At a meeting of the SEC’s Investor Advisory Committee last week, the Committee voted to make recommendations to the SEC on three topics: accounting and financial disclosure; ESG (environmental, social and governance) disclosure; and disclosure effectiveness. The ESG recommendation concluded that “the time has come for the SEC to address this issue,” and it should be no surprise that there was some controversy—including some dissenting votes—surrounding that recommendation. While recommendations from SEC advisory committees often hold some sway with the commissioners, given the long-held views of the current commissioners, it seems highly unlikely that the ESG recommendation will have much traction—at least not in the near term. The recommendations come as the membership of the committee undergoes a substantial shift as many members time out on their appointments. The recommendations are discussed below.
Accounting and financial reporting
The Committee adopted recommendations covering four topics:
- proposed omission of fourth quarter financial results from annual reports;
- “increased use of ‘reverse factoring’ and its effects on investors’ ability to evaluate issuers’ financial positions and known financial risks”;
- use of non-GAAP financial measures and other metrics in investor communications; and
- proposed omission of tabular information regarding contractual obligations.
Q4 results. In January 2020, the SEC proposed to simplify and modernize MD&A and the other financial disclosure requirements of Reg S-K, including elimination of the requirement to provide supplementary quarterly financial data, the effect of which would be to jettison publication of discrete results for the fourth quarter. (See this PubCo post.) The committee opposed this component of the proposal.
The argument in favor of the proposal is that the information is readily calculable from available information. Not so much, said the recommendation. Based on a study of data from 2010 through 2019 undertaken at the request of the committee, researchers at Harvard Business School found that
“between twenty and 300 companies (out of between 3000 and 4500) had differences between reported and derived Q4 results. Roughly two-thirds of companies with differences had differences of greater than one percent of net income. For companies with differences, more than ten percent of the differences exceed 10% in a typical year. These differences relate to just one line-item—net income—which while important is not the only item of importance to investors.”
The committee recommended reconsideration of this aspect of the proposal, or alternatively, allowing “companies to omit Q4 results if and only if they are not different from what could be easily derived from other reported results.”
Reverse factoring. What’s that? The recommendation defined “reverse factoring” (sometimes referred to as “supply chain financing”) as typically involving “a downstream company arranging for a bank or other intermediary to pay the company’s suppliers on its behalf, and subsequently the company pays the bank or intermediary back (often with a fee).” Apparently, use of this technique has been on the increase since 2008. To the committee, this technique looked more like a debt arrangement that should be reflected on balance sheets and in the statement of cash flows, but, under current accounting guidance, the accounting is left to the discretion of companies. The Big Four have requested guidance from FASB and credit rating agencies have been “sounding the alarm.”
According to the committee, reverse factoring may disguise a company’s financial position, impact key performance ratios and increase financial risks, especially in light of COVID-19-related disruptions in supply chain relationships and financing. But, the committee argues, current disclosure in inadequate. The committee recommended that the SEC closely monitor accounting developments related to this issue, review MD&A disclosures and make inquiry where disclosure is absent, and consider adoption of a line-item disclosure requirement.
Non-GAAP measures. Non-GAAP financial measures may be a good addition to GAAP, but not where companies “manipulate or deceive investors with non-GAAP metrics, either relative to GAAP or by changing metrics over time.” The committee recommended continued monitoring by the SEC as well as a study of whether companies are using non-GAAP metrics prominently in communications to investors that are not part of formal SEC reports, “changing their non-GAAP metrics’ definition or calculation, or otherwise using them in ways that may be materially deceptive to investors.” The SEC “should also consider whether any of the commonly used non-GAAP metrics may be better presented within MD&A or other non-GAAP elements of formal reporting documents, where full SEC oversight and monitoring can be brought to bear.”
Table of contractual obligations. The recommendation contends that, although “much of the information [in the table] can be derived from other places in a Form 10-K, it is more complete and substantially less costly and less time-consuming for analysts to gather and analyze, and for investors to use, in its current presentation.” The committee recommended that the SEC reconsider its proposal to eliminate the table and even consider augmenting the table with links.
ESG disclosure
The committee observed that the issue of whether to mandate ESG disclosure has been under consideration for about 50 years, and it was now time to make a move. The ESG recommendation—which was not prescriptive, but in essence more of a plea that the SEC “do something”—was the only controversial recommendation, and there were several dissenters. Certainly no surprise there. Interestingly, the committee described the contours of ESG by reference to the “broad set of subjects germane to businesses as highlighted by The Business Roundtable August 19, 2019 in its Statement of Purpose: customers, employees, suppliers, the community (environment), and shareholders.” (See this PubCo post.)
The committee contended that the use of ESG-related disclosures “has gone from a fringe concept to a mainstream, global investment and geopolitical priority.” In the course of its inquiry, the committee maintained, it has heard a consistent message:
“investors consider certain ESG information material to their investment and voting decisions, regardless of whether their investment mandates include an ‘ESG-specific’ strategy. Our work has informed us that this information is material to investors regardless of an Issuer’s business line, model or geography, and is different for every Issuer. Yet, despite a plethora of data, there is a lack of material, comparable, consistent information available upon which to base some of these decisions.”
Issuers and asset managers also face pressures to consider ESG. (For a discussion of some of the presentations on ESG to the committee, see this PubCo post.)
In the absence of regulation, a number of ESG providers have emerged, all using different standards and criteria. Responding to these providers and the volume of lengthy questionnaires they submit to companies has imposed a “significant burden” on companies, especially smaller companies with fewer resources. Not only do the providers publish the results of their surveys, some companies also publish their own ESG reports. With regard to voluntary reporting, concerns have been raised regarding the potential for greenwashing. All of this information notwithstanding, the committee concluded, “there is a lack of consistent, comparable, material information in the marketplace and everyone is frustrated—Issuers, investors, and regulators.”
Instead of materiality decisions