Monthly Archives: April 2021
In a series of blogs, that is likely to be an ongoing topic for the foreseeable future, I have been discussing the barrage of environmental, social and governance (ESG) related activity and focus by capital markets regulators and participants. Climate change initiatives and disclosures have been singled out in the ESG discussions and as a particular SEC focus, and as such was the topic of the first blog in this series (see HERE). The second blog talked more generally about ESG investing and ratings systems and discussed the role of a Chief Sustainability Officer (see HERE). The last blog on the topic focused on current and prospective ESG disclosure requirements and initiatives, including the Nasdaq ESG Reporting Guide (see HERE).
ESG is not just a topic impacting social position disclosures but can go directly to the financial condition of a reporting company, and as such its financial statements. Accordingly, ESG reporting requires auditor and audit committee engagement.
Board of Directors, Audit Committees and ESG Disclosures
The “G” in ESG generally refers to the governing structure, policies, and practices employed by a company related to responsibilities and decision-making rights that provide the foundation for overall accountability and credibility. In other words, the “G” goes directly to corporate governance and internal controls, the oversight of which rests with the board of directors and its audit committee. Although not a completely new topic, ESG has gained momentum following the Covid-19 pandemic and social justice movement, prompting many companies to take a proactive instead of reactive approach to the matter.
A company that is either merely reacting to the ESG disclosure pressure or that simply has not developed an ESG thought process as of yet, generally does not have a system in place that integrates ESG considerations into its management decision ecosystem, nor does it have active board oversight on the topic. These companies are now developing controls and procedures that include reporting to and updating board members, creating accountability, often hiring a Chief Sustainability Officer and creating a reporting regime within the company that abides by specific standards. Although I am still skeptical on ESG-driven management decisions as a whole (my thoughts align more with Jay Clayton and Hester Peirce), the train has left the station and I wouldn’t be surprised if, in the near future, it goes so far as to include executive compensation tied to ESG performance.
Board oversight of an entity’s ESG reporting is critical for establishing and maintaining good governance, policies, and controls over the ESG reporting process. The board of directors’ responsibilities extend beyond simply reviewing past disclosures or current systems, but also include being proactive and ready for future implementation of new processes. Where ESG matters impact financial statements, oversight clearly lies with the audit committee of the board of directors, but the nominating and governance committee clearly has a role, and many boards are forming a separate ESG/Sustainability committee.
Where a board of directors is considering hiring a third party, such as its audit firm, to provide ESG attestation (and thus give assurances), it should be informed about (i) the purpose and objectives of the ESG information (SEC reports; separate sustainability reporting; future planning; investigation of potential deficiencies, etc..); (ii) the intended users of the ESG information (internal; public filings; investors; ratings organizations); (iii) why the intended users want or need the information; (iv) the potential risks associated with misstatements or omissions; (iv) the type of ESG information intended users are expecting; and (v) the level of ESG attestation service that will achieve the goals (full audit, review, etc.).
Regardless, all boards of directors should be considering (i) what are the company’s policies and processes with respect to the gathering and reporting of ESG information; (ii) how old or dated is the current available information; (iii) who in the company has responsibility for the oversight of ESG information; (iv) is ESG information material to or included in financial statement reporting; (v) what are the company’s internal controls vis-a-vis ESG information gathering and reporting; (vi) have ESG-related internal controls been tested; and (vii) what disclosure controls and procedures and related documentation are available for ESG information.
Auditor Role in ESG Disclosures
Generally, an auditor is only responsible for information contained in an SEC registration statement or report. However, under PCAOB auditing standards, an auditor must at least read the balance of a filing, including ESG information to ensure that such information is consistent with, and at least not materially inconsistent with, the financial statements and notes thereto. Where sustainability reports are presented by a company, either on its website or as an exhibit to a SEC filing, an auditor would have no responsibility for the information contained in those reports.
However, in today’s ESG-centric environment, some companies are seeking third-party assurance on its ESG information. Third-party assurance can (i) assist the board of directors in assessing the quality of ESG disclosures and in overall company oversight; (ii) enhance the reliability of ESG information for investor analysis; (iii) enhance management’s confidence in the integrity of the company’s disclosed ESG information; (iv) assist stakeholders such as customers, suppliers and prospective employees in making ESG based relationship decisions; and (v) impact a company’s ESG rankings and rating on sustainability indices (such as the Dow Jones Sustainability Index).
Public company auditors have stepped up to fill this role and are now regularly being engaged by their public company clients to provide ESG-related assurances. Other third parties, such as engineering or consulting firms, are also competing for this business. Where a public company audit firm is retained, they are guided by the American Institute of CPAs (AICPA) Statements on Standards for Attestation Engagements. That is, where an auditor is engaged to provide ESG attestations, they must comply with standards involving data and systems testing and evaluating evidence and procedures. Accordingly, there is a belief that auditor ESG assurances are reliable.
As when engaged to perform an audit, the auditor engaged for ESG matters must: (i) be independent of the company; (ii) be skilled in understanding the company including its business and processes; (iii) have the resources, such as specific expertise, to provide the requested services (think expert on greenhouse gas emissions); (iv) are required to plan and perform attestations with professional skepticism; (v) are experienced in reporting on compliance matters (not just standard audits); (vi) are required to maintain a system of quality controls; and (vii) are required to maintain continuing professional education and other licensing requirements. A company will often retain the same firm that is performing its regular audit work as that auditor will have a depth of knowledge about the company making the ESG attestation more economical and efficient.
Generally, an auditor’s ESG attestation is made more reliable because of their requirement to test against specific standards. Those standards must be recognized as reliable, such as those published by the Sustainability Accounting Standards Board or the Global Reporting Initiative. Where a company makes a broad statement related to ESG matters not supported by evidence or capable of being measured against a specific metric, the auditor would not be able to provide assurance.
Moreover, just like the difference between an annual audit and quarterly review of financial statements, an auditor can be retained to provide a full independent report and opinion on ESG information or a more limited review such as for material deficiencies with no separate report. An auditor may also provide consulting services helping a company determine its ESG reporting systems, internal controls and best metrics and standards.
Unlike a Securities Act of 1933 (“Securities Act”) registration statement, a Securities Exchange Act of 1934 (“Exchange Act”) Section 12(g) registration statement does not register securities for sale or result in any particular securities becoming freely tradeable. Rather, an Exchange Act registration has the general effect of making a company subject to the Exchange Act reporting requirements under Section 13 of that Act. Registration also subjects the company to the tender offer and proxy rules under Section 14 of the Act, its officers, directors and 10%-or-greater shareholders to the reporting requirements and short-term profit prohibitions under Section 16 of the Act and its 5%-or-greater shareholders to the reporting requirements under Sections 13(d) and 13(g) of the Act.
