Companies face increasing pressure from investors to disclose voluntary environmental data. A 2018 survey showed that 82% of investors claim to incorporate ESG data into their investment decisions in some financial context. With the increase in investors relying on ESG data in companies’ voluntary disclosures, litigation risk is on the rise surrounding those disclosures. More investors are bringing lawsuits under Rule 10b-5 of the Securities Exchange Act targeting companies who disclose too little, or unreliable, environmental data.
Companies are taking note. A recent study found that companies are likely to alter their ESG disclosure practices if companies in the same industry are sued based on their environmental disclosures. In addition to illustrating cascading effects shareholder suits can have on disclosure practices in an industry, the study also raises important questions about how the SEC’s climate disclosure proposal may increase litigation risk.
Types of Shareholder Suits
A shareholder bringing a suit under 10b-5 must prove six elements:
- a material misrepresentation or omission by the defendant;
- a connection between the misrepresentation or omission and the purchase or sale of a security;
- reliance upon the misrepresentation or omission;
- economic loss; and
- loss causation.
The study analyzes 10b-5 suits in two separate categories: those based on omissions and those based on misrepresentations. Claims brought based on omissions argue that there was not sufficient information provided to investors, whereas those brought based on misrepresentations argue that statements in company disclosures were factually inaccurate.
The study also separates statements in company disclosures into two categories forward-looking, and historical. Forward-looking statements are those that discuss a company’s plans for environmental programs. For example, a net-zero by 2050 target would be a forward-looking statement. Historical statements relate to things the company has done, such as past emissions inventories and reductions.
The authors observed that forward-looking statements are less likely to result in misrepresentation claims under 10b-5 because courts tend to interpret future targets as “aspirational” or “non-actionable puffery.” This means that lawsuits arguing misrepresentation are more difficult to bring based on forward-looking statements. However, litigation is growing around historical statements because these types of statements are becoming increasingly verifiable. When investors attempt to verify historical information and come to a different conclusion than what was reported by the company, litigation is more likely to be successful.
How companies respond to lawsuits against their peers largely depends on the substance of the suits. When lawsuits are brought based on omissions, then peer companies are likely to respond by disclosing more information. However, when the claims are based on misrepresentations – particularly misrepresentations made regarding historical statements – peer companies respond by cutting back on the number of historical statements made in their disclosures. In managing this risk, companies end up moving in the opposite direction from what investors claim to want from their holdings.
Litigation Exposure from the SEC’s Climate Disclosure
The authors also raise an interesting point regarding the SEC’s Climate-Related Disclosure proposal. Companies respond to historical misrepresentation claims by cutting back on the number of historical statements in their disclosures; however, SEC rulemaking may make that strategy less effective. The SEC Climate-Related Disclosure proposal requires reporting of a certain amount of historical statements – especially related to GHG emissions and in certain cases progress towards emissions reductions. This would limit the amount of historical statements companies can cut from their disclosures without facing regulatory enforcement.
What This Means
While companies appear to be trending away from disclosing historical ESG statements in response to litigation, I see a couple of issues with this course of action. For one, as pointed out in the study, SEC rulemaking may be making this avenue less effective and riskier. Additionally, it is possible that by cutting back on historical statements in an effort to avoid misrepresentation litigation, companies may inadvertently increase their exposure to omission litigation.
To walk the tightrope between misrepresentation risk and omission risk companies should be thoughtful about what ESG data they disclose. When deciding what gets disclosed issues should be examined primarily through a materiality lens. One study suggests considering the following factors in determining whether an issue gets disclosed:
- whether a reasonable investor would rely on environmental information,
- whether this information should be considered material, and
- whether reliance on environmental information could result in loss causation.
Honestly, this isn’t too different from considerations companies apply in other reports and disclosures. But a difficulty in using these factors for ESG is that related data doesn’t typically go through the same level of internal controls, consideration and validation that disclosed financial data does. For those looking for more information on how to determine ESG materiality and ESG data quality management, check out our Guidebook: How to Conduct a Materiality Assessment and E&S Data Validation Guidebook. If you’re not already a PracticalESG.com member with access to these podcasts and other resources, sign up now and take advantage of our no-risk “100-Day Promise” – during the first 100 days as an activated member, you may cancel for any reason and receive a full refund.