In our last article, we spent some time on the steps and actions leading up to the new SEC Climate Change Risk Disclosure guidance (hereinafter, the “Guidance”). In this article, we will examine the details and requirements of the new SEC guidance. In a following article we will discuss the potential benefits of a certification program, and also measure the relevance this action has on non-public companies.
What the Climate Change Guidance Really Means
The most important thing to realize about the Guidance is that it is not law, it is merely guidance. The requirements of public company disclosures, as set out in the Securities and Exchange Act of 1934 (the “1934 Act”) and Regulation S-K have not changed. The Guidance merely provides some gloss on how the SEC might interpret a disclosure issue if one arose. In addition, to the extent SEC staff provides comments on a public issuer’s financial report discloses, SEC staff are likely to refer to the Guidance when commenting.
The 1934 Act requires quarterly and annual financial reports (with quarterly reports on Form 10-Q and annual reports on Form 10-K) for companies with registered securities (defined in the regulations as “registrants”). The public disclosure requirements of the 1934 Act apply to all publicly-traded companies (i.e., those whose shares are traded on public exchanges like the NYSE and the NASDAQ) and those few companies who have so many shareholders that the public reporting requirements apply to them.
Attorneys, accountants and business people accustomed to working on financial reports under the 1934 Act are familiar with the touchstone of disclosure in those reports: the company must disclose those material elements of its business that a reasonable investor would consider to be material. Nearly all of the other regulations and guidance concerning financial reports spring from this basic principle. Information is considered “material” for disclosure purposes if there is a substantial likelihood that a reasonable investor would consider it relevant in deciding how to vote or make an investment decision.
Item 101 of Regulation S-K requires that the registrant disclose the material effects of compliance with any laws that might apply to the registrant. The Guidance states what should be obvious, that Item 101 “requires disclosure of the material effects that compliance with environmental laws may have on capital expenditures, earnings or the competitive position of a company”.
So, by way of example, if a registrant operates facilities with significant air or water emissions, the registrant should disclose in its financial reports its cost of complying with the Clean Air Act, the Clean Water Act and other environmental laws and the potential financial impacts of non-compliance. In contrast, a public company with no material air or water emissions would not have a duty to disclose its hypothetical liability where there is not reasonable likelihood of that liability coming to pass.
With respect to climate change, the general rule of disclosure under Item 101 means that the registrant must also disclose its actual costs of legal compliance and the potential costs of non-compliance. For example, if legislation imposed a system of emissions cap and trade, companies whose emissions exceed the stated caps, will be forced to buy “credits” and perhaps pay fines. Conversely, companies with emissions under a stated level, will be able to “sell” their credits and potentially improve their financial position. In addition, countries around the globe have and are continuing to assess fines to companies they believe are inflicting environmental damage to their nations.
Importantly, a registrant is not required (and is, in fact, prohibited) from making disclosures that are speculative. Unless and until emissions cap and trade legislation becomes law, a disclosure about the potential benefits of a cap and trade system would generally be ill-advised. In the same way that the benefits of prospective legislation are too speculative to disclose, the cost and expense of potential future legislation would also be too speculative to disclose.
Public reporting companies disclose in their quarterly reports on Form 10-Q and their annual reports on Form 10-K pending legal proceedings. Item 103 of Regulation S-K contains specific requirements about the extent to which particular items of litigation must be disclosed. Again, in general, materiality is the touchstone of disclosure.
The Guidance states that litigation disclosures under Item 103 must include any environmental enforcement actions and orders material to the registrant. As the Guidance notes, there already have been enforcement actions (notably in the State of New York) with respect to the accuracy of environmental disclosures in financial reports. There are also several lawsuits pending in which private litigants have sued companies over alleged climate change resulting from the emissions of those companies. Public companies who are defendants to such suits would be required to disclose them, applying the same materiality standards applied to any other kind of litigation.
If national climate change legislation, including a cap and trade system, became law, disclosures of potential or hypothetical litigation might be appropriate under Item 103. Until such potential legislation becomes law, however, disclosures of hypothetical or potential contingencies under Item 103 are premature. Disclosures must include “such further material information, if any, as may be necessary to make the required statements, in light of the circumstances under which they are made, not misleading.” See 17 CFR 230.408 and 17 CFR 240.12b-20.
In quarterly and annual reports, public issuers provide a discussion of the issuer’s financial results and future prospects called “Management’s Discussion and Analysis” (or “MD&A”). Item 303 of Regulation S-K requires an issuer “to disclose known trends, events, obligations or uncertainties that will, or are reasonably likely to, materially affect the company’s liquidity, capital, resources or operations”. In addition, companies are also required to disclose any other information the company believes is necessary to an understanding of its financial conditions, changes in financial condition and results of operations.
Discussing “known trends, events, obligations or uncertainties” is a potential bottomless pit. While management will be aware of immediate and obvious trends (such as increasing or decreasing sales, or increasing or decreasing costs of goods sold) there is an infinite list of potential contingencies that might impact the issuer’s financial performance. In the MD&A, however, the issuer is not required to identify every possible contingency, but rather only those “known trends, events, obligations or uncertainties” that are “material” to a reasonable investor’s decision to invest or vote securities.
Item 503(c) of Regulation S-K helps issuers draw the line between “known trends” and mere speculation by providing that the issuer must disclose "the most significant factors that make the offering speculative or risky" (emphasis added).
By way of example, an actual lawsuit that is pending is more significant than a threatened lawsuit that has not been filed. A threatened lawsuit is more significant than the risk of a possible future lawsuit that has not yet been threatened.
Put into this context, the disclosure of climate change impacts should be ranked against the issuers other known trends and contingencies. If the issuer reasonably believes that certain environmental or climate change impacts are more significant than other contingencies, that belief should guide its disclosure.
By way of example, if an issuer had facilities in low-lying coastal areas that might be threatened by an increase in sea level brought about by an increase in global temperatures, that might be a contingency with the potential to impact the issuer’s financial statements. Whether that risk is one that should be disclosed in a financial report, however, will depend on the relative immediacy and potential impact of that risk in comparison to other risks that the issuer faces. Ultimately, while the Guidance discusses these types of disclosures and provides some color on how issuers should consider them the Guidance does not change the law regarding disclosures and does not necessarily require issuers to disclose new or different kinds of risks.
The practical impact of the Guidance, however, is to raise the awareness of public issuers regarding environmental and climate change risks and costs. In light of the Guidance, public issuers should not reasonably be able to claim surprise if future enforcement actions challenge the adequacy of disclosures of these kinds of risks.
Because the disclosure of contingencies, however, requires a weighing of immediacy and impact against other potential risks, a well-advised issuer will adopt a consistent theoretical construct for considering and weighing the immediacy and impact of risks for disclosure purposes. Part of that theoretical construct, many issuers may conclude, is a process for assessing and measuring the potential impact of environmental and climate change risk. It is to this end that we will address some practical steps issuers may take to perhaps mitigate their environmental and climate change risks in Part 3 of this article series.
About the authors:
Keith Winn is vice president of marketing and chief operating officer of GreenProfit Solutions Inc., a Ft. Lauderdale based sustainability consulting, certification and contracting firm. You may contact him at 800-358-2901 or kwinn@greenprofitsolutions.com.
Jonathan B. Wilson is a corporate and securities attorney at the Atlanta law firm of Taylor English Duma LLP. Mr. Wilson is also the founding chair of the Renewable Energy Committee of the American Bar Association’s Public Utility Section. You may contact him at 678-336-7185 or jwilson@taylorenglish.com.