Business Owners & Leaders: What is Environmental, Social, and Governance (ESG) & What Laws Are Forcing ESG Company Compliance?

ESG has been a hot topic in the news and on the minds of corporate lawyers for a few years now. It’s a huge topic with many moving and intertwined parts and laws. This article covers a broad brush of what ESG is, an overview of important ESG regulations, key drivers, and ESG ratings. Companies are faced with an increasing focus by corporate stakeholders on corporate social responsibility (CSR), and more recently, on environmental, social, and governance (ESG) issues and sustainability. What starts as a focus on big companies also often trickles down to main street.

So What Is ESG?

The term ESG was first introduced at the Who Cares Wins conference in 2005 by the financial sector focused on integrating ESG issues into investment analysis, processes, and decision-making. Today the term is used widely by the business community, driven by the continued focus placed on the topic by corporate stakeholders. ESG generally is an umbrella term for a broad range of environmental, social, and governance factors:

• Environmental. Environmental factors relate to a company’s impact on the environment, and include carbon emissions, waste management, water usage deforestation, biodiversity, and pollution.
• Social. Social factors relate to how a company treats people, such as its employees, customers, local communities, and society generally. Social factors include human rights, diversity and inclusion, health and safety, nondiscrimination, human capital management, privacy and data protection, and how these issues are addressed within supply chain.
• Governance. Governance factors relate to how the company is run, and include director independence, board diversity, other board structure and composition issues, executive compensation, bribery and corruption, and maintaining ethical standards.

There is a broad range of examples of ESG factors. It is difficult to provide a full list, considering the varying interpretations and approaches. For example, the United Nations Principles of Responsible Investment (the UN PRI) contains one list with 40 categories.

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There is no standard or universally accepted definition of ESG. The ESG factors that are relevant to a particular entity differ depending on the industry and the countries in which the entity operates. In addition, the focus on specific factors varies over time. For example, climate change and other environmental issues have been and are likely to remain top ESG considerations. However, in 2020, as a result of the COVID-19 pandemic and the circumstances surrounding the death of George Floyd, companies and stakeholders shifted their focus more towards social issues. Companies:

• Had to quickly adopt health and safety measures to protect their employees, such as moving to remote work and providing extended health coverage options.
• Demonstrated greater commitment to diversity, equity, and inclusion in the workforce, the executive suite, and the boardroom.

ESG has largely replaced CSR (Corporate Social Responsibility) as the more commonly used term. CSR refers to a company’s sustainability efforts, while ESG refers to how investors measure those sustainability efforts. Sustainability is the broadest term, encompassing both ESG and CSR.

Note ESG investing has its own set of difficulties, including:

• The lack of standardization in ESG investing terminology: strategies that are referred to as sustainable, socially responsible, impact investing, and environmental, social, and governance conscious, which incorporate ESG criteria.
• The variety of approaches to ESG investing. For example, a portfolio may be labeled as ESG because of consideration of ESG factors alongside traditional financial, industry-related, and macroeconomic indicators, while other portfolios may use ESG factors as the driving or main consideration in selecting investments. In addition, some portfolios engage in impact investing seeking to achieve measurable ESG impact goals.

Why Is ESG Important for Companies?

The notion that profits and sustainability can go hand-in-hand is now generally accepted in the corporate world. As a result of the increased emphasis on ESG by corporate stakeholders, companies are embracing the concept that focusing on ESG can be good for business and help build long-term shareholder value.

Companies with an ESG focus:

• Are better able to attract and retain employees.
• Can more easily meet customer and supplier demands.
• Are more attractive to sustainability-conscious investors.
• Will be better prepared to respond to future regulation.

Conversely, companies with poor ESG performance risk:

• Losing customers, employees, and investors.
• Reputational harm.
• Litigation and enforcement actions.

While the importance of ESG continues to grow worldwide, some headwinds have arisen in the US. ESG is becoming increasingly politicized, with many states seeking to restrict the use of ESG investing for state funds and prohibiting the use of ESG factors by financial firms (see Iowa Attorney General November 29, 2023 Letter). The demand for fossil fuels may also increase in the short and medium term due to higher energy prices resulting from the war in Ukraine. Despite these challenges, ESG-minded investors, consumers, and regulators are likely to continue to drive companies to earn their “social license” .

