Hot topic: SEC climate disclosure rule divides industry

In the corridors of the Capitol, where lawmakers and lobbyists are haggling over a new rule for climate change disclosures, the temperature is rising.

A contentious proposal from the US Securities and Exchange Commission has divided the financial industry. Lawyers predict the rulemaking will face legal challenge all the way up to the Supreme Court.

At stake is the availability of key information on public companies, that could inform investor decisions on trillions of dollars of listed equities, bonds and other securities.

The SEC’s climate-related disclosure rule would require large public companies to publish information on climate risks and greenhouse gas emissions. The rule was first put forward in March 2022 but has faced numerous delays, pushing its finalization target-date to this spring. The subcommittee on oversight has been investigating the proposal for over a year.

Central to the debate is an exemption from the First Amendment to the US Constitution available to government agencies such as the SEC. The exemption allows the SEC to force companies to disclose financial information that is “factual and uncontroversial”. Normally, the First Amendment prohibits legally compelled speech.

Some experts believe the SEC’s proposed climate disclosures are neither factual nor uncontroversial. Should the climate rule face litigation on this First Amendment basis, failure to qualify for the exemption would torpedo the rulemaking, experts believe. “The SEC faces an uphill battle,” says a senior securities lawyer.

Compelled speech classed as “controversial” faces heightened judicial scrutiny. It is nearly impossible to provide the legal justifications to survive strict scrutiny, say legal experts.

“In my opinion, and the opinion of others, the SEC wouldn’t be able to survive that level of scrutiny,” says Sean Griffith, professor of business law at Fordham University.

Opponents of the proposal also argue the SEC lacks the authority for its rulemaking and view it as an administrative agency’s attempt to enact policy—a role they say is reserved for Congress.

Those more optimistic about the rule’s prospects say the SEC is squarely within its statutory mandate of authority. They view the proposed disclosures in line with other factual disclosures meant to serve investor protection and dismiss claims that they are “controversial”.

We’ve been here before

Similar legal battles have played out before, most notably in a 2014 lawsuit of the SEC’s conflict minerals rule, which requires companies to state whether their products contain minerals from conflict zones.

Though the SEC was following an explicit mandate by Congress which granted it unambiguous authority to issue the rule—unlike the current proposal—the rule was subject to intermediate judicial scrutiny. The DC Circuit Court of Appeals found the disclosures of the rule violated the First Amendment.

“The line of reasoning in the conflict minerals case is certainly apt in understanding how to think about these climate rules,” says Griffith.

The plaintiffs in the case argued that the disclosures would have required companies to take a position on a controversial matter.

And other cases are taking place now across the US, brought from both sides of the political spectrum.

Notably, last month, several industry groups sued the state of California for its climate-risk reporting law on the basis that it violated the First Amendment by compelling speech with its emissions disclosure requirements.

The SEC proposals “will certainly test out some of the First Amendment arguments”, says Lawrence Cunningham, a special counsel at Mayer Brown and emeritus professor at the George Washington University. “The SEC is limited by Congress and by statute in the scope of its mission. The state of California isn’t.”

Last year, the US trade body representing banks and brokers, Sifma, sued Missouri’s secretary of state for his disclosure rule that would require broker-dealers and investment advisers that offer ESG strategies or “investment strategies that propagate values-based agendas” to tell their clients they are not purely focused on generating profits for them—for violating the First Amendment protection against compelled speech.

These two cases show how groups can use free-speech principles to argue from opposing sides of the climate debate.

“What’s good for the goose is good for the gander,” says Nick Morgan, president of the Investor Choice Advocates Network.

What is controversial?

Compelled commercial disclosures that are purely factual and uncontroversial are more insulated from First Amendment challenges. So long as the disclosures reasonably serve investor or consumer protection and are factual and uncontroversial, courts will tend to apply a legal framework that favors the government agencies’ authority in the matter. But the definition of “controversial” is often the critical factor.

“What do we mean by controversy—that’s a hard question that at some point, some court will have to answer,” says Griffith. “Until we get a very clear pronouncement, what we have to do is connect the dots.”

In defining uncontroversial, US courts have shown an increased appetite to treat the “political” as part of the controversy. And given the polarization of US political debate on climate change, a designation as uncontroversial is less likely.

A recent Supreme Court case that dealt with a California law mandating pro-life pregnancy centers to notify clients about birth control and abortion options was shot down on First Amendment issues, illustrating the courts’ view that certain polarizing topics are inherently controversial.

What’s factual turns out to be tricky to pin down too. The SEC proposals would require companies to disclose Scope 1, 2 and 3 greenhouse gas emissions. Scope 1 is direct emissions; Scope 2 is indirect emissions produced on a firm’s behalf; Scope 3 is indirect emissions produced through its value chain.

Scope 3 emissions are the most contentious, mainly because of the difficulty that companies would face in gathering supply chain data. In turn, this could lead to accusations that the information is an estimate and thus not factual.

