Financial Reporting and Regulatory Update

Second Quarter 2021

From the SEC

Environmental, social, and governance (ESG) focus

Risk alert on ESG investing

The SEC Division of Examinations released, on April 9, 2021, a risk alert, “The Division of Examinations’ Review of ESG Investing,” detailing observations from recent exams of investment advisers, registered investment companies, and private funds offering ESG products and services. The alert is intended to highlight risk areas and assist firms in developing and enhancing their compliance practices. The alert notes that entities approach ESG investing in various ways. It details observations of deficiencies and internal control weaknesses related to ESG investing from the examinations and provides observations of effective practices. The alert also says that firms should present disclosures that are clear, precise, and tailored to firms’ specific approaches to ESG investing and that align with the firms’ actual practices.

Statement on ESG risk alert

SEC Commissioner Hester M. Peirce issued, on April 12, 2021, a statement following the release of the staff ESG risk alert on April 9. Peirce says, “Firms claiming to be conducting ESG investing need to explain to investors what they mean by ESG and they need to do what they say they are doing.” She says that the risk alert requires some context and should not be interpreted as a sign that ESG investment strategies are a unique consideration for examiners. As with any other investment strategy, the SEC examiners will be looking for consistency between claims and practices, not assessing whether a firm’s strategy is a good one and not attempting to insert the SEC’s own views in the investment advisory process.

In addition, Peirce notes that the risk alert should be considered with the SEC’s two recent proxy voting interpretive releases, and she clarifies that firms do not need a special set of policies and procedures for ESG or for any investment strategy. Firms’ policies and procedures should be designed around the investment strategies the firm uses, and the risk alert does not create new obligations for registrants. Peirce says that the staff’s role is to understand whether firms are adhering to their own ESG claims.

Peirce concludes that while the risk alert raises questions, she hopes that it will be a useful tool for sellers of ESG products and services and that it will help protect buyers.

Remarks on ESG reporting

On April 28, 2021, SEC Commissioner Peirce provided remarks before the International Swaps and Derivatives Association Derivatives Trading Forum on Regulatory Change. Peirce spoke about the enhanced focus on ESG reporting among other topics.

Peirce warned the audience that it must learn from the London Interbank Offered Rate (LIBOR) situation before rushing into the ESG space. She said that LIBOR lacked precision and that many are diving right into adopting ESG measures that portray an impression of precision but may not be as precise with such varying approaches. She noted that it is very difficult to measure how green a particular investment, issuer, or transaction is, and numerous factors need to be considered when making capital decisions. She further stressed caution and the need to proceed with care as ESG strategies are implemented, as there is a responsibility to shareholders and customers not to embrace approaches that will harm the capital markets, the financial system, or the planet.

Testimony on ESG guidance

While testifying on market volatility before the House Committee on Financial Services on May 6, 2021, SEC Chair Gary Gensler was questioned about the increased focus on climate-related disclosures and updates to climate disclosure guidance. In response, Gensler said that the staff has been asked to prepare recommendations based on public input about what climate-related disclosures and climate risk areas are important to investors to help bring consistency and comparability to such disclosures.

Determinations about guidance will be made through those recommendations; economic analysis; information gathered by the ESG task force; and other critical input from the public, including responses to the request for public comment on climate change disclosures issued by former acting Chair Allison Herren Lee. Comments on that request were due in June 2021. Based on analysis of the information gathered, the SEC will prepare a proposal for public comment.

ESG disclosure materiality misconceptions

On May 24, 2021, SEC Commissioner Lee presented keynote remarks at the 2021 ESG Disclosure Priorities Event hosted by the American Institute of CPAs, the Chartered Institute of Management Accountants, the Sustainability Accounting Standards Board, and the Center for Audit Quality. Her remarks concentrated on the misconceptions about materiality specifically related to ESG and required disclosures.

