At an open meeting this morning, the SEC voted (three to two) to adopt amendments, substantially as proposed, to modernize the Reg S-K disclosure requirements related to the descriptions of business, legal proceedings and risk factors. As Chair Jay Clayton observed in his Statement, these Reg S-K disclosure items “essentially have not changed in over 30 years,” but much has changed in our economy since that time, making these updates well warranted. The changes are a component of the SEC’s Disclosure Effectiveness Initiative and reflect public comments on the SEC’s 2016 Concept Release (see this PubCo post) and the 2019 proposal (see this PubCo post)—although the extent to which those comments were taken into account was subject to some debate, as discussed below—as well as learning from the staff’s disclosure review process. As described in the press release, the amendments mainly adopt a “principles-based, registrant-specific approach to disclosure” that is intended to elicit information “on a basis consistent with the lens that management and the board of directors use to manage and assess the registrant’s performance.” The amendments are also intended to discourage repetition, reduce disclosure of information that is not material and simplify compliance. While there are changes throughout, the most significant change is the enhancement of the disclosure requirement for human capital, a topic that has been front-burnered by the impact of COVID-19 on the workforce. The amendments will become effective 30 days after publication in the Federal Register.
Please note that I will provide an updated post following review of the final rule, which the SEC has now published.
(Note that amendments to the accredited investor definition, originally scheduled for adoption at the open meeting, were instead adopted prior to the meeting. Here is the press release.)
At the open meeting
The benefits/detriments of principles-based disclosure was the principle subject of debate at the open meeting. Chair Clayton maintained that the SEC’s principles-based disclosure
“framework in providing the public with the information necessary to make informed investment decisions has proven its merit time and again as markets have evolved when we have faced unanticipated events. This has been widely demonstrated in registrant disclosures regarding the effects of COVID-19. We have seen disclosures shift to emphasize matters such as liquidity, cash needs, supply chain risks, and the health and safety of employees and customers. This has served as a reminder that our rigorous, principles-based, flexible disclosure system, where companies are required to communicate regularly and consistently with market participants, provides countless benefits to our markets, our investors and our economy more generally.”
To illustrate the approach, Clayton highlighted the new principles-based focus on metrics in the area of human capital:
“in crafting their human capital disclosure, companies must incorporate the key human capital metrics, if any, that they focus on in managing the business, again to the extent material to an understanding of the company’s business as a whole. Experience demonstrates that these metrics, including their construction and their use, [vary] widely from industry to industry and issuer to issuer, depending [on] a wide array of company-specific factors and strategic judgments. As I have said previously, I would expect that the material human capital information for a manufacturing company will be vastly different from that of a biotech startup, and again vastly different from that of a large healthcare provider. And the human capital considerations for a multi-national car manufacturer will be different from that of a regional home manufacturer. It would run counter to our proven disclosure system, particularly as we first increase regulatory emphasis in an area of such wide variance, for us to attempt to prescribe specific, rigid metrics that would not capture or effectively communicate these substantial differences. That said, under the principles-based approach, I do expect to see meaningful qualitative and quantitative disclosure, including, as appropriate, disclosure of metrics that companies actually use in managing their affairs.”
Similarly, Commissioner Hester Peirce applauded the shift toward making the rules more principles-based and rooted in materiality and would have “preferred to eliminate the remaining vestiges of a prescriptive approach, such as the requirement to disclose the number of employees. That metric—like others some advocated for inclusion under the human capital rubric—might be material for some companies under some circumstances, but not for others.” Likewise Commissioner Elad Roisman.
However, Commissioners Allison Lee and Caroline Crenshaw, in her debut at an open meeting as a new commissioner, both dissented, principally on the basis that the rules should have included more prescriptive requirements that would have more certainly elicited disclosure regarding diversity and climate risk. Instead, Lee objected, the rule is completely silent on those two critical topics. Lee explained that she had voted to publish the proposal, notwithstanding her misgivings about proposal’s substantial shift toward a principles-based approach, because she hoped that
“investors—the consumers of this information—would weigh in regarding specific disclosures on human capital and climate risk, and help us get the balance right between principles-based and line-item disclosures. And that they did, in large numbers. We received thousands of comments seeking disclosure on workforce development, diversity, and climate risk. There were letters explaining why principles-based disclosure requirements, without at least some specifics, would not produce the disclosures investors need. Letters explaining what metrics were most important in terms of building long-term value for investors. Letters explaining what metrics cut across industries and what companies were already tracking.”
