ESG and Materiality in an Evolving Market
Thank you, Emily, for that kind introduction and to the GFOA for inviting me to speak today. I also would like to especially thank all of the government finance officers who are attending this session. The focus of my remarks will be on ESG and materiality in an evolving market. My hope is to clarify how the materiality standard may apply to ESG-related disclosures and to share observations about our evolving market from a regulatory perspective.
But first, let me briefly introduce the MSRB to those of you who may not be familiar with the regulatory framework of the municipal securities market.
Created by Congress in 1975, the MSRB serves as the principal regulator of the municipal securities market. I say principal because we work in concert with other financial regulators, most notably the SEC and FINRA who are responsible for enforcing the rules that we are responsible for writing. We also coordinate with bank regulators, including the Federal Reserve as well as with the US Treasury.
Our rules regulate the municipal advisors who advise you on your bond deals and the broker-dealers who underwrite and sell those bonds. Congress also entrusted the MSRB with the responsibility to protect issuers, investors and the public interest, so please know that you – the issuer community – represent a core stakeholder of the MSRB.
Congress also mandated that the MSRB’s Board of Directors have a majority of public – as opposed to regulated – members and that one seat on our 15-member board is reserved for an issuer representative. Currently, the MSRB has two active issuers and one former issuer who is now retired serving on our Board.
Beyond our rulemaking responsibilities, one of the most important ways that we protect issuers is by promoting market transparency through our technology solutions and market data. If you are familiar with filing annual financials or making continuing disclosures, then you are probably familiar with our EMMA website. This is our flagship technology platform that promotes transparency and ensures a more fair and efficient market.
The MSRB also serves as the market’s central – and sole – repository for market data. EMMA is not only the right place to go to make your required disclosures, but it is also the best place to go to make any voluntary disclosures.
The MSRB’s new Strategic Plan calls for an extensive investment in EMMA to improve the user experience and system security, performance and functionality. We look forward to and depend upon continued collaboration with issuers like you and industry associations like the GFOA to help us make EMMA easier to use and better able to meet your evolving needs, such as for investor relations.
So, on this note, let me turn to the subject of ESG and materiality in an evolving market.
I wanted to start by sharing a personal story about my own understanding of the concept of materiality. As Emily mentioned, I was an issuer before I was a regulator. In fact, I was a two-time issuer serving as the Deputy Comptroller of the City of New York and as the Chief Financial Officer of DC Water. And when I was an issuer, I held firmly onto the belief that I got to determine what information was material and what risks needed to be disclosed in the official statement. Interestingly, now that I am a regulator, I have come to appreciate that it is not necessarily the issuer that defines materiality but rather the investor. Now, of course, you the issuer remain responsible in the first instance for making all required disclosures of material information, but the standard against which those disclosures will be evaluated is whether a reasonable investor would consider them important in the context of the “total mix” of all the information made available. So, to be clear, it is the reasonable investor standard and not the reasonable issuer standard that will determine the materiality and legal sufficiency of your disclosures.
The Supreme Court defined “materiality” in a landmark 1976 decision1 – coincidentally, the year after Congress established the MSRB – in a case involving shareholder voting. The Court held that “an omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote.” Almost every single part of this standard has been subsequently litigated so there is a well-established body of case law and precedent supporting this interpretation and its application to municipal issuers and their disclosure obligations. The reasonable investor standard is a principles-based rule of law rather than a prescriptive regulation establishing a “bright line” standard of disclosure. As such, the proper application of the materiality standard to ESG-related disclosures requires judgment and a facts-and-circumstances determination. One size does not fit all. And that, in my opinion, is a good thing for the municipal securities market.
This principles-based approach to disclosure is also consistent with the approach the GFOA adopted when it recently released its E, S and G suite of best practices. I want to applaud Tim Ewell (Chair), Cindy Harris (Vice-Chair) and the other members of the GFOA’s Debt Committee in developing these best practices and releasing them, along with the updated best practice on voluntary disclosures. As a former member of the GFOA’s debt committee, I know how challenging the review and approval process can be for issuing a best practice so kudos to all involved.