“Even counting up the emissions is an opinion,” says Cunningham. “You might be able to do an okay job with your own emissions, but you have to try to count the emissions of the supply chain and then of your customer value chain. A lot of those measurements are really estimates.”

More broadly, climate-related risk is an imprecise science. Establishing cause and effect can be open to interpretation. “The exact relationship between emissions, climate change and certain weather events or other damages that a business might face are all contestable,” says Cunningham.

Nothing but facts

Some legal experts reject the notion that the rule asks companies to disclose information beyond neutral facts about the business.

“The proposed rule does not call for opinion or “controversial” speech of the kind that raises First Amendment concerns. It specifies disclosure of facts, in neutral language,” writes John Coates, professor of law and economics at Harvard Law School, in a post on corporate governance.

Proponents of the rule argue that emissions data is widely used as a measure of transition risk and thus material to investor protection.

“Read fairly and dispassionately—non-politically, one might say—disclosures specified by the rule are not about environmental impact, or climate change, but about financial risks and opportunities related to climate change,” writes Coates.

Other lawyers believe that, in adjudicating on any challenge to the SEC’s proposals, a court would need to apply a consistent legal standard to determine what is controversial.

“It’s true that in the United States right now, we characterize almost anything as controversial and political. But I don’t think that because some people think an issue is controversial, somehow that sets a different regulatory standard,” says Jill Fisch, professor of business law at University of Pennsylvania Law School, and one of 30 law professors co-signing a comment letter supporting the view that the proposal is within the SEC’s rule-making authority.

Power trip

The new rule also plugs into a debate about the level of power that government agencies such as the SEC wield. Skeptics say the SEC lacks the authority to do what it is trying absent a bill from Congress on company climate-disclosures.

The Securities Exchange Act of 1934 requires US public companies to disclose financial information for investors. This includes details on performance, funding, risk exposures and other metrics: essentially, information relevant to the economic and business health of a company. Critics of the SEC proposals are asking whether information about the environmental impact of a company falls into this category.

“The arguments are that investors would want to know if a company will be sustainable over the long term and that’s an economic decision. Now, that’s interesting, but that’s really pushed it way beyond where the 34 Act really started,” says Charles Elson, retired professor of finance from the University of Delaware, and one of 22 legal experts co-signing a comment letter to the SEC critiquing the proposal as legally misguided.

"Some institutions have social goals in addition to their economic goals, but that doesn’t represent the vast majority of investors,” he adds.

What’s happening is the executive branch is trying to push something through the rulemaking process that the legislative branch has not been able to get through Congress

Lawrence Cunningham, Mayer Brown

The Supreme Court, meanwhile, has begun to scrutinise agency reach. “The kind of question of how administrative agencies relate to the constitutional branches of government is a central preoccupation of the US Supreme Court. That’s an area where things are changing and where there’s a reconsideration of what the law is,” Griffith says.

Fisch adds: “Certainly, at the Supreme Court and in the 5th Circuit we see a lot of skepticism of administrative agencies and agency power. The SEC is not the main target, but they really could be caught up in that.”

The debate is also shaped by a key additional layer—the major questions doctrine, a newer principle of statutory interpretation gaining traction in the Supreme Court, which is the idea that administrative agencies cannot enact major policy without direct congressional approval.

Legal experts have cited a recent case as evidence of the Supreme Court’s shift in thinking. In the case, 19 US states and a number of energy companies challenged the Environmental Protection Agency over its clean air rules. The court found that the EPA lacks authority to regulate climate-change related emissions. “You could easily see that kind of reasoning apply here,” says Griffith.

If courts decide that mandatory disclosures may violate the First Amendment, they will presume the SEC’s rule is invalid unless the commission can explain how the measure advances a compelling governmental interest and why there was no less-restrictive way to achieve this interest.

Griffith thinks the SEC could say its aim was to prevent the negative consequences of climate change. It would then have to prove, though, that this interest plausibly extended to investor protection, and then establish the relationship between corporate disclosure regulations and climate change.

Jumping through these hoops of strict scrutiny can be deadly. “Strict in theory, fatal in fact,” says Griffith, quoting a famous epithet of American constitutional law.

From here, compromise outcomes are possible, the experts say. “The SEC could require a company to disclose emissions that hurt or affect the company itself, but not how much the company is emitting or pollution it is causing,” says Cunningham.

Though from a practical and political matter it is uncertain whether such a washed-out rule would hit its mark.

Overall, experts believe the proposal speaks to a wider issue in which agencies are used as a tool to force through political policies. Or, as Elson describes, “It’s basically pushing a political doctrine through the backdoor of the SEC.”

Cunningham agrees: “What’s happening is the executive branch is trying to push something through the rulemaking process that the legislative branch has not been able to get through Congress.”

“It’s a classic. This is what happens in American politics.”

Editing by Alex Krohn