The Convergence of Financial and ESG Materiality: Taking Sustainability Mainstream

• Date: 01 September 2019
• Published date: 01 September 2019
• DOI: http://doi.org/10.1111/ablj.12148

American Business Law Journal

Volume 56, Issue 3, 645–702, Fall 2019

The Convergence of Financial and

ESG Materiality: Taking

Sustainability Mainstream

Ruth Jebe*

Sustainability reporting can be seen as an attempt to bring improved environmen-

tal, social, and governance (ESG) practices to mainstream business. However, this

movement to mainstream is hampered by the disconnect between financial and

ESG information. Both reporting streams use the concept of materiality to shape

firms’ disclosure obligations, but the term carries different meanings fo r different

organizations. One sustainability organization, the Sustainability Accounting

Standards Board (SASB), has developed reporting standards to merge sustainabil-

ity and financial information by leveraging the definition of materiality for finan-

cial reporting purposes. This use of financial materiality positions the SASB to

collide with the Security and Exchange Commission’s (SEC) hands-off attitude to

ESG reporting. In the regulatory void left by the SEC’s inaction on sustainability

reporting, the SASB provides the best route to reconceptualize materiality in line

with society’s interest in sustainable business.

INTRODUCTION

In 2014, Securities and Exchange Commission (SEC) Commissioner

Daniel Gallagher publicly denounced attempts by “third parties” to influ-

ence the U.S. financial reporting regime.

1

According to Gallagher,

*

Assistant Professor of Legal Studies in Business, College of Business and Economics, Boise

State University. My thanks to the editors of the American Business Law Journal and all of the

discussants and participants in the 2018 ABLJ Invited Scholars Colloquium, whose thought-

ful comments and ideas were invaluable

1

Commissioner Daniel M. Gallagher, Commissioner, SEC, Remarks at the 26th Annual Cor-

porate Law Institute, Tulane University Law School: Federal Preemptionof State Corporate

Governance (Mar. 27, 2014), https://www.sec.gov/news/speech/2014-spch032714dmg.html

[hereinafter Gallagher Speech].

©2019 The Author

American Business Law Journal ©2019 Academy of Legal Studies in Business

645

shaping this disclosure system was the exclusive domain of the SEC.

2

The Commissioner specifically called out the Sustainability Accounting

Standards Board (SASB), a U.S. nonprofit organization that creates sustain-

ability reporting standards,

3

stating it should be remembered that “groups

like SASB have no role in the establishment of mandated disclosure

requirements.”

4

This, even though the SASB bases its disclosure standards

on exactly the same definition of material information as does the SEC.

5

Corporate disclosure is defined by the concept of materiality, embodied in

the requirement that firms disclose material information.

6

The definition of

materiality has historically been controlled by the government, which focuses

on a narrow concept of materiality confined to economic information.

7

Sustain-

ability organizations, however, have argued for a companion materiality concept

that includes environmental, social, and governance (ESG) information.

8

Dis-

agreement over the definition of materiality has resulted in financial and ESG

disclosure occupying separate domains, a result that hampers mainstreaming

of sustainability by keeping ESG factors separate from business operations.

2

Id.

3

The terms “sustainability,” “environment, social and governance (ESG),” and “corporate

social responsibility” reporting have all been used to refer to reports with emphasis on envi-

ronmental, social, or governance issues and to distinguish these reports from mandated

financial disclosures. For example, the Global Reporting Initiative (GRI) defines a “sustain-

ability report” as a report about environmental and social impacts. What Is Sustainability

Reporting?,G

LOB.REPORTING INITIATIVE, https://www.globalreporting.org/information/

sustainability-reporting/Pages/default. aspx (last visited May 6, 2019). Others equate a

corporate social responsibility (CSR) report with a sustainability report. See CSR Report—

Definition, Meaning, Benefits & Examples of Companies/Official & Simple Definition of a

CSR Report, E-CSR, https://e-csr.net/definitions/csr-report-important-examples/#what-is-the-

definition-of-a-csr-report (last visited May 8, 2019) (using the GRI definition of sustainabil-

ity reporting for CSR reporting). Still others identify the common theme of disclosure of

environmental stewardship, social responsibility, and corporate ethics in these reports,

regardless of nomenclature. Georg Kell, Five Trends That Show Corporate Responsibility is Here

to Stay,T

HE GUARDIAN (Aug. 13, 2014), https://www.theguardian.com/sustainable-business/

blog/five-trends-corporate-social-responsbility-global-movement. For simplicity, this article

uses the terms “sustainability” and “ESG” interchangeably to refer to environmental, social,

and/or governance factors or reports.

