating green upsides, much uncertainty is built into predictions – global market conditions, mercurial consumer behavior, pricing dynamics, supply chain risk. It can be difficult to demonstrate the ROI on expenditures related to sustainability performance monitoring or not achieving the sustainability goals. SLB covenants, on the other hand, specifically define the real cost of missing the mark – pre-emptively answering certain “what if?” questions and making an ROI calculation for project monitoring costs more defensible than other green investments.
What You Can Do
If you have the opportunity to raise capital through SLBs, how can you make sure you can verify that you’ve hit your targets? First, knowing the cost of missing SLB sustainability goals in advance should make it easy to justify monitoring and assurance efforts – but here are some wrinkles that could arise:
– Is the company using emissions offsets to achieve at least part of its GHG reduction commitments? There are meaningful risks associated with offsets (see my blog below!) – therefore, additional monitoring activities are warranted.
– Are SLB targets related to social or workplace condition improvements in the company’s supply chain? Companies should consider augmenting industry-wide supplier audit/monitoring programs by either participating directly or engaging qualified third parties to conduct supplier evaluations in parallel with – or as a replacement to – industry programs.
– How is raw data concerning the goals collected and verified? Automated systems such as meters and probes are great, but they are not flawless and need ongoing maintenance. Procedures to detect errors or failure should be put into place and it may be optimal for those to be manual to some extent.
Carbon Offsets: Widespread “Sustainability” Practice is Under Internal Review
Liz blogged a few weeks ago about investors specifically discouraging portfolio companies from using carbon offsets to achieve net zero goals. As reported in this piece by World Oil, the Nature Conservancy is also launching an internal review of its carbon offset & trading projects and procedures. Offsets have a long history of controversy, misuse and fraud, yet play an outsized role in corporate Net-Zero pledges and strategies.
This is big news, as WorldOil points out:
The internal review is a sign that it’s [The Nature Conservancy] at least questioning some practices that have become widespread in the environmental world, and could carry implications for the broader market for carbon credits.
Carbon offsets can be a viable tool in corporate greenhouse gas reduction plans. It’s tempting to wave a hand, write a check and not give it much consideration. Yet offsets carry a large amount of risk in the mid to long term – both on a project-specific basis and in terms of maintaining a credible market.
To be valid, offsets are supposed to be “additional” – meaning that they arise from an activity that would not have occurred otherwise. As an example, offsets for not cutting trees that were intended to be harvested meets the “additionality” definition. But if those trees were never to be harvested, offsets cannot be claimed for doing nothing. Also, plant-based offsetting assets such as trees can disappear before their “job” is done, meaning the expected – and contracted – carbon uptake is incomplete. Forest fires, droughts, infestations, regulatory changes, nationalization/imminent domain and illegal harvesting are very real threats to their ability to absorb the promised amount of CO2 over the decades typically needed.
The article states that “in 2020, companies purchased more than 93 million carbon credits,” and the emissions trading market is expected to exceed $100 billion in the coming decades. That is a lot of hot air needing global credibility.
What You Can Do
If you’re using carbon offsets as part of your net-zero strategy, it’s good to be aware that they’re not a full solution – and that they’re coming under additional scrutiny right now. It’s not a bad idea to work with your internal risk management group to conduct a risk assessment exercise. Among the potential perils:
– Reputational risk
– Contract breach
– Customer mandate non-conformance
– Loan and bond covenant breach
– Regulatory non-compliance
– Materiality disclosure non-compliance
– Third-party exposure
Once the risk picture is in focus, you can develop specific mitigation strategies – such as:
– Risk transfer (such as insurance and contractual terms)
– Verifying project assumptions, calculations, controls and technologies
– Direct involvement in project verification, monitoring and auditing
– Contingency plans for offset losses
– Rebalancing the mix of tools used to achieve reductions
– Reconsideration of greenhouse gas commitments or strategy
Biden Infrastructure Plan May Pay to Avoid Emissions
Speaking of carbon offsets, here is an interesting thought. Biden’s Infrastructure Plan announced March 31 includes a proposal to
reform and expand the bipartisan Section 45Q tax credit, making it direct pay and easier to use for hard-to-decarbonize industrial applications, direct air capture, and retrofits of existing power plants.
For a short refresher, Section 45Q values a metric ton of qualified avoided CO2 emissions at $50 (for geologic capture/sequestration) or $35 (for other methods of capture/sequestration). As a tax credit, it only applies to the owner of the carbon capture/sequestration equipment or user of the captured CO2.
But changing to a “direct pay” model could open the doors to innovative revenue sharing arrangements between electricity producers, capture/sequestration technology providers and even other parties.
Yesterday, the Senate voted to confirm Gary Gensler’s nomination as the next SEC Chair by a 53-45 vote. Gary will likely be sworn in early sometime early next week – and many expect he will hit the ground running.
Usually, when the Senate approves a new SEC Chair, the person is approved to serve in that capacity for a 5-year term. In this case, the Senate approved Gary to serve only for the remainder of former SEC Chair Jay Clayton’s term, which ends on June 5th of this year. An SEC Commissioner can serve up to 18 additional months following expiration of their initial term if a successor isn’t named – but another Senate vote is required to serve beyond that.
Although there’s no imminent plan for another Senate vote on this position, the Senate Banking Committee already cleared the reappointment of Gary for a second five-year term ending on June 5, 2026 when they advanced his nomination. So it’s on the Senate calendar, but the vote is subject to Gary’s commitment to respond to testify before any Senate committee. This Cooley blog gives more detail about the confirmation hearing and potential priorities for a Gensler SEC.
Environmental, Social and Governance (ESG) reports are becoming “table stakes” for public companies, regardless of a company’s industry or market capitalization. Whether you have been publishing a report for years or you haven’t started the process yet, given recent SEC developments, and increased focus on ESG by various stakeholders, including investors, proxy advisors, commercial partners, customers and employees, now is the time to revisit and reassess your disclosure.
