Any doubts about the commitment of the Securities and Exchange Commission (SEC or Commission) to environmental and social governance (ESG) disappeared in recent months, as its Division of Corporation Finance (DCF) slammed the door on requests by prominent issuers to exclude shareholder proxy proposals related to human rights, diversity, equity and inclusion (“DEI”), and climate change.
Read in isolation, the DCF decisions, which were memorialized in no-action letters from the SEC staff (Staff), may not seem groundbreaking. But when considered alongside other SEC activity, including (1) the growing number of ESG-focused comments from DCF, (2) numerous public statements about the importance of ESG by high-ranking SEC officials, (3) the SEC’s recent $55.9 million settlement with Vale SA regarding its sustainability reports and ESG disclosures, and (4) the anticipated release of the final SEC rule on climate-related disclosures, the DCF proxy rulings reflect an agency-wide emphasis on “values-based” capitalism.
In this article, we start by analyzing DCF’s no-action letters and demonstrate how the Staff has narrowly interpreted Rule 14a-8(i)(12)(i) of the Securities Exchange Act of 1934 (the Exchange Act) and related regulations, empowering activists to demand action on matters that, until recently, were not the focus of shareholder scrutiny. We then frame the no-action responses in the broader context of SEC actions across multiple Divisions and commentary from Commission leaders, demonstrating that the emphasis on ESG starts at the top, and filters down to ordinary matters of corporate regulation. Finally, we provide key takeaways for issuers struggling to manage the expanding impact of ESG across corporate operations.
I. The No-Action Letters
Shareholders of public companies may seek to have matters acted on by the board or management of a company by submitting proposals for inclusion in a corporate proxy statement if the proposal meets certain conditions. Even if more than fifty percent of the shareholders’ votes are cast in favor of the proposal, the proposal is typically non-binding on a company or its board. As a practical matter, however, it is difficult for the board and management simply to ignore proposals that have support from a majority of shareholders. The SEC’s rules concerning shareholder proposals do not require that the board or management include every proposal that is submitted and Rule 14a-8(i)(7) of the Exchange Act allows the exclusion of proposals concerning “ordinary business operations.” Traditionally, when activists sought information on how a corporation was responding to a matter of broad social concern, issuers could exclude the proposal by demonstrating the absence of any nexus between the issue and corporate operations. However, DCF issued a bulletin (the “2021 guidance”) on November 3, 2021, regarding Rule 14a-8 of the Exchange Act, which instructed the Staff to focus not just on whether a proposal related to “ordinary business operations,” but also indicated that they should consider whether a proposal addressed a “significant social policy.” Put another way, the guidance informed issuers that (1) the Staff had discretion to determine matters of social significance, and (2) shareholder proposals implicating these matters cannot be excluded, regardless of the relevance to corporate operations. As discussed in more detail below, the recent no-action letters from DCF broadly align with the 2021 guidance.
