Will SEC's climate disclosure proposal trigger D&O coverage?
The landscape for ESG reporting is rapidly changing in a way that will likely impose new risks and costs on companies.
Public companies and their stakeholders often struggle with effective environmental, social and governance (ESG) programs in the absence of clear and common standards and regulations. But the landscape is rapidly changing in a way that will likely impose new risks and costs on companies.
In a dramatic expansion of previous obligations, the U.S. Securities and Exchange Commission (SEC) released a nearly 500-page proposal on March 21, 2022, requiring that publicly traded companies disclose their greenhouse gas emissions and business risks imposed by the changing climate.
The draft rule requires public disclosure of a company’s Scope 1 and 2 emissions — emissions from owned or controlled sources and from the generation of purchased electricity, steam, heating and cooling. In contrast, Scope 3 emissions — indirect emissions from their supply chain — need to be disclosed if deemed “material,” or if there is a substantial likelihood that a reasonable investor would consider them important when making an investment or voting decision.
The SEC’s proposal attempts to impose a more “consistent, comparable and reliable” climate reporting standard to enable investors to make informed judgments about the impact of climate-related risks on current and potential investments. Although painted as being the product of investor demand, the proposed rules are quite controversial. In fact, the SEC extended its comment period through June 17, 2022, as many believe it is outside the scope of SEC authority.
Preventing misrepresentation by ‘greenwashing’
Many public companies seek investment and reputational benefits by pursuing “clean,” “green” or “net zero emissions” development strategies. But the meaning of these terms is not well defined, and can be manipulated to paint an overly rosy picture of the company’s ESG efforts. As a result, shareholders (and shareholder attorneys) scrutinize climate related disclosures for evidence that management is underestimating the company’s environmental impact, or over-promising the steps it is taking to minimize climate change contributions, a practice known as “greenwashing.”
Activist stakeholders and environmentalists view greenwashing on the same level as misreporting financial performance and have been suing public companies based on allegations of ESG-related disclosures. Examples abound and are increasing. In Jochims v. Oatly Group AB, investors in a Swedish oat milk company alleged that the share price had been inflated by overstating the company’s commitment to environmentally friendly business practices. In another case shareholders alleged that a dam collapse demonstrated that a Brazilian mining company’s sustainability and safety disclosures were misleading. Shareholders of oil and gas companies continue to raise similar allegations over representations concerning the long-term effects of climate change on their business and proxy costs for carbon.
If enacted, the proposed SEC rule is expected to increase the risk of shareholder litigation by requiring environmental disclosures and setting standards that companies may unintentionally miss. Public companies must determine whether their insurance policies provide coverage for potential litigation, such as for failing to publicly disclose information required by the SEC to prospective investors and shareholders.
Insurance coverage for ‘claims’ caused by the SEC’s proposed rule
Companies attempting to mitigate the risks of the SEC’s proposed rule should look at its existing coverage portfolio, and particularly at its directors and officers (“D&O”) policies, which routinely provide coverage for claims against companies and their officers, directors, and personnel for a “Wrongful Act,” frequently defined to include securities claims brought by investors and often defined to include public entity investigations.
Investor lawsuits alleging that management’s misrepresentations caused a decline in share value are routinely covered in D&O policies. However, each policy has its own exclusions and conditions, which must be evaluated annually upon renewal. Recognizing the increased risks of ESG litigation, some insurers are seeking to include new exclusions that would limit coverage for these types of claims under certain circumstances. Policyholders should be wary at renewal to make sure they are purchasing the right coverage for these litigation risks.
But even if the investors are satisfied, the SEC itself has the authority to investigate and enforce compliance with its own rules. Responding to an SEC investigative subpoena imposes significant costs. Including internal audits, document collections, and attorneys’ fees. Many policies include coverage to indemnify these costs.
The most important factor in evaluating coverage for SEC investigations is the language of the policy. Some policies expressly include entity investigations coverage up to certain limits, which may or may not be adequate to cover the entire cost of the investigation response. Other policies include coverage for demands for non-monetary relief, including an SEC subpoena, as long as the claim is for a wrongful act, as in Patriarch Partners, LLC v. AXIS Ins. Co.
The SEC’s proposed rule suggests that greenwashing is a wrongful act, and an SEC investigative subpoena concerning disclosures of climate risks and emission reduction efforts may trigger insurance coverage. Public companies must take steps to maximize this potential coverage and resist industry pressure to exclude greenwashing investigations from coverage.
Preparation for ESG securities investigations & litigation
Now more than ever, ESG is important in the field of insurance. If the SEC’s proposed rule is enacted, public companies can expect that insurance companies will scrutinize their ESG strategies because these strategies may affect the risks of litigation and SEC enforcement actions.
In the event a company receives a claim or subpoena involving its environmental disclosures, it must actively pursue coverage. Most policies have notice requirements proscribing how and when companies must provide notice of a potential claim.
Policy portfolios should be reviewed early and often. At renewal, proposed changes in coverage should be analyzed to avoid a later misunderstanding in the scope of coverage.
The true costs of ESG securities litigation and enforcement will be discovered over the next few years, with public companies bearing most of these costs. But insurers collect on these costs throughout the industry by charging premiums reflecting these risks. Public companies must understand the scope of their coverage for these losses in the wake of the SEC’s proposed rule.
David Halbreich is chair of the Reed Smith Insurance Recovery Group. He represents policyholders in a variety of industries in coverage disputes and litigation claims. Ben Fliegel is a partner in the Reed Smith Insurance Recovery Group and a member of the firm’s global environmental, social and governmental practice. Kya Coletta is an associate in the Reed Smith Insurance Recovery Group.
Opinions expressed here are the authors’ own.
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