In this post, we offer guidance on how companies can perform a “health check” on their ESG reports:
1. The horse must come before the cart. As a result of the focus on disclosure by investors and other stakeholders as well as proxy advisors and ESG ratings organizations, it is easy for companies to fall into the trap of prioritizing disclosure over the underlying ESG framework that forms the basis for such disclosures. Companies should focus on implementing a tailored framework that identifies key performance measures, establishes effective oversight at the Board, committee and management levels, addresses commercial requirements, is responsive to stakeholder interests, and ensures legal compliance.
2. Review disclosure controls and procedures. Companies should consider employing some the same disclosure controls and procedures in reviewing and approving an ESG report that they employ in reviewing and approving SEC filings, which may require internal and external audit review. Given the amount of information included in such filings and the critical business issues addressed, the publication of an ESG report can expose a company to risk if the report is not vetted properly. Having disclosure controls and procedures in place will also enable an auditor to provide assurance with respect to the company’s disclosures, if the company deems that advisable.
3. Be cognizant of language describing the purpose of ESG measures and the timeline for implementation of ESG goals. Throughout its pages, an ESG report will, in various ways, address the connection between the ESG measures described in the report and the impact on value for stakeholders – this relationship must be articulated carefully and should be consistent across the report. Statements closely tying representations about ESG to financial performance may heighten litigation risks if those representations are later considered misleading. In addition, to the extent forward-looking ESG goals are presented, any timelines for implementation should be realistic and caveated appropriately. Special attention should be paid to this issue when it comes to letters composed by members of management or the board that are included in the report.
4. Refrain from employing the concept of materiality. Given the SEC’s stated intention to revise its guidance regarding what may be considered material with respect to climate-related disclosure, companies should refrain from using the word “materiality” in their ESG reports so that the term is not conflated with materiality as defined by the SEC. Alternatives include referring to “priority,” “significant,” or “relevant” ESG factors.
5. ESG report or website? Certain companies have opted to provide their sustainability disclosures on internal website pages as opposed to within a separate published report. While this approach enables a company to update the material more easily and avoid some of the costs associated with preparing a stand-alone report, it’s also possible that it may be more difficult for proxy advisors, ESG ratings organizations, investors and others to quickly find relevant information and, more importantly, it may work against the company’s efforts to ensure consistent disclosure controls and procedures are applied with respect to ESG disclosure.
6. Leverage your lawyer. Legal counsel can advise the company on governance, board fiduciary duties and director liability, and litigation risks associated with ESG programs and disclosures. Any communications with legal counsel may be privileged. Company counsel should be involved in a targeted fashion at key points in the process – most importantly at the outline stage, after an initial draft has been put together by the company/its consultant(s), and before the report is finalized.
7. Should we hire a consultant? There are many different types of firms that offer ESG reporting services, including traditional management consultancies, ESG-specific management consultancies, communications firms and engineering firms. Each brings a unique perspective and set of skills. A company should identify the resources it has internally and through its existing advisors and consider hiring a consultant to extent there are any gaps in its capabilities, and the company should select the type of consultant based on the consultant’s skill set and the nature of the identified gap(s).
Companies are under increasing pressure to publicly disclose a broad and detailed set of information regarding their ESG practices. Such information is used by institutional investors in their investment decisions by all major proxy advisors in developing their reports for shareholders (and may guide voting recommendations), and may also be used by potential and current commercial partners, consumers and employees. Given the potential opportunities and risks, companies preparing an ESG report for the first time should exercise great care in determining content and drafting language, and companies that have publishing reports for some time should reexamine their disclosures in the light of recent developments.
This Mediant announcement caught my eye as it says the firm offers proxy voting by voice with Alexa. It’s only available to a small subset of companies and retail shareholders right now – those who use Mediant – and shareholders with access to an Amazon Alexa device so they can tell Alexa their 12-digit control number in order to get access to voting. This could be big though – it could be a step up from voting by phone, especially if Broadridge ends up offering it down the road.
Retail voting is important because instances where retail shareholders tip the scales on a vote outcome do crop up – last year, I blogged about this on our “Proxy Season Blog.” The Alexa feature to vote all proposals at once could help companies get a positive retail turnout, because the default is to vote with management on everything. With Alexa, the possibilities for voice-enabled automation are seemingly endless, right now it’s unclear whether companies could also set up reminders. It’s kind of a fun concept, although I was disappointed that I didn’t have a 12-digit control number to test it…
Division of Examinations Observes Instances of ESG Proxy Voting Inconsistencies
Last week, the SEC’s Division of Examinations issued a risk alert with observations from its review of investment advisers, investment companies and funds that offer ESG investment products and services. The Division examined firms to evaluate whether they accurately disclose their ESG investment approach, and whether they implement policies, procedures and practices that synch with their ESG-related disclosures. The risk alert describes some of the Division’s observations relating to deficiencies and internal control weaknesses, including this excerpt about inconsistencies in proxy voting with advisers’ stated approaches:
The staff observed inconsistencies between public ESG-related proxy voting claims and internal proxy voting policies and practices. For example, the staff observed public statements that ESG-related proxy proposals would be independently evaluated internally on a case-by-case basis to maximize value, while internal guidelines generally did not provide for such case-by-case analysis. The staff also noted public claims regarding clients’ ability to vote separately on ESG-related proxy proposals, but clients were never provided such opportunities, and no policies concerning these practices existed.
The takeaway here is that companies, who think they may be doing and disclosing what certain investment companies and funds will value and evaluate, might not be able to count on these firms following their proxy voting guideline of a case-by-case analysis for a particular proposal. Whether this means the vote would be with management or not isn’t clear but when voting determinations are “case-by-case,” companies doing the right thing might think there’s a chance votes would be cast with management’s recommendation. This discrepancy highlights the need for companies, particularly those with ESG-related ballot items, to actively engage with shareholders to help stay on top of how different investment firms intend to cast their votes.