A. Eli Lilly
This “significant social policy” approach from the 2021 guidance is reflected in a recent Eli Lilly no-action letter. As You Sow is a California non-profit that seeks to “harness corporate responsibility and shareholder power to create lasting change.” In late 2022, As You Sow submitted a proposal for inclusion in Lilly’s 2023 proxy statement, on behalf of four individual shareholders. Specifically, As You Sow proposed that Lilly commission a report on the “effectiveness” of “diversity, equity, and inclusion efforts,” using “quantitative metrics for hiring, retention, and promotion of employees.” Lilly wrote to DCF on December 23, 2022, asking to strike the proposal because it related to “ordinary” business matters. Lilly argued that the proposal, at its core, addressed the management of a corporate workforce. According to the company, workforce management was a “prime example of an ordinary business matter,” and prior SEC precedent supported exclusion. By letter dated March 10, 2023, the Staff disagreed, finding that the proposal implicated “human capital management issues” with a “broad societal impact”—the precise outcome called for by the 2021 guidance. The Staff also rejected Lilly’s request to exclude the proposal under Exchange Act Rule 14a-8(i)(10), a provision allowing exclusion of proposals that have been substantially implemented by the company. Through counsel, Lilly provided an analysis of its prior efforts at diversity and inclusion, including public statements and disclosed metrics. The Staff disposed of Lilly’s substantial implementation argument, finding that “… it appears that the Company’s public disclosures do not substantially implement the Proposal.” A final aspect of the Lilly letter deserves particular attention. Lilly drew attention to the SEC letter to Deere & Company dated January 3, 2022, where the Staff allowed Deere to strike a proposal seeking broader data on employment and training practices. Lilly pointed out similarities between the shareholder proposal to Deere and As You Sow’s request. The Staff did not specifically address its prior Deere decision, where it found that the proposal “micromanage[d]” Deere. Nor did the Staff reference similar determinations it made during the prior season that arguably had “precedential” value. Rather, it seems that the Staff implicitly found the “precedent” distinguishable because As You Sow’s proposal to Eli Lilly explicitly focused on DEI while the earlier Deere proposal did not. Even though the proposals sought very similar data, the inclusion of a request for DEI metrics by As You Sow carried the day in favor of the shareholder. The lesson for issuers is that going forward, a nexus to ESG and DEI can transform a workforce-related proposal from mundane or improper “micromanagement” to meaningful in the eyes of the Staff.
B. Similar Issuer Proposals
Also in late 2022, a coalition of activists submitted a shareholder proposal to another prominent issuer, asking the company to “conduct a third-party, independent racial equity audit” that analyzed the impact of corporate operations on certain populations, and provided recommendations for reducing that impact. After receiving the request, the company wrote to DCF, asking to exclude the proposal from its forthcoming 2023 proxy statement under Exchange Act Rule 14a-8(i)(12)(i). That provision allows issuers to strike shareholder proposals that address “substantially the same subject matter” as a proposal within the prior five years if the earlier proposal did not pass. The issuer pointed the Staff to an earlier 2022 proposal by a separate group of activists requesting that the company analyze the impact of corporate operations on marginalized populations and civil rights. Despite a reasoned argument by the company that demonstrated nearly identical language across the two proposals, and evidence that less than one percent of shareholders supported the previous proposal, the Staff required the company to include the proposal in its 2023 proxy materials. The no-action letter has two significant implications for issuers. First, at least in matters related to ESG, the Staff will narrowly construe the language of Rule 14a-8(i)(12)(i). And second, even trivial modifications to a prior proposal that do not alter the underlying substance of a previous request are now sufficient to circumvent the rule. In other words, issuers that defeat an ESG-related proposal in 2023 could very well face a nearly-identical proposal in 2024—and should expect little sympathy from the SEC.
II. The Increase in ESG-Related Comment Letters
DCF has also increased the frequency of comments on climate-related disclosures provided by issuers in quarterly and annual filings. This trend began in 2021 after DCF published a sample comment letter (the “sample letter”) that provided nine climate-related comments that the Staff could potentially transmit to issuers to ensure compliance with Regulation S-K. The sample letter demonstrated the broad sweep of the SEC’s interest in ESG matters and instructed issuers to expect comments on risk factors (including policy and regulatory changes), management decision and analysis (including changes in law omitted from SEC filings, past and future capital expenditures related to ESG, and the potential economic impact of climate change), and the impact of ESG and climate change on compliance costs.