A company may voluntarily register under Section 12(g) at any time and, under certain circumstances, may also terminate such registration (see HERE).
In addition, unless an exemption is otherwise available, a company must register under Section 12(g), if as of the last day of its fiscal year: (i) it has $10 million USD in assets or more as shown on the company’s balance sheet; and (ii) the number of its record security holders is either 2,000 or greater worldwide, or 500 persons who are not accredited investors or greater worldwide. Such registration statement must be filed within 120 days of the last day of its fiscal year.
A company that is registering on a national securities exchange accomplishes its registration under Section 12(b) of the Exchange Act. Other than the referenced section, the process and registration statements used are the same as for a Section 12(g) registration.
Benefits of Registration
There are numerous business and legal benefits to registration under Section 12(g). Below are a few of the most compelling benefits.
Rule 144 is the most often used exemption to remove the restrictive legend and sell unregistered securities into the public marketplace. For more on Rule 144, see HERE and HERE. In order to utilize Rule 144, the security holder must satisfy certain requirements including a holding period. The holding period varies based on whether the company is subject to the SEC reporting requirements or not.
The holding period for a company subject to the SEC reporting requirements is six months whereas it is one year for a company that is not. An Exchange Act registration statement under Section 12(g) results in the company becoming subject to the SEC reporting requirements. Although a Securities Act registration statement, such as on Form S-1, will also make a company subject to the Exchange Act reporting requirements, that requirement may only be temporary. That is, a company only reporting as a result of a Securities Act registration statement may slip into voluntary reporting status whose security holders would be subject to the longer one-year Rule 144 holding period. For more on voluntary reporting status, see HERE.
Furthermore, w is not available for a company that is or was ever a shell company unless the company: (i) is no longer a shell company; (ii) is subject to the Exchange Act reporting requirements (such as through the filing of a 12(g) registration statement); (iii) has filed all reports under the Exchange Act during the preceding 12 months; (iv) has filed current Form 10 information with the SEC reflecting its status as no longer a shell company; and (v) one year has elapsed since the filing of the Form 10 information.
Similarly, registration under the Exchange Act has implications on the applicable distribution compliance period in a Regulation S offering. For more on Regulation S, see HERE. A distribution compliance period is defined in Rule 903 of Regulation S and provides for a holding period in which securities issued in a Regulation S transaction cannot be re-sold to a U.S. person or for the account or benefit of a U.S. person. There are three categories of distribution compliance periods. Rule 903 imposes duties on a company, a distributor and any affiliates of the company or a distributor to ensure that the distribution compliance periods are abided by to prevent the sale of securities to a U.S. person during the distribution compliance period.
Category 1 can only be relied on by a Foreign Private Issuer (“FPI”) with no substantial U.S. market interest and where the offering is directed into a single country other than the U.S. Category 1 does not impose any additional time restrictions on re-sales. Category 2 applies to equity securities of an Exchange Act reporting FPI and can be relied upon even if there is a substantial U.S. market interest in the securities. The category 2 distribution compliance period is 40 days. Category 3 applies to domestic reporting and non-reporting companies and non-reporting FPI’s where there is a substantial U.S. market interest in the securities. The distribution compliance period for category 3 companies tracks Rule 144 and, as such, is one year for non-reporting U.S. and FPI’s and six months for reporting U.S. companies. Accordingly, both U.S. companies and FPI’s may benefit from becoming subject to the SEC reporting requirements through the filing of an Exchange Act registration statement.
A basic requirement for any company to be able to use an S-3 registration statement is that it have a class of securities registered under Section 12(g) (or 12(b)) and has otherwise be required to file SEC reports for a period of 12 months. For more on S-3 eligibility, see HERE.
Exemptions; Section 12g3-2
A company that would otherwise be required to register under Section 12(g) may instead register under Section 12(b) by registering with and listing on a national securities exchange. Other than the referenced statutory section, the process and registration statements used are the same as for a Section 12(g) registration.
An FPI has two exemptions from the Section 12(g) registration requirement. First, Exchange Act Rule 12g3-2(a) exempts FPI’s who have fewer than 300 U.S. record holders from the registration requirement. In determining record holders for purposes of this exemption, the calculation is the same as described below except that where the record holder is a broker, dealer, bank or other nominee, the company must look through and count each of the accounts of customers held by such broker, dealer, bank or nominee.
Second, Exchange Act Rule 12g3-2(b) provides an automatic exemption from registration for an FPI if the following three conditions are met: (i) the FPI is not required to file reports under Exchange Act Sections 13(a) or 15(d) (such obligations arising generally as a result of a public offering of securities, a listing on a national securities exchange, or voluntary registration under the Exchange Act); (ii) the FPI maintains a listing of the subject class of securities on one or two exchanges in a non-U.S. jurisdiction(s) that comprise more than 55% of its worldwide trading volume (its “Primary Trading Market”) as of its most recently completed fiscal year; and (iii) the FPI publishes in English on its website or through another electronic delivery platform generally available to the public in its primary trading market certain material items of information.
Calculation of Holders of Record
As mentioned, a company is required to register under Section 12(g) if as of the last day of its fiscal year the number of its record security holders is either 2,000 or greater worldwide, or 500 persons who are not accredited investors or greater worldwide. The determination of record holders and the determination of accredited status are both made as of the last day of the fiscal year.
Accredited investor is defined in Securities Act Rule 501(a) (see HERE) and specifically provides that an accredited investor can be one that the company “reasonably believes” comes within the specific enumerated accreditation categories. In making the determination as to whether a company has over 500 non-accredited investors as of the last day of its fiscal year-end, a company must consider all facts and circumstances, including whether prior information obtained at the time of a sale of securities can reasonably be relied upon to still be correct.
It is important that all private companies with more than 500 shareholders consider the accredited status of its shareholders as of the last day of each fiscal year to be sure it is not inadvertently violating the federal securities laws requiring registration. During times of financial uncertainty and the dramatic impact upon some people’s net worth that has followed the Covid crisis, it is even more important to keep an eye on this ball. All such, companies should consult with competent securities counsel.
At the time of adopting the last amendment to Section 12(g) in 2016, the SEC was asked by many commenters to provide guidance or establish safe harbors related to the requirement to determine shareholder accreditation as of the last day of each fiscal year-end. At that time, the SEC declined to do so and as of today has still not done so, even using C&DI.
The calculation of held of record starts with the actual record holders on the company’s shareholder list, assuming that list has been properly maintained. If it was not properly maintained, any corrections should be made to get to a starting point. Securities held in similar names with the same address can be counted as one holder.