Commissioner Hester Peirce released a Public Statement about the ESG risk alert providing some added context. With respect to the risk alert discussion about inconsistencies in proxy voting, Commissioner Peirce reminds readers to keep the Commission’s previously issued proxy voting interpretive releases in mind. Commissioner Peirce notes that ‘While not applicable only to advisers using ESG strategies, these Commission statements remind advisers that proxy voting, when such authority is undertaken on behalf of the client, is subject to advisers’ fiduciary duty and must be undertaken in the client’s best interest.’
Corp Fin & OCA Staff Clarify How to Account for SPAC Warrants – Restatement Analysis Coming Your Way?
Warrants are a standard part of how SPACs raise money, and they’re often classified on balance sheets as equity. But as part of the SEC’s ongoing scrutiny of these deals – and as a follow-up to statements issued in early April – Acting Corp Fin Director John Coates and Acting Chief Accountant Paul Munter issued a Joint Statement on Monday saying that these instruments might instead need to be classified as liabilities, which means that they need to be revalued every period and cause fluctuations in net income that are complicated to explain.
That’s a big issue, especially for SPACs that have been filing financials for many reporting periods that could now be considered erroneous, and also for SPACs that are trying to go effective with registration statements.
When it comes to accounting for warrants, the statement discusses fact patterns and specific warrant terms that can impact whether the warrants can be classified as equity or as an asset or liability that requires a fair value assessment each period. Equity classification requires that the instrument (or embedded feature) be indexed to the company’s own stock (e.g., the payoff can’t depend on who the holder is). Another common situation that GAAP treats as a liability is if an event not within the company’s control could require net cash settlement. There’s a big emphasis on this being a “facts & circumstances” analysis – for each entity and each contract. Here are a couple of examples from the statement:
We recently evaluated a fact pattern relating to the terms of warrants that were issued by a SPAC. In this fact pattern, the warrants included provisions that provided for potential changes to the settlement amounts dependent upon the characteristics of the holder of the warrant. Because the holder of the instrument is not an input into the pricing of a fixed-for-fixed option on equity shares, OCA staff concluded that, in this fact pattern, such a provision would preclude the warrants from being indexed to the entity’s stock, and thus the warrants should be classified as a liability measured at fair value, with changes in fair value each period reported in earnings.
We recently evaluated a fact pattern involving warrants issued by a SPAC. The terms of those warrants included a provision that in the event of a tender or exchange offer made to and accepted by holders of more than 50% of the outstanding shares of a single class of common stock, all holders of the warrants would be entitled to receive cash for their warrants. In other words, in the event of a qualifying cash tender offer (which could be outside the control of the entity), all warrant holders would be entitled to cash, while only certain of the holders of the underlying shares of common stock would be entitled to cash. OCA staff concluded that, in this fact pattern, the tender offer provision would require the warrants to be classified as a liability measured at fair value, with changes in fair value reported each period in earnings.
Even though it may be painful, if you haven’t already talked with your auditors about this, it’s probably time to give them a call. If you determine there’s a material error in previously filed financial statements — such as a reclassification of warrants from equity to a liability that also experienced a material fluctuation in value — the statement includes a reminder about information to include in an amended Form 10-K and any subsequent Form 10-Qs. It also reminds companies of their need to maintain internal controls over financial reporting and disclosure controls and procedures to determine whether those controls are adequate.
This latest statement could have the effect of slowing the deluge of SPAC transactions, as companies will need to wrangle with their accountants and others over terms of any warrants. If you have questions about technical accounting matters involving SPAC warrants, you should contact the Office of the Chief Accountant – and for questions about restating financial statements, contact Corp Fin’s Chief Accountant’s Office.
Earlier this month, following a comment period during which it received no comments, the SEC approved amendments to the NYSE Listed Company Manual relating to shareholder approval requirements for related-party equity issuances and private placements exceeding 20% of a company’s outstanding stock or voting power. The amended requirements bring the NYSE’s shareholder approval rules into closer alignment with Nasdaq rules and provide listed companies with greater flexibility to raise capital.
The NYSE initially issued a waiver to its shareholder approval requirements back in April 2020 as companies were trying to raise capital during the Covid-19 pandemic – the waiver was extended a couple of times and the rule amendments are substantially the same as the waivers. Steve Quinlivan’s blog details the amendments relating to Sections 312.03, 312.04 and 314.00 of the NYSE Listed Company Manual. This excerpt summarizes changes to Section 312.03(b):
– Shareholder approval would not be required for issuances to a Related Parties’ subsidiaries, affiliates or other closely related persons or to any companies or entities in which a Related Party has a substantial interest (except where a Related Party has a five percent or greater interest in the counterparty, as described below).
– Shareholder approval would be required for cash sales to Related Parties only if the price is less than the Minimum Price.
– Issuances to a Related Party that meet the Minimum Price would be subject to shareholder approval for any transaction or series of related transactions in which any Related Party has a five percent or greater interest (or such persons collectively have a 10 percent or greater interest), directly or indirectly, in the company or assets to be acquired or in the consideration to be paid in the transaction and the present or potential issuance of common stock, or securities convertible into common stock, could result in an increase in either the number of shares of common stock or voting power outstanding of five percent or more before the issuance.
“Robust” Disclosure about Virtual Shareholder Meetings: Glass Lewis Expectations
Earlier this year, I blogged about some refinements Glass Lewis made to its disclosure expectations for virtual shareholder meetings. Virtual shareholder meetings were new for many last year and this year, expectations relating to information about the meetings are likely higher. For companies short on resources, some may have relied on an if-it-ain’t broke, don’t-fix-it-model, which we’ve heard may have caught some companies off-guard when receiving a Glass Lewis recommendation “against” members of their nominating committee. As a reminder, here’s an excerpt from a Glass Lewis blog entry describing their expectations:
From 2021, our expectations of companies holding virtual meetings globally are as follows:
Glass Lewis believes that virtual-only meetings have the potential to curb the ability of a company’s shareholders to meaningfully communicate with company management and directors. However, we also believe that the risks of a reduction in shareholder rights can be largely mitigated by transparently addressing the following points:
When, where, and how shareholders will have an opportunity to ask questions related to the subjects normally discussed at the annual meeting, including a timeline for submitting questions, types of appropriate questions, and rules for how questions and comments will be recognised and disclosed to shareholders.
