Last year, the Wall Street Journal described an event that was previously unheard of – ‘a climate change bankruptcy’. A series of wildfires in California destroyed assets worth millions, pushing the Pacific Gas and Electricity (PG&E) Company into bankruptcy and causing huge losses to its investors. Later it was found that the executives of the Company knew that the wires were outdated and that there was a high risk of electricity plants catching fire. Not only did they not do anything to reduce the risk, but they also did not inform prospective shareholders of the potential fire hazard and financial risk. This raises an important practical question that had so far only been discussed in theory – should companies be made liable for failure to disclose climate change risks?
Over the last year, numerous countries have been discussing and debating the introduction of new regulations that mandatorily require companies to disclose potential risks to their business operations from climate change. There is, however, another school of thought, particularly prominent in the US, which holds that any information regarding climate change risks are ‘material information’ and accordingly, even in the absence of any new regulation, a failure to disclose such information to potential investors amounts to securities fraud. It has also been argued that a failure to disclose such information amounts to a breach of the fiduciary duty that the management of the company owes to tits investors. Although such a reasoning is yet to be espoused by any court in the US or elsewhere, the long-drawn litigation against Exxon indicates that there is some merit in these arguments.
In India, although the government has flagged climate change as a systemic risk that can affect the stability of the financial system, no steps have been taken in this regard by the Securities and Exchange Board of India (SEBI) or other regulatory bodies. The SEBI, like the Securities and Exchange Commission (SEC) in the US, relies on the subjective standard on materiality to determine the extent of disclosures required. No rule or regulation in India explicitly requires companies to disclose information about climate change risks. My new article in the Business Law Review argues that even in the absence of such an explicit regulation, the failure of Indian companies to disclose information about climate change risks violates the existing SEBI regulations.
Understanding materiality: In finance and in law
Ever since mandatory disclosures were introduced in the Securities Exchange Act in 1933, they have formed a key part of securities regulation across the world, including India. The primary purpose behind mandatory disclosures is to remedy the information asymmetry between the management of the company and the investors, so as to allow the investors to make informed decisions about where to put their money, and enable them to engage meaningfully with the company management. The understanding of what counts as material information is based on two broad theories.
The first is the efficient markets hypothesis. Postulated by the Nobel economics laureate Eugene Fama, it posits that the value of securities in a market reflects all the publicly available information. If the risks to the value of a corporation are not adequately disclosed, its shares are traded on the stock exchange at a value far above their actual worth, enhancing the possibility of a bubble on the market. Fischel further developed the idea into the fraud-on-the-market theory, which argues that because the securities market effectively reflects public information in the price of stock, fraudulent disclosures that artificially inflate or depress market prices create fraud on the entire securities market, leading to economic loss for the investor. According to this theory, therefore, material information amounts to everything which, if disclosed, will affect the price of the stock on the market. The US Supreme Court explicitly endorsed the theory in Basic v Levinson, effectively laying down the financial and economic basis for securities fraud adjudication.
The second financial theory underlying mandatory disclosures is the investor suffrage theory. According to the governance theory, the purpose of disclosures is to encourage investors to police the role of corporate decision making. This theory, also described as the agency cost model, postulates that disclosures reduce the costs of monitoring an agent’s use of corporate assets and allows shareholders to monitor self-interested directors, leading to efficiency in corporate governance. The increasing emphasis on non-financial disclosures, such as environmental compliance, boardroom diversity and human rights due diligence, lend support to this theory.
In India, the SEBI (Issue of Capital and Disclosure Requirements) Regulations, (ICDR) as well as the SEBI (Listing Obligations and Disclosure Requirements) Regulations (LODR) stipulate that all publicly listed companies are to disclose material information. Although Indian courts have not adopted the fraud-on-the-market theory as the US courts have, the concept of materiality has been defined in a similar way. In DLF Limited v. SEBI, the Securities Appellate Tribunal (‘SAT’) observed, ‘Disclosure … which is required to be made in the offer documents, is one which, if concealed would have devastating effect on the decision-making process of the investors, and without which the investors could not have formed a rational and fair business decision of investment in the IPO’. In the matter of IPO of OneLife Capital Advisors Ltd., the SEBI clarified, “‘material’ means anything likely to have an impact on an investor’s investment decision … the test to determine whether a fact is ‘material’ depends on the facts and circumstances of each case.”
Although the precise contours of materiality have not been laid down by the courts, it is clear that the term is to be construed liberally. The SAT further clarified in a recent decision – ‘The emphasis is on disclosure; not otherwise, which means disclose even when the issuer doubts whether there is materiality … ’. Given the extremely broad definition, it may be inferred that corporations may be liable for the non-disclosure of unprecedented events even if there are no guidelines from the
SEBI in that regard.
Materiality of climate change risks
There is a huge volume of economic literature postulating that climate change can bring about the next financial crisis. The slowly increasing frequency and severity of natural calamities threatens the assets owned by firms, comprising the first category of financial risks posed by climate change. The second category involves the potential decline in stock value as the society transitions to more eco-friendly lifestyle – that is, the stock value of petroleum firms is expected to decline over the next few decades as the society moves to electric vehicles and the like. The third category of risks arises from the ever-increasing cost of complying with stringent and pervasive environmental regulations that can severely limit the profitability of firms – for instance, regulations on stricter air controls have the potential to reduce the output of a manufacturing plant by almost 5%, imposing an annual cost of
USD 21 million to the entire manufacturing sector.
Given the financial effects of climate change, it is evident that awareness about these risks would affect the decisions of prospective investors and therefore amount to ‘material information’. Moreover, with the rapid rise of Socially Responsible Investing, nonfinancial information are playing a greater role in investment decisions. More and more investors are factoring in environmental concerns in deciding which companies to invest in – the emergence and rapid rise of companies like CDP that provide information about the environmental implications of a companies’ activities to potential investors, shows that climate change information is clearly material.
The obvious defence that most companies would resort to when charged with failure to disclose climate change risks would be that the management of the company was unaware of the degree and extent of the risks, as the financial impact of climate change is often hard to predict and take steps against. Recent investigations, however, have shown that this is not true. The ongoing lawsuits have revealed that the directors of Exxon deliberately concealed the information relating to potential damages to business operations from climate change. A study by the Center for International Environmental Law found that the entire global oil industry has been aware of climate change risks since as early as the 1980s but deliberately led efforts ‘to mislead or confuse the public about climate science … even when the industry’s own scientists were warning them about climate risks’. Even in India, shareholders of a number of public companies have expressed their discontent regarding the lack of information available to them about financial risks arising from climate change.
While the US SEC is considering making it mandatory for listed companies to disclose their climate change risks, there is still widespread disagreement regarding the materiality of climate change disclosures. It is essential that securities regulators rethink their understanding of materiality, and recognize climate change risks as material information that ought to be disclosed.
Anik is a final year student at NALSAR University of Law, Hyderabad. The author is thankful to Rudresh Mandal and Karan Sangani for their inputs.