4

Gallagher Speech, supra note 1.

5

See infra notes 117–18, 216 and accompanying text.

6

See infra notes 43–48 and accompanying text.

7

See infra notes 43–61, 170–79 and accompanying text.

8

See infra notes 72–84 and accompanying text.

646 Vol. 56 / American Business Law Journal

The separation offinancial and ESG reporting can be pegged to different

facets of materiality. The SEC represents the compliance aspect of material-

ity,wherein the government uses the concept to define specific legal obliga-

tions. The SEC’s adherence to the traditional definition of materiality as

encompassing solely financial information purports to reflect the investor

protection focus of U.S. securities law and sets the threshold for complying

with the legal duty toprovide information to investors.

9

Investors, on the other hand, represent the market aspect of materi-

ality. Although ostensibly intended to protect them, investors show dis-

satisfaction with the traditional definition of materiality.

10

Increasingly,

investors recognize the financial relevance of ESG issues, such as how

companies respond to climate change, whether effective water manage-

ment is in place, how companies manage their supply chains, and

whethertheyhaveeffectiveworkplacesafetypolicies.

11

Though once

the domain of specialized socially responsible investing, mainstream

investors now pursue ESG integration, where ESG impacts are factored

into financial analysis.

12

However, attempting to integrate sustainability

9

Roberta S. Karmel, Disclosure Reform—The SEC Is Riding Off in Two Directions at Once,

71 BUS.LAW. 781, 786 (2016); Cynthia A. Williams, The Securities and Exchange Commission

and Corporate Social Transparency, 112 HARV.L.REV. 1197, 1204 (1999) (noting that existing

language could include social disclosure).

10

See, e.g., Rachel Fixsen, Institutional Investors Dissatisfied with Companies’ ESG Reporting,

IP&E (Nov. 16, 2016), https://www.ipe.com/news/esg/institutional-investors-dissatisfied-with-

companies-esg-reporting/www.ipe.com/news/esg/institutional-investors-dissatisfied-with-

companies-esg-reporting/10016201.fullarticle; Ben Maiden, Investors Press for SEC Rule

on ESG Disclosure,IRM

AG. (Oct. 10, 2018), https://www.irmagazine.com/esg/investors-

press-sec-rule-esg-disclosure (describing petition for rulemaking).

11

Georg Kell, The Remarkable Rise of ESG,FORBES (July 11, 2018, 10:09 AM), https://www.

forbes.com/sites/georgkell/2018/07/11/the-remarkable-rise-of-esg/#1d05df221695; Christo-

pher P. Skroupa, High ESG Performance Translates into High Financial Performance,F

ORBES

(June 16, 2017, 02:06 PM), https://www.forbes.com/sites/christopherskroupa/2017/06/16/

high-esg-performance-translates-into-high-financial-performance/#78f787f8d708 (noting

that two-thirds of institutional investors believe it is possible to build models showing the

relationship between ESG factors and financial performance).

12

Skroupa, supra note 11 (defining ESG integration); ESG Versus SRI: Successfully Aligning Your

Investments and Values,RBCW

EALTH MGMT., https://www.rbcwealthmanagement.com/cn/en/

research-insights/esg-versus-sri-successfully-aligning-your-investments-and-values/detai l/ (last vis-

ited Apr.7, 2019) (distinguishing SRI from ESG investing); Julie Gorte, The Financial Performanceof

Sustainability: ESG and Risk, PAX WORLD FUNDS (Jan. 18, 2019), https://paxworld.com/the-financial-

performance-of-sustainability-esg-and-risk/ (reviewing key ESG issues associated with financial per-

formance). In 2018, funds that invest based on sustainability criteria passed the $1 trillion mark.

2019 / Taking Sustainability Mainstream 647