In particular where there are restrictions on the ability of shareholders to question the board during the meeting – the manner in which appropriate questions received prior to or during the meeting will be addressed by the board; this should include a commitment that questions which meet the board’s guidelines are answered in a format that is accessible by all shareholders, such as on the company’s AGM or investor relations website.
The procedure and requirements to participate in the meeting and/or access the meeting platform.
Technical support that is available to shareholders prior to and during the meeting.
We believe that shareholders can reasonably expect clear disclosure on these topics to be included in the meeting invitation and/or on the company’s website at the time of convocation.
In the most egregious cases where inadequate disclosure of the aforementioned has been provided to shareholders at the time of convocation, we will generally recommend that shareholders hold the board or relevant directors accountable. Depending on a company’s governance structure, country of incorporation, and the agenda of the meeting, this may lead to recommendations that shareholders vote against:
Members of the governance committee, or equivalent (if up for re-election);
The chair of the board (if up for re-election); and/or
Other agenda items concerning board composition and performance as applicable (e.g. ratification of board acts).
On Friday, Corp Fin updated its guidance for conducting shareholder meetings in light of COVID-19 concerns. Here’s the new stuff:
Exchange Act Rule 14a-8(h) requires shareholder proponents, or their representatives, to appear and present their proposals at the annual meeting. In light of the possible difficulties for shareholder proponents to attend annual meetings in person to present their proposals, the staff encourages issuers, to the extent feasible under state law, to provide shareholder proponents or their representatives with the ability to present their proposals through alternative means, such as by phone, during the 2020 and 2021 proxy seasons.
Furthermore, to the extent a shareholder proponent or representative is not able to attend the annual meeting and present the proposal due to the inability to travel or other hardships related to COVID-19, the staff would consider this to be “good cause” under Rule 14a-8(h) should issuers assert Rule 14a-8(h)(3) as a basis to exclude a proposal submitted by the shareholder proponent for any meetings held in the following two calendar years.
Some have noted that encouragement falls short of a mandate – but companies are already reacting. Following the Staff’s announcement, Reuters reported that Berkshire Hathaway is now permitting As You Sow to present a diversity-related proposal remotely for the company’s upcoming annual meeting. As You Sow welcomed the accommodation and said Berkshire cited the updated Staff guidance when it contacted As You Sow.
SPACs: Less Risky Than IPOs? Corp Fin Chief Says “Don’t Bet On It”
As I’ve previously blogged, some commentators have suggested a driving force behind the SPAC boom may be the availability of the PSLRA safe harbor for a de-SPAC merger. The availability of the safe harbor supposedly provides greater freedom for sponsors to share projections than would be the case in an IPO, to which the safe harbor doesn’t apply. The presumed availability of the safe harbor is one reason why some have suggested that a de-SPAC transaction involves less risk than a traditional IPO.
In a statement issued yesterday, the Acting Director of Corp Fin, John Coates, called the assumption that de-SPAC deals involve less liability risk than traditional IPOs into question. Here’s an excerpt:
It is not clear that claims about the application of securities law liability provisions to de-SPACs provide targets or anyone else with a reason to prefer SPACs over traditional IPOs. Any simple claim about reduced liability exposure for SPAC participants is overstated at best, and potentially seriously misleading at worst. Indeed, in some ways, liability risks for those involved are higher, not lower, than in conventional IPOs, due in particular to the potential conflicts of interest in the SPAC structure.
More specifically, any material misstatement in or omission from an effective Securities Act registration statement as part of a de-SPAC business combination is subject to Securities Act Section 11. Equally clear is that any material misstatement or omission in connection with a proxy solicitation is subject to liability under Exchange Act Section 14(a) and Rule 14a-9, under which courts and the Commission have generally applied a “negligence” standard. Any material misstatement or omission in connection with a tender offer is subject to liability under Exchange Act Section 14(e).
De-SPAC transactions also may give rise to liability under state law. Delaware corporate law, in particular, conventionally applies both a duty of candor and fiduciary duties more strictly in conflict of interest settings, absent special procedural steps, which themselves may be a source of liability risk. Given this legal landscape, SPAC sponsors and targets should already be hearing from their legal, accounting, and financial advisors that a de-SPAC transaction gives no one a free pass for material misstatements or omissions.
Director Coates also highlighted the limitations of the PSLRA’s safe harbor for forward-looking statements. Among other things, he noted that it only applies in private litigation, not SEC enforcement proceedings, applies only to forward-looking statements, and doesn’t apply to statements that are made with actual knowledge of their falsity. He also suggested that a de-SPAC merger may well be regarded as an “initial public offering” not subject to the safe harbor, and raised the possibility of clarifying rulemaking from the SEC concerning the scope of the safe harbor and its application to SPAC transactions.
PCAOB Issues Audit Committee Resource About 2021 Inspections
The PCAOB recently issued an Audit Committee Resource aimed at helping audit committees engage with their auditors about the PCAOB’s planned focus areas for 2021 inspections of public company audits. The resource provides a list of questions for audit committees as suggestions to spur dialogue between the audit committee and the company’s auditor. The suggested questions relate to the auditor’s risk assessments, auditor quality control systems, how auditors comply with auditor independence requirements, fraud procedures, critical audit matters, implementation of new auditing standards and supervision of audits involving other auditors.
Also, the PCAOB will continue to seek feedback from audit committee chairs as part of its effort to support improvements in audit quality. Like it has done in previous years, the PCAOB will seek feedback from audit committee chairs of companies where the PCAOB conducted inspections of the audit.
Netflix’s newest documentary Seaspiracy is all over social media and the news. You may have already watched it, or maybe it’s in your queue for this weekend. The movie looks at wide ranging environmental and social impacts of the seafood industry – it’s hard to watch and there’s a lot to unpack. Some are saying they went too far. But for now, let’s look at one topic with which I have direct experience: ESG claims and assurance systems.