Securities held in the name of a corporation or other entity are counted as a single holder, regardless of the number of beneficial holders of that entity. This is one of the reasons that special purpose acquisition vehicles or SPV’s are very popular for use in investing in private placements.
Securities jointly owned, such as by a husband and wife, are counted as one record holder. Although bearer certificates (i.e., certificates that are owned by the person who is the physical bearer of such document) are rare in today’s world, where such certificates exist, each one is deemed to be held by a separate owner unless there is direct evidence otherwise.
Securities held by a trustee, executor, guardian or other fiduciary are deemed held by one record holder. Securities held of record by a broker, dealer, bank or nominee may be counted as a single shareholder. However, institutional custodians, such as Cede & Co. and other commercial depositories, are not single holders of record for purposes of the Exchange Act’s registration and periodic reporting provisions. Instead, each of the depository’s accounts for which the securities are held is a single record holder.
In addition, persons that received the securities under an employee compensation plan that was exempt from U.S. registration may be excluded (generally shares issued under Rule 701 – see HERE). Securities issued in a Regulation CF offering or a Regulation A, Tier 2 offering may also be excluded.
In order to exclude shares issued in a Regulation CF offering, the company must: (i) be current in its Regulation CF annual reporting (see HERE); (ii) have total assets of less than $25 million as of the end of its most recently completed fiscal year; and (iii) have engaged an SEC registered transfer agent. Moreover, if a company would be required to register solely because it exceeds the asset limit, it can avail itself of a two-year transition period as long as it continues to file its Regulation CF annual reports.
In order to exclude shares issued in a Regulation A, Tier 2 offering, the company must: (i) be required to file SEC reports under Regulation A; (ii) be current in its annual, semi-annual and other Regulation A reports; (iii) have engaged an SEC registered transfer agent; and (iv) have a non-affiliate public float of less than $75 million as of the last day of the second quarter of its most recently completed fiscal year or if no public float, have annual revenues of less than $50 million as of its most recently completed fiscal year. If a company would be required to register solely because it exceeds the market value or revenue limit, it can avail itself of a two-year transition period as long as it continues to file its Regulation A SEC reports.
A few other securities are exempt from the 12(g) calculation, including (i) a security issued under an employee stock option or similar plan which is not transferable except upon death or incapacity; (ii) subject to certain regulations, any interest or participation in a common trust fund by a bank exclusively for collective investment; (iii) any class of equity security which will not be outstanding 60 days after a registration statement would be required to be filed with respect thereto; (iv) standardized options issued by a clearing agency and traded on a national exchange; (v) securities futures traded on a national exchange; and (vi) certain compensatory stock options.
Form of Registration Statement and Time for Effectiveness
Eligibility to use a particular form of registration is determined by a review of the instructions for such form at the time of use. A Form 10 is the general form of registration statement for a U.S. domestic company; however, the short Form 8-A may be used by a company that is already required to filed reports under the Exchange Act, usually as a result of having filed a registration statement under the Securities Act, or that is concurrently qualifying a Tier 2 offering statement relating to that class of securities using the Form S-1 or Form S-11 format.
A Form 20-F is the common basic registration statement for an FPI and a Form 40-F is favored for Canadian companies that qualify for its use. An FPI may voluntarily file a registration statement using a U.S. domestic form, but must meet FPI status within 30 days of filing its first registration statement in order to rely on an “F” form.
Generally, an Exchange Act registration statement automatically goes effective on the 60th day following filing; however, a company may request accelerated effectiveness from the SEC. A Form 8-A goes effective either upon filing, or if a Securities Act registration statement is concurrently being filed, upon effectiveness of that Securities Act registration statement.
Since I wrote about the SPAC IPO boom in June 2020 (HERE), the trend has not waned. However, as soon as celebrities like Jay-Z, Shaquille O’Neal, A-Rod and astronaut Scott Kelly jumped in, I knew the tide was shifting, and recent SEC alerts bring that to light. To be clear, SPACs have been used as a method for going public for years and will continue to do so in the future. In fact, I firmly believe that going public through a SPAC will continue and should continue to rival the traditional IPO. With so much SPAC money available in the market right now (an estimated $88 billion raised in 2021 so far already exceeding the estimated $83.4 billion raised in all of 2020) and the Dow and S&P beating historical records, SPACs are an excellent option as an IPO alternative.
However, SPACs should not be viewed as the trendy investment of the day and both investors and potential IPO targets should be aware of the reality behind the hype and make informed business decisions considering all available information. At the end of the day, there are some fundamental differences between a traditional IPO and going public via a merger with a SPAC, both at the onset of the process and for a few years following the transaction. Moreover, although most SPACs are structured very similarly (more on that below), the SPAC sponsor team is integral to the success of a deal and to providing strategic assistance to the IPO target following the transaction. Some celebrities have vast business success and experience, but no one should complete an IPO transaction or invest in a company just because a celebrity is attached to the deal.
On March 10, 2021, the SEC issued an investor alert warning of celebrity-backed SPACs and more recently on March 31, 2021, the SEC issued two statements on SPACs. One highlighted certain issues, including relating to shell status, and the other on financial reporting and audit considerations. Then again on April 8, 2021 the SEC issued another statement on SPACs, this time from John Coates, Acting Director of the Division of Corporation Finance. As discussed below, Coates statement is compelling and thoughtful, clearly targeting the rise in over-valued targets in the de-SPAC process. In addition to discussing the SEC statements, this blog will delve a little further into SPAC structures as well.
SEC Investor Alert on Celebrity Involvement in SPACs
On March 10, 2021, the SEC issued an investor alert warning investors not to make investment decisions related to SPACs based solely on celebrity involvement. As obvious a statement as this seems, with the influx of celebrity-backed SPACs, the SEC thought it necessary to remind the investment community. In an interesting choice of words, the SEC continues, “[C]elebrities, like anyone else, can be lured into participating in a risky investment or may be better able to sustain the risk of loss.”
The investor alert points out that a sponsor may have a conflict of interest and always has a different economic position than shareholder investors. Although the SEC doesn’t get into details, as discussed further below, a sponsor receives founder shares for a fixed price of $25,000 which founder shares will typically represent 20% of the total issued and outstanding capital stock immediately following the closing of the SPAC IPO. The sponsor must also invest enough capital to cover the IPO costs, ongoing SPAC upkeep legal and accounting fees, and costs associated with the de-SPAC transaction (locating and conducting due diligence on a target and transaction costs associated with the merger), which is generally approximately 5% of the total IPO amount. However, the terms of this sponsor PIPE are also more favorable than the IPO terms.
