On February 2, 2010, the U.S. Securities and Exchange Commission (the SEC) published Release Nos. 33-9106 and 34-61469 (collectively, the Release), to provide interpretive guidance to public companies regarding the SEC’s existing disclosure requirements relating to climate change matters. The Release provides an overview of existing climate change disclosure obligations and a framework for public companies to use in evaluating the types of direct and indirect climate-related issues that, if material to a company’s business, must be disclosed under the existing federal securities laws and regulations.
The Release is available on the SEC’s website.
Climate change has long been a topic of intense public discussion among scientists, government leaders, legislators, regulators, businesses (including insurance companies), investors, analysts and the public at large. In recent years, institutional investors and social activists have called for the SEC to require public companies to address the impact of climate change on their businesses in their securities filings. While a few companies have provided a limited amount of climate change disclosure in the past, the practice has not been widely adopted outside of the energy industry and the level of disclosure has been largely limited to compliance with environmental regulation. In June 2009, Ceres, a national coalition of investors purporting to manage approximately $7 trillion in assets, published a study regarding inconsistency in the climate-related disclosures that companies have filed with the SEC. Shareholder activists clearly believe that climate change affects every company, and that all companies need to participate in limiting the effects of global warming. For example, in November 2009, the AFL-CIO submitted a shareholder proposal to a leading multinational retailer to adopt a number of principles for national and international action to stop global warming.
Although the Release was met with criticism from certain Republican lawmakers who feel that the SEC should not be inserting itself into a sensitive scientific and social debate, the Release itself does not create any new disclosure requirements. Instead, it merely reflects the SEC’s position that the federal securities laws only require disclosure of information that is “material” to investors (all investors, that is, not just the socially minded) and that current disclosure requirements already provide a basis for disclosures related to climate change, to the extent the requisite materiality standards are met.
Commentators have suggested that the Release itself is a signal that the SEC intends to scrutinize compliance with existing disclosure rules, and that the Release will serve as the basis for SEC comments issued to companies questioning the adequacy of companies’ climate-related disclosures in their SEC filings. As such, public companies are well advised to carefully consider these matters and update their disclosures to reduce the likelihood of receiving such a comment from the SEC.
Climate Change Disclosure Obligations under the Federal Securities Laws
The Release provides an overview of the existing standards for determining materiality and a review of the primary non-financial statement disclosure rules that may require registrants to make disclosures related to climate change in, among other SEC filings, quarterly Form 10-Q and annual Form 10-K reports under the Exchange Act, and Registration Statements under the Securities Exchange Act of 1933, as amended (the Securities Act).
Description of Business
Item 101 of Regulation S-K requires a registrant to describe its business, including, among other things, its principal products and services, major customers and competitive conditions. In particular, Item 101(c)(1)(xii) expressly requires disclosure of “the material effects that compliance with federal, state and local provisions which have been enacted or adopted regulating the discharge of materials into the environment, or otherwise relating to the protection of the environment, may have upon the capital expenditures, earnings and competitive position of the registrant and its subsidiaries.” The rule also requires disclosure of material estimated capital expenditures for environmental control facilities for current and succeeding fiscal years and for any further periods deemed material.
Item 103 of Regulation S-K requires a registrant to briefly describe any material pending legal proceeding to which it or any of its subsidiaries or property is a party (including possible actions contemplated by governmental authorities). Although a registrant generally does not need to disclose ordinary routine litigation incidental to its business, Instruction 5 to Item 103 expressly requires disclosure of any proceeding arising under any federal, state or local laws regulating the discharge of materials into the environment or otherwise having the purpose of protecting the environment if (A) the proceeding is material to the business or financial condition of the registrant, (B) the amount of the controversy exceeds 10 percent of the current assets of the registrant and its subsidiaries on a consolidated basis or (C) a governmental authority is a party to such proceeding and such proceeding involves potential monetary sanctions, unless the registrant reasonably believes that such proceeding will result in no monetary sanctions, or in monetary sanctions of less than $100,000.
