ESG disclosure in the municipal securities market

Introduction

Municipal bond industry participants should be aware of environmental, social and governance (ESG) initiatives and enforcement actions by the US Securities and Exchange Commission (the SEC), as well as a related market assessment by the Municipal Securities Rulemaking Board (the MSRB). In the first half of 2022, the SEC proposed rules requiring (a) climate-related disclosures for registered companies, (b) changes to the Investment Company Act "Names Rule" that would restrict the use of ESG terms in investment fund names and (c) specific ESG‑related disclosures for investment funds and advisers. Through the Climate and ESG Task Force within the SEC's Division of Enforcement, in May 2022, the SEC also brought an enforcement action against an investment adviser for failing to confirm the ESG parameters of investments by an ESG fund. In August 2022, the MSRB released a summary of responses to its public inquiry regarding ESG disclosure and ESG‑labeled bond practices in the municipal securities market. Although neither the SEC nor the MSRB has imposed any ESG‑related rules on municipal issuers, conduit borrowers or underwriters, their recent actions provide insight into how existing rules may apply to ESG disclosure, including practices regarding ESG‑labeled bonds.

Proposed ESG‑related SEC rules

In March and May of this year, the SEC proposed new rules relating to ESG considerations for registered corporate issuers and investment funds and advisers. The proposed rules generated interest in the public finance community because of their potential precedential impact and insight into the SEC's current views on the potential materiality of ESG‑related facts.¹ While the rules may not be adopted by the SEC in their current form, or at all, the following summary of certain key provisions of the proposed rules may be useful in evaluating the potential materiality of ESG‑related facts.

Mandatory climate-related disclosures

On March 21, 2022, the SEC proposed comprehensive new climate disclosure requirements for domestic and foreign publicly traded companies.² The rules proposed by the SEC would require registrants to include climate-related disclosures in registration statements and periodic reports, including information about climate-related risks that are reasonably likely to have a material impact on the registrants' business or consolidated financial statements along with greenhouse gas emissions metrics.³ The framework for the proposed disclosure requirements is based in part on the Task Force on Climate-Related Financial Disclosures (TCFD) Framework and the Greenhouse Gas Protocol used by European regulators.

The proposed rules would require disclosure about the following:

• Oversight and governance of climate-related risks by the board and management
• Material impact of climate-related risks on the registrant's business and consolidated financial statements, which may be manifested over the short-, medium- or long-term⁴
• Impact of climate-related risks on strategy, business model and outlook
• Processes for identifying, assessing and managing climate-related risks and whether those processes are integrated into the overall risk management system or processes
• Impact of climate-related events (i.e. severe weather events and other natural conditions) and transition activities (i.e. activities associated with addressing climate-related risks) on the registrant's consolidated financial statements and related expenditures and disclosure of financial estimates and assumptions impacted by the events and activities
• Climate-related targets or goals and transition plan, if any
• Greenhouse Gas (GHG) Scopes 1 and 2 emissions (emissions that result directly or indirectly from facilities owned or controlled by the reporting company) and
• Scope 3 GHG emissions (indirect emissions not included in Scope 2 emissions, which occur in the upstream and downstream activities of a company's value chain), if material or if the registrant has set a GHG emissions reduction target or goal that includes its Scope 3 emissions⁵

Under the proposed rules, public companies would also be required to include climate-related financial statement metrics and related disclosure as a note in their audited financial statements. The proposed financial statement metrics would consist of disaggregated climate-related impacts on existing financial statement line items. As part of the registrant's financial statements, the financial statement metrics would be subject to audit by an independent registered public accounting firm and come within the scope of the registrant's internal control over financial reporting.

Investment fund rules

On May 25, 2022, the SEC proposed two separate ESG‑related rule changes. ⁶

The first proposed change would revise Rule 35d-1 under the Investment Company Act of 1940, as amended, known as the "Names Rule."⁷ The existing "Names Rule" requires that, under normal circumstances, at least 80 percent of the assets of a fund must be invested in investments of the type or industry described by its name. The proposed revisions to this rule would apply the requirement to funds with names suggesting a focus on investments with particular characteristics, including ESG factors. Significantly, the proposed revisions would provide that if ESG factors are being considered alongside, but "do not play a central role" compared to, other factors in a fund's investment decisions, then ESG‑related terms cannot be used in its name, as doing so would be "materially deceptive or misleading."