The investor alert suggests (i) checking the background, including registration or license status of anyone recommending a SPAC; (ii) investing the SPAC sponsors background, experience and financial incentives, how the SPAC is structured, the securities being offered, the risks of the investment, plans for a business combination and other shareholder rights; and (iii) consider the investments costs, risks and benefits in light of an individual’s risk tolerance and investment objectives.
SEC Statement on Particular Issues Related to SPACs
On March 31, 2021, the SEC issued a statement on certain legal specifics associated with a SPAC, some of which differ from a traditional IPO and can follow the SPAC target for years after a transaction.
Shell Company Status
The first point raised by the SEC is one I’ve touched about in a prior blog related to SPACs (see HERE), and that is that a SPAC is a shell company and as such carries all of the legal effects of a company that is or once was a shell company.
- Financial statements and Form 10 information for the acquired business must be filed within four business days of the completion of the business combination in a Super 8-K (financial statements for an acquired business by a non-shell are not due until 71 days following the filing of the initial closing 8-K).
- A SPAC will be an ineligible issuer for three years following completing a business combination and, as such, (i)is not entitled to use a free writing prospectus in its IPO or subsequent offerings; (ii) cannot qualify as a well-known seasoned issuer (WKSI); (iii) may not use a term sheet free writing prospectus available to other ineligible issuers; (iv) may not conduct a road show that constitutes a free writing prospectus, including an electronic road show (see HERE for more on road shows and eligibility considerations); and (v) may not rely on the safe harbor of Rule 163A from Securities Act Section 5(c) for pre-filing communications made more than 30 days prior to the filing of the registration statement (see HERE for more on gun jumping).
- A SPAC does qualify to use incorporation by reference in Exchange Act reports, proxy or information statements, or Form S-1 (including forward incorporation by reference) until three years after completing a business combination (see HERE for more on incorporation by reference).
- After completing the IPO and until it completes a business combination, the SPAC must identify its shell company status on the cover of its Exchange Act periodic reports.
- A SPAC cannot use a Form S8 to register any management equity plans until 60 days after completing a business combination and filing Form 10 information.
- A SPAC may not file an S-3 in reliance on Instruction 1.B.6 (the baby shelf rule) until 12 months after it ceases to be a shell and has filed “Form 10” information (i.e., the information that would be required if the company were filing a Form 10 registration statement) with the SEC reflecting its status as an entity that is no longer a shell company. See HERE on S-3 eligibility. More recently, the SEC issued a C&DI extending the 12 months post-shell status eligibility requirements to Instruction 1.B.1 (the full shelf rule) and as such, a SPAC may not use S-3 for a shelf registration until 12 months following its business combination.
- Although not pointed out in the SEC alert, holders of SPAC securities may not rely on Rule 144 for resales of their securities after the SPAC completes a business combination until one year after the company has filed current “Form 10” information with the SEC reflecting its status as an entity that is no longer a shell company and so long as the SPAC remains current in its SEC reporting obligations.
Books and Records and Internal Controls
Although applicable to all companies, whether going public via a SPAC or IPO, the SEC reminds these companies that they have obligations associated with being subject to the Exchange Act reporting requirements. These obligations include maintaining books and records in reasonable detail such that they accurately reflect the company’s transactions and disposition of assets. The second if to maintain internal controls and procedures over financial reporting (ICFR), have management assess such ICFR, and file CEO and CFO certifications regarding such assessment.
An ICFR system must be sufficient to provide reasonable assurances that transactions are executed in accordance with management’s general or specific authorization and recorded as necessary to permit preparation of financial statements in conformity with US GAAP or International Financial Reporting Standards (IFRS) and to maintain accountability for assets. Access to assets must only be had in accordance with management’s instructions or authorization and recorded accountability for assets must be compared with the existing assets at reasonable intervals and appropriate action be taken with respect to any differences. These requirements apply to any and all companies subject to the SEC Reporting Requirements, including SPACs and the post-business-combination entity.
Likewise, all companies subject to the SEC Reporting Requirements are required to provide CEO and CFO certifications with all forms 10-Q and 10-K certifying that such person is responsible for establishing and maintaining ICFR, have designed ICFR to ensure material information relating to the company and its subsidiaries is made known to such officers by others within those entities, and evaluated and reported on the effectiveness of the company’s ICFR. As the company grows, it will be subject to additional internal control requirements as set out in the Sarbanes Oxley Act (see HERE ).
Exchange Listing Standards
Both Nasdaq and the NYSE have initial and continued listing standards as well as ongoing compliance obligations, which I’ve written about many times. See HERE and HERE for some information on Nasdaq listing requirements and HERE for basic NYSE listing standards). During the SPAC IPO process, it was required to meet the initial listing standards, and thereafter to comply with the continued listing standards.
Unlike in an IPO process where certain corporate governance requirements may be phased in (such as having a majority of the board of directors be independent), as part of the merger process, the combined SPAC and target entity must meet all of the initial listing requirements of the national exchange. As part of the process, an application for approval of the listing of the combined entity must be filed with the exchange, and again, all of the initial listing standards must be met at the outset.
The SEC points out that the de-SPAC business combination process can impact the listing qualifications. For example, a company must have at least 300 round lot shareholders, holding freely tradable securities and there must be at least 1,000,000 shares in the public float. In addition, of the 300 holders, at least 151 of them must own securities valued at $2,500 or more. If the SPAC loses round lot holders through redemptions prior to the business combination, the combined company might not meet the round lot holder requirement upon consummation of the business combination, in which case it could be delisted.
Likewise, all corporate governance standards must be in place at the time of the closing the SPAC business combination, including a majority of independent board of directors, an independent audit committee, and independent compensation and nomination committees. A company must also have a code of conduct, whistleblower policy and insider trading policy.
Statement on Financial Reporting and Auditing Considerations
On March 31, 2021, Paul Munter, Acting Chief Accountant of the SEC, issued a statement on financial reporting and auditing considerations associated with SPAC transactions. The majority of the statement was the usual rhetoric regarding how important reliable financial statements are to our public markets. Mr. Munter rightfully points out the accelerated timeline to complete a SPAC transaction as opposed to a traditional IPO and the fact that the target company must be fully loaded and ready for public company regulatory compliance from day one. Target companies need to ensure they have the staff with associated expertise to comply with SEC reporting requirements, exchange compliance requirements and internal controls over financial reporting (ICFR).
Statement on SPACs, IPOs and Liability Risk under the Securities Laws
On April 8, 2021, John Coates, Acting Director of the Division of Corporation Finance issued a statement expressing concern with the “unprecedented surge in the use and popularity” of SPACs. Mr. Coates makes it clear that the SEC is carefully reviewing filings for appropriate disclosure including related to the sponsor fees and promote, conflicts of interest, other fees and the target (including valuation).