ESG Regulation

ESG regulations are as difficult to define as the ESG terminology. There are no overarching laws that regulate ESG. However, there are many ESG-related federal disclosure requirements for public companies as well as federal statutes in areas related to ESG, such as bribery and corruption, forced labor, green marketing, and environmental conservation. State regulation of ESG and related areas include compliance with the federal conflict minerals disclosures, required disclosures regarding the supply chain and greenhouse gas (GHG) emissions, investments of state pension funds, and board diversity. In addition, the major US stock exchanges, Nasdaq Stock Market (Nasdaq) and the New York Stock Exchange (NYSE), have mandatory qualitative corporate governance standards for listed companies and both encourage, but do not require, ESG disclosures.

This section is not an exhaustive review of ESG-related regulation. For example, laws and regulations regarding pollution and clean-up, federal regulations regarding worker health and safety enforced by OSHA, employment discrimination enforced by the EEOC, and provisions against human trafficking in the Federal Acquisition Regulation (FAR) are all related to ESG. The currently existing patchwork of federal and state regulation in the US is in contrast to the more structured regulatory framework in Europe.

Federal Regulation

Federal Securities Laws and Regulations

To date, there are no US laws and regulations mandating a uniform ESG-reporting framework. However, certain ESG-related disclosure has been made mandatory through legislative and regulatory action. For example, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act) mandated the SEC to adopt rules requiring certain ESG-related disclosure, including disclosure related to:

• Conflict minerals, aimed at reducing exploitation of conflict minerals believed to be financing violent conflict in Democratic Republic of the Congo and neighboring countries.
• The ratio between a company’s CEO annual total compensation and the median of the annual total compensation of all company employees other than the CEO.
• Payments made to foreign governments or the US federal government by certain resource extraction issuers.

In addition, the SEC has increasingly made ESG a regulatory priority. The disclosure framework for public companies has generally been based on the concept of materiality, rather than uniform mandatory ESG disclosure requirements.

Bribery and Corruption

The Foreign Corrupt Practices Act of 1977 prohibits US companies and persons from bribing foreign government officials to obtain or retain business. The US Travel Act prohibits engaging in any interstate or foreign travel or using the mail or facilities associated with interstate or foreign travel with the intent to carry on or further any unlawful activity (18 U.S.C. § 1952).

Forced Labor

Federal law has long prohibited the importation into the US of any goods made by forced labor. The Smoot-Hawley Tariff Act of 1930 prohibited imports of goods mined, produced, or manufactured wholly or in part in any foreign country by forced labor (defined to include convict, indentured, and child labor) (19 U.S.C. § 1307). However, this prohibition was rarely enforced due to the consumptive demand exception, which allowed imported goods made by forced labor if these goods were not produced in sufficient quantities domestically. The Trade Facilitation and Trade Enforcement Act of 2015 (TFTEA) (Pub. L. No. 114-125, 130 Stat. 122) repealed the consumptive demand exception.

Two other statutes create a rebuttable presumption that forced labor was used in products made:

• By North Korean nationals or citizens, wherever located (Countering America’s Adversaries Through Sanctions Act of 2017 (CAATSA) (Pub. L. No. 115-44, 131 Stat. 886)).
• In China’s Xinjiang Uyghur Autonomous Region (Uyghur Forced Labor Prevention Act of 2021 (UFLPA) (Pub. L. No. 117-78, 135 Stat. 1525)).

CAATSA and UFLFA effectively make these imports illegal unless the importer can prove that the goods were not made using force labor.

In addition, the FAR contains provisions against human trafficking. In 2015, in response to President Obama’s Executive Order 13,627 “Strengthening Protections Against Trafficking in Persons in Federal Contracts,” the Federal Acquisition Regulatory Council issued rules prohibiting federal government contractors, subcontractors, and their employees and agents from engaging in activities related to human trafficking and slavery (80 FR 4967). The FAR provisions also require federal contractors to take certain actions to combat human trafficking in their supply chains.

Green Marketing

Federal law also regulates companies making marketing claims about environmentally friendly or green products or services. The Federal Trade Commission(FTC) is the primary federal agency responsible for ensuring that advertising claims comply with the Federal Trade Commission Act (FTC Act). The FTC has outlined general principles for green marketing claims in its Green Guides. The Green Guides are part of the FTC’s efforts to prevent greenwashing, a practice by which companies make false or misleading claims about the environmental impact of their products or services.