What’s more, she added, “recent events have provided a real-time case study on the need for many of these disclosures.” However, the final rules address neither diversity nor climate risk—the adopting release is “even silent on the very fact that there was a vast outpouring of comment letters on these subjects.” To her dismay, the final rules “look largely like the proposal, ignoring both overwhelming investor comment and intervening events. We have declined to include even a discussion of climate risk in the release despite significant comment on this subject. And we have declined to go beyond merely introducing the topic of human capital generally, despite investors’ views that this is not nearly enough.” She would have supported the final rule, she reflected, had it included “even minimal expansion on the topic of human capital to include simple, commonly kept metrics such as part time vs. full time workers, workforce expenses, turnover, and diversity. But we have declined to take even these modest steps.” However, she observed, the SEC “takes the position that it does not need to require or specify these types of disclosures because our principles-based disclosure regime is on the job and will produce any disclosures on these topics that are material. Investors are asked to trust that each individual company has gauged materiality on these complex issues with flawless precision and objectivity.” But hundreds of companies don’t include disclosure on diversity—should we assume that it is therefore not material, she asks? Similarly, she argues, by “some estimates, over 90% of U.S. equities by market capitalization are exposed to material financial impact from climate change. We are long past the point at which it can be credibly asserted that climate risk is not material. We also know today that investors are not getting this material information.”
Crenshaw echoed the views expressed by Lee, observing that questions regarding the materiality of climate change and human capital are “no longer academic,” considering, for example, the damage caused by the California fires and 2017 hurricane season. The SEC’s “steps to modernize the securities laws should facilitate the efficient comparison of long-term sustainability in the face of present-day risks to issuers. But today’s failure to address climate change risk continues to hamper the efficient sorting and comparison of modern companies, as does the failure to adopt detailed, specific disclosure requirements concerning human capital.” She advocated the establishment of an internal task force to study “how investors can and do use information about human capital management, climate change risk, and other [ESG] metrics to assess the long-term financial performance of a company.” She also advocated formation of an external ESG Advisory Committee to provide advice and guidance over the longer term. (Of course, the SEC’s Investor Advisory Committee has already studied and recently recommended that the SEC mandate ESG disclosure. See this PubCo post.)
Remarkably, as the meeting concluded, Peirce observed that perhaps the split regarding principles-based versus prescriptive regulation reflected in the votes today should be part of a larger discussion. (I say “remarkably” because, as discussed in the sidebar below, this divergence of view has been percolating at the SEC since at least August of last year, so it is hardly a revelation. Don’t the commissioners talk to each other behind the scenes?) In her view, prescriptive line item requirements tend not to age well. In addition, prescriptive requirements assumed more wisdom than she thought five commissioners might have—especially as compared to people immersed in these topics at the companies themselves. Lee agreed that the topic merited further conversation. She was not advocating that requirements be completely prescriptive, but rather that there be more of a balance. How will we know, she asked, whether the information that companies disclose is what’s really material? Jumping in, Clayton observed that our disclosure framework is the “envy of the world” and that he was heartened by the extensive forward-looking disclosure elicited during the pandemic. He believed that that information was effective in calming the markets. In addition, he noted that, as SEC Chair, he valued the SEC’s diversity and pointed to the SEC’s strategic plan. In the same way, he expected that companies would also disclose their approaches to diversity. (He also noted that the staff has given guidance on board diversity disclosure. (See this PubCo post.)
Summary of the final rule
According to the press release, the final amendments will, among other things:
- “amend Item 101(a) by:
- making it largely principles-based, requiring disclosure of information material to an understanding of the general development of the business;
- replacing the previously prescribed five-year timeframe with a materiality framework; and
- permitting a registrant, in filings made after a registrant’s initial filing, to provide only an update of the general development of the business focused on material developments that have occurred since its most recent full discussion of the development of its business, which will be incorporated by reference;
- amend Item 101(c) by:
- clarifying and expanding its principles-based approach, with a non-exclusive list of disclosure topic examples drawn in part from topics currently contained in Item 101(c);
- including, as a disclosure topic, a description of the registrant’s human capital resources to the extent such disclosures would be material to an understanding of the registrant’s business; and
- refocusing the regulatory compliance disclosure requirement by including as a topic all material government regulations, not just environmental laws;
- amend Item 103 by:
- expressly stating that the required information may be provided by hyperlink or cross-reference to legal proceedings disclosure located elsewhere in the document to avoid duplicative disclosure; and
- implementing a modified disclosure threshold for certain governmental environmental proceedings resulting in monetary sanctions that increases the existing quantitative threshold for disclosure of those proceedings from $100,000 to $300,000, but that also affords a registrant some flexibility by allowing the registrant, at its election, to select a different threshold that it determines is reasonably designed to result in disclosure of material environmental proceedings, provided that the threshold does not exceed the lesser of $1 million or one percent of the current assets of the registrant; and
- amend Item 105 by:
- requiring summary risk factor disclosure of no more than two pages if the risk factor section exceeds 15 pages;
- refining the principles-based approach of Item 105 by requiring disclosure of ‘material’ risk factors; and
- requiring risk factors to be organized under relevant headings in addition to the subcaptions currently required, with any risk factors that may generally apply to an investment in securities disclosed at the end of the risk factor section under a separate caption.”