Item 503(c) of Regulation S-K requires a registrant to provide, under the heading “Risk Factors,” a discussion of the most significant risk factors that make an investment in the registrant speculative or risky. Item 503(c) specifies that risk factor disclosure should clearly state the risk and specify how the particular risk affects the particular registrant (rather than boilerplate disclosures applicable to all companies). In addition to the need to comply with Item 503(c), registrants should also consider material environmental factors when crafting their risk factors, since the “safe harbors” for forward-looking statements under § 27A of the Securities Act and § 21E of the Exchange Act only shield liability for non-intentional false and misleading forward-looking statements if such statements were accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially. As a result, failure to disclose meaningful climate-related risk factors could potentially expose companies to additional liability for forward-looking statements that are unrelated to climate change.
Management's Discussion and Analysis
Item 303 of Regulation S-K requires disclosure known as the Management's Discussion and Analysis of Financial Condition and Results of Operations (the MD&A). The MD&A is intended to provide material historical and forward-looking information to investors so that they can see the registrant through the eyes of management and assess the registrant’s financial condition and results of operations. In particular, registrants must identify and disclose in the MD&A known trends, events, demands, commitments and uncertainties that are “reasonably likely” (a lower disclosure standard than “more likely than not”) to have a material effect on the registrant’s financial condition or operating performance. Under previous SEC guidance restated in the Release, known trends and other uncertain events do not need to be disclosed if they are not reasonably likely to come to fruition. However, if management cannot make that determination, disclosure is required unless management determines that the occurrence of such known trend or other uncertain event would not be reasonably likely to have a material impact on the registrant’s financial condition or operations. Registrants should also address in the MD&A, when material, the difficulties involved in assessing the effect of the amount and timing of uncertain events, and provide where possible an indication of the time periods in which resolution of the uncertainties is anticipated.
Other Disclosure Obligations Under the Federal Securities Laws
In addition to the disclosures described above under Items 101, 103, 503(c) and 303 of Regulation S-K, Rule 408 of the Securities Act and Rule 12b-20 of the Exchange Act require registrants to disclose such further material information, if any, as may be necessary to make the required statements, in light of the circumstances under which they are made, not misleading. The Release restates the SEC’s view that disclosure controls and procedures should not be limited to disclosure specifically required, but should also ensure timely collection and evaluation of information that must be evaluated in the context of the disclosure requirement of Exchange Act Rule 12b-20.
Standard for Determining the Materiality of Information Under the Federal Securities Laws
The standard for determining the materiality of information (including climate-related matters) under the federal securities rules is whether there exists a substantial likelihood that a reasonable investor would consider the information important in deciding how to vote or make an investment decision. This standard does not take into account subjective sensitivities that certain investors have to issues such as climate change. With respect to contingent or speculative information or events (such as pending legislation), materiality depends at any given time upon a balancing of both the probability that the event will occur and the anticipated magnitude of the event in light of the totality of the company activity.
Ways Climate Change May Trigger Disclosure Required in SEC Filings
The Release identifies the following framework of examples of ways that climate change may trigger disclosure in SEC filings.
Impact of Legislation and Regulation
With respect to existing federal, state and local laws which relate to greenhouse gas emissions, Item 101 requires disclosure of any material estimated capital expenditures for environmental control facilities for the remainder of a registrant’s current fiscal year and its succeeding fiscal year and for such further periods as the registrant may deem material. Depending on a registrant’s particular circumstances, Item 503(c) may require risk factor disclosure regarding existing or pending legislation or regulation that relates to climate change. Item 303 requires registrants to assess whether any enacted climate change legislation or regulation is reasonably likely to have a material effect on the registrant’s financial condition or results of operation. In the case of a known uncertainty, such as pending legislation or regulation, the analysis of whether disclosure is required in the MD&A consists of two steps, as further described in the section captioned “Management's Discussion and Analysis” above. Examples of possible risks and uncertainties of pending legislation and regulation related to climate change include the following:
Costs to purchase, or profits from sales of, allowances or credits under a “cap and trade” system
Costs required to improve facilities and equipment to reduce emissions in order to comply with regulatory limits or to mitigate the financial consequences of a “cap and trade” regime
Changes to profit or loss arising from increased or decreased demand for goods and services produced by the registrant arising directly from legislation or regulation
Costs from upstream suppliers or service providers who are directly affected by such legislation or regulation and who pass through some or all of their cost increases to the registrant
Practical Note: The Release clarifies that companies other than those in industries traditionally considered to be most at risk by “cap and trade” and greenhouse gas legislation (e.g., electricity, oil and gas, and heavy manufacturing) need to consider how they might be affected indirectly by potential legislation and regulation. In addition, companies should consider both negative and positive ways in which their businesses could be affected by new legislation and regulations. For example, while “cap and trade” programs could hurt the financial performance of some companies, trading markets for emission credits could benefit companies that have excess allowances available for trading.
