April 4, 2024

Commissioner Uyeda warns: the SEC “has gone astray”

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Cooley LLP

In remarks at PLI’s SEC Speaks, SEC Commissioner Mark Uyeda expressed his concern that the SEC “has gone astray”: instead of focusing on “its narrow mission,” Uyeda fears, the SEC is acceding to the pressure of political activists who “seek to transform the agency’s authority to achieve policy objectives that are outside of its statutory mandate.” To illustrate, Uyeda highlights two examples: the climate disclosure rules, just adopted by the SEC, and the conflict minerals rules, which were adopted by the SEC over a decade ago and are here presented as a cautionary tale. While the conflict minerals rules were actually mandated by Congress, the climate disclosure rules are something different: the SEC has “acted on its own volition,” Uyeda contends, in adopting “a climate disclosure rule that seeks to exert societal pressure on companies to change their behavior. It is the Commission that determined to delve into matters beyond its jurisdiction and expertise.” To Uyeda, “this action deviates from the Commission’s mission and contravenes established law.”

In Uyeda’s view, the SEC’s climate disclosure rules are “designed to alter the behavior of public companies in a manner that serves political interests that have otherwise failed to achieve such change through the legislative process.” What is the problem with these rules? According to Uyeda, the climate disclosure rules mandate disclosures that are “not financially material to investors,” and thus are not within the remit of the SEC: “[a]bsent financial materiality,” he contends, the SEC “lacks the authority to broadly regulate the operating activities of public companies under the pretext of disclosure requirements.” Rather, these national economic or political policy issues are a job for Congress.

In the adopting release, Uyeda argues, the SEC is simply “mask[ing] the climate rule’s intent with superficial references to financial materiality, suggesting that nothing in the climate rule is inconsistent with historical disclosure practice.” Contrary to those who argue that SEC authority is not limited to materiality and that mandated disclosures can be for the benefit of a variety of stakeholders, Uyeda maintains that “public company disclosures are intended for investors, and those disclosures should be material to those investors.” Although a materiality requirement is “not explicitly address[ed]” in the statutes, nevertheless, “materiality is an important principle” under the laws and precedents.

SideBar

Although they’re a few years old, these remarks by former SEC Commissioner Allison Herren Lee, “Myths and Misconceptions about ‘Materiality,’” are certainly relevant here. In the context of the discussion about, at that time, potential mandatory ESG disclosures, Lee observed that there has been a lot of attention to the concept of materiality, which is fundamental to our securities laws. The public company disclosure system “is generally oriented around providing information that is important to reasonable investors,” and “the viewpoint of the reasonable investor is the lens through which we all are meant to operate.” Since investors are the ones who make the investment choices, “investors are also the ones who decide what information they need to make those choices.” Nevertheless, she maintained, a number of myths have proliferated about the role and meaning of materiality. She analyzed four of them.

One myth that she identified was the myth, in her view, that SEC disclosure requirements must be strictly limited to material information. In her view, however, “this is affirmatively not what the law requires, and thus not how the SEC has in fact approached disclosure rulemaking.” Rather, the SEC has broad statutory rulemaking authority that is not qualified by “materiality.” Where materiality does come up is in connection with the anti-fraud rules, “such as Rules 10b-5 and 14a-9, where it plays a role in limiting how much information must be provided. In other words, materiality places limits on anti-fraud liability; it is not a legal limitation on disclosure rulemaking by the SEC.” Historically, she observes, Reg S-K has always required disclosure that is “important to investors but may or may not be material in every respect to every company making the disclosure. We have done this, for example, with respect to disclosures of related party transactions, environmental proceedings, share repurchases, and executive compensation.” For example, the requirement to disclose environmental proceedings has a bright-line threshold of $1 million—and, until recently, it was $100,000—without regard to materiality. Similarly, the prescriptive requirements for executive comp, such as the comp tables, include a number of metrics that may not be material to all companies, but are still required to be disclosed. And without these types of broadly applicable requirements, “comparability would be sacrificed almost completely. Indeed such an approach would be at odds with modern capital markets which have become increasingly comparative in nature thus requiring at least some specific metrics in order to make appropriate comparisons. The idea that the SEC must establish the materiality of each specific piece of information required to be disclosed in our rules is legally incorrect, historically unsupported, and inconsistent with the needs of modern investors, especially when it comes to climate and ESG.”

Another myth she identified was the myth, in her view, that climate and ESG are matters only of social or political concern and not material to investment or voting decisions. Here, Lee argued that, rather than climate’s being just a political concern, the idea that “scientifically supported risks like those associated with climate change” should be ignored is what’s really questionable. And just because climate or ESG has political or social significance does not preclude its being material; rather, “all manner of market participants embrace ESG factors as significant drivers of decision-making, risk assessment, and capital allocation precisely because of their relationship to firm value. Finally, investors, the arbiters of materiality, have been overwhelmingly clear in their views that climate risk and other ESG matters are material their investment and voting decisions.” (See this PubCo post.)

Uyeda also maintains that the APA gives rise to a materiality requirement in its mandate that agencies not act in a manner that is arbitrary or capricious. That involves consideration of a rule’s economic consequences. As a result, agencies need to perform a cost-benefit analysis. Uyeda asserts that if information “were not material to investors, the costs imposed by requiring those disclosures would likely render the rule arbitrary and capricious under the law.”

Uyeda reminds us that the materiality standard for Section 10(b) and the SEC’s own rules was articulated in TSC Industries v. Northway. In that case, SCOTUS said that information is material if “there is a substantial likelihood that a reasonable shareholder would consider [an omitted fact] important in deciding how to vote.” In addition, a fact is material if there is “a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.”

With regard to the climate disclosure rules, Uyeda argues that, faced with a number of legal challenges to the rules, the SEC stripped out some of its most contentious provisions, such as the Scope 3 mandate, and added a number of materiality qualifiers. The SEC’s failure to repropose the rules after the significant changes to the proposal is, in his view, likely a violation of the APA. Moreover, the changes designed to “mitigate legal risk do not necessarily convert a climate change activism rule to a material risk disclosure rule.” Uyeda considers the rules’ “invocation of the term ‘material’ [to be] a red herring.” Why? Because the granularity of the mandated disclosure, along with “the elevated treatment of the financial impact of those climate risks in a company’s financial statements, reveals the rule’s true purpose to pressure companies into making operational changes to reduce greenhouse gas emissions. Put simply, the rule elevates one potential factor impacting a company’s financial condition above all others. Therefore, even if climate risks are ‘material’ under certain circumstances, the climate rule uses the materiality standard as a shield to advance a very different agenda.”

As noted above, Uyeda adverts to the conflict minerals rules as kind of cautionary tale. When the legislation mandating that the SEC adopt the conflict minerals rules was signed into law, Uyeda observes, then-Chair Mary Jo White, while “acknowledg[ing] that these mandates might be in service of worthy goals,” questioned, “‘as a policy matter, using the federal securities laws and the [Commission’s] powers of mandatory disclosure to accomplish these goals.’ One thing that we should have learned from the conflict minerals rule,” Uyeda contended, “is that SEC-mandated disclosures are not particularly well-suited to implement broad social policy decisions, especially because these types of issues are constantly evolving. Have any of these disclosures made a difference? Unlikely. The Government Accountability Office reported in 2023 that violence in the DRC has persisted and ‘that overall peace and security in the region has not improved.’” One reason he cites is that the conflict minerals—tin, tungsten, tantalum and gold—covered by the rules do not include copper or cobalt, minerals that are now in high demand in the DRC because they are used in the manufacture of electric vehicles, particularly lithium-ion batteries. Amnesty International reports that the demand for these minerals has led to serious human rights violations. If the goal of the conflict minerals laws, Uyeda continues, was to effect

“positive changes to human rights in the DRC, then one can reasonably conclude that the rule has failed….Thus, public companies and investors are stuck with a mandatory disclosure rule that deviates from financial materiality but fails to resolve the social purpose for which it was adopted. It is not hard to imagine the climate rule facing similar challenges. Prescriptive disclosure requirements lend themselves to predictable behavioral outcomes. Perhaps companies will outsource certain functions that otherwise would have been performed internally to avoid generating emissions that would trigger climate disclosures. Perhaps companies will not commit to any emissions reduction targets to avoid making costly disclosure requirements with attendant liabilities under the federal securities laws. Perhaps new technology will emerge to mitigate the effect of greenhouse gas emissions and these rules—such as the ‘severe weather events and other natural conditions’ provision in Regulation S-X—will continue to impose significant compliance costs without providing any real value to investors.”

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