The SEC shouldn’t be in the business of attempting to pick sides among competing idiosyncratic definitions of materiality beyond material impacts on return on investment.
The Biden Administration passed several new corporate disclosure requirements through SEC rulemaking during its last year. The rule codifying these requirements, “The Enhancement and Standardization of Climate-Related Disclosures for Investors,” was aimed at requiring publicly traded companies to engage in a considerable amount of climate impact disclosures. These would have been in conjunction with companies’ yearly mandatory disclosures pertaining to their financial prospects and status.
The eagle-eyed reader will likely have at least two questions. First, why was the SEC promulgating these rules? After all, we already have the Environmental Protection Agency, whose role it is to impose environment-based regulations on private entities. The second is why would the SEC request these kinds of disclosures in the first place?
The answer to both questions revolves around an evolving definition of materiality.
17 C.F.R. § 230.405 provides the SEC’s working definition of what kinds of items are material for the purposes of annual corporate disclosures: “The term material, when used to qualify a requirement for the furnishing of information as to any subject, limits the information required to those matters to which there is a substantial likelihood that a reasonable investor would attach importance in determining whether to purchase the security registered.”
Put more simply, material disclosures are those which a reasonable investor would rely on when deciding to buy a security. But who’s a reasonable investor? What kinds of information do they privilege when making investment decisions?
There is a lot of writing on this topic in the legal community. Some scholars have proposed a “least common denominator” test. They ask if the most disinterested investor would be interested in the contents of a disclosure if published. Others have advocated for democratizing the question, conducting broad surveys of investors to see what kinds of items they care about most when investing. Some think that materiality is too broad a topic to universalize; they argue that what is material will differ by company and that this area is nearly impossible to regulate fairly. This question is unlikely to be answered conclusively any time soon, but we should recognize that there is a profound difference between classes of investors. Specifically, institutional and individual investors may privilege different aspects of a company in their materiality considerations.
Individual investors have a far more personal relationship with the stock market. They won’t have the millions in diversified assets of a large investment firm or bank and may be invested in only a few companies to make a little extra money to supplement their salaries. While their investment decisions may not be wholly based on return on investment or the financial health of their assets, how any individual asset performs year over year will be far more important for these small-dollar investors. Non-monetary elements of a company’s business will, by necessity, be less important for these investors. Thus, traditional financial disclosures will be material when considering where to put their comparatively exiguous capital.
Due to the large amount of capital that they can invest into diversified assets, institutional investors like banks, activism groups and asset management firms have more flexibility when it comes to building their portfolio. Instead of any one company or asset needing to perform well for the sake of an institutional investor’s financial solvency, these investors are more insulated to the failure of any one company so long as their holdings are performing well overall. Thus, while return on investment is still material for institutional investors, these entities can also afford to more freely consider secondary metrics as material to their investment strategies. These considerations may not be purely based on potential returns. You can see clear examples of these kinds of firms in those who limit their investments to organizations who align with an internal values metric, investing in companies who align with their views on climate policy, social activism, or sustainable sourcing of materials, for example.
Thus, due to a quantifiable difference in interests, there is the potential for small-dollar investors’ interests to be at odds with institutional investors, and these conflicts can materialize in regulation passed at the highest level.
Institutional investors with a penchant for environmentally interested investment policies scored a significant win with the Biden Administration’s environmental disclosure rules. You only need to look at the footnotes present in the final rule within the Federal Register to confirm this: the SEC frequently relied on letters submitted to the Commission by investment firms with climate responsibility commitments such as Blackrock, Calvert Research and The Vanguard Group. They relate how important climate impact is to their investment decisions, and these attestations aided in justifying a federally mandated climate disclosure regulation.
Such disclosure requirements as promoted by the Biden SEC would have been both costly and time intensive to produce. This is not to mention that compliance may have required entirely novel analysis or programs to research prospective climatological impact. Thus, the SEC was imposing a quasi-climate regulation in the guise of a financial services regulation. Further, such broad measures would have detracted from every company’s profitability as they raced to ensure their own regulatory compliance. It is likely to the benefit of both companies and small investors that enforcement of this disclosure rule was discontinued by the SEC earlier this year.
Unfortunately, the SEC now has a track record of privileging non-financial elements as material to benefit institutional investors. There is nothing to stop this or a future Board of Directors of the SEC from adopting other non-monetary considerations as “material” for a group of favored investors and then applying the equivalent of sector regulation under the auspices of regulating financial services. Also, seeing as a court has not yet spoken to the merits of the SEC’s determination of climate materiality. Thus, we don’t have a clear answer as to whether such would be a determination violative of the Administrative Procedure Act. Accordingly, Congress or the Administration should agitate for the SEC to adopt financial materiality rules, where the Agency specifically precludes non-financial metrics as a part of material SEC disclosures.
Fortunately, the government has reference from which to draw such a prohibition. Until 2022, under regulation administered by the Department of Labor, fiduciaries of an ERISA retirement plan were not permitted to consider non-pecuniary factors when investing. Resultant, there is a great volume of case law and discussion pertaining to what non-pecuniary factors are under this standard. Seeing as this prohibition may come back into effect through rulemaking consistent with Executive Order 14173, a parallel rule applied at the SEC pertaining to disclosures would be a useful step to safeguard companies from the regulatory burden of immaterial disclosure.
While there may be a divergence of interests between institutional and small investors, the one thing these two groups ought to broadly agree on is that return on investment is always material for a responsible investor. The SEC shouldn’t be in the business of attempting to pick sides among competing idiosyncratic definitions of materiality beyond material impacts on return on investment. Other items can be left to the better judgment of companies as to what they believe is essential to disclose. If these companies seek to conceal material information, the SEC can then assume its proper role and compel those disclosures.
In short, leave finances to the SEC, and the rest to the market.
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