Registrants also should consider, and disclose when material, the impact on their business of treaties or international accords relating to climate change, such as the Kyoto Protocol, the EU Emission Trading System (ETS) and other international activities in connection with climate change remediation. The potential sources of disclosure obligations related to international accords are the same as those discussed in the previous section with respect to U.S. climate change regulation. Registrants whose businesses are reasonably likely to be affected by such agreements should monitor the progress of any potential agreements and consider their possible impact in satisfying their disclosure obligations based on the MD&A and materiality principles discussed above.
Indirect Consequences of Regulation or Business Trends
Legal, technological, political and scientific developments regarding climate change may create new opportunities or risks for registrants. These developments may create demand for new products or services, or decrease demand for existing products or services. The Release provides the following examples of possible indirect consequences or opportunities relating to these developments that companies should consider for purposes of their SEC disclosures:
Decreased demand for goods that produce significant greenhouse gas emissions
Increased demand for goods that result in lower emissions than competing products
Increased competition to develop innovative “green” products
Increased demand for generation and transmission of energy from alternative energy sources
Decreased demand for services related to carbon-based energy sources, such as drilling services or equipment maintenance services
These business trends or risks may be required to be disclosed as risk factors or in the MD&A and, in some cases, could have a significant enough impact on a registrant’s business that disclosure may be required in its business description under Item 101 of Regulation S-K. For example, a registrant that plans to reposition itself to take advantage of potential opportunities, such as through development of “green” products, may be required by Item 101(a)(1) to disclose this shift in plan of operation. Another example of a potential indirect risk from climate change that would need to be considered for risk factor disclosure is the impact that changes in the public’s perception of a registrant’s products, and publicly available data relating to such registrant’s greenhouse gas emissions, could have on its reputation, business operations or financial condition. Registrants should consider their own particular facts and circumstances in evaluating the materiality of these opportunities and obligations.
Physical Impacts of Climate Change
In addition to legislative, regulatory, business and market impacts related to climate change, there may be significant physical effects of climate change that have the potential to have a material effect on a registrant’s business and operations. These effects can affect a registrant’s personnel, physical assets, supply chain and distribution chain. They can include the impact of changes in weather patterns, such as increases in storm intensity, rising sea levels, and temperature extremes, on facilities or operations. Changes in the availability, cost or quality of natural resources on which the registrant’s business depends, as well as damage to facilities and increased insurance premiums and deductibles, or a decrease in the availability of coverage, for registrants with plants or operations in areas subject to severe weather, can all have material effects on companies. Physical changes associated with climate change can decrease consumer demand for products or services; for example, warmer temperatures could reduce demand for residential and commercial heating fuels, service and equipment.
For some registrants, financial risks associated with climate change may arise from physical risks to entities other than the registrant itself. For example, climate change-related physical changes and hazards to coastal property can pose credit risks for banks whose borrowers are located in at-risk areas. Companies also may be dependent on suppliers or customers who suffer disruptions due to severe weather resulting from climate change, such as companies that purchase agricultural products from farms adversely affected by droughts or floods. Registrants whose businesses may be vulnerable to severe weather or climate-related events should consider whether they are subject to and disclose material risks of, or consequences from, such events in their publicly filed disclosure documents.