Sunday, April 25, 2010

Will Integrated Financial And Sustainability Reporting Become A Legal Mandate?

Much of what we think of as corporate sustainability reporting is currently done on a voluntary basis. But most observers believe it is only a matter of time until sustainability disclosure will be a legal requirement just as financial disclosure is today.

The Securities and Exchange Commission recently took an important and celebrated step toward mandating sustainability disclosure with a guidance on climate related risks.  The guidance clarified duties of companies to disclose certain kinds of climate data and analysis in SEC filings.  The guidance was based on existing legal requirements, such as the duties to report on litigation and liabilities and on emerging trends, events and uncertainties.

Since these requirements are already on the books, why the need for guidance?  NGO and investor reviews of SEC filings show that, in the absence of SEC guidance, environmental and social issues disclosure in SEC filings is sparse, inconsistent, and typically omits large issues facing the reporting company.

For instance, there is growing concern by investors on how potential environmental impacts from natural gas extraction including drilling and related processes may affect energy companies. An estimated 60-80% of natural gas wells drilled in the next decade will require a process known as “hydraulic fracturing”  (“fraccing”) in which  huge volumes of water, chemicals and particles are injected underground to release natural gas. Public concerns regarding toxicity and water impacts are already having an effect.

For instance, Chesapeake Energy, recently withdrew several natural gas-related development plans after public and government expressions of concern on potential environmental hazards. These  included plans to drill in the New York City watershed, to dispose of waste water in an abandoned well near a water supply in upstate New York, and to withdraw water for fracturing from the Delaware River basin.  Yet, the company did not mention these problems in its latest annual 10-K report filed with the SEC.  

Another company, Cabot Oil & Gas, was hit with numerous environmental enforcement actions in 2009 around its operations in Pennsylvania due to toxic spills, and to methane entering nearby private drinking wells. Enforcement included a temporary shutdown order and a  consent agreement containing a civil penalty of $120,000.  Again,  these did not appear in the Company’s SEC filings.
The lack of disclosure of the $120,000 penalty might seem notable in light of an SEC regulation requiring disclosure of pending or likely environmental enforcement actions where the penalty is expected to exceed $100,000. But a recent study found that 73% of all companies are not disclosing environmental enforcement actions with penalties in excess of $100,000.  It seems either the rule’s applicability to specific cases is considered by companies to be equivocal, or the absence of SEC enforcement is not inspiring broad compliance.

For Cabot,  the $120,000 penalty was not the end of the matter. On April 15, 2010, the state modified the consent agreement with a fine of $240,000, and a continuing penalty of $30,000 per month until Cabot rectifies identified environmental problems. The new order also bans the company from drilling new wells in the area for a year.  In response, the company issued a news release (but so far, not an SEC disclosure) noting that “This modified order does not impact the number of wells scheduled to be drilled under Cabot’s 2010 drilling effort, nor will it impact our production guidance.”
Shareholders monitoring the gas companies remain concerned about poor disclosure. New York State Comptroller Thomas DiNapoli,  Green Century Funds and numerous other investors are attempting to fill the natural gas sector’s disclosure gap through a series of shareholder resolutions requesting reports on this issue by energy companies. Beyond the disclosure gaps on this specific issue, it is obvious that additional SEC guidance and enforcement could enhance disclosure of an array of issues in SEC filings.

On the other hand, better enforcement or single issue approaches like the climate guidance, are not the end-all and be-all of sustainability disclosure. Arguably, fully integrating current financial reporting to the SEC with data associated with impacts of the corporation on society could be far more useful.  The Social Investment Forum submitted a proposal to the SEC last summer calling for movement in the direction of an integrated disclosure requirement, such as that suggested by Harvard business professor Robert G. Eccles and Michael P. Krzus of Grant Thornton LLP in their new book, One Report: Integrated Reporting for a Sustainable Strategy.

The SIF proposal had two elements. First it requested that the SEC require issuers to report annually on a comprehensive, uniform set of sustainability indicators. The letter suggested that the Global Reporting Initiative (GRI) reporting guidelines would be a reasonable starting point.  Secondly, it asked that the SEC issue a guidance to ensure disclosure of short- and long-term sustainability risks in the Management Discussion and Analysis section of the 10-K (MD&A).   The latter proposal would reduce the subjectivity of a company’s decisions to disclose by providing more objective thresholds to trigger disclosure obligations, such as disclosing the emergence of peer-reviewed studies indicating potential hazards of a company’s products or activities.  

Such changes would go much further in ensuring that investors and other stakeholders have ready access to the information needed for an integrated examination of where and how finances and sustainability converge.

