CRIMINALIZING ESG: A FRAMEWORK TO HOLD CORPORATIONS ACCOUNTABLE FOR INCORRECT ESG DISCLOSURES.

• Author: Anderson, Sierra
• Position: Environmental, social, and governance

INTRODUCTION 176 I. BACKGROUND 178 A. Determining Materiality 179 B. Increased Interest in ESG Disclosures 182 II. LOOKING TO CURRENT, VOLUNTARILY DISCLOSED ESG STATEMENTS FOR GUIDANCE 183 A. The "Reasonable Investor" 184 B. The Nature of the Statements 194 III. MOVING FORWARD: HOW SHOULD THE SEC DEVELOP A USEFUL ESG DISCLOSURE SYSTEM? 199 A. Providing Useful, Comparable Metrics 200 CONCLUSION 205 INTRODUCTION

Over the last several years, investors have become increasingly interested in companies' strategic, long-term plans regarding certain social issues, integrating environmental, social, and governance ("ESG") factors into their decision-making processes. (1) As these factors, including those relating to climate change and diversity, gain traction in the investment community, many publicly traded corporations have begun voluntarily disclosing certain ESG data and information in their public statements and filings. (2) But, as the law now stands, the SEC and DOJ might not be able to regulate ESG public statements to ensure that companies are being truthful about their ESG activities. (3) ESG disclosures must ultimately be material to attach any liability, (4) and materiality standards under the law seem, at first glance, difficult to apply to the type of information that ESG statements communicate.

In response to investor interest and voluntary ESG disclosures, the chairman of the U.S. Securities and Exchange Commission ("SEC"), Gary Gensler, has made statements showing his support for mandatory and uniform disclosures of ESG. (3) In May, the SEC proposed ESG rules, signaling further the Commission's intent to implement mandatory disclosures. (6) Opponents of mandatory ESG disclosures are concerned that ESG information is too uncertain and varied and would subject companies to undue liability both civil and criminal. (7) This paper explores whether ESG information can be the basis for successful civil or criminal securities fraud claims and how the SEC might create a system of mandatory disclosures to motivate companies to more accurately capture their ESG practices.

Part I of this paper provides a description of current securities laws and the standards used to determine materiality--the key to attaching liability to ESG information. (8) In Part II, the paper examines current voluntarily-disclosed ESG information and determines the likelihood that certain statements would be material. Part III presents recommendations for how the SEC could adopt an ESG disclosure regime that would provide investors with practical information while also ensuring that companies could be held accountable for providing inaccurate information in their statements and filings.

1. BACKGROUND

   Created in 1934 through the Securities Exchange Act, (9) the SEC has a three-part mission: 1) protect investors, 2) maintain fair, orderly, and efficient markets, and 3) facilitate capital formation. (10) To meet this mission, the Commission "require[s] public companies, fund and asset managers, investment professional[s], and other market participants to regularly disclose significant financial and other information" in an effort to meet these goals."

   The SEC indirectly creates avenues of criminal law through its power to promulgate rules and regulations, as companies can be prosecuted for failure to comply with those regulations. (12) The rules and regulations the Commission creates can provide a basis for the Department of Justice ("DOJ") to bring criminal actions through the use of 15 U.S.C. [section][section] 77x and 78ff, which criminalize willful violations of the statutes or rules and regulations adopted under the statutes. (13) This includes any willful, material misstatements. (14) Therefore, public companies must provide accurate information in their requisite annual reports. (15) If the information provided is inaccurate and the misstatement is willful and material, the company and individuals at the company could face criminal prosecution for securities fraud within the federal criminal law system. (16)

   1. DETERMINING MATERIALITY

      A civil or criminal finding of securities fraud hinges on the question of its materiality. (17) In TSC Industries v. Northway, Inc. and Basic Inc. v. Levinson, the Supreme Court determined that material statements are those that a "reasonable investor" would have considered important enough to significantly alter the total mix of information made available. (18) This standard is not met just because an investor might have found the information to be of interest. (19) Rather, materiality is an objective standard looking at the reasonable investor, which depends on the market and the types of investors involved. (20) Therefore, the standard of materiality cannot be distilled into a bright-line test and is highly fact-dependent. (21) TSC Industries instructs that "[t]he determination [of materiality] requires delicate assessments of the inferences a 'reasonable shareholder' would draw from a given set of facts and the significance of those inferences to him." (22)

