Written by John E. Piasta, Michael P. Theroux, Alexander Baker and Jennifer Power
Since 2013, investors in Exxon Mobil Corporation ("Exxon") stock have consistently shown an interest in understanding how the effects of climate change will impact their investment. Over the years, in response to these concerns, Exxon released a series of voluntary publications such as their Energy and Carbon—Managing the Risks, Energy and Climate, which described certain actions that Exxon was undertaking and, in 2016, their Outlook for Energy report. In the latter report, Exxon indicated that it used a proxy cost1 in its long-term projections for purposes of business planning, investment decision-making, and financial reporting. As investor concerns grew and became more public in 2015, the Attorney General of New York State ("AG") launched an investigation into the company’s disclosures.
On October 24, 2018, the AG filed a lawsuit alleging that Exxon engaged in "a long-standing fraudulent scheme" to defraud investors concerning the company’s management of the risks posed to its business by increasingly stringent climate change regulation. The AG alleges that Exxon "lowballed" carbon costs by an aggregate of $30-billion dollars and asks that this amount be disgorged of the company. The AG claims that prior to 2016, Exxon misled investors by not incorporating proxy costs into its business calculations at all. The AG further claims that post-2016, Exxon made representations in various voluntary publications that Exxon released to its shareholders (not mandatory securities disclosures) that a general proxy cost would be applied to all business planning, investment decisions and financial reporting. The AG is seeking damages to be paid to investors and restitution of all funds obtained in connection with or as a result of the alleged fraudulent and deceptive acts.
The state of New York brought their action against Exxon under securities fraud legislation, Executive Law (persistent fraud or legality), "actual fraud" and equitable or, common law fraud. The AG made the following factual allegations and claims:
1. Exxon’s fraud regarding its use of a proxy cost in its cost projections.
a. Exxon misrepresented its use of a proxy cost in investment decision-making and business planning.
The AG alleges that Exxon’s representations regarding its use of proxy costs were inconsistent with actual practices in a number of ways: 1) Exxon’s undisclosed internally applied proxy cost figures were much lower than those set out in the company’s public representations; 2) in projects located in developing non-OECD countries, Exxon did not apply any proxy costs to its projected GHG emissions contrary to its representations; and 3) Exxon applied much lower proxy costs than those represented to its projected GHG emissions for Alberta oil sands projects, LNG projects and North American gas assets.
b. Exxon misrepresented its use of a proxy cost in oil and gas reserves and resource-based assessments.
The AG alleges that: Exxon made three distinct representations with regard to applying a proxy cost to its reserves and resource base: 1) it applied a proxy cost to all reserve assessments until 2040 (in Exxon’s 2016 Energy and Carbon Summary); 2) a proxy cost was applied as part of its business planning process; and 3) all resource-based assessments were aligned with the PRMS guidelines. PRMS stands for Petroleum Resources Management System, the common industry standard for evaluating reserves and resources. PRMS requires that all evaluations must be based on the estimates of future production. The AG alleges that Exxon represented that its resource-based assessments were aligned with PRMS guidelines and that the publicly disclosed proxy costs were not, in fact, incorporated into those estimates.
c. Exxon misrepresented its use of a proxy cost in evaluations for impairment of long-lived assets.
The AG claims that prior to 2016, Exxon misled investors by not incorporating proxy costs into cost projections for impairment evaluations at all. The AG then alleges that beginning in 2016, Exxon incorporated proxy costs in cost projections for impairment evaluations but applied the proxy costs in a limited and internally inconsistent manner.
An impairment evaluation is the process mandated by accounting rules for determining whether the value of an asset is less than the value listed on a company’s balance sheet. The accounting rules are provided for under US Generally Accepted Accounting Principles ("GAAP"). GAAP are accounting standards that companies reporting their financial results in the United States must follow. The AG alleges that Exxon did not follow GAAP protocol when assessing indicators of a potential impairment to long-lived assets even though Exxon had represented in its public filings that it has complied with its obligations under this accounting requirement.
2. Exxon’s fraud regarding its use of a proxy cost in its demand and price projections.
The AG alleges that 1) no proxy cost was applied in estimating demand in the transportation sector; and 2) that the projected oil and gas prices that Exxon applied in its economic models were set with little reference to the company’s demand analysis.
a. Failure to apply the proxy cost in projecting demand in transportation sector.