Coates goes on to talk about SPAC structures in general and the potential liability in a SPAC transaction. As discussed below, SPACs generally rely on projections and other valuation materials that are not used in a traditional IPO and as such valuations of a target company are generally higher than in a traditional IPO. One of the reasons for the is a belief that the Private Securities Litigation Reform Act (PSLRA) safe harbor for forward-looking statements provides protection from liability during the de-SPAC process. Coates warns that the belief in reduced liability in a SPAC transaction is “overstated at best, and potentially seriously misleading at worst.” He continues “in some ways, liability risks for those involved are higher, not lower, than in conventional IPOs, due in particular to the potential conflicts of interest in the SPAC structure.”
In particular, any material misstatement in or omission from an effective Securities Act registration statement as part of a de-SPAC business combination is subject to Securities Act Section 11. Any material misstatement or omission in connection with a proxy solicitation is subject to liability under Exchange Act Section 14(a) and Rule 14a-9, under which courts and the SEC have generally applied a “negligence” standard. Any material misstatement or omission in connection with a tender offer is subject to liability under Exchange Act Section 14(e). De-SPAC transactions also may give rise to liability under state law. Delaware corporate law conventionally applies both a duty of candor and fiduciary duties more strictly in conflict of interest settings (see HERE for more on a board of directors responsibilities in a merger transaction).
Coates also attacks reliance on the PSLRA pointing out that it only protects against civil litigation, not SEC enforcement actions, provides no protection for knowingly false and misleading statements, and only applies to forward looking statements, not current information on valuation. As an example if a company has multiple sets of projections that are based on reasonable assumptions, Coates believes there could be liability if it only disclosed favorable projections and omitted disclosure of equally reliable but unfavorable projections.
He also questions the PSLRAs applicability in total to a de-SPAC transaction. The PSLRA specifically excludes statements made in connection with an offering of securities by a blank check company, a penny stock issuer, or in connection with an initial public offering (for more on the PSLRA and other protections that can be afforded forward looking statements, including common law protections, see HERE ). Although the terms “blank check company” and “penny stock issuer” (see HERE) are clearly defined in the federal securities laws, “initial public offering” is not nor is there any dicta or case law on point.
Perhaps foreshadowing a new SEC perspective (including by enforcement), Coates believes that a de-SPAC transaction could be considered an initial public offering. Although not a conventional IPO, a de-SPAC transaction is a method for a private company to go public and as part of that process the initial SPAC shareholders have a right to redeem or sell their shares. Moreover, generally new money is raised, and that new money may involve a registration. Coates notes that at the time of the passing of the PSLRA, a going public transaction generally only involved an IPO but today there are many options including direct listings and SPAC transactions.
Further “[T]he economic essence of an initial public offering is the introduction of a new company to the public.” Coates makes a good argument that the purpose of the disclosure laws in an IPO, and the added liability, should apply in a de-SPAC transaction as well. Coates view is that regardless of the structure, an IPO should encompass any transaction wherein the public first learns about a private company, including financial information, and that results in that private company being a public company. Coates calls on the SEC to clarify the applicability of the PSLRA in all forms of going public transactions either through rulemaking or guidance. He also suggests that the term “underwriter” may need to be revisited, hinting that a sponsor may be acting in such a role.
More on SPAC Structure
A special purpose acquisition company (SPAC) is a blank check company formed for the purpose of effecting a merger, share exchange, asset acquisition, or other business combination transaction with an unidentified target. Generally, SPACs are formed by sponsors who believe that their experience and reputation will facilitate a successful business combination and public company. SPACs are often sponsored by investment banks together with a leader in a particular industry (manufacturing, healthcare, consumer goods, etc.) with the specific intended purpose of effecting a transaction in that particular industry. However, a SPAC can be sponsored by an investment bank alone, or individuals without an intended industry focus.
SPACs follow substantially the same structure. A sponsor receives founder shares for a fixed price of $25,000, which founder shares will typically represent 20% of the total issued and outstanding capital stock immediately following the closing of the SPAC IPO. The sponsor must also invest enough capital to cover the IPO costs, ongoing SPAC upkeep legal and accounting fees, and costs associated with the de-SPAC transaction (locating and conducting due diligence on a target and transaction costs associated with the merger), which is generally approximately 5% of the total IPO amount. This amount is referred to as the sponsor PIPE, and the terms of the sponsor PIPE is more favorable than the IPO terms. The sponsor PIPE may involve a different class of stock, warrants or a combination of both.
The sponsor entity generally conducts its own private placement, within the sponsor entity, to raise the capital necessary to fund the sponsor PIPE. Generally, one or more of the sponsor investors will also commit to participate in a closing PIPE as part of the business combination, assuming they agree with the target choice and valuation. Sponsor capital is at risk – sponsors do not make money unless a successful business combination is completed, and the value of their ownership increases enough to justify the time and capital commitment of acting as a sponsor.
The common stock and warrant received by a sponsor are generally the same as those sold in the IPO with a few key differences. The sponsor common stock is not redeemable in a business combination transaction (i.e., it stays at risk) and agrees to vote in favor of any business combination approved by the board of directors. The sponsor common stock converts into regular common stock on a one-for-one basis upon completion of the business combination but is subject to a 12-month lock-up period thereafter (though the lock-up may be released upon achieving certain trading price milestones). Sponsor warrants usually are not callable and contain cashless exercise provisions.
A SPAC IPO is usually structured as one share of common stock and either a whole, half or quarter warrant for a unit price of $10.00. The unit may sometimes also contain an additional “right” (similar to a warrant). Whereas a warrant has an exercise price, a right is usually just exchanged for a new security. For example, a SPAC unit may include a right to receive 1/10th of a share of common stock upon completion of a business combination, and so holders of 10 rights could exchange those rights for a share of common stock. The exercise price for a warrant is almost always $11.50 with a call option by the company if the stock trades at $18.00 or higher for 20 out of 30 trading days. Warrants sometimes have a downward adjustment on exercise price for if the SPAC trades below $9.20.
A SPAC generally has 24 months to complete a business combination; however, it can get up to one extra year with shareholder approval. If a business combination is not completed within the set period of time, all money held in escrow goes back to the shareholders and the sponsors will lose their investment.
The value of the SPAC is negotiated by the sponsor, the target and any investors that are putting in new money at the closing (the closing PIPE) and as a result, the valuation of a target entity may be higher in a SPAC transaction. In a traditional IPO, neither the underwriter nor the IPO company rely on future growth projections and same are almost never included in a registration statement or as part of a road show. The reason is that the Securities Act imposes the stricter Section 11 liability standard on a company and its underwriters in an IPO process. Although a new Securities Act registration statement may be filed as part of the de-SPAC process, it is not a necessary component.