She explained that materiality is a fundamental proposition in the securities laws and in the capital markets and disclosure is focused on providing information that is important to reasonable investors. Lee identified four misconceptions about materiality specifically related to ESG:

  • “Myth #1: ESG matters (indeed all matters) material to investors are already required to be disclosed under the securities ” Lee said that without a specific requirement to disclose, the existence of material or important information by itself does not mandate its disclosure. She also noted that current securities laws do not include much regarding specific ESG disclosure requirements.
  • “Myth #2: Where there is a duty to disclose climate and ESG matters, we can rest assured that such disclosures are being made.” To this point, Lee shared that determinations about what is material are judgment calls that might differ for all parties involved and disclosures might not include all information considered material to reasonable investors.
  • “Myth #3: SEC disclosure requirements must be strictly limited to material information.” According to Lee, this is not what the law requires and not how the SEC approaches rules about disclosures.
  • “Myth #4: Climate and ESG are matters of social or ‘political’ concern, and not material to investment or voting decisions.” Lee pointed out that the SEC is seeing increased interest from market participants in ESG factors as significant drivers of decision-making, risk assessment, and capital allocation.

Lee closed with a warning not to believe these misconceptions. She shared her hope that the misconceptions can be overcome as the deliberations continue on how best to craft a rule proposal on climate and ESG risks and opportunities.

Potential costs of ESG disclosures

On June 3, 2021, before the Environmental, Social, and Governance Board Forum, SEC Commissioner Elad L. Roisman spoke on ESG disclosures and the potential costs of requiring specific disclosures. He shared reservations regarding the SEC issuing ESG disclosure requirements because it would be difficult to standardize such requirements to provide meaningful and not misleading information. He then raised several questions that the SEC would need to address when crafting new rules over ESG disclosures and ways to mitigate costs and difficulties of new requirements.

Roisman first identified the importance of minimizing costs and burdens related to understanding what investors want. He warned of the foreseeable costs not only of obtaining and presenting new information but also of increased liability related to such new disclosures. Roisman stated that if the costs are foreseeable, they can be addressed beforehand as the new rules are developed.

Roisman then offered ways to tailor ESG disclosure requirements, including:

  • Scaling the disclosures for public issuers based on size
  • Providing flexibility in sources and methodologies
  • Considering safe harbors for companies that are making an earnest effort to provide this new information
  • Considering having the disclosure information furnished to instead of filed with the SEC
  • Extending the implementation period and having a phased-in approach

In closing, Roisman said, “any new ESG disclosure rules will inevitably come with costs. Especially since such disclosure would involve information that is based on uncertain underlying assumptions, or is difficult to calculate, the Commission should be particularly careful to ensure that (1) investors understand the limitations of the information disclosed and (2) companies can actually provide such information without incurring undue costs and burdens.”

Climate and ESG resource page

The SEC has created a new page addressing the SEC’s response to climate and ESG risks and opportunities. The page brings together all of the recent climate- and ESG- related actions in one location.

Public statements and announcements

Executive trading plans

On June 7, 2021, SEC Chair Gensler announced he had directed the staff to recommend changes to Exchange Act 10b5-1, which provides affirmative defenses for corporate insiders and companies themselves to buy and sell stock when trading plans are adopted in good faith (that is, before insiders or the company become aware of material nonpublic information).

Remarks on LIBOR

SEC Chair Gensler discussed LIBOR transition in his June 11, 2021, remarks to the Financial Stability Oversight Council (FSOC). He encouraged the FSOC to consider his concerns regarding the robustness of the Bloomberg Short-Term Bank Yield Index (BSBY), which is a rate that “a number of commercial banks are advocating as a replacement for LIBOR.” He remarked that he believes BSBY has many of the same flaws as LIBOR and cautioned against the pitfalls of allowing BSBY as a replacement rate. As an alternative, Gensler supports as a preferable alternative to LIBOR the Secured Overnight Financing Rate (SOFR), which is based on a nearly trillion-dollar market.

Remarks on regulatory change and LIBOR

On April 28, 2021, SEC Commissioner Peirce provided remarks before the International Swaps and Derivatives Association Derivatives Trading Forum on Regulatory Change. Among other topics, Peirce spoke about upcoming changes related to the discontinued use of the LIBOR.