So, what happens if an issuer fails to make required disclosures of material information in connection with issuing municipal bonds? Under federal securities law, the issuer may have committed securities fraud. There are two relevant legal standards pertaining to disclosures by municipal issuers. One is established by the Securities Exchange Act of 1934 and SEC Rule 10b-5. The standard for securities fraud under this rule is strict and requires ‘scienter’ or, in other words, the issuer must have acted recklessly, knowingly or purposely in making a material misstatement or omission; mere negligence is not enough to constitute fraud under this rule. The other legal standard for securities fraud is established by Section 17(a) of the Securities Act of 1933, which establishes a lower negligence threshold and does not require scienter in making an untrue statement or omission of a material fact in the disclosures pertaining to the “offer or sale” of securities. As applied to issuers, the negligence standard has been interpreted to mean that the issuer should have acted with “reasonable care” and should have known that its statements were false or misleading.
There is another aspect of materiality that I would like to discuss, and that is its relationship to an issuer’s financial position and creditworthiness, in particular its willingness and ability to timely repay principal and interest on its bonds. It is a commonly held belief that any information that is material to a municipal issuer’s financial position must be disclosed. I believe that this position may overstate the requirements of federal securities law as it pertains to disclosures made in connection with the issuance of municipal securities. Thus, I would qualify this statement to be that only material information which is subject to a specific duty to disclose is required to be disclosed, such as the information identified in a continuing disclosure agreement or described in SEC Rule 15c2-12. However, even information that is not expressly identified in the CDA or Rule 15c2-12 might need to be disclosed to investors, such as information necessary to make the other information that is disclosed not misleading.
Clearly, when it comes to the offer and sale of municipal securities, the issuer’s financial position is deemed to be material and issuers are generally obligated to disclose such information. But does this mean that the only information that must be disclosed to investors must be related to an issuer’s financial position? I would suggest that the answer to this question is “no”. Just as there is no way to disclose every single detail about your financial position, nor is disclosing everything material that is required to be disclosed about your financial position necessarily sufficient to give a reasonable investor what they consider material to make an informed investment decision.
This brings me, finally, to discuss the emergence of ESG factors in our evolving market. We have all been hearing a lot about ESG these days and I think the national discourse has moved from main street to pop culture. I read an article in the WSJ last week that Prince Harry and Meghan Markle are getting into the sustainable investing space by joining a FinTech asset manager as “impact partners” looking to make investments in the ESG space… When my teenage daughter starts asking me about impact investing and Prince Harry, I know that ESG has gone viral! Now let’s get back to the municipal securities market. What we have observed is that investors and other market participants are increasingly integrating ESG factors into their investment decisions and credit analysis. In other words, investors are incorporating ESG factors into the total mix of the information being used in their portfolio valuation and risk models. Credit rating agencies now offer an ESG score in addition to the credit rating or are incorporating certain ESG factors into the credit rating process itself. Remember, the standard of materiality is not what the reasonable issuer thinks is material, it is what the reasonable investor thinks is material. And in my view, the kinds of information that today’s reasonable investor thinks are material is evolving. The results of the Bond Buyer’s ESG market survey that were released yesterday and the GFOA’s own best practices on E, S and G seem to reinforce this view.
The MSRB will be issuing a Request for Information in the coming weeks seeking comment from market participants on ESG trends in the municipal securities market. For issuers, we are interested in whether you are providing the market with climate risk and other types of E, S and G disclosures and, if so, to share examples of such disclosures with us. We are interested in how you quantified the risks and the types of ESG information you are disclosing. We are asking related questions to your underwriters, municipal advisors and investors. I hope that you will take the time to respond and help inform us about what you are seeing and doing in the market with respect to ESG.
This is a separate topic, but we are also interested in whether you have self-labeled your bonds green, climate, social or sustainable and, if so, the reasons why you decided to market them as such and what standards you used to determine that they qualify to be labeled as that type of a bond. I know that “ESG” means different things to different people, and for some, talking about ESG is the same thing as talking about green bonds. I want to reassure you that the MSRB appreciates that there is a difference between ESG-related disclosures and the labeling and marketing of bond deals on the other hand. Both topics are of interest to the MSRB and I look forward to reading your responses to our RFI.
Let me close by saying thank you again to the GFOA for inviting me to speak today and to all the government finance officers who zoomed into this session. I hope to see you in person next time!