There is also a belief that the Private Securities Litigation Reform Act (PSLRA) provides coverage from liability based on forward looking statements. However, as discussed above, the coverage is not iron clad. Of course, as pointed out by John Coates, the general federal anti-fraud provisions still apply to all aspects of the transaction, including the proxy materials in connection with voting on the merger.
The SPAC IPO process is the same as any other IPO process. That is, the SPAC files a registration statement on Form S-1 that is subject to a comment, review, and amend process until the SEC clears comments and declares the registration statement effective. Concurrent with the S-1 process, the SPAC will apply for listing on a national exchange.
At the time of its IPO, the SPAC cannot have identified a business combination target; otherwise, it would have to provide disclosure regarding that target in its IPO Registration Statement. Moreover, most SPACs (or all) will qualify as an emerging growth company (EGC) and will be subject to the same limitations on communications as any other IPO for an EGC. See HERE related to testing the waters and public communications during the IPO process.
When trading commences, investors can trade out of their shares, choosing to attempt to make a short-term profit while the company is looking for a business opportunity. Likewise, buyers of SPAC shares in the secondary market are generally either planning to quickly trade in and out for a short-term profit or betting on the success of the eventual merged entity. If a deal is not closed within the required time period, holders of the outstanding shares at the time of liquidation receive a distribution of the IPO proceeds that have been held in escrow.
Upon entering into an agreement for a business combination, the SPAC will file an 8-K regarding same and then proceed with the process of getting shareholder approval for the transaction. The SPAC must offer each public shareholder the right to redeem their shares and request a vote on whether to approve the transaction. Shareholder approval is solicited in accordance with Section 14 of the Exchange Act, generally using a Schedule 14A, and must include delineated disclosure about the target company, including audited financial statements.
Upon approval of the business combination transaction, the funds in escrow will be released and used to satisfy any redemption requests and to pay for the costs of the transaction. Target companies generally require that a certain amount of cash remain after redemptions, as a precondition to a closing of the transaction, or as talked about above, that a simultaneous PIPE transaction provide the needed cash. The exchanges all require that the newly combined company satisfy their particular continued listing requirements.
In a series of blogs, I have been discussing the barrage of environmental, social and governance (ESG) related activity and focus by capital markets regulators and participants. Former SEC Chair Jay Clayton did not support overarching ESG disclosure requirements. However, new acting SEC Chair Allison Herron Lee has made a dramatic change in SEC policy, appointing a senior policy advisor for climate and ESG; the SEC Division of Corporation Finance (“Corp Fin”) announced it will scrutinize climate change disclosures; the SEC has formed an enforcement task force focused on climate and ESG issues; the Division of Examinations’ 2021 examination priorities included an introduction about how this year’s priorities have an “enhanced focus” on climate and ESG-related risks; almost every fund and major institutional investor has published statements on ESG initiatives; a Chief Sustainability Officer is a common c-suite position; independent auditors are being retained to attest on ESG disclosures; and enhanced ESG disclosure regulations are most assuredly forthcoming.
New Corp Fin Director John Coates is fully on-board, making speeches and otherwise being vocal in his support of ESG centered disclosures. On March 22, 2021, the SEC launched a new page on its website bringing together all things ESG including agency actions and the latest information on ESG investing.
Climate change initiatives and disclosures have been singled out in the ESG discussions and as a particular SEC focus, and as such was the topic of the first blog in this series (see HERE). The second blog talked more generally about ESG investing and ratings systems and discussed the role of a Chief Sustainability Officer (see HERE) and this third in the series is centered on ESG disclosures other than climate change.
Non-U.S. countries have also been beating the ESG drum with Europe requiring increased disclosures and the International Organization of Securities Commissions or “IOSCO,” without the participation of the SEC, issued a statement “setting out the importance of considering the inclusion of environmental, social, and governance matters when disclosing information material to investors’ decisions.” At the end of January 2021, 61 companies signed on to the World Economic Forum’s “Stakeholder Capitalism Metrics,” which is a set of ESG metrics and disclosures intended to serve as a “set of universal, comparable disclosures focused on people, planet, prosperity and governance that companies can report on, regardless of industry or region.” A summary of the metrics is below.
Current ESG Disclosure Requirements
Although there is not an ESG facing Regulation S-K item, the current disclosure obligations certainly encompass many ESG topics. For a discussion of the existing and proposed climate change disclosure obligations, see HERE. From a thirty-thousand-foot view, any information that is material to a company’s financial position, regardless of whether it can be labeled under an ESG category, is disclosable. Also, the Nasdaq stock market has published an ESG Reporting Guide, which is discussed below and has proposed a rule requiring listed companies to meet certain minimum board membership diversity targets (that rule proposal will be the subject of another blog).
Countless memorandums and publications have been written on ESG matters, including what in particular and how they should be reported (with countless differing opinions). The recent changes to Regulation S-K added the topic of human capital as a disclosure item including any human capital measures or objectives that management focuses on in managing the business, and the attraction, development and retention of personnel (such as in a gig economy) (see HERE).
Item 407 of Regulation S-K requires disclosure of “whether, and if so how, the nominating committee (or the board) considers diversity in identifying nominees for director” and “if the nominating committee (or board) has a policy with regard to the consideration of diversity in identifying director nominees, describe how the policy is implemented, as well as how the nominating committee (or the board) assess the effectiveness of its policy.”
Audit committees and auditors must also consider ESG. The Center for Audit Quality has published a roadmap for auditors and separate memo directed at audit committees to help them understand the role of auditors in connection with company-prepared ESG information. I’ll cover ESG audit committee and audit-related matters in a separate blog.
Current disclosure rules require a company to make disclosures as needed to prevent other disclosures from being materially misleading. As ESG rises in importance, and impacts financial statements, additional disclosures should naturally be considered by company management today.
Potential ESG Disclosures
On March 11, 2021, Acting Corp Fin Director John Coates issued a statement on ESG Disclosure clearly supporting additional disclosure requirements while at the same time acknowledging the complexity of a standardized system. To invoke more thought on the topic, Director Coates believes the SEC must consider: (i) what disclosures are useful; (ii) what is the right balance between principles and metrics (including mandatory vs. voluntary disclosure); (iii) standardization across industries; (iv) evolving standards; (v) verification of disclosures; (vi) global comparability; and (vi) alignment with current practices.
