In remarks today in London at the 18th Annual Institute on Securities Regulation in Europe, Corp Fin Director William Hinman discussed the application of a “Principles-Based Approach to Disclosing Complex, Uncertain and Evolving Risks,” specifically addressing Brexit and sustainability. With regard to Brexit disclosure, Hinman offers a very useful cheat sheet of good questions to consider in crafting appropriately tailored disclosure.
As described by Hinman, “principles-based disclosure” means that “requirements articulate an objective and look to management to exercise judgment in satisfying that objective by providing appropriate disclosure when necessary.” With regard to risk-related disclosure, for example, MD&A should allow investors “to understand how management is positioning the company in the face of uncertainties.” Similarly, risk factors should provide investors with material “decision-useful” information that is company-specific by explaining how each risk affects the company, without “bury[ing] the reader in generic boilerplate or laundry lists of risks that might apply to any company.” One benefit of principles-based disclosure is that its inherent flexibility allows disclosure to evolve with emerging issues.
Hinman first reminds the audience that SEC representatives have recently been urging companies to address the potential impact of Brexit in their disclosures. (See this PubCo post, this PubCo post and this PubCo post.) Apparently, the staff has conducted a survey across a number of industries to evaluate the quality of Brexit disclosure, finding a broad range of responses to the issue. Hinman indicates that he finds generic disclosure without any specifics—the kind that just states “that Brexit presents a risk, that the outcome is uncertain and that it could materially and adversely impact the business and its operations”—not very helpful. However, some companies, especially those in the EU and UK that may be more directly affected, have provided more tailored disclosure. The issue of Brexit is especially fraught with uncertainty, and businesses have had to prepare for different possible outcomes and make decisions to mitigate associated risk, which will certainly vary from company to company and industry to industry.
In that regard, Hinman observes that “investors are better served by understanding the lens through which each company’s management looks at its exposure. How does management assess and analyze Brexit-related risks and the potential impacts on the company and its operations? What is management doing to mitigate and manage these risks? What is the nature of the board’s role in overseeing the management of these risks?” While recognizing the need for confidentiality of some information, Hinman suggests that the disclosure be evaluated by comparing it to management’s disclosure to the board: are there “material gaps between how the board is briefed and how shareholders are informed. For those of you involved in crafting disclosure documents, you can ask yourself a straightforward question: would these disclosures satisfy the curiosity of a thoughtful, deliberative board member considering the potential impact of Brexit on the company’s business, operations and strategic plans?” To the extent material, Hinman advises, “Brexit disclosure should provide tailored insight into how management views the risks posed to the business and operations and what actions they are taking to address these risks.”
Hinman then offered a number of disclosure topics for companies to consider in the context of Brexit, reproduced in full below. (Hint: Corp Fin may well be asking these same questions in reviewing company disclosures on the issue.)
- “Is the business exposed to new regulatory risk given the uncertainty of which set of laws and regulations will apply and whether transition agreements will be in place? We have seen useful, tailored disclosure by some financial institutions that addresses the regulatory risks associated with the potential loss of passporting arrangements that currently permit U.K. entities to provide services to businesses and customers throughout the EU. Similarly, some firms have provided disclosure explaining specific efforts undertaken to re-locate their U.K. operations, or to merge with or acquire EU subsidiaries, to mitigate the regulatory risks of Brexit. Banking and financial services are obviously not the only industries subject to regulatory risk in light of Brexit. Biopharmaceutical companies with substantial U.K. operations face risks concerning how their products and clinical trials will be regulated. Airlines face risks that potential restrictions on flying rights or changes in administration of antitrust laws may negatively impact their joint ventures. For companies in these industries and others affected by regulatory risk, we would expect tailored disclosure explaining these risks where appropriate.
- “Are there significant supply chain risks due to the potential disruption to the U.K.’s access to free trade agreements with other nations and any resulting changes in tariffs on exports and imports? Will potential changes to customs administrations and delays materially impact a company’s business, particularly if the business relies on just-in-time supply chains? We believe that companies are actively considering the potential impact of these matters on their business, and we look forward to seeing disclosures that provide insight as to how management is assessing and mitigating these risks.