      Invoking this objective, reasonable-investor standard, courts have emphasized the difference between facts and opinions. (23) Courts have concluded that statements of facts express certainty about a thing, whereas statements of opinion only express a belief or view. (24) With this distinction in mind, some courts distinguish "hard information" from "soft information" and have concluded that only "hard information" can be regulated by the SEC and prosecuted by the DOJ. (25) Courts have defined "hard information" as "typically historical information or other factual information that is objectively verifiable." (26) On the other hand, "soft information" includes "predictions and matters of opinion" and is only actionable if it is virtually as certain as hard facts. (27) Therefore, misstatements that consist of vague, aspirational statements or statements of policy and values are generally not considered material. (28) Additionally, courts have distinguished "puffery" from material misstatements, holding that sales talk that is merely aspirational does not rise to the level of materiality. (29) Importantly, this materiality analysis is independent of the subject of the statement. (30) Thus, this materiality framework applies just as much to ESG disclosures as it does to a company's financials and projections.

      Courts also weigh both qualitative and quantitative factors when determining materiality. (31) The SEC even provides internal guidance on qualitative materiality in its Staff Accounting Bulletin ("SAB") No. 99, (32) and some courts have found that guidance to be persuasive authority. (33) In SAB No. 99, the SEC notes that a numerical threshold, although not conclusive of materiality, can be an initial step in assessing materiality. (34) Moreover, SAB No. 99 instructs that a materiality analysis should not be concluded after a quantitative analysis but should also consider qualitative factors. (35) In fact, the bulletin notes several qualitative factors that allow for a finding of materiality in cases where the quantitative size of the misstatement is small but the effect of the misstatement is large. (3)'' This non-exhaustive list of factors includes: (1) whether the misstatement arises from an item capable of precise measurement or whether it arises from an estimate; (2) whether the misstatement masks a change in earnings or other trends; (3) whether the misstatement concerns a segment or other portion of the registrant's business that has been identified as playing a significant role in the registrant's operations or profitability; and (4) the management's expectation that the misstatement will result in a significant market reaction. (37)

      These factors beg the question of whether ESG statements can ever be qualitatively material because they do not directly impact a company's profitability; rather, they are a measure of a company's behavior environmentally and socially. (38) But, ESG data often takes the form of backward-looking metrics, meaning many statements are capable of precise measurement, a qualitative factor heavily considered when determining materiality even if the quantitative size of the misstatement is small. (39)

      All of these concepts that are intended to help courts make determinations of materiality can be applied to ESG information. (40) But, ESG information, which is currently disclosed voluntarily, can consist of a mixture of hard and soft data, opinions, estimations, and predictions; primarily, it does not impact corporations' financial standings; and it is absent of any uniform standards, which makes finding materiality complicated. (41) Nevertheless, investors are increasingly asking for more ESG information. (42)

   2. INCREASED INTEREST IN ESG DISCLOSURES

      Originally, disclosures required by the SEC revolved around companies' financial performance, such as net sales, operating revenue, total assets, and cash flows. (43) Over the years, the SEC required disclosures of increasingly nonfinancial information, such as risk factors and stock compensation. (44) Now, more and more investors are calling for ESG data, such as climate risk data and employee diversity information. (45) Since Gary Gensler has taken over as SEC Chairman during the Biden Administration, he has continued to steer the Commission toward adopting mandatory disclosures of ESG data, specifically focusing on disclosures of greenhouse gas emissions and climate change risk management plans. (46) In early 2021, the Commission asked for public input from investors, registrants, and other market participants regarding climate change information and whether current disclosures adequately inform investors. (47)

      The SEC also announced the creation of the Climate and ESG Task Force in the Division of Enforcement. (48) This Task Force was created to develop initiatives and proactively identify ESG-related misconduct, with an initial focus on identifying...