Of course, the costs of disclosure must be considered, but Coates puts more emphasis on the costs of not requiring ESG disclosure. There is currently a lack of consistent, comparable, and reliable ESG information available for investors. As I noted in the second blog in this series, companies face higher costs in responding to investor demand for ESG information because there is no consensus ESG disclosure system. A unified system would reduce the redundant requests for information from multiple sources.
Coates is a proponent of adding more provisions like certain board audit committee disclosures which allows a company to explain why they make certain decisions (if a company does not have an audit committee financial expert, it can explain why).
Coming in second place behind climate change, political spending disclosures are a favorite topic at the SEC. In her March 15 speech, which was mainly focused on climate change, Chair Allison Herron Lee stated, “[A]nother significant ESG issue that deserves attention is political spending disclosure.” And that “political spending disclosure is inextricably linked to ESG issues.” One example raised is a company that makes carbon neutral pledges or other climate change friendly disclosures but donates heavily to a politician that consistently votes against these initiatives. Commissioner Caroline A. Crenshaw has also been vocal in her support of political spending disclosures.
However, for now, any rule-making is on hold. Although both a recent House and Senate bill have been introduced that would require additional political spending disclosures, the Consolidated Appropriates Act of 2021, which has already been passed into law, currently restricts the SEC from finalizing a rule requiring company political spending disclosures.
Gary Gensler, who will likely take over as SEC Chair in April, expressed support for the SEC to consider company political spending disclosures while testifying at his senate confirmation hearing in early March. As an aside, Mr. Gensler is very knowledgeable about and supportive of cryptocurrencies. Many are hopeful he will implement the regulatory clarity the industry needs and wants, and in any event, should provide lots of blog material on that topic.
General Topics – World Economic Forum’s “Stakeholder Capitalism Metrics”
As mentioned above, the World Economic Forum has put together Stakeholder Capitalism Metrics. Although a complete summary of the publication is beyond the needed scope for this blog, the main topics include:
- Governing Purpose – a statement by companies as to how they propose solutions to economic, environment and social issues;
- Quality of governing body – qualifications, background and diversity information on board members and executives;
- Stakeholder engagement – what topics are engaged on and how were they decided;
- Ethical behavior – (a) anti-corruption – including training against and disclosure of incidences; and (b) ethics – including training and internal reporting mechanisms;
- Risk and opportunity oversight – risk disclosures and a mandate that opportunities and risks should integrate material economic, environmental and social issues, including climate change and data stewardship;
- Climate Change – including greenhouse gas emissions and implementation of the Task Force on Climate-related Financial Disclosures;
- Nature Loss – land use and ecological sensitivity;
- Freshwater availability – water consumption and withdrawal in water-stressed areas;
- Dignity and equality – including diversity and inclusion; pay equality; wage levels and risks for incidents of child, forced or compulsory labor;
- Health and well-being – work related injuries and fatalities;
- Skills for the future – training provided;
- Employment and wealth generations – absolute number and rate of employment; economic contribution; and financial investments;
- Innovation of better products and services – R&D spending; and
- Community and social vitality – total tax paid by category.
Many other articles and memos have been published recently containing similar lists of proposed and expected ESG reporting.
Nasdaq ESG Reporting Guide
Nasdaq has had a corporate sustainability program in place for six years and has a decidedly positive viewpoint on ESG, seeing these factors as beneficial to investors, “but also for public companies trying to increase operational efficiency, decrease resource dependency, and attract a new generation of empowered workers.” Nasdaq states, “[E]ffective management of sustainability issues helps Nasdaq (and our listed companies) better understand operational performance, address resource inefficiencies, and forecast enterprise risk. In addition, there is a growing body of academic and analytic evidence suggesting that ESG excellence correlates with other benefits, such as lower costs of capital, reduced shareholder turnover, and enhanced talent recruitment and retention. With a renewed market emphasis on long-term value creation, we also believe that ESG is an effective and mutually beneficial communication channel between public companies and the investment community.”
With that said, the Nasdaq ESG Reporting Guide is merely a recommendation for the record keeping and reporting of material information on ESG matters. In determining materiality, Nasdaq suggests that companies consider impacts to external stakeholders and ecosystems in addition to those directly affecting the company. Nasdaq does not impose financial or legal reporting requirements beyond those required by Regulations S-K and S-X. Many companies choose to report ESG matters in separate ESG reports made available to investors on their website, rather than in formal reports to the SEC.
The Nasdaq guide focuses on economic principles and specific data, rather than moral or ethical arguments. The ESG topics that Nasdaq address include:
- Environmental – (i) GHG Emissions (i.e., greenhouse gas emissions); (ii) emissions intensity; (iii) energy usage; (iv) energy intensity; (v) energy mix; (vi) water usage; (vii) environmental operations; (viii) climate oversight/board; (ix) climate oversight/management; and (x) climate risk mitigation.
- Social – (i) CEO pay ratio; (ii) gender pay ratio; (iii) employee turnover; (iv) gender diversity; (v) temporary worker ratio; (vi) non-discrimination; (vii) injury rate; (viii) global health and safety; (ix) child and forced labor; and (x) human rights.
- Corporate Governance – (i) board diversity; (ii) board independence; (iii) incentivized pay; (iv) collective bargaining; (v) supplier code of conduct; (vi) ethics and anti-corruption; (vii) data privacy; (viii) ESG reporting; (ix) disclosure practices; and (x) external assurance.
For each topic, Nasdaq provides an explanation as to why such a measurement is important and a formula for completing the measurement or setting a policy addressing the topic.
As I mentioned in the last blog in this series on ESG, back in September 2019, when I first wrote about environmental, social and governance (ESG) matters (see HERE), and through summer 2020 when the SEC led by Chair Jay Clayton was issuing warnings about making ESG metric induced investment decisions, I was certain ESG would remain outside the SEC’s regulatory focus.
Enter Chair Allison Herron Lee and in a slew of activity over the past few months, the SEC appointed a senior policy advisor for climate and ESG; the SEC Division of Corporation Finance (“Corp Fin”) announced it will scrutinize climate change disclosures; the SEC has formed an enforcement task force focused on climate and ESG issues; the Division of Examinations’ 2021 examination priorities included an introduction about how this year’s priorities have an “enhanced focus” on climate and ESG-related risks; almost every fund and major institutional investor has published statements on ESG initiatives; a Chief Sustainability Officer is a common c-suite position; independent auditors are being retained to attest on ESG disclosures; and enhanced ESG disclosure regulations are most assuredly in the works.
Investors are focused now more than ever on ESG matters. The world is experiencing an enormous intergenerational wealth transfer concurrently with the rise of Robinhood type trading platforms and digital asset acceptability that value ESG in making investment decisions. Heavyweight investors are also on board. In his annual letter to CEOs, Larry Fink, head of giant BlackRock, was very clear that he wants to see climate disclosure including a net zero plan and board responsibility for overseeing such a plan.
