Part 2: Reasons a Court Should Find that the SEC Lacked Legal Authority for the Climate-Change Disclosure Rules
Part 2: Reasons a Court Should Find that the SEC Lacked Legal Authority for the Climate-Change Disclosure Rules
Part 2 of a 4-part series
In this series of blog posts, I am discussing the SEC’s assertions about its statutory authority to adopt the climate-change disclosure rules. That power is in doubt for several reasons.
In the first blog, I summarized the SEC’s position on its statutory authority and explained the statutory analysis the SEC should have done. The SEC’s position failed to follow the Supreme Court’s method of construing the full text and context of the statutes on an agency’s rulemaking power and instead relied on isolated statutory language taken out of context. The comment on authority I submitted to the SEC during the rulemaking, which has some further details, is here.
In this second post, I describe the ways the SEC’s approach to its authority departed from restrictions on the SEC in the text and context of the relevant securities statutes. The SEC relied on considerations not in the statutes and ignored the narrow form of the disclosure obligations Congress used.
The third blog reports an anecdote from the drafting history of the Securities Act that confirms the statutory context imposing restrictions on the discretion of the SEC to create new disclosure obligations. The anecdote involves President Franklin Roosevelt, Representative Sam Rayburn, and Harvard Law Professor Felix Frankfurter. The report of the House Commerce Committee on the bill that became the Securities Act contains language evidencing the episode, and a House report for the bill that became the Securities Exchange Act also has language restricting the discretion of the SEC to compel company disclosures. The relevant statutes have not changed in a way that matters since they were enacted in the early 1930s.
The fourth and final post shows the SEC ignored its own earlier decisions that the agency lacked the power to adopt special disclosure rules on environmental, climate change, and social policy issues. In the earlier decisions, the SEC said it needed a specific congressional mandate to have that power, which it did not have for the new climate-change disclosure rules. These decisions confirm that the SEC lacked authority for the new rules.
The series of blogs will refer to the SEC’s statement supporting the final rules as the “Release.”[1] The new “Rules” are at the end of the Release. References to page numbers of the Release will usually be inside parentheses in the text.
Comparison of the SEC position and a fair construction of the SEC’s disclosure rulemaking power
This post discusses the second reason: The SEC in the Release did not fairly read, report, or account for the statutory limitations on its authority to adopt disclosure rules set out in the first blog post. Instead, the SEC explanation of its statutory authority derived and asserted rulemaking powers nowhere to be found in the statutes. According to the SEC, the critical justifications for the Rules were that climate-change information is important to investors, investors want and need it, and the Rules will make the disclosures more consistent, comparable, and reliable.
The statutes on company disclosures in the Securities Act and Exchange Act do not mention consistency or comparability as a basis for a disclosure rule. They do not mention investor desire or need as a basis. They do not mention importance to investors as a basis.
The statutes do not authorize the SEC to “build on” the disclosures specified in the securities acts “by requiring additional disclosures of information.” (21683) To the contrary, since 2011, Congress twice told the SEC to simplify the disclosure items in Regulation S-K and reduce the disclosure burdens on small issuers.[2]
When saying that climate-change information is important to investors, the SEC might have meant the information is “material” to investors. Definitions of materiality refer to the importance of information,[3] but, even if the SEC meant to equate importance with materiality for purposes of its analysis of authority, the SEC would not have a statutory basis to issue the climate-change rules. The SEC does not have authority to impose a disclosure obligation solely because information is material. The materiality of information is not a separate and independent ground for a disclosure rule. The statutes for the SEC do not say that the agency may issue a rule to require a company to disclose any information that is material to investors or that investors demand.
Importance of information to investors and their demand for it are not sufficient for a new disclosure rule but are not irrelevant. Importance and need should be factors to begin a thought process at the SEC about the possibility of a new disclosure rule because the statutes oblige the SEC to take investor protection into consideration. Investor demand might or might not demonstrate an area needing investor protection. The SEC would also be required to determine that a disclosure rule satisfied the restrictions discussed in the first blog in this series and, in accordance with other statutes, to consider efficiency, competition, and capital formation.[4]
The problem is that the SEC seemed to view investor need as a proxy for investor protection. The Release said the SEC responded to investor need for information, and other factors, when determining that a disclosure was necessary or appropriate to protect investors. (21684; see also 21683, 21848 (rules will allow investors “to better assess material risks” and compare different firms)) The SEC apparently believes that any additional company disclosure is for the protection of investors because more information is always good for the securities markets.
That is a debatable conclusion as a factual matter and is not an acceptable construction of investor protection. Investor need or demand is not the same as investor protection and is too broad and vague a standard to serve as a principle of statutory interpretation for SEC disclosure rulemaking. If every new disclosure from a company advances investor protection within the meaning of the Acts, then the SEC has power to order a company to disclose any information the company has or could obtain.[5] The statutory requirement would have no limit on the SEC’s disclosure power and would be inconsistent with the textual restrictions on SEC discretion that Congress included in the Acts, as already described. The SEC’s interpretation of investor protection must be consistent with the objectives of Congress as revealed by the text and context of the Securities Act and the Exchange Act and not at an unacceptably high level of generality. [6] The SEC’s recitations about the importance of climate-change information to investors and their need for it were not closely aligned with the terms of the statutes and instead were about convenience or preference of some investors (consistency and comparability), not investor protection.
The SEC’s assertion that it had statutory authority to adopt the climate-change disclosure rules suffers from a further fundamental defect. The SEC failed to adhere to the methodology or form of Congress’s approach to company disclosure obligations.