Monday, April 5, 2010

Do Directors have a fiduciary duty on sustainability?

I'm a guest blogger today on CSRwire Talkback on "Legal frontiers of Sustainability." As investor's counsel, I explain why/how we asked Intel's Board to address CSR/Sustainability as fiduciaries.

According to a recent CERES report, aligning economic prosperity and environmental sustainability will demand new strategies in the board room and executive suite. First among the strategies identified by CERES is a need for every corporate board of directors to assign a board committee to oversee sustainability. A number of US companies have already taken this step. There is a sound business case for doing so. Companies that are attentive to sustainability in many sectors have done better than average financially during the financial slowdown. Also, many companies are finding that they can use a sustainability focus to drive their leadership as innovators.

Notably, just a week after CERES issued its report, Intel’s Board of Directors decided to modify a committee charter to better integrate sustainability and corporate social responsibility. Moreover, the company acknowledged that the change makes these issues part of committee members’ fiduciary duties.

These changes to the committee charter happened after my legal client, Harrington Investments, Inc. (HII) had filed a shareholder resolution, for the second year in a row, to amend Intel’s bylaws to create a Board Committee on Sustainability.  Intel initially opposed the resolution at the Securities and Exchange Commission.  But a subsequent dialogue with HII yielded an agreement  (in exchange for withdrawal of the resolution) to propose changing the governance and nominating committee charter to require the committee to:

“review(s) and report(s) to the Board on a periodic basis with regards to matters of corporate responsibility and sustainability performance, including potential long and short term trends and impacts to our business of environmental, social and governance issues, including the company’s public reporting on these topics.”

As part of the dialogue, Intel also had its outside legal counsel Gibson, Dunn & Crutcher LLP ink an opinion clarifying that pursuant to Delaware law, the committee’s charter generates a fiduciary obligation. The legal memo cites the notion of a “charter imposed duty” as clarified by In re Walt Disney Co. Derivative Litigation, 906 A.2d 27, 53-54 (Del. 2006).

Although the case cited, Walt Disney involved a finding by the  Delaware Supreme Court that a $130 million severance payment  to Michael Ovitz did not entail a breach of the directors’ duties,  the case is widely cited for  the notion that directors have a fiduciary duty to “act in the face of a known duty to act.”  Thus by integrating sustainability and corporate social responsibility into a committee charter, committee members gain a fiduciary duty to attend to those issues.

As HII’s lawyer in this process, I find the inevitable legal questions flowing out of this analysis particularly interesting.  First of all, do all directors already have a fiduciary obligation regarding sustainability and corporate social responsibility? The answer is that within certain relatively uncharted boundaries they do. For instance, when it comes to oversight of environmental compliance, or social issues that may affect a company’s reputation, the duty of care attendant to directorship clearly extends such issues interwoven with the company’s prospects. An excellent aw review article,  “Is There An Emerging Fiduciary Duty To Consider Human Rights?” by law professor Cynthia Williams details this obligation, for instance, in the arena of human rights.  

How then does the insertion of specific language into a committee charter alter the scope of directors’ fiduciary duty on these issues? Contrary to the vagaries of evolving fiduciary obligations, with little delineation of the scope of a director’s obligation, the committee charter is very specific. It asks for the members to examine, for instance, “potential long and short-term trends and impacts to our business of environmental, social and governance issues.”  It gives much clearer guidance as to the range of issues under committee scrutiny, including  “long term” trends, and “potential” issues.
Finally, under what circumstances might the resulting fiduciary duty be deemed enforceable by the courts?

In general, the deliberations of directors are shielded by the “business judgment rule” which“ presumes that ‘in making a business decision the directors of a corporation acted on an informed basis, in good faith, and in the honest belief that the action taken was in the best interests of the company.’ ” Aronson v. Lewis, 473 A.2d 805, 812 (Del.1984).  So, it takes more than just a mistake by board members to face any liability exposure.  In general, the kinds of failures in their duties of care and good faith that would trigger liability would involve intentional dereliction, a conscious disregard for one’s responsibilities, an actual intent to do harm, or gross negligence.  

I believe the most immediate legal implication may be the enhanced duty of the directors to inquire and to oversee.  Specifically, when potential sustainability or corporate social responsibility issue present significant risks or opportunities to the company, the committee members have a duty to ensure that they are reasonably well informed. Secondly, they must ensure that the management is on top of the details, with sufficient internal controls in place, such as enterprise risk management systems.

Given the fiduciary duties that accompany this expanded committee role, it seems well worthwhile to encourage more boards of directors to ensure that sustainability and corporate social responsibility are well- delineated in committee charters.