Peirce shared her thoughts on the importance of embracing changes and warns of consequences of not addressing changes. As LIBOR is set to be discontinued, Peirce, referencing others’ statements, warns that LIBOR discontinuation “could have a significant impact on the municipal securities market and may present a material risk for many issuers of municipal securities and other obligated persons.” She said that trillions of dollars of contracts still reference LIBOR, that many of these contracts lack fallback language, and that changing to alternative reference rates creates a diverse mix of significant challenges. She noted that the SEC is continuing to closely follow developments in this area and is working with other regulators and entities to help ensure steps are being taken to address this challenge. She mentioned the SEC risk alert covering LIBOR transition readiness and the work that the SEC, in conjunction with other regulators, has been doing to address the transition from LIBOR. Peirce also discussed proposed legislation that would insert a fallback into contracts that do not include one, and the concern that such legislation would override private contracts.

Special purpose acquisition companies

On April 8, 2021, acting Director of the Division of Corporation Finance (Corp Fin) John Coates released a statement discussing special purpose acquisition companies (SPACs), initial public offerings (IPOs), and liability risk under the securities laws. According to the statement, over the past six months, a significant increase in the use and popularity of SPACs has raised concerns and has increased the scrutiny of these transactions as they continue to evolve.

Coates says that SEC staff members are looking carefully at SPAC filings and disclosures and their private targets and are providing guidance so that the public can make informed investment and voting decisions about these transactions. The statement also describes basics of a typical SPAC and notes some of the complexities of the transactions. SPACs might offer private companies an alternative pathway to go public and obtain a stock exchange listing, a broader shareholder base, status as a public company with securities registered under the Exchange Act, and a liquid market for its shares, and this raises questions regarding securities law liability exposure, investor protections, and other filing requirements.

In his statement, Coates says that those involved in promoting, advising, processing, and investing in SPACs should understand the limits on any alleged liability difference between SPACs and conventional IPOs. He adds that providing greater clarity on the scope of the safe harbor in the Private Securities Litigation Reform Act (PSLRA) might offer advantages.

Coates’ statement follows the release of a March 31, 2021, staff statement on SPACs. That statement addresses certain accounting, financial reporting, and governance issues that should be carefully considered before a private operating company undertakes a business combination with a SPAC.

On March 31, 2021, acting Chief Accountant Paul Munter also issued a statement, which outlines considerations relating to markets and timing, financial reporting, internal controls, corporate governance, and audit committees. Munter’s statement provides auditing considerations, including independence issues relating to de-SPAC mergers (that is, the combination of the SPAC with the target operating company).

On April 12, 2021, Coates and Munter issued a statement on accounting and reporting considerations for warrants issued by SPACs. The statement provides that certain warrants issued by a SPAC should be classified as liabilities rather than equity and, therefore, these warrants would need to be measured at fair value, with the changes in fair value included in net income. As this treatment may require some SPACs to change their classification of certain warrants, companies and their auditors should consider whether financial statements previously filed contain a material error that would require restatement.

Rules and guidance

Conducting shareholder meetings

The SEC has updated sections of its staff guidance for conducting shareholder meetings in light of disruptions caused by the COVID-19 pandemic. The April 7, 2021, update addresses changes to the date, time, or location of a shareholder meeting and delays in printing and mailing of full set of proxy materials. The April 9, 2021, update deals with presentation of shareholder proposals in person.

Universal proxy rule

The SEC, on April 16, 2021, reopened the comment period for the proposed universal proxy rule that was originally published in the Federal Register on Nov. 10, 2016. The proposal would require the use of universal proxy cards in all nonexempt solicitations in connection with contested elections of directors. The proposed rules create new procedures for the solicitation of proxies and address other improvements to the proxy voting process. The comment period was reopened as there have been significant developments in proxy contests, corporate governance over funds, and shareholder activism since 2016.

