The Materiality Debate and ESG Disclosure: Investors May Have the Last Word
January 11, 2022
In 2021, investors and regulators continued to focus on the scope and quality of public company disclosure of environmental, social and governance (ESG) information. In the background, the controversial debate intensified over whether ESG information, while of interest to many stakeholders, should be considered “material” for the purposes of the securities laws such that disclosure of inaccurate or misleading ESG information could be a basis for liability. Some commentators have recently defended the traditional view of financial materiality that focuses on the impact of disclosure on the economic value of a company, for which share price is often used as a proxy, whereas others have suggested a broader notion of materiality that would include any information investors decide is important to them.
While the debate rages on, however, market trends may well bypass the discussion altogether, with implications for risk assessment by boards and management. As ESG considerations become mainstream investment criteria for larger numbers of investors, the potential for ESG information to impact investment allocations (and therefore share price), and thus meet the traditional definition of financial materiality, increases significantly. If these trends continue into 2022 and beyond, public companies could face potential legal exposure concerning the accuracy of their voluntary ESG disclosure – even if the legal definition of materiality remains unchanged.
The Materiality Debate
ESG disclosure is on the rise. More investors are asking for it than ever before, an increasing number of companies are producing it voluntarily and the SEC is expected to require it in some form in the near future. Practitioners, scholars and regulators have not been shy in debating whether the emergence of ESG as a mainstream concern should impact the legal definition of materiality under the U.S. federal securities laws.
Some practitioners have defended the traditional view of financial materiality, arguing that ESG information should not be deemed to be material unless it directly impacts the company’s economic valuation. On the other hand, certain SEC commissioners have recently discussed materiality as a broader concept encompassing any information that investors ask for or deem important. In Europe, the concept of “double materiality” has also been proposed, which would require companies to consider the impact of their activities on the environment and society, in addition to any impact on investors.
In the meantime, regardless of which side of the debate prevails over time, changes in the practices of investors may be important for companies to consider as they continue to make materiality assessments with respect to their voluntary ESG disclosure.
Bypassing the Debate
The standard legal definition of materiality, which remains in effect today, is whether 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.” The impact of any given piece of information on a company’s stock price thus remains a key element of the materiality analysis under current law. And yet, over the past few years, the scope of information that investors are calling for has expanded beyond purely financial information, as many investors are now using more and more ESG information to inform their valuation determinations and investment decisions.
Stakeholders at every level – investors, customers, suppliers, etc. – are increasingly incorporating ESG information into their business decisions. Climate change and environmental sustainability issues remain paramount, while social issues related to diversity and workplace culture continue to attract attention as well. What this means for companies is that more of their ESG information is likely to be “decision-useful” than ever before.
Materiality and Financial Performance
The most obvious way in which ESG information may become material is by having a direct and significant impact on a company’s business performance and financial results. Some ESG-related issues have long fit this description, such as the regulatory and litigation risk associated with a company’s environmental practices and disclosures. To give a dramatic example, the Deepwater Horizon oil spill resulted in enormous civil and criminal penalties to BP for gross negligence and willful misconduct in its practices leading up to the accident, and BP also settled claims that it deceived shareholders about the severity of the spill. It is not hard to see how the burden on management of defending lawsuits of this type, in addition to whatever settlement or penalty they may ultimately result in, could be viewed by the reasonable investor as having an impact on the valuation of the company and otherwise significantly altering the “total mix” of information made available about the company.
The point applies to social and governance issues as well. For example, shareholder lawsuits involving allegations relating to a “culture of harassment” in the workplace, and the role of senior executives in concealing it, have become increasingly common and have resulted in settlements that include both financial and governance-enhancement components. While it may be unlikely that the legal definition of materiality in the United States will be modified in the near future to include impact on employees, the importance of these concerns for investors should not be underestimated.
Materiality and Stock Price
Even when ESG information does not appear to directly impact a company’s business results or financial performance, there are more subtle ways in which it could nonetheless be alleged to be material. Two related trends may increase the likelihood that ESG information will directly impact companies’ stock prices in ways that have not previously been typical, which may strengthen arguments that such ESG information is material even under the existing legal definition of materiality:
- In response to demand from investors, companies have started to produce ESG disclosure that is specific and concrete. The days in which investors could be satisfied with companies’ generalized statements and commitments on ESG issues seem to be behind us – investors now often seek quantitative information about companies’ goals and performance with respect to certain key ESG issues (e.g., carbon emissions, board diversity, etc.).
- As disclosure becomes more concrete, investors are increasingly making portfolio allocation decisions or creating investment guidelines based on ESG information that dictate trading and voting activity. Some of the biggest institutional investors like BlackRock and State Street have revised their proxy guidelines such that they will now typically vote against sitting directors on all-male boards, in an attempt to pressure companies to nominate women as directors. And there are an increasing number of mutual funds and ETFs that use a variety of criteria to deploy capital toward companies that perform well in the categories of gender and diversity. It is now conceivable that a company’s stock could be immediately excluded from the portfolios of large funds or institutional investors – for no other reason than the company’s failure to meet certain gender or diversity metrics. A drop in stock price for these reasons may be no less likely to attract the attention of enterprising plaintiff’s attorneys.
This scenario, while hypothetical, introduces new considerations to the traditional discussions of materiality described above – without any change to the legal definition. In the past, it was more or less a safe assumption that investors bought and sold a company’s stock based primarily on their assessment of its business outlook and prospects for financial performance. Thus, the disclosure of an ESG issue that did not impact financial results – e.g., information concerning a company’s environmental impact that did not result in any underlying regulatory exposure – was unlikely to have been seen as material. Today, the emergence of ESG as a basis for investor capital allocation calls that assumption into question.
As more and more investors begin to make investment decisions based on ESG information that appears to have limited or no direct impact on a company’s financial valuation, ESG information is more likely to be considered material even under the current legal definition of materiality. What matters, as always, is not simply whether the ESG information has an immediate impact on the company’s business outlook, but whether it has a substantial likelihood of being viewed by the reasonable investor as having significantly altered the ‘total mix’ of information available about the company. As the concerns of investors continue to expand, though, the type of information that meets this standard can be expected to expand as well.
Boards and management of public companies should be mindful of these emerging trends as they evaluate their potential disclosures under the current materiality standard. Regardless of how the materiality debate plays out, these trends are already expanding the amount of ESG information that investors and courts may consider to be material.
If the ESG concerns of investors continue to cohere around specific and concrete criteria, the overlap between information that has an impact both on stock price and on society or the environment will continue to grow as well. A company can be proactive in this area by engaging key shareholders and becoming familiar with their main ESG priorities, paying particular attention to shareholder concerns about the company’s:
- environmental impact and efforts to implement sustainable practices;
- supply chain management, including with respect to suppliers’ environmental practices;
- treatment of employees, especially with respect to issues of diversity, equity and inclusion; and
- considerations toward customers and surrounding communities.
Regular shareholder engagement on ESG issues will allow companies to monitor these trends and be well-positioned to make informed assessments about the materiality of potential ESG disclosure. In turn, the level of freedom and boldness with which companies voluntarily disclose ESG information should be tempered to reflect these developments. And to the extent that the SEC mandates ESG disclosure in the future, the landscape of materiality assessments is likely to shift once again.
Public companies should think holistically about their ESG disclosure to balance investor wishes with sound risk assessment. ESG disclosure should be subject to the same rigorous review, including verification and disclosure controls, as other public disclosures in SEC filings.
 Chair Gary Gensler, “Testimony Before the United States House of Representatives Committee on Financial Services” (October 5, 2021), available here; Commissioner Allison Herren Lee, “Living in a Material World: Myths and Misconceptions about ‘Materiality’” (May 24, 2021), available here.
 See European Commission, “Proposal for a Corporate Sustainability Reporting Directive (CSRD)” (April 21, 2021), available here; see also European Commission “Non-Binding Guidelines on Non-Financial Reporting Update” (June 20, 2019), available here; and United Kingdom “Companies Act 2006” (August 12, 2017), available here.
 Basic Inc. v. Levinson, 485 U.S. 224, 240 (1988) (quoting TSC Indus., Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976)).
 However, it is important to note that volatility of stock price, by itself, is typically considered insufficient for the relevant information to be deemed material. See, e.g., SEC Staff Accounting Bulletin “No. 99 – Materiality” (August 13, 1999), available here; see also ECA & Local 134 IBEW Joint Pension Trust of Chicago v. JP Morgan Chase Co., 553 F.3d 187, 205 (2d Cir. 2009).
 Reuters, “L Brands inks deal with shareholders to exit workplace harassment cases” (July 30, 2021), available here; Reuters, “Signet Jewelers in $240 million settlement over sexual harassment, loan portfolio” (March 26, 2020), available here.