Congress’s approach was to specify an internal feature or financial element common to disclosing companies that would inform a potential investor about the company’s business and financial prospects. For example, among the disclosures required by Schedule A are the business of the company, its capital structure, the terms of the securities, and detailed balance sheet and profit or loss statements. These features provide information about financial performance and business prospects. They are key to the economics of an investment decision in the company.
Congress wanted a disclosure about anything that materially affected the specified financial or business characteristic. It did not single out one or more specific events or factors that might affect those characteristics. The disclosure rules were directed inward toward effects on the company from any outside or internal event and were not directed at a particular type of external event and the possibility that the event might affect the disclosing company. Climate-change considerations are among the many events or factors that can affect a company’s business or finances, but Congress said disclosures should be from the perspective of specific business and financial traits of a company no matter what event or factor, internal or external to the company, caused an effect.
Current Regulation S-K takes the same approach. Over time, the SEC has broadened disclosure obligations from the original items in Schedule A but remained true to the form set by Congress. Examples are the requirements to include a section on management discussion and analysis and the need for a section on risk factors, an item heavily emphasized in the Release. Item 303(a) on management discussion and analysis states:
The objective of the discussion and analysis is to provide material information relevant to an assessment of the financial condition and results of operations of the registrant including an evaluation of the amounts and certainty of cash flows from operations and from outside sources. The discussion and analysis must focus specifically on material events and uncertainties known to management that are reasonably likely to cause reported financial information not to be necessarily indicative of future operating results or of future financial condition. This includes descriptions and amounts of matters that have had a material impact on reported operations, as well as matters that are reasonably likely based on management's assessment to have a material impact on future operations.
The SEC issued guidance in 2010 discussing application of Item 303 and other parts of Regulation S-K to events related to climate change.
The new climate-change rules are the opposite of the form Congress prescribed. The Rules turn the standard disclosure obligation around, identify a specific category of event, climate-related risks, and demand a disclosure about its effects on company-specific characteristics such as results of operations or financial condition. New Item 1502(a) states: “Describe any climate-related risks that have materially impacted or are reasonably likely to have a material impact on the registrant, including on its strategy, results of operations, or financial condition.” Item 1500 states that climate-related risks are “the actual or potential negative impacts of climate-related conditions and events on a registrant’s business, results of operations, or financial condition.” The new Rules are only about climate change and the potential effects of climate change on the company.
The requirements for disclosures of greenhouse gas emissions (21916) are even less like the disclosures in Schedule A or Regulation S-K. They require information about the effects of the company on the external world on the theory that emissions could lead to transition risk for the company, such as new government controls, financial penalties, or reduced customer demand. (21732, 21733, 21914)
In these ways the Rules are inconsistent with the scope of the disclosure rulemaking authority Congress conferred on the SEC. The approach Congress used is inherently limited to the business and financial characteristics of a commercial enterprise that feed into investor valuation. The number and scope of those characteristics are limited and are thoroughly covered by Regulation S-K. On the other hand, the events or factors that could affect the business or financial performance of a company are endless. Accepting the climate-change disclosure rules would grant the SEC discretion to order companies to comply with disclosure rules on any topic favored by special interests making a plausible argument on investor protection, efficiency, and capital formation.
[1] SEC, The Enhancement and Standardization of Climate-Related Disclosures for Investors, 89 Fed. Reg. 21668 (Mar. 28, 2024).
[2] Section 108 of the JOBS Act, Pub. L. No. 112-106, 126 Stat. 306 (2012), required the SEC to review Regulation S-K to determine how it could be modernized and simplified and to reduce the costs and burdens of compliance for emerging growth companies. At the end of 2015, Congress ordered the SEC to revise Regulation S-K to reduce the disclosure burden on emerging growth companies and small issuers. Fixing America’s Surface Transportation Act, Pub. L. No. 114-94, § 72002, 129 Stat. 1784, 1784 (December 4, 2015). Congress also ordered the SEC to conduct a study to determine “how best to modernize and simplify” the requirements in Regulation S-K “in a manner that reduces the costs and burdens on issuers while still providing all material information.” Id. § 72003, 129 Stat. 1784, 1785 (2015).
[3] The Release said “materiality refers to the importance of information to investment and voting decisions about a particular company.” (21671) Existing SEC regulations are more precise and define materiality as “those matters to which there is a substantial likelihood that a reasonable investor would attach importance in determining whether to purchase the security registered.” 17 C.F.R. § 230.405; 17 C.F.R. § 240.12b-2.
[4] See 15 U.S.C. §§ 77b(b), 78c(f).
[5] Cf. Am. Meat Inst. v. U.S. Dep’t of Agric., 760 F.3d 18, 31-32 (D.C. Cir. 2014) (en banc) (in a case needing a substantial government interest to justify a compelled disclosure, concurrence said: “were consumer interest alone sufficient, there is no end to the information that [authorities] could require manufacturers to disclose about their production methods”) (Kavanaugh, J., concurring) (quotation marks and citation omitted).
[6] See John F. Manning, Federalism and the Generality Problem in Constitutional Interpretation, 122 Harv. L. Rev. 2003, 2004 (2009) (“abstracting from a law’s specific means to its general aims dishonors the level of generality at which lawmakers choose to legislate”).
Andrew N. Vollmer is a senior affiliated scholar with the Mercatus Center at George Mason University; former deputy general counsel of the Securities and Exchange Commission; former professor of law, general faculty, at the University of Virginia School of Law; former partner in the securities enforcement group of Wilmer Cutler Pickering Hale and Dorr LLP.