Governing to Make ESG Disclosures Fun and Profitable

The proposed US Securities Exchange Commission (SEC) rules requiring climate change disclosures are more than a costly but poorly conceived attempt at getting useful, standardized information to shareholders. They are likely just the beginning of an effort to standardize reporting on all environmental, social, and governance (ESG) activities—a goal that may end up being a boon for lawyers and consultants, while providing little meaningful, actionable information to investors.

Rules like these will also have the unintended consequence of raising the profile of ESG raters, all of which use different, often questionable, and sometimes meaningless criteria, and will draw a straight line of accountability to the board of directors. Some investors and other stakeholders may see everything as proof of greenwashing and greenwashing as securities fraud. As Jean Case, CEO of the Case Impact Network and board chair at the National Geographic Society, said, “At the end of the day, boards have to be held accountable in this space.”

As insurers of ESG and reputation risk, we’ve seen boards blindsided by tactical distractions to the type of major strategic reputational issues that In re Caremark International Inc. delineates as their purview. ESG disclosures could become the next distracting frontier. Rather than viewing these rules as merely a costly new burden, boards should view them as an opportunity. They can take this moment to create a more expansive framework for ESG governance that will yield two precious benefits: improve the quality of the board work experience and demonstrably boost enterprise value.

Data the SEC is requesting on climate oversight is granular. According to governance experts, the SEC is asking the board to describe the process by which it provides oversight over climate risks and how these risks are integrated into the enterprise risk management system. No one doubts boards have the intellectual firepower to focus on these granular details. But that’s not what boards were designed to do.

Since Marchand v. Barnhill’s update to Caremark, a board’s role has been strategic oversight of a firm’s finances, compliance, and mission-critical operations. Failure to appreciate and oversee what is mission critical or material is the new issue tripping boards up today, and where boards must avoid tactical distractions.

We described in an NACD BoardTalk blog earlier this year that six of 18 Caremark claims raised in the Delaware Court of Chancery survived motions to dismiss—an approximately 33 percent success rate over the past two years. Of the six that survived, only one was linked to alleged environmental oversight failure. Others were associated with issues such as financial and compliance control failures, or with core reputation issues including safety and innovation.

Other ESG issues have been raised in court, however, including oversight failures in the context of social misrepresentations. Shareholders sued Wells Fargo & Co., for example, for a stock price drop following an ethics scandal arguing they were misled by the CEO’s public statements about ethics, greater accountability, and transparency within the company. Signet Jewelers settled their shareholder case over sexual harassment in the face of an explicit code of conduct promising no harassment. The price tag: $240 million.

Here’s the opportunity: Let’s assume that a board wishes to raise the strategic focus of its oversight, protect the assets of the firm, meet the expectations set by Caremark post-Marchand, and comply with the new climate disclosures without overreaching into executive tasks.

First, the board would leave the minutiae to management and have them wrap compliance work into an integrated enterprise reputation risk management activity. For most firms with a silo-busting operational or enterprise risk management apparatus that has a core intelligence-gathering capability, this would simply entail an overlay of a behavioral economics-inspired reputation risk management framework. We highlighted additional details in Directorship in 2019.

As is likely the case now, the board would be connected to that process through a firm’s risk leadership (CEO, chief legal officer, or chief risk officer). Its role would be to look beyond compliance to understand the expectations of employees, vendors, creditors, activists, regulators, and various other stakeholders. Through this apparatus, a board would gain visibility into those issues beyond climate that represent potential mission-critical risks. Climate risks would be among them, but only part of the picture.

We shared late last year in Directorship a few vignettes of companies that earned reputation premiums through superior ESG and reputation risk governance. Looking at a larger population, we recently reported that companies with ESG and reputational risk protection strategies have seen their stock prices rise 5 percent above the market within two weeks of a reputational challenge. Firms that validated and disclosed those strategies publicly before an event have seen their stock prices rise nearly 10 percent in the same time frame. We also found that stock prices of firms that managed, validated, and publicized ESG and reputation risk management strategies on average gained 9.3 percent over the subsequent seven months after a reputation-threatening event.

More than merely public relations, the evidence shows that the market rewarded firms that had implemented authenticated oversight of operational controls over the mission-critical process that underpinned a firm’s reputation. In addition, the firms that earned equity rewards were usually among the first in their peer group to make public their processes for managing mission-critical risks. Firms in which such risk management processes were assumed by shareholders to be in place gained 4.3 percent on average.

To adapt a Warren Buffet aphorism, firms shown to be swimming without out shorts as the tide receded were punished by equity investors. Companies that failed to institute, validate, and communicate risk management strategies lost 13.2 percent of their stock value over those seven-month periods, and they underperformed their peers by an average of 23.3 percent.

Compliance is necessary and expensive, with the usual return on investment being zero. Board directors are more likely to derive more personal satisfaction; earn stronger marks from asset managers, proxy advisors, investors, and other stakeholders; and realize a corporate equity boost by governing above ESG disclosure minutiae. Think of it as strategic reputation risk oversight for fun and profit.