Comments were due June 7, 2021.

Proxy voting rules

SEC Chair Gensler, on June 1, 2021, issued a directive to SEC staff to consider whether to recommend further regulatory action specifically related to the September 2019 interpretation and guidance addressing the application of the proxy rules to proxy voting advice businesses and the July 2020 amendments to Rules 14a-1(l), 14a-2(b), and 14a-9 concerning proxy voting advice. He also asked staff to consider whether to recommend that the SEC revisit its 2020 codification of the definition of solicitation as encompassing proxy voting advice, the 2019 interpretation and guidance regarding that definition, and the conditions on exemptions from the information and filing requirements in the 2020 rule amendments.

Responding to Gensler’s directive, Corp Fin staff announced that it will not recommend enforcement action to the SEC based on the 2019 interpretation and guidance or the 2020 rule amendments during the period in which the SEC is considering further regulatory action in this area. Also, if regulatory action leaves the 2020 exemption conditions in place with the current compliance date of Dec. 1, 2021, the staff will not recommend any enforcement action based on those conditions for a reasonable period of time.

In response to the directive from Gensler and the Corp Fin announcement, SEC commissioners Roisman and Peirce noted that they are open to seeing what, if any, rule changes the staff recommends. However, they said they find it difficult to imagine what has changed since the amendments were issued in July 2020, especially considering that the compliance date has not yet occurred. They stated that the amendments that were adopted already reflected a long analysis process that considered a broad range of input. They also shared that they hope that any actions would not “deprive users of proxy voting advice of information they need to properly consider such advice or lead them to make decisions based on misinformation.”

Regulatory agenda

On June 11, 2021, the SEC announced updates to its regulatory agenda, which lists short- and long-term regulatory actions the SEC plans to take. They include:

  • Disclosure relating to climate risk; human capital, including workforce diversity and corporate board diversity; and cybersecurity risk
  • Market structure modernization within equity markets, treasury markets, and other fixed-income markets
  • Transparency around stock buybacks, short sale disclosure, securities-based swaps ownership, and the stock loan market
  • Investment fund rules, including money market funds, private funds, and ESG funds
  • 10b5-1 affirmative defense provisions
  • Unfinished work directed by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, including, among other things, securities-based swaps and related rules, incentive-based compensation arrangements, and conflicts of interest in securitizations
  • Enhancement of shareholder democracy
  • Special purpose acquisition companies
  • Mandated electronic filings and transfer agents

The SEC’s current agenda is maintained by the Office of Management and Budget. Commissioners Roisman and Peirce provided perspectives on certain aspects of Chair Gensler’s regulatory agenda on June 14, 2021.

Staffing updates

On June 14, 2021, the SEC announced that Renee Jones has been appointed director of the Division of Corporation Finance. John Coates, Corp Fin’s current acting director, has been named SEC general counsel. Both appointments were effective June 21, 2021. Jones most recently taught courses on various aspects of corporate and securities law and governance while serving as professor of law and associate dean for academic affairs at Boston College Law School. Previously, she practiced at Hill & Barlow law firm. Coates has served as the Corp Fin’s acting director since February 2021.

On May 3, 2021, the SEC announced that Jessica Wachter has been named chief economist and director of the Division of Economic and Risk Analysis (DERA). She has been a professor at the Wharton School at the University of Pennsylvania since 2003 and is a leading academic researcher on financial markets. DERA is involved in a wide range of SEC activities, including policymaking, rulemaking, enforcement, and examination, and the division assists in identifying, analyzing, and responding to economic and market issues. DERA also provides subject-matter expertise and cost- benefit economic analysis for rule proposals and final rules.

The Senate confirmed Gary Gensler as chair of the SEC on April 14, 2021, and he was sworn in on April 17. His nomination by President Joe Biden was approved on March 10 by a vote of 14-10 by the Senate Committee on Banking, Housing, and Urban Affairs, to fill both the remaining term of retired Chair Jay Clayton and for a full term ending on June 5, 2026.