The second proposed change would establish disclosure requirements for registered investment companies and business development companies (collectively, funds) and registered investment advisers and certain unregistered advisers (collectively, advisers) concerning ESG factors.⁸ The proposal would (1) require additional specific disclosure requirements regarding ESG strategies in fund prospectuses, annual reports and adviser brochures; (2) implement a layered, tabular disclosure approach for ESG funds to allow investors to compare ESG funds; and (3) require environmentally focused funds to disclose GHG emissions associated with their portfolio investments.⁹ The proposed amount of required disclosure would depend on the degree to which ESG factors are important to a fund's strategy. The proposal identifies three types of ESG funds, reflecting different levels of ESG focus in their investment guidelines and proposes heightened disclosure requirements for the second and third types: (1) Integration Funds (funds that integrate ESG factors alongside non-ESG factors), which would be required to describe how ESG factors are incorporated into their investment process; (2) ESG‑Focused Funds (funds that center or focus on ESG factors), which would be required to provide detailed disclosure, including a standardized ESG strategy overview table; and (3) Impact Funds (a subset of ESG‑Focused Funds that seek to achieve a particular ESG impact), which would also be required to disclose how it measures progress on its objective. 

Guidance from SEC Office of Municipal Securities

In his remarks at a Government Finance Officers Association (GFOA) conference in June 2022, Dave Sanchez, director of the SEC's Office of Municipal Securities, addressed concerns about the SEC's increased focus on ESG matters. He shared personal thoughts regarding both disclosing ESG risks affecting municipal securities and disclosure around ESG‑designated bonds.¹⁰ He suggested that, when evaluating climate change disclosure, municipal issuers would "be in a good place" if they continued "using the same principles" they should use for disclosing other facts, for example by looking at factors "like do they have a credit impact, a financial impact on revenues used to pay back the bonds." He noted that the "rules have not changed, you're just applying it to a different topic."¹¹

However, when disclosing facts relating to green bonds and other designated bonds, Director Sanchez noted that additional considerations apply and warned, "What are we promising and are we actually delivering what we're promising? You're marketing to investors in a specific way; you have to be careful."¹²

Although the SEC is not authorized to regulate municipal issuer disclosure directly (rather than indirectly as it has through Rule 15c2-12), Director Sanchez acknowledged that more SEC guidance on ESG disclosure is desired, particularly in the area of voluntary disclosure, similar to the well-received May 2020 guidance on voluntary disclosure relating to COVID-19.¹³

In recent comments at the National Association of Bond Lawyers' Bond Attorneys Workshop in October 2022, Director Sanchez suggested that the SEC may not need to issue a specific ESG rule for the municipal securities market because existing SEC ESG proposals applicable to corporate issuers may be sufficient "if the [municipal] market responds," in which case, "there doesn't need to be any additional rule writing."¹⁴ Director Sanchez recommended that municipal market practitioners read through the SEC's ESG proposals, even though "they don't apply" to the municipal market because the proposed rules "are more prescriptive, they do give you those additional touch points and that's usually enough to get you to be able to make a decision to think through" difficult disclosure issues.

SEC enforcement activity

In March 2021, the SEC announced the creation of a Climate and ESG Task Force in its Division of Enforcement. According to the announcement, the task force's initial focus would be "to identify any material gaps or misstatements in issuers' disclosure of climate risks under existing rules," and it would also "analyze disclosure and compliance issues relating to investment advisers' and funds' ESG strategies."¹⁵

As a result of the Task Force's work, on May 23, 2022, the SEC initiated and settled public administrative and cease-and-desist proceedings against an investment adviser. According to the SEC, the investment adviser had represented or implied in various statements that all investments in certain mutual funds that it managed had undergone an ESG quality review, even though that was often not the case. The SEC concluded that the investment adviser's statements violated Section 206(4) of the Investment Advisers Act and SEC Rule 206(4)-8, "which provides in relevant part that it is unlawful for an investment adviser to a pooled investment vehicle to make any untrue statement of a material fact or to omit to state a material fact necessary to make the statements made, in the light of the circumstances under which they were made, not misleading, to any investor or prospective investor in the pooled investment vehicle."¹⁶ The investment adviser ultimately settled the charges by agreeing to pay a US$1.5m penalty.¹⁷

