SEC's Climate Risk Disclosure Proposal Likely To Face Legal Challenges

• Published date: 12 May 2022
• Subject Matter: Corporate/Commercial Law, Employment and HR, Environment, Corporate and Company Law, Corporate Governance, Health & Safety, Environmental Law, Securities, Climate Change
• Law Firm: Mayer Brown
• Author: Ms Jacqueline Vallette and Kathryne M. Gray

On March 21, 2022, the US Securities and Exchange Commission (SEC) voted 3:1 to propose new rules that, if adopted, would require public companies to, among other things, provide audited financial statements containing climate-related financial impact and expenditure metrics, report their greenhouse gas emissions, and disclose details of how climate change is affecting their businesses (the "Proposal"). Though some companies voluntarily report climate-related information, currently there are not any standardized requirements imposed by the SEC. In a statement of support, SEC Chair Gary Gensler said that the Proposal responds to demand from investors and companies given the increased push for information on the risks climate change-related events pose to businesses.

The Proposal signifies a substantial change to existing law and, if adopted, would have wide-ranging implications for companies' disclosure requirements and internal procedures. Given the significant additional expense the proposed rules would impose on public companies, the Proposal will likely face legal challenges. Dissenting and supporting statements from, and in response to, SEC commissioners have previewed the wide range of debate. SEC Commissioner Hester Peirce issued a lengthy dissenting statement sharply rebuking the Proposal, including on the basis that the SEC lacks authority to issue climate-related disclosure rules. As Commissioner Peirce described it, the Proposal "turns the disclosure regime on its head."

Summary of the Proposal

A summary of the Proposal's key disclosure requirements and resulting concerns is necessary for context before examining the potential legal challenges in detail. (A comprehensive description of the Proposal was previously discussed in the March 24 Mayer Brown Legal Update "SEC Proposes Climate Change Disclosure Rules Applicable to Public Companies.") At a high level, the approximately 500-page Proposal would require a public company to disclose the following information in registration statements and periodic reports:

• Climate-related risks and their actual or likely material impacts on the company's business, strategy, and outlook, as well as on the company's business and consolidated financial statements, which may manifest over the short-, medium-, or long-term;
• The company's governance of climate-related risks including its processes for identifying, assessing, and managing climate-related risks and whether any such processes are integrated into the company's overall risk management system or processes;
• Certain climate-related financial statement metrics and related disclosures in a note to audited financial statements;
• Information about climate-related targets and goals, and a transition plan, if any; and
• Direct and indirect greenhouse gas (GHG) emissions, which, for accelerated and large accelerated filers and with respect to certain emissions, would require third-party attestation reports ¹

Publicly Expressed Concerns with the Proposal

While the entirety of the Proposal faces criticism, there are two specific aspects of it that some have strongly opposed: (1) the Scope 3 emissions disclosure requirement and (2) the SEC's elimination or recasting of the materiality qualifier in certain areas of the Proposal.

The Proposal requires the disclosure of three "Scopes" of emissions: (1) "Scope 1" emissions occur from sources directly owned or controlled by the company; (2) "Scope 2" or "indirect" emissions derive from the activities of another party, such as the generation of electricity purchased and consumed by the company; and (3) "Scope 3" emissions are all other indirect emissions generated from sources that are neither owned nor controlled by the company, including emissions occurring from upstream and downstream activities and goods. Compliance with disclosure requirements of Scope 3 emissions may be difficult and could impose considerable costs on issuers. The resources required to collect, quantify, and ensure the accuracy of Scope 3 data may be significant, not just in terms of the volume of required information but also because of the liability risk that companies face for inaccuracies in their disclosures. Indeed, the liability risk could be particularly elevated for Scope 3 emissions disclosures, which must rely on data generated from sources that are neither owned nor controlled by the reporting company. For instance, a company may have to disclose upstream emissions from purchased goods, capital goods, fuel and energy-related activities, transportation and distribution, waste generated in operations, and even business travel, employee commuting, and leased assets. Downstream emissions subject to disclosure could include processing of sold products, end-of-life treatment of sold products, leased assets and franchises, and transportation and distribution activities.

With respect to materiality, certain of the Proposal's disclosure requirements would dispense with materiality entirely (such as disclosure of Scope 1 and Scope 2 emissions). In other areas, it could be difficult to discern material from immaterial environmental impacts. Materiality has been the long-standing standard used to determine whether an investor is entitled to company information. ² Disclosure is required when information is material, meaning there is a substantial likelihood that a reasonable investor would consider it important in deciding how to vote or make an investment decision. While issuers have generally been tasked with assessing their own disclosure obligations, including what information is material, courts have typically appealed to common sense: investors should get information that is important to consider in their investment decisions. Given that approach, many are left wondering why companies should be required to disclose nonmaterial information, which by definition is not important to investors, and relatedly why the SEC feels the need to mandate disclosure of such information to protect investors. The skepticism extends even further when you consider "the clear link between materiality of information and its relevance to the financial return of an investment" ³

Trade groups and organizations, state attorneys general, US senators, and other officials have already voiced opposition to mandatory reporting of Scope 3 emissions and its relationship to the materiality standard. For example, the Proposal's materiality qualifier for Scope 3 disclosures has been criticized as presuming materiality determinations that should be made by the reporting company in the first instance, imposing significant deterrents to omitting Scope 3 data, and presenting obscure quantitative and qualitative metrics at which emissions may be material. ⁴ Sixteen state attorneys general dispute the SEC's authority to require disclosures that are not financially material, arguing that existing SEC rules prohibiting misrepresentation of material information is "not a freestanding source of authority for the Commission to require climate change disclosures-at least without a showing that they are needed to prevent misleading or fraudulent representations." ⁵ These objections will likely be incorporated into formal comments on the Proposal during the rulemaking process.

Opposition to the Proposal has been swift and strong. ⁶ If the Proposal is adopted as a final rule in its current or a substantially similar form, affected companies, trade associations, or state officials are likely to challenge the new disclosure rules. There are at least four potential bases on which legal challenges could be made: (1) the SEC lacks statutory authority to adopt mandatory disclosure rules on climate change because such rules are outside the subject matters and purpose prescribed by Congress; (2) the new rules involve major questions of climate change policy that...