- “Does the company face a material risk of losing customers, a decrease in sales or revenues or an increase in costs due to tariffs or other factors? Is demand for the company’s products especially sensitive to exchange rates or changes in tariffs? Discussion and analysis of these types of questions regarding known trends, demands, commitments, events and uncertainties are critical for investors to understand the extent to which a company’s reported financial information is indicative of future results. To the extent management sees the potential impact of Brexit in terms of anticipated costs, reductions in forecasted sales or changes in working capital, it may be appropriate in some cases to include estimates or ranges of quantitative changes, as well as qualitative disclosures.
- “Does the company have exposure to currency devaluation, foreign currency exchange rate risk or other market risk? Given the potential for heightened foreign exchange volatility, we are aware of reports that companies are increasing their hedging activities. We will look at quantitative and qualitative disclosures about market risk to better understand each company’s approach to market risk management in this area.
- “What is the company’s exposure to contractual risk in the face of Brexit? Has the company undertaken a review of its existing contracts with counterparties in the U.K. or the EU to determine whether renegotiation or termination is necessary in light of contractual obligations? To the extent these discussions involve material contracts, we would expect disclosure to reflect these discussions.
- “Do Brexit-related issues affect financial statement recognition, measurement or disclosure items, such as inventory write-downs, long-lived asset impairments, collectability of receivables, assumptions underlying fair value measurements, foreign currency matters, hedge accounting or income taxes? We expect that boards and audit committees are considering these reporting implications and that these considerations will be discussed in company disclosures, as appropriate.”
The adequacy of environmental, social and governance (ESG), or sustainability, disclosure has become an issue for a number of investors and other market participants. Hinman views the issue as “complicated,” largely because of the tension between the desire of some for specific sustainability disclosure requirements—along with the debate about which set of reporting standards should apply—and the concern of others that specific sustainability disclosure requirements will elicit information that is not really material to a reasonable investor. (See, for example, this PubCo post and this PubCo post.) These issues have not yet settled out in the marketplace, and the SEC is continuing to monitor the evolution of market-driven solutions, comparing information in SEC filings with information provided voluntarily outside of SEC filings. In particular, the SEC is wary of imposing specific bright-line disclosure requirements that can increase the costs being a public company without delivering relevant and material information to investors and others, thus potentially decreasing the attractiveness of public-company status.
In preparing principles-based disclosure regarding sustainability, Hinman advises that companies apply the MD&A standard of allowing investors to see the company “through the eyes of management,” including describing plans to mitigate material risks and the material impact of these decisions on the business. He would again suggest evaluating the disclosure relative to the disclosure that management provides to the board.
With regard to climate-related disclosures specifically, Hinman adverts to the SEC’s 2010 interpretive release, which discussed the application of existing disclosure requirements to climate change issues. The approach taken here is consistent with the approach to cybersecurity—looking to the current disclosure obligations under existing laws and regulations for direction. Hinman cites as examples the discussions in the guidance of how “businesses that may be vulnerable to severe weather or climate-related events should consider disclosing material risks of, or consequences from, these events,” as well as the nature of the disclosure that a company should provide, if material, if the company “determines that its physical plants and facilities are exposed to extreme weather risks and it is making significant business decisions about relocation or insurance.” Hinman notes that the guidance does not address the board’s risk management role in this area, but that board risk oversight, including the relationship between the board and senior management in managing material risks, is a disclosure requirement under Item 407(h) of Reg S-K and Item 7 of Schedule 14A. Accordingly, Hinman advises, “[t]o the extent a matter presents a material risk to a company’s business, the company’s disclosure should discuss the nature of the board’s role in overseeing the management of that risk.” Hinman suggests that the SEC’s cybersecurity guidance may provide useful parallels to sustainability and other emerging risks. (See this PubCo post.)