In her brief time as acting chairwoman of the Securities and Exchange Commission earlier this year, Democrat Allison Herren Lee did not play the traditional role of “caretaker.” Initiating a flurry of activity in early March, Lee effectively set the SEC’s trajectory on a new progressive agenda.
This new direction at the SEC is playing out with an initiative to mandate prescriptive environmental, social, and corporate governance disclosures in the annual filings of public companies.
As a financial regulator, the SEC requires certain economic information to be made public to investors to guide their investment decisions. The underlying principle that has long guided these disclosures is “materiality.” In 1976, the Supreme Court recognized the fundamental role investor-driven disclosures play in capital markets and defined information as material if it “significantly altered the total mix of information” to an individual’s investment decision. Materiality has thus been determined by investors and companies, with the SEC setting the principles to guide disclosure.
As the ESG agenda grows stronger, its advocates are lobbying the commission to move away from its principles-based disclosure regarding climate issues. Announcing a new public comment period on the topic of mandatory disclosures in March, Lee didn’t hide her alignment with ESG activists. Before a single public comment was reviewed, Lee’s staff had already “begun to take critical steps toward a comprehensive ESG disclosure framework aimed at producing the consistent, comparable, and reliable data.”
While the SEC may move in this direction, any ultimate rulemaking will expose the structural flaws of a prescriptive disclosure approach. The central flaw of ESG disclosure is the assumption that financial regulators can determine and prescribe the large, shifting mix of information deemed material to investors as dynamic markets change constantly.
That flaw helps explain why among the ever-expanding categories of “ESG information” that now includes gender pay ratios, political spending, climate change, human rights, and tax disclosure (to name a few), no single definition has emerged. SEC Commissioner Hester Peirce was right when she urged colleagues “to rethink the wisdom of recommending that we embark on a program to write standards for a set of issues nobody can define.”
The current ESG activism isn’t new. In 2018, two corporate law professors issued a petition for rulemaking to the SEC on ESG disclosure. The petition called on the commission to institute a prescriptive framework, but it amazingly failed to define “ESG information” and note specific metrics it deemed financially material.
The SEC’s Investment Advisory Committee advocated for ESG disclosure in May of last year. In her analysis of its proposal in a paper last month, Vanderbilt Law Professor Amanda Rose notes its lack of specifics. This proposal opts for a definition of ESG as “a broad set of subjects germane to businesses” before declining to endorse any existing ESG framework.
These previous ESG efforts, including similar attempts in Congress, are all confronting the same problem: It is not the role or purview of regulators to determine what information is material to investors. Prescriptive frameworks, drawn from any combination of the growing universe of private ESG standard-setting organizations and metrics, cannot capture the highly specific circumstances of each company, its industry, and the multiple issues it faces.
What always gets lost in ESG activism is the wisdom of the SEC’s principles-based framework. On the question of climate disclosures, for example, the SEC responded over a decade ago with interpretative guidance to issuers detailing how to meet the materiality standard specifically concerning the climate. The guidance already highlights the requirement to discuss the most significant factors that may make an investment risky — the goal of disclosures in the first place.
What’s defined as ESG today will change next year and several more times over the next decade. While financial regulators struggle with that reality, the best course of action the SEC can take is to rely on its time-tested framework for principles-based disclosure. The SEC can choose to step into an uncertain and ever-changing world of ESG progressive virtue-signaling wokeness, or it can maintain the market-focused regulatory approach that has served us so well for so long and had made America the envy of the global capital markets.
Mark J. Perry is a professor of economics at the Flint campus of the University of Michigan and a scholar at the American Enterprise Institute.