The film’s producer interviews Mark Palmer, Associate Director USA for the Earth Island Institute’s International Marine Mammal Project (IMMP), which operates the “Dolphin Safe Tuna” label program. The “Dolphin Safe” mark is used on canned tuna to indicate dolphins were not killed as bi-catch during tuna fishing. The interview as presented in the film can be summed up in this exchange:
Producer: You [Dolphin Safe] have observers, but they are rarely there [on the fishing vessels], and they can be bribed and so you can’t guarantee that dolphin safe tuna is dolphin safe.
Palmer: That’s certainly true in terms of how the system works.
Producer: But it’s not guaranteed to be dolphin safe.
Palmer: Nothing can guarantee it’s dolphin safe.
Producer: But if it’s not guaranteed to be dolphin safe, why is it called dolphin safe?
Palmer: We can pretty well guarantee it’s dolphin safe… it’s not guaranteed in the same way that, uh.. the world is a difficult place sometimes.
To be fair, in the “they’ve gone too far” camp, the IMMP has issued a statement expressing concern about how the film presents the interview.
In the bigger picture, though, there’s some merit to examining these programs – and the “Dolphin Safe” folks certainly aren’t the first responsible sourcing assurance mechanism to be on the hot seat. Another high-profile example is the London Bullion Marketers Association (LBMA) – and their “Good Delivery List” that’s intended to incentivize responsible gold production. Recent developments include NGOs claiming systemic flaws and a major assurance provider acknowledging shortcomings in managing conflict of interest. Many other metals and the mining industry have their own – but very similar – responsible sourcing due diligence mechanisms (the proliferation of these systems is a topic for another day). Responsible timber due diligence assurance uses the same basic construct, so these issues may not be limited to gold due diligence assurance programs.
Encouragingly, these mechanisms aren’t deaf to the feedback. They are aware of improvements needed and are working to implement changes – but it takes time to develop, field test and launch solutions.
One takeaway for companies who rely on some of these programs is that major investors and financial institutions will soon be looking over your shoulder too. Jamie Dimon, CEO of JPMorganChase, stated in his 66-page Letter to Shareholders (2020):
… we will measure our clients’ carbon performance against sector-based GHG reduction targets that we’re setting for 2030 – with the goal of helping the reduce emissions from their direct operations and, in the case of oil and gas and automotive companies, reduce GHG from the use of their products.
What does this all mean? Basically, it’s reinforcement of companies’ misgivings around ESG assurance and certifications. They don’t offer the impenetrable protection of Captain America’s shield, and you can embrace that and add checks & balances. You never know when the next “Seaspiracy” will attract stakeholder attention – and investors are already developing their own systems to track, verify and question fundamental ESG information.
More on ESG Assurance: Using a Belt & Suspenders
While it’s true that many of the myriad ESG certifications/assurance mechanisms have responded to criticism by making systemic improvements, some have not. And even with improvements, gaps still exist. Either way, they don’t provide blanket protection from liability or business losses. Let’s dive in to how you can use industry assurance and labeling mechanisms in a prudent way.
In my opinion, there are two major elements to the risk:
Becoming a movie star villain. Seaspiracy is only the most recent example of becoming a reluctant movie star. A few years ago, another Netflix documentary brought economic devastation to one of my old consulting clients, and they are still struggling to get back where they were. Before that happened, I brushed off the idea that the film would have such impact. Having now seen it firsthand, I strongly suggest not ignoring it. Who knows what ESG matters – or companies – will be targeted next, and these documentaries have a track record of going viral.
Following the crowd. There are certainly advantages to using industry ESG assurance mechanisms, including the “safety in numbers” philosophy. In my experience, this tends to lead to complacency by individual companies about assurance quality and execution. But as previously discussed, those mechanisms are not perfect and you can essentially become a hostage to their flaws. Continuing to participate in or rely on these programs without doing something more may create more problems than expected.
Once a company recognizes the exposures, it should implement mitigation strategies. As a friend of mine at OECD frequently says: “You can’t outsource due diligence responsibility.” Perhaps the most effective of ways of taking responsibility are actually easy to do:
– Invite your Internal Audit group to learn more about industry assurance programs your company uses. Ask them to do a deep dive into the program’s procedures, practices, standards and auditors/assurance providers.
– Take an active role in shaping the industry assurance program(s) to close gaps or address concerns you or your Internal Audit group identified.
– Do your own monitoring of the assurance program(s) by participating in their audits where possible. Compare your experience and results with the programs’ final results. Where differences are identified, explore those with the program(s).
Finally, while not necessarily easy, it is worth considering augmenting your company’s use of industry programs with your own activities, including further use of Internal Audit to evaluate ESG risks of business partnerships or hiring qualified and screened third party ESG assurance experts.
Will Climate Pledges Outlive the Companies that Make Them?
Forever is a long time, except in corporate timelines. I remember visiting the Hoover Dam in the early 1990s and marveling at a plaque listing the construction contractors. Although construction was completed in 1936, a handful of the companies listed were still operating at the time I was there. But the world has changed in the past century. Companies aren’t really built to last.
Credit Suisse noted in 2017 that “the average lifespan of a S&P500 company is now less than 20 years, from 60 years in the 1950s.” Management is not necessarily stable over the long term. A Harvard Law study showed that CEO tenure has been on a downward trend and, for large cap companies, “the plurality of large-cap CEOs have been in the corner office between one and five years.”
These trends matter for a few reasons, but nothing may be as obvious as corporate climate commitments, especially the oh-so-popular Net-Zero pledge. This article from Canary Media does a fine job of summarizing last month’s analysis by Climate Action 100+ that benchmarked current corporate climate commitments against company actions and schedules (spoiler alert: there are substantial gaps between commitments made public, what those commitments should address and plans for execution).
Yet what I found most compelling is this perspective related to the current trends on company and CEO lifespan:
This shifts the critical question from whether we believe today’s corporate giants genuinely want to make good on these commitments to whether we think they, or their leadership, will even be around at all. Rather than congratulating companies that promise to clean up their act for a tomorrow they may never see, we need to be holding them to account for what they’re doing today.