Since releasing the sample letter, DCF has substantially increased the frequency of its comments related to climate change. Internal research by Katten demonstrates that companies now receive, on average, at least 6 first-round comments from the Staff. DCF is also issuing more comments with each letter, and frequently following up with additional comments seeking more information. And very few issuers are avoiding second-round comments. These findings are particularly significant in light of the pending release of the SEC’s final rule on climate-related disclosures. Many of the comments pointed to gaps between risk disclosures and Corporate Social Responsibility (CSR) reports. Such comments demonstrate that DCF views Regulation S-K as a powerful tool to police “greenwashing” — the practice of including broad commitments to climate and social goals in CSR reports that do not reflect actual corporate behavior. Such comments also demonstrate that DCF may diverge from the holdings of some courts that statements in documents like CSR reports and codes of conduct are not actionable under the securities laws because they are “inherently aspirational.” See Retail Wholesale & Department Store Union Local 338 Retirement Fund v. Hewlett-Packard Co., 845 F.3d 1268 (9th Cir. 2017); In re Plains All American Pipeline, L.P. Sec. Litig., 307 F. Supp. 3d 583 (S.D. Tex. 2018). The publication of the final rule on climate change-related disclosures is likely to accelerate these efforts to force more fulsome disclosures and to police them more intensely.
III. The Vale Enforcement Action
The agency-wide embrace of ESG was also on display in the recent settlement of an enforcement action involving Vale S.A., a resource extraction company based in Brazil. The Staff first announced charges against Vale in April of 2022, based on the alleged failure of Vale to accurately disclose potential risks related to its Brumadinho dam, which collapsed in 2019. The Complaint alleged that Vale’s public statements about the dam and its overall commitment to safety — many of which were broad and prophylactic — “belied the safety risks” of the dam. And the charges also focused on Vale’s sustainability reports and ESG disclosures, alleging these were “materially false” and misled investors about the stability of the dam, the prevailing culture of safety, and the “actual risk of catastrophic financial consequences” should any dam collapse. In resolving the case, the SEC specifically addressed the importance of ESG. Associate Director of Enforcement Mark Cave stated that “… public companies can and should be held accountable for material misrepresentations in their ESG-related disclosures, just as they would for any other material misrepresentation.”
IV. Statements by SEC Management
The overall approach to ESG articulated in recent years by senior SEC management may drive aggressive interpretations of materiality in ESG enforcement actions going forward. As recently as April 6, 2023, SEC Chairman Gary Gensler highlighted the importance of diversity, equity, and inclusion, and his belief that investors are critically concerned about the accurate disclosure of climate risks. Those remarks are part of a pattern of consistent messaging from Chair Gensler about the increasing importance of ESG to the Commission. That pattern began shortly after Gensler was confirmed, when he spoke in London about enforcement priorities, including climate-related risk disclosures and ensuring that issuers honored ESG-related commitments in their daily operations. Chairman Gensler also instructed the Staff to examine the accuracy of “human capital disclosures” — the precise topic at issue in the Eli Lilly no-action letter. Chairman Gensler has set the tone at the top on ESG, and other senior SEC leaders have reinforced that messaging. For example, in November of 2022, the SEC’s Director of Enforcement Gurbir Grewal spoke at the Institute on Securities Regulation and vowed to bring enforcement actions against companies that misled investors about climate risks. Importantly, Director Grewal linked SEC priorities, including the formation of the Commission’s ESG Task Force, to investor concern, promising to be “on top of” ESG issues, because they are “important to investors.”
V. Takeaways and Best Practices
As noted above, none of these developments are necessarily profound in isolation. Because ESG enforcement to date is in its infancy — the ESG Task Force has so far only been linked to three enforcement actions — it can be dangerously easy to marginalize. After all, Vale is not the first issuer to face regulatory scrutiny after an industrial accident. And, DCF has periodically modified its approach to proxy statements in the past to reflect changes in SEC priorities. But when viewing these developments in the aggregate, only one conclusion is possible: the SEC is fully committed to meaningful action on ESG issues. Issuers should therefore consider the regulatory activity discussed above as the opening salvo of a broader SEC offensive on ESG. Issuers should also expect that the SEC will increasingly side with climate and social activists seeking information on ESG-related corporate behavior and carefully consider whether ESG-related disclosures (and omissions) will be deemed material to retail and institutional investors after the fact. Issuers who fail to heed these warnings may find themselves in the crosshairs of the SEC and other regulators.