Given the similarity of SEC Rules 206(4)-8 and 10b-5, this administrative proceeding provides insight into how the SEC views ESG disclosure requirements. The adviser managed two types of funds: "Sustainable Funds," which incorporate ESG investment principles as part of their principal investment strategies and "Overlay Funds," which do not. However, the adviser allegedly represented to investors and intermediaries that ESG considerations were part of the Overlay Funds' investment process. The administrative proceedings were brought in respect of the Overlay Funds.

Neither the SEC Order nor its press release explains why statements concerning the ESG characteristics of investments were "material," although the press release noted investor demand for "investments that employ ESG strategies or incorporate certain ESG criteria."¹⁸ Were the statements material because ESG risks could be important to investors when they evaluate likely financial return, or because social investors want to reward issuers that are socially responsible? Since the Overlay Fund was not an ESG‑labeled fund, the administrative proceeding is evidence that the SEC is willing to bring disclosure-related enforcement actions in respect of bonds that are not ESG‑labeled, as well as those that are, if issuers make misstatements or misleading omissions regarding material ESG facts.¹⁹

Responses to the MSRB's RFI on ESG practices in the municipal securities market

In December 2021, the MSRB issued a request for information (the RFI) from the public relating to ESG practices in the municipal securities market.²⁰ According to the MSRB, the purpose of the RFI was to promote greater understanding "of how ESG practices are being integrated in the municipal securities market and to engage in information-gathering" in furtherance of the MSRB's statutory mandate to protect investors, issuers and the public interest.²¹ When the RFI was issued, MSRB CEO Mark Kim explained that it was prompted by "the absence of uniform standards surrounding ESG disclosures and bond labeling" and wanting "to hear from stakeholders on their perspectives for how to enhance issuer and investor protections relating to these matters."²²

In response to the RFI, the MSRB received 52 comment letters. Although some of the letters welcomed increased guidance from the MSRB, other letters expressed intense concerns about the RFI and that the MSRB might be exceeding its mandate.²³ A comment letter from the State of Utah, which was signed by the attorneys general and treasurers from nearly 24 Republican-controlled states, was especially critical of the MSRB's request for information, arguing among other things that the MSRB request overstepped the limitations set forth by Congress on the MSRB's authority could create a regime that would burden small municipal issuers and fail to focus on "material" ESG‑related information.²⁴

The MSRB published its summary of responses to the RFI (the Summary)²⁵ on August 9, 2022.

The Summary discussed three broad themes of the responses: (1) ESG practices in the municipal securities market, (2) challenges associated with ESG integration in the municipal securities market and (3) suggestions for the improvement of market transparency about ESG through the MSRB's Electronic Municipal Market Access (EMMA) website. 

With respect to ESG practices in the municipal securities market, the Summary noted that (1) there was a general consensus that they are still evolving, (2) market-based solutions in response to ESG considerations appear to be emerging and (3) most responders thought that regulatory action by the MSRB would be premature, as it could be costly for issuers and impede the market-based development of best practices.

The Summary also discussed how the evolving nature of ESG integration poses challenges in the municipal market, including (1) the lack of ESG standards and uniform practices and the resulting potential harm to investors and issuers and (2) potential regulatory compliance challenges for dealers and municipal advisors. According to some responses, because standards and uniform practices were lacking, investors and issuers were confused about disclosing ESG risks and in the labeling of ESG bonds, resulting in information gaps and asymmetries for investors, particularly individual retail investors. The responses were divided over whether standardization would be helpful to the market and result in increased market efficiency. 

The Summary also described ESG‑related regulatory compliance challenges. For instance, underwriters face challenges in checking the truthfulness of ESG claims for labeled bonds. In primary offerings, order priority is starting to be granted to "ESG investors" (for which there is no standard definition), but how such priority might impact pricing is unclear. Also, dealers are concerned that when bonds are traded in the secondary market, an ESG label may no longer be accurate, so it may be misleading.