Given the unprecedented complexity of the climate issue, uncertainty is to be expected. I hope that companies making long term climate pledges will last longer than most celebrity marriages – and it’s heartening to see companies making commitments, while recognizing this is a long term play. But will investors – many of whom already have short-term horizons – see corporate climate action from this perspective and push for nearer term goals/solutions? For companies making climate pledges that face the risk of no longer being a going concern – how will they manage or disclose the risk of failing to meet climate commitments?
This is one reason why it’s probably inappropriate to “shame” companies for favoring annual incentive programs as the vehicle for ESG metrics – it may be an annual program, but if you incentivize the correct year-over-year building blocks, it can lead to lasting change. In the fervor of this push for big change, it is worth considering the risk that a corporate climate pledge may outlive the company itself. Short-term stepping stones are a valuable part of the bridge to the future.
Shortly after the onset of the pandemic, many companies opted to discontinue providing quarterly EPS guidance for the remainder of 2020. This McKinsey article says that companies thinking about providing that guidance in 2021 may want to think again:
McKinsey compared the market performance of companies that offer quarterly earnings guidance with the performance of those that don’t. It found that the companies that did not provide EPS guidance did not generate lower total returns to shareholders (TRS). That same body of research revealed no difference in TRS between companies that regularly met the earnings consensus and those that occasionally missed it.
Lower TRS occurred only if companies missed consensus consistently over several quarters because of systematically lower performance. Further, McKinsey research showed that only 13 percent of investors surveyed thought that consistently beating EPS estimates was important for assessing a potential investment.
What’s the harm, then, in providing quarterly earnings guidance if investors don’t weigh such information heavily? One potential problem is the overemphasis of quarterly earnings to evaluate management teams’ performance, which can create unnecessary noise in corporate boardrooms. More important, EPS-focused companies are known to implement actions to “meet the number”—deferring investments or cutting costs excessively, for instance.
McKinsey’s views on quarterly guidance echo those of many business and investor groups. Instead of returning to the practice of providing quarterly EPS guidance, McKinsey says that the better approach is to provide long-term guidance, and that “For most companies, this would mean providing three-year targets (at a minimum) for revenue growth, margins, and return on capital.”
CARES Act Fraud: Whatcha Gonna Do When They Come for You?
I couldn’t resist using the lyrics of Inner Circle’s “Bad Boys” in the title of this blog. That’s because they ran through my head as I read this Womble Bond memo on the government’s investigations of CARES Act fraud. Unfortunately, as this excerpt dealing with the conclusions of the House Select Subcommittee on the Coronavirus reveals, it’s a target rich environment:
– Reviews of applications, records, and other data tend to show that there was around $84 billion in potential fraud from the PPP (more than $4 billion) and Economic Injury Disaster Loans (more than $79 billion) government payments;
– Over 1.3 million EIDL fraud referrals (over 700,000 of which involved identify theft) have been made to the SBA’s Inspector General’s Office;
– Nearly 150,000 hotline complaints related to potential PPP or EIDL fraud have been made to the SBA Inspector General’s Office;
– Financial institutions filed nearly 40,000 Suspicious Activity Reports related to potential PPP or EIDL fraud during May-October 2020 alone.
That’s quite a bit of potential fraud – but then again, these programs involved quite a bit of money that was moved out the door as quickly as possible. But the message is that if you’re a fraudster, Sherriff John Brown is most definitely coming for you. The memo says that the FBI has initiated hundreds of investigations into potential PPP fraud, and that they’ve been joined by more than 30 federal & state agencies investigating fraud in these programs.
Disclosure: Cybersecurity Breaches
This Audit Analytics blog summarizes its recent report on discovery and disclosure of cybersecurity breaches. One noteworthy aspect of the report is that the number of disclosed cybersecurity incidents actually declined in 2020. That was the first decline since Audit Analytics began reporting on cybersecurity disclosures in 2011, but the blog suggests that it is uncertain whether that decline reflects an actual decline in attacks or greater challenges monitoring cybersecurity incidents in a remote work environment. Here are some other key findings:
– The median number of days to discover a cyber breach was just 16 days in 2020, while the median number of days to disclose a breach was 37 days.
– The median number of days to discover a breach was the lowest since 2017. The decreasing number of days to discover a breach may be a sign that companies are implementing better controls to monitor for cyber incidents, which enables more timely discovery.
– The median number of days to disclose the breach was at its highest since at least 2016. The increase in the median time to disclose a breach could be a sign companies are prioritizing complete notification over quick notification. This can be seen in the percentage of companies that disclose a type of attack, which grew to 90% in 2020 from less than 60% between 2011 and 2019.
The blog also notes that nearly 30% of public companies with a cyber breach between 2011 and 2020 disclosed the breach in an SEC filing, and reviews the sections of SEC filings in which disclosures of cybersecurity breaches most commonly appear.
That’s it for me this week, folks. Our new colleague, Lawrence Heim, will take the helm of this blog tomorrow – and I think we can all agree that you’re getting an upgrade.
Fenwick & West recently published this report on board gender diversity among large public companies & the Silicon Valley 150. Here are some of the key findings:
– The representation of women on boards continued to increase between 2018 (the last year Fenwick published the gender diversity survey) and 2020 in the United States and at rates higher than in years past. The average percentage of women directors increased 8 percentage points in the SV 150 to 25.7% in 2020 and in the S&P 100 rose 4 percentage points to 28.7% (with the SV Top 15 increasing 4.5 percentage points to 30.3%).
– In the last few years in both the S&P 100 and the SV Top 15, 100% of companies have had at least one woman director. In the SV 150 overall, the percentage of companies with at least one woman director increased 16.4 percentage points to 98%.
– In the S&P 100, gender diversity has grown slowly but steadily at a cumulative rate of 61%, or a compound annual growth rate (CAGR) of 2.37%. The SV 150 has lower scores overall, but a greater cumulative growth rate of 216%, and more than double the CAGR, 5.42% (with more rapid growth over the past decade).