Several states have also adopted legislation regulating certain types of environmental claims, particularly related to degradable, compostable, and recyclable claims.

Environmental Conservation

The Lacey Act is a US conservation law that prohibits trade in wildlife, fish, and plants that have been illegally taken, possessed, transported, or sold (16 U.S.C. § 701).

State Regulation

Compliance with the Conflict Minerals Disclosure Rules

At the state level, two states have passed legislation requiring companies contracting in-state to comply with the federal disclosure rules on conflict minerals:

• California (see California Senate Bill 861 (2011 CA S.B. 861 (NS) 2011 WL 4827599).
• Maryland (see Maryland’s House Bill 425 (2012 MD H.B. 425 (NS) 2012 WL 1647053).

Climate Disclosure

In 2023, California enacted three climate-related disclosure bills:

• SB 253 (the Climate Corporate Data Accountability Act) which requires business entities with more than one billion in total annual revenues to report annually their Scope 1, Scope 2, and Scope 3 GHG emissions, and to obtain assurance for their reported emissions.
• SB 261 (Greenhouse gases: climate-related financial risk) which requires business entities with more than $500 million in total annual revenues to disclose their climate-related financial risk in accordance with the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD) biennially beginning on or before January 1, 2026.
• California A.B. 1305 (Voluntary Carbon Market Disclosure Act) which requires disclosures for business entities that participate in carbon offset markets or that make claims about achieving net zero.

Supply Chain

California has also passed legislation on human trafficking and slavery in the supply chain. The California Transparency in Supply Chains Act of 2010 requires disclosures on measures companies are taking to eliminate slavery and human trafficking in their supply chains. The Supply Chains Act applies to any company that:

• Is a manufacturer or retailer.
• Has worldwide gross receipts more than $100 million.
• Does business in California.

(Cal. Civ. Code § 1714.43 and Cal. Rev. & Tax Code § 19547.5).

State Pension Funds

State governments are taking opposing positions on considering ESG issues in investing and risk management decisions. Some states have restricted the use of ESG investing for state funds and banned financial institutions, while others are enacting disclosure requirements for GHG emissions and other ESG factors. Businesses operating in multiple states must navigate diverse, and often conflicting, state laws. California and Illinois have used their state pension funds to drive ESG-related change. California, through its Public Employees’ Retirement System (CalPERS) and its State Teachers’ Retirement System (CalSTRS), has issued specific requirements for ESG investing. Illinois, under the Sustainable Investing Act, requires all public agencies that manage public funds in the state to develop, publish, and implement sustainable investment policies (2019 Ill. Legis. Serv. P.A. 101-473 (H.B. 2460)). In 2021, Maine passed a law requiring its pension fund state treasure to divest from coal, oil, and gas companies by 2026. Other states, such as Massachusetts, Minnesota, New Jersey, New York, and Vermont have introduced legislation that would limit or eliminate public funds investment in fossil fuels.

Other states are pushing back against the use of ESG factors and are challenging major financial institutions that manage state pension funds. For example, attorneys general from Alabama, Arizona, Arkansas, Georgia, Idaho, Indiana, Kansas, Kentucky, Louisiana, Mississippi, Missouri, Montana, Nebraska, Ohio, Oklahoma, South Carolina, Texas, Utah and West Virginia sent a letter to BlackRock’s CEO stating that the company’s objectives on decarbonization may violate the Sherman Antitrust Act and may breach statutory state fiduciary duties to clients (see Letter from Attorneys General to Laurence Fink, August 4, 2022). For more information.

In 2023, several states passed laws prohibiting the use of ESG factors in making investment decisions for state funds. More states introduced similar legislation in 2024. In February 2024, South Carolina restricted the ability of fiduciaries of state pensions to use ESG factors in making investment decisions.

Board Diversity

California became the first state to enact a mandatory gender quota for boards of directors (SB 826) in 2018, requiring any public company (domestic and foreign) with principal executive offices located in California to have a minimum of two female directors, if the company has five directors, or three female directors if the company has six or more directors. In September 2020, California expanded its board diversity requirements by adopting AB 979, requiring these companies to include at least one director from an “underrepresented community” by the end of 2021, and at least two or three directors (depending on the size of the board) from underrepresented communities by the end of 2022. A director from an “underrepresented community” is defined as an individual who self-identifies as Black, African American, Hispanic, Latino, Asian, Pacific Islander, Native American, Native Hawaiian, or Alaska Native, or who self-identifies as gay, lesbian, bisexual, or transgender. However, both statutes have since been held unconstitutional by the Los Angeles County Superior Court (SB 826 in May 2022 and AB 979 in April 2022). In each case, the court ruled that the diversity requirement violated the equal protection clause of California’s Constitution. California’s Secretary of State has appealed both decisions. In addition, in May 2023, the US District Court for the Eastern District of California ruled that AB 979 is an unconstitutional racial quota in violation of the equal protection clause of the Fourteenth Amendment of the US Constitution and 42 U.S.C. § 1981.

In Washington State, public companies subject to the Washington Business Corporations Act must either have a “gender-diverse board” or comply with board diversity disclosure requirements. To be deemed gender-diverse, individuals self-identifying as women must comprise at least 25% of the board for at least 270 days of the fiscal year preceding the company’s annual meeting of shareholders. If a company’s board does not meet the gender-diverse requirement, the company must disclose a “board diversity discussion and analysis” either in its annual proxy statement or posted on its primary website.

Other states, including New York, Illinois, and Maryland have enacted laws requiring companies doing business in the respective state to report their board diversity information to the state.

Stock Exchange Requirements

Both the NYSE and Nasdaq have qualitative corporate governance standards with which listed companies must comply. Failure to comply could result in a company’s securities being delisted. These standards relate to, among other subjects, the composition and structure of the board of directors, including certain required board committees, codes of ethics and conduct and the circumstances under which the issuances of securities must be approved by stockholders.

Nasdaq’s requires its listed companies to disclose aggregate board diversity data and whether they have, or an explanation of why they do not have, at least two diverse directors on their board. Both Nasdaq and the NYSE encourage ESG-related disclosures and have guidance on ESG disclosures (see Nasdaq’s ESG Reporting Guide 2.0O and the NYSE’s Best Practices for Sustainability Reporting). Both exchanges also maintain ESG resources on their websites for listed companies.

Sustainability Organizations and Initiatives

The increase in ESG disclosure is driven in large part by multiple global sustainability organizations and initiatives. However, there is currently no standardization of ESG disclosure. In the absence of a uniform mandatory ESG-reporting framework, companies and other stakeholders look to these organizations and initiatives for guidance on integrating ESG principles into business and investment strategies. These organizations and initiatives have aligned with or developed sustainability reporting frameworks.

UN Global Compact

The United Nations Global Compact (UNGC) is the largest global sustainability initiative and invites companies to voluntarily align their strategies and operations with ten principles surrounding ESG issues in the areas of human rights, labor, environment, and anti-corruption (see UNGC: The Ten Principles of the UN Global Compact). The UNGC also integrates with other organizations and initiatives, such as:

• The UN Sustainable Development Goals
• The UN Principles for Responsible Investment
• The World Federation of Exchanges and the Sustainable Stock Exchanges (SSE) initiative

Sustainability Accounting Standards Board (SASB)

The SASB is an independent nonprofit organization whose mission is to develop sustainability accounting standards that help public companies make ESG disclosures and investors assess ESG performance of public companies in the same industry. The SASB sustainability topics are organized under five dimensions:

• Environment.
• Social capital.
• Human capital.
• Business model and innovation.
• Leadership and governance.

The SASB standards provide industry-specific guidance for 77 industries, and while they are voluntary, they are some of the most important.

ESG Ratings

ESG ratings, also referred to as ESG scores, measure a company’s ESG performance. They often resemble bond-ratings, for example:

• Leader (AAA, AA).
• Average (A, BBB, BB).
• Laggard (B, CCC).

Investors are increasingly using ESG ratings for assistance with their investment decisions and voting decisions. These ratings are provided by rating agencies and analysts. One of the most significant ESG ratings is the State Street Global Advisors’ R-Factor™ which is based on the SASB standards. Other examples of leading ESG data and ratings providers include:

• ISS ESG
• Glass Lewis ESG Profile
• S&P Global (Dow Jones Sustainability Indices & Corporate Sustainability Assessment)
• FTSE Russell
• MSCI
• Bloomberg
• RepRisk
• Sustainalytics

Conclusion

For current laws, regulations, and standards, contact your attorney today. This is an ever-changing landscape and the laws cited above may be changed in Congress or the Courts. Goosmann Law Firm is committed to helping guide leaders and companies through this complex web of ESG.