The Summary reported a general consensus that enhancements to the MSRB's EMMA website could increase market transparency. Some responders suggested that the MSRB should make it easier to enter and access ESG disclosures, including voluntary disclosures and include more information about third-party verifiers.

According to CEO Mark Kim, "[o]ne of the most important insights … shared by the public commentary was the need to be more precise in defining what aspect of ESG" is being discussed, noting that "public commentators made distinctions between, for instance, credit risk related ESG disclosures, versus non-credit related ESG information that might pertain to the bonds or to the issuer of the bonds."²⁶

The Summary did not identify any proposed regulatory action that might result from the inquiry; rather, it stated that the MSRB would "continue to monitor and engage with the broader market on understanding emerging ESG practices and their implications for market fairness, efficiency and transparency."²⁷ In light of the controversy surrounding the RFI, the Summary clarified that the RFI was "categorically different from a request for comment" on a proposed rule or potential regulatory approach and was intended to seek feedback "for the limited purpose of further informing the MSRB's ongoing dialogue with stakeholders, not for the specific purpose of advancing its rulemaking objectives."²⁸

Implications for the municipal market

SEC's proposed rules – Applicability to municipal securities

The SEC is currently reviewing comments on its proposed ESG disclosure rules for registered companies, so it has not yet decided to adopt the rules in their proposed form or at all.²⁹ Nevertheless, are there takeaways from the SEC's ESG rule proposals or, if adopted, final rules that should be considered by municipal issuers, conduit borrowers, or municipal securities underwriters?

The proposed rules, if adopted, would not apply to municipal issuers or conduit borrowers that are not registrants. Municipal securities are generally exempt from registration and the specific line-item disclosure requirements that must be followed by registered companies.³⁰

Municipal issuers and conduit borrowers are subject to compliance with the antifraud provisions of the federal securities laws,³¹ so they must not fail to disclose "material" facts that make their statements to investors misleading. A fact is "material" for these purposes if there is a substantial likelihood that a reasonable investor would consider it important to an investment decision.³² The SEC's ESG rule proposals may be relevant to municipal issuers and conduit borrowers because they reveal the type of facts that the SEC believes may be important to investors.

But a "reasonable investor" in corporate securities may attach different importance to ESG facts than an investor in municipal securities. First, corporate registrants typically do business in competitive markets, so their relative vulnerability to GHG transition costs, for example, could affect their financial prospects. Most municipal issuers derive their revenue from involuntary taxes and sales of essential goods and services without competition, so their financial prospects may be less vulnerable to GHG transition costs. Second, corporate disclosure is used to inform investments in equities, the value of which is generally more volatile than the value of debt securities. Municipal issuers, on the other hand, issue only debt securities. Third, corporate disclosure is also used to inform shareholder proxy voting on management and shareholder initiatives. The holders of municipal securities have no say in issuer governance. Consequently, that the SEC may consider a fact material to an investment in corporate securities does not mean that it would consider the fact material to an investment in municipal securities.³³

The SEC releases proposing ESG rules do explain why ESG facts may be important to an investment in corporate registrants and investment funds. They reveal how some ESG facts may be important to an investment in municipal securities, too and therefore "material."³⁴

Climate-related disclosure

Keeping the above considerations in mind, the proposed rules do offer a sense as to what types of climate-related facts may be considered "material" by the SEC and may serve as a helpful guide for municipal issuers and conduit borrowers. When ESG disclosure rules were proposed in March, SEC Chair Gary Gensler explained that, in identifying the climate-related disclosures for inclusion in the proposed rules, the SEC was "guided by the concept of materiality" and that the proposal was driven by the "needs of investors and issuers" and the "demand for consistent and comparable information that may affect financial performance."³⁵

The proposed climate disclosure rules, referred to above, cover disclosure in the following general categories, with the first two categories being more relevant to municipal issuers and conduit borrowers:

1. Climate-related risks and their past and potential impact on an issuer (e.g. how climate-related risks have had or are likely to have a material impact on its business and consolidated financial statements; impact of climate-related events and transition activities on financial statements and related expenditures)
2. The issuer's governance structure, process and strategy to assess and address climate risks (e.g. oversight and governance of climate-related risks; how climate risks are identified, assessed and managed; impact of climate-related risks on strategy, business model and outlook; climate-related transition plan, targets or goals) and
3. Certain climate-related standardized data (e.g. greenhouse gas emissions, financial statement metrics)

The proposed rules that fall under categories (1) and (2) relate to information that could apply to a municipal issuer or conduit borrower (although some may not have any significant climate risks to discuss other than very generalized risks). For example, if an issuer has incurred one or more devastating hurricanes in the recent past, the extent of its lost revenue and property valuers and additional expense could be material because it might inform investors of the potential extent of weather risks. Similarly, suppose an issuer has determined that substantial capital investments are needed to make its infrastructure sustainable. In that case, that fact might be material because it could affect its future debt-to-value or debt-service coverage ratios. Category (3) data, such as greenhouse gas emissions or detailed financial statement metrics, may be of less relevance to an investment in municipal securities.³⁶

Overall, if they have not already done so, municipal issuers and conduit borrowers should review the SEC-proposed climate-related disclosure rules and consider whether they have any material climate-related risks. The proposed rules offer a sense of what topics may be considered "material" by the SEC, with the caveat that the proposed rules are designed for registered corporate issuers, not municipal issuers. The uniform application and scope of the proposed corporate-style disclosure rules would not necessarily make sense for municipal issuers; consequently, the proposed rules should be evaluated in each case for relevance.

Investment fund rules

While they are not legally applicable to municipal securities, some municipal market participants believe that the proposed investment fund ESG rules could influence the SEC's future activities and are "absolutely relevant as a precedent as sort of a description of an approach" that could apply to labeled municipal bonds.³⁷

Currently, there are no uniform standards or regulations applicable to disclosure for ESG‑labeled bonds, aside from the general materiality and antifraud concerns discussed above. Although the Names Rule proposals described above apply to investment funds, ESG‑labeled bonds could be a target for potential future scrutiny if ESG factors do not play a "central role" in those bonds. On the Names Rule issue, SEC Commissioner Allison Herren Lee indicated that, for funds using terms such as "ESG," "sustainable" or "green" in their names, it is "important to protect against overstatement or exaggeration" to the extent the names factor into investment choices and "what the names convey to investors must be consistent with those choices."³⁸ As referenced earlier, Director Sanchez has similarly warned that municipal issuers should be careful about any promises or predictions made to investors regarding ESG‑labeled bonds,³⁹ suggesting potential regulatory or enforcement action in this area. Therefore, it may be beneficial to evaluate whether an ESG factor is being overstated with respect to the use of proceeds of a bond issue prior to using an ESG designation.

The SEC proposal to require ESG disclosures from funds and advisers may also indirectly affect municipal issuers by increasing the scope of ESG‑related information expected by funds that incorporate ESG factors. In particular, ESG‑Focused Funds and Impact Funds may request additional information from municipal issuers about ESG factors (such as data on GHG emissions in the case of environmental-focused funds), in order to comply with the new proposed disclosure requirements.

MSRB: No regulatory action for now

The Summary noted that MSRB regulatory action would not be welcome by most municipal market participants since ESG practices in the municipal securities market are evolving. Consequently, despite initial public concerns about the MSRB's intentions, the Summary suggests that the MSRB will propose no regulatory action on ESG issues in the near future.⁴⁰

Conclusion

As discussed in the MSRB's Summary, expectations and practices relating to ESG in the municipal markets are evolving. Further, neither the MSRB nor the SEC has adopted specific ESG rules applicable to municipal market participants. While ESG disclosure expectations continue to evolve, the SEC's recent ESG‑related proposals and enforcement actions, as well as the guidance and best practices provided by various public finance professional organizations,⁴¹ may provide guidance for municipal issuers, subject to the limitations discussed above.

If you have further questions regarding the SEC's and the MSRB's recent activities relating to ESG disclosure in the public finance space, please contact Mary Kimura or Fredric (Rick) Weber or with respect to SEC enforcement actions, Kevin Harnisch, Seth Kruglak, Todd Batson or your customary Norton Rose Fulbright lawyer or lawyers.