The report says that most SV 150 companies met the initial 2019 standard for board gender diversity mandated under California’s SB 826, but that 57% of those companies will need to add women to meet the law’s 2021 standard. Only 14% of S&P 100 companies would need to add women to their boards in order to satisfy the 2021 standard.
Board Diversity: Does Diversity Enhance Shareholder Value?
Most of the studies on board diversity that I’ve seen referenced have concluded that increasing the diversity of corporate boards enhances shareholder value. That conclusion is a cornerstone of Nasdaq’s justification for its board diversity listing proposal, which cites a number of these studies. But UCLA’s Stephen Bainbridge points to a recent paper by Harvard Law School Prof. Jesse Fried, which claims that the studies Nasdaq cites provide little support for that conclusion. Here’s the abstract:
In December 2020, Nasdaq asked the Securities and Exchange Commission to approve new diversity rules. The aim is for most Nasdaq-listed firms to have at least one director self-identifying as female and another self-identifying as an underrepresented minority or LGBTQ+. While Nasdaq claims these rules will benefit investors, the empirical evidence provides little support for the claim that gender or ethnic diversity in the boardroom increases shareholder value. In fact, rigorous scholarship—much of it by leading female economists—suggests that increasing board diversity can actually lead to lower share prices.
There are all sorts of good reasons to promote increased gender & ethnic diversity on public company boards, including (as the paper points out), data indicating that it results in improved oversight of executives & financial reporting. But if this study is correct, it appears that there isn’t much in the way of quality empirical research to support Nasdaq’s claims about the positive impact of board diversity on shareholder value.
Tomorrow’s Webcast: “ESG Considerations in M&A”
Tune in tomorrow for the DealLawyers.com webcast – “ESG Considerations in M&A” – to hear the Hunton Andrews Kurth’s Richard Massony, Seyfarth’s Andrew Sherman and K&L Gates’ Bella Zaslavsky discuss the ESG considerations that are increasingly “front and center” for both buyers and sellers in M&A transactions.
It wasn’t that long ago when discussions about the “materiality” concept focused on things like the efficient market hypothesis and the probability and financial magnitude of contingent events. Underlying all of these discussions was a core belief that the market prices of stocks generally moved for reasons that reflected investors’ rational assessments of the financial implications of new developments. Yeah, well that was then & this is now.
Today, nothing seems to move the market for individual stocks quite like a rogue tweet, an internet meme, or – in the latest example of market mania – a dumb marketing department prank gone awry. Of course, I’m talking about Volkswagen’s ill-conceived April Fools’ “Voltswagen” prank, which resulted in its stock popping by 10% before coming back to earth. This CNN article says that the combination of the announcement & stock gyrations that followed may expose VW to liability under the federal securities laws:
Volkswagen of America says its “Voltswagen” name change was merely a joke “in the spirit of April Fools’ Day” to promote a new electric car. But even if it was meant as a lighthearted marketing gag, the move could land the carmaker in some serious trouble. The situation may have put the company at risk of running afoul of US securities law by wading into the murky waters of potentially misleading investors. “This is not the sort of thing that a responsible global company should be doing,” said Charles Whitehead, Myron C. Taylor Alumni Professor of Business Law at Cornell Law School.
Making a securities law issue out of this stunt seems kind of silly to me. Yes, I get the long-term importance to VW of moving to electric vehicles & how investors might be interested in a name change that signifies that importance – but c’mon, gimme a break! What I think this situation really does is illustrate the consequences of equating “materiality” under the securities laws with any information that might be “interesting” to an investor. That’s something courts have been concerned about for quite some time – for instance, here’s a quote from the 1st Circuit’s 1992 decision in Milton v. Van Dorn:
The mere fact that an investor might find information interesting or desirable is not sufficient to satisfy the materiality requirement. Rather, information is “material” only if its disclosure would alter the “total mix” of facts available to the investor and “if there is a substantial likelihood that a reasonable shareholder would consider it important” to the investment decision.
The reason for concerns about catering solely to investor desires when it comes to disclosure obligations is the risk that the Northway Court identified of setting materiality at such a low standard that companies will flood investors with “an avalanche of trivial information,” which obscures important data & doesn’t help a reasonable investor make an investment decision. In other words, courts are worried about creating what economists call “noise,” and I think those concerns are heightened during a period when the market seems to be a particularly noisy place.
Right now, we’re engaged in an important discussion about what non-financial information should be regarded as material under the securities laws. If the SEC serves up new disclosure mandates intended to give investors “what they want” without worrying about creating a lot of noise, its actions may end up lowering the overall quality & usefulness of corporate disclosures.
SEC Enforcement: Public Companies in the Cross-Hairs?
This Baker Donelson memo discusses expectations that the SEC will engage in intensified enforcement efforts on a number of fronts, and says that public companies are among other entities that should should expect greater scrutiny from the Division of Enforcement than they’ve received in recent years. Here’s an excerpt:
Chairman-designate Gensler testified at his March 2, 2021 confirmation hearing on several new areas of focus. Principal is the emphasis on new disclosure rules, which might require companies to report more about political contributions, workforce diversity, corporate governance, and the risks of climate change. Then, on March 4, 2021, the SEC created a Climate and ESG Task Force in the Division of Enforcement.
Another new focus would be on trading apps, like Robinhood, regarding whether investors get the best deals when such apps sell their trades for execution by market-making firms. Whereas former Chairman Jay Clayton emphasized cybersecurity issues and protecting retail investors under his Main Street investor initiative, more emphasis may now be placed on public companies (and possibly private equity and hedge funds, e.g., conflicts of interest) and issues such as inadequate disclosures, revenue recognition, and improper accounting.
The memo says that following the SEC’s COVID-19-specific pronouncements in March 2020 and thereafter about disclosure requirements and safe harbors for appropriate forward-looking statements, both SEC enforcement and private class actions can be anticipated. In addition, the memo suggests that companies in industries such as travel, health care, software, energy, and financial services, among others, may face enforcement actions similar to the proceeding that the SEC brought against The Cheesecake Factory late last year.
March-April Issue of “The Corporate Counsel” – New Podcast Coming Soon!
The March-April issue of “The Corporate Counsel” newsletter is in the mail (try a no-risk trial). It’s also available now online to members of TheCorporateCounsel.net who subscribe to the electronic format – an option that many people are taking advantage of in the “remote work” environment. The issue includes articles on:
– Climate Change Disclosures: Preparing for Staff Scrutiny
– The SEC’s Rule 144 Proposals: Our Suggestion to Combine the Form 144/Form 4 Filing Process Sees the Light of Day!
– SEC Eases Auditor Independence Rules
Dave & I have been doing a series of “Deep Dive with Dave” podcasts addressing the topics we’ve covered in recent issues (here’s the most recent one). We’ll have a podcast for this issue up shortly, so be sure to check them all out!
I’m thrilled to announce that Lawrence Heim has joined our team – and will be leading the charge on our upcoming launch of a new sustainability/E&S platform! With the plethora of ESG ratings models & reporting frameworks, and what feels like a rapid but uncertain move towards new regulations, one of the hardest things about this exploding practice area is being able to cut through the deluge of information & gobbledygook. You need to know which developments matter – and what you actually need to be doing to gather E&S data and report on progress & risks. Lawrence is here to break that down for all of us.
Lawrence is going to be sharing insights & tips based on over 35 years of experience in ESG management. He’s been in the trenches to evaluate supply chains & environmental risks, he sits on the board of ASSET (a non-profit anti-slavery organization), and he wrote the book “Killing Sustainability.” Back when the conflict minerals rules were under consideration, he was the only non-financial auditor selected to give testimony to the SEC. You might also recognize his name from our webcasts over the years.
Lawrence understands the players in this space and how multi-disciplinary ESG teams can work together to make real progress and avoid risks. One of Lawrence’s early professional highlights was saving a major petroleum refinery $150 million through a unique waste management regulatory strategy. He built on that experience to help create the Global Environmental Risk Consulting Practice at Marsh and to support clients in environmental, health & safety compliance and management for many years at Elm Sustainability Partners. Most recently, Lawrence led development of supply chain due diligence standards at the Responsible Business Alliance/Responsible Minerals Initiative.
When we launch our new sites, we’ll be able to give more in-depth & practical coverage to the wide range of E&S topics that you’re grappling with – tailored to the corporate counsel and sustainability officer perspectives. We’ll continue to cover the “G” here on TheCorporateCounsel.net. We’ll also continue to act as a “hub” in our network of ESG experts, so always feel free to reach out with questions or topics that you want to see covered – or practice pointers that you want to share.
This has been in the works for a while and I’ve been dying to share the news with all of you. So, consider this the “preliminary announcement,” with more details coming soon about how you can sign up for Lawrence’s blogs and the new resources. In the meantime, Lawrence is going to be running a few blogs here on TheCorporateCounsel.net, starting today, so that you can get to know him! You can also contact him via email – firstname.lastname@example.org.
– Liz Dunshee
Last Thursday (April 1), Responsible Investor wrote about an initiative intended to stem proliferation of new ESG codes/principles, or at least encourage collaboration between existing frameworks. According to the article, the “Principles for Responsible Principles” were launched due to:
“… concern that the growing number of voluntary codes creates a reputational risk for the better known and more established sets of responsible principles if their numbers continue to proliferate unchecked.”
The program contains five main points that “reflect those of similar initiatives and aim to create self-regulation within a sector that lacks clear KPIs.” Details are here, but if you want to skip that I can quickly summarize it thusly: pay attention to the date of publication.
Yes, I fell for it. No, none of my colleagues did.
To many ESG practitioners, this prank brings an uncomfortable grin because we painfully recognize the truth therein. And with that, my new career I begin. Inauspiciously.
Want to Get Ahead on ESG Data Quality? Internal Audit Is Your Not-So-Secret Weapon
Last month, Doug Hileman published this white paper on Internal Audit’s role in corporate ESG programs. Among Doug’s rather stark findings:
– 44% of respondent companies indicated a “complete commitment” to ESG, yet 25% don’t know where the ESG function “lives”
– 44% of respondents had not performed any internal audits of ESG topics in the past 5 years
– Another 36% didn’t know if any internal audits performed in the past 5 years included ESG topics
– Diversity & inclusion was identified as the top material ESG topic (44%). Supply chain ESG risks garnered exactly zero votes.
The results are based on polling at the Institute of Internal Auditing (IIA) March 2021 Los Angeles conference, so it’s not too surprising that this cohort would think they should be more involved with anything that could border on a compliance issue. Nor is it surprising that there’s some reluctance to add this layer of review to voluntary disclosures. In fact, it’s consistent with my own experience.
But, my humble prediction is that the absence of internal audit from ESG data gathering, evaluation & disclosure is going to start raising alarm bells very soon. Now’s the time to get ahead by starting to involve your own team, if you haven’t done so already. Much rides on ESG information quality these days: investors make decisions/issue guidance on it, media outlets write about it and the Biden administration has made clear that regulatory actions and enforcement will be taken based on it. With so much at stake, it’s only a matter of time before companies will be expected to have more stringent internal controls over this non-financial information – or face reputational & litigation risks for inaccurate disclosure.
Some simple steps for bringing Internal Audit to the ESG party:
– Have IA include internal environmental and social responsibility experts in audits. Blended teams merge IA’s governance and controls expertise and the E&S technical subject matter knowledge.
– Ensure established audit procedures are understood and followed by the blended team – especially evidence sampling methodologies. IA may be concerned about the amount of in scope E&S data and E&S staff may not understand controls testing. E&S staff can filter E&S data/evidence for technical appropriateness and IA can ensure evidence sufficiency.
– Recognize that there are risks with industry collaborative supplier ESG audit programs and certifications. IA needs to understand how these programs produce audit results on which companies rely and disclose to customers, the public and increasingly – regulators.