One thing has not changed and that is that the system of “rating” or “scoring” a company based on all things ESG is extremely over-inclusive and imprecise. The Aggregate Confusion Project from Massachusetts Institute of Technology (MIT) found that “It is very likely…. that the firm that is in the top 5% for one rating agency belongs in the bottom 20% for the other. This extraordinary discrepancy is making the evaluation of social and environmental impact impossible.”
In a series of blogs I am tackling the wide and popular current ESG conversation. In the first blog, I focused on climate change initiatives (see HERE). In this second blog I am discussing ESG investing, ratings and the role of a Chief Sustainability Officer, and the third blog will be on ESG disclosures in general.
Backing up – What is “Environmental, Social and Governance” or “ESG”
It is clear that ESG matters are an important factor for analysts and investors and thus for reporting companies to consider. It is also clear that companies have increasing pressure to report ESG matters and will be judged on those reports by different groups with different criteria in a current no-win environment (pun intended).
In the broadest sense, “Environmental, Social and Governance” or “ESG” refers to categories of factors and topics that may impact a company and that investors consider when making an investment and analysts and proxy advisors consider when making recommendations about investments or voting matters for corporate America. However, from a micro perspective, ESG means different things to different constituencies and has become a sort of catch-all phrase for a spectrum of topics ranging from very real and serious societal issues to the topic de jour touted by paid special interest groups and influence peddlers.
The G (governance) in ESG is a little more concrete, including, for example, whether there are different share classes with different voting rights, the ease of proxy access, or whether the CEO and Chairman of the Board roles are held by two people. The environmental category can include, for instance, water usage, carbon footprint, emissions, what industry the company is in, and the quantity of packing materials the company uses. The social category can include how well a company treats its workers, what a company’s diversity policy looks like, its customer privacy practices, whether there is community opposition to any of its operations, and whether the company sells guns or tobacco.
However, once a topic is fitted into a category, the measurement of that category and the meaning behind the information are much more nebulous. Furthermore, ESG topics are being heralded by non-shareholder stakeholders influencing investors. A number of self-identified ESG experts have developed and many groups produce ESG ratings. The ratings are not standardized, and as such the analysis can be arbitrary as it may treat similarly situated companies differently and may even treat the same company differently over time for no clear reason.
ESG Investing and Ratings
It is clear that ESG matters carry great weight with the investment community, especially powerful investors such as hedge funds, ESOPs, pension funds, family offices, unions, and private equity groups, and as such companies cannot ignore potential ratings and analyst coverage on these matters. Investors are pouring billions into asset managers who proclaim ESG who are in turn pumping out new ESG products (I can’t help but think about the mortgage bundling and complicated hedging products created around it right before the housing bubble in 2007-2008).
However, just like with ratings organizations, ESG fund managers and ESG products are not standardized in their meaning. As Commissioner Roisman said in a recent speech:
“When an asset manager markets a fund as having an ESG strategy, it has an obligation to disclose material information about that fund to investors and potential investors. Additionally, it would make sense to me that asset managers who want to use these terms to name their funds or advertise their products should be required to explain to investors what they mean. How do the terms “ESG,” “green,” and “sustainable” relate to a fund’s objectives, constraints, strategies, and the characteristics of its holdings? Are “E,” “S,” and “G” weighted the same when selecting portfolio companies? Does the fund intend to subordinate the goal of achieving economic returns to non-pecuniary goals, and if so, to what extent?”
Also, it would not make sense for ESG to mean the same thing for different funds. That is, one investor may be much more interested in investing in a fund that is concerned with renewable resources while another wants one focused on social issues such as diversity. I note that the same issue presents itself when talking about a standardized ESG disclosure regime, which I will talk further about in another blog in this series.
Irrespective of the difficulty in defining ESG, it is clear that index funds and long-term investors are interested in long-term value for their portfolios. In order to preserve long-term value, a fund or investor must have a diverse portfolio that mitigates systematic risk including climate change risk, financial stability risk and social stability risk. This long-term portfolio management means that not every investment will be a winner and not every investment will consider ESG, but a diverse portfolio definitely involves ESG considerations.
We also now have an ESG friendly administration, meaning that ESG issues could find more support by the SEC for inclusion in a company’s annual proxy statement. Shareholder proposals such as demands for reporting of greenhouse gas emissions, gender and race issues in the workforce and of course more on climate change, have historically been blocked as involving ordinary management decisions or micromanagement of the corporate structure. Under the new administration, these proposals may survive attack and appear on proxy statements for shareholder approval.
Likewise, the new administration is likely to support regulatory changes that will either directly or indirectly impact public companies. For example, near the end of the Trump administration the Department of Labor (DOL) passed rules that would prohibit ERISA fund managers from considering factors, that were not directly cost benefit based, such as ESG, in making voting and investment decisions for retirement funds. On March 10, 2021, the DOL announced that it will not enforce these new rules. Rather the DOL recognizes the use of ESG considerations in improving investment value and long-term investment returns for retirement investors and as such fiduciaries will not be prohibited from using these factors in any voting or investment decision analysis.
Who is a Chief Sustainability Officer
The time and expense of covering ESG ratings and attracting ESG investors is substantial. Enter a Chief Sustainability Officer (CSO). A CSO is now a common position in Fortune 500 companies and growing in all sectors. In addition to fielding the numerous ratings organizations and assisting management with messaging on ESG matters, a CSO is generally responsible for reviewing and helping to formulate ESG policies. These policies include both engaging in more socially responsible activities (investments in climate change initiatives) and reducing irresponsible activities (reducing pollution from corporate plants or changing materials to make products more sustainable). A CSO will also be integral in assisting with compliance with the existing and new climate and ESG disclosures in general.
Importantly, a CSO has the potential to reduce the impact of third-party ratings organizations. Until there are standardized rating systems in place, third-party ratings remain arbitrary and capricious. A CSO can work on data and analytics that are presented to rating organizations and analysts that reduce the information gaps and analyst irregularities. A CSO can also put programs and messaging in place for direct corporate engagement with the investment community related to ESG matters.
It is now commonplace for a company to issue sustainability reports and those reports, although not generally currently filed with the SEC, are made publicly available on a company’s website. A CSO should likewise be integral in the reports contents and importantly communicating its meaning to the board of directors.
Regardless of the noise surrounding ESG, there is no doubt that ESG is an important factor in Enterprise Risk Management (ERM) and must be understood and considered by a board of directors in its duties for ERM oversight. An effective CSO must be able to help the board unpack these issues as well.