The AG cites disclosure materials that make broad, sweeping statements about Exxon's application of a proxy cost. The AG further cites the importance of the transportation sector to the oil and gas business and that despite its importance, and alleges Exxon did not apply the publicly represented proxy cost to demand projections in that sector and never disclosed its failure to do so to investors.
b. Failure to apply proxy cost in projection oil and gas prices.
The AG alleges that Exxon represented that it applied a proxy cost of GHG emissions in estimating future demand for oil and gas and that this representation leads a reasonable investor to conclude that Exxon’s oil and gas projections also took into account such proxy costs. The AG claims that because Exxon never told investors that the proxy cost was disconnected from the company’s actual business decisions, all public statements touting the proxy cost were materially false and misleading.
3. Exxon’s fraud regarding risks to its business posed by the "two-degree" scenario.
In Managing the Risks, in 2014, Exxon stated that it did not believe that governments would impose more stringent climate regulations than would be necessary to achieve a "two-degree" scenario2 after investors expressed concern that Exxon’s oil and gas reserves were vulnerable to becoming stranded under this scenario. Exxon wrote in Managing the Risks, that a two-degree scenario is "highly unlikely" to occur because such a scenario would impose enormous CO2 costs on consumers, and that Exxon therefore does not face a risk of its assets becoming stranded. The AG investigation indicates that it had uncovered correspondence post-publication of the report, between an MIT economist and Exxon wherein the MIT economist warned the company that the numbers reported were extremely high and that if the figure represented undiscounted costs as a percentage of income (which the AG alleges it does), that the analysis was misleading and overstated the costs associated with a two-degree scenario. Exxon is alleged to have disregarded the warning and used the analysis and infographic well into June of 2016.
4. Exxon’s fraud caused significant harm.
The AG alleges that Exxon did not incorporate climate change regulatory risk into its business processes in the manner it represented to investors and this failure resulted in the company having a "materially different risk profile" than it would have had if it had actually incorporated climate change regulatory risk using the proxy cost it purported to.
The AG claims that Exxon’s investments were riskier than investors were led to believe. Further, the AG claims that Exxon is faced with greater risk associated with the two-degree scenario than it represented to investors. As a result, the AG alleges that Exxon’s securities are overvalued, and investors purchased or held Exxon securities at artificially-inflated prices.
Securities laws in Canada and the United States take a similar approach to climate change disclosure and do not prescribe specific disclosure requirements in relation to climate change related information. Rather, the concept of materiality governs an issuer's disclosure decision. In particular, when reporting on environmental matters, issuers are reminded that determining materiality, and, accordingly, whether disclosure is required, does not involve a bright-line quantitative test. It is a dynamic process that depends on the existing market conditions at the time of reporting and all facts available, and the time horizon of a known trend, demand, commitment, event or uncertainty may be relevant to an assessment of materiality as well. When in doubt, issuers should err on the side of materiality. This is particularly true since there is evidence that environmental and social governance matters are becoming an increasingly important part of disclosure to investors, industry groups and non-governmental organizations. In this context, issuers should not rely on boiler-plate risk factors and disclosure and should methodically and carefully consider when climate change related matters may have an impact on their business.
Issuers should remain aware of the civil liability that can arise in connection with secondary market disclosure in non-core documents and oral statements under part 17.01 of the Securities Act (Alberta). It appears that the AG's claims against Exxon are primarily based on Exxon's mandatory disclosure which, in the Canadian context, goes beyond the required level of disclosure in non-core documents and provided disclosure that seemed inconsistent or in contrast to its mandatory disclosures.
Bennett Jones will continue to monitor this case for the publication of a defense by Exxon. To date, no defense has been made public, but Exxon has made public statements asserting that the AG's claims are unfounded. Notwithstanding that the AG's claims may be unfounded, issuers should take care to be consistent in their required disclosure and voluntary disclosure to avoid piquing the interest of regulators. Strategically, issuers are advised to create long-term plans for their climate change disclosure. Issuers should have safeguards in place to ensure that they do not voluntarily disclose information that may contradict or undermine required or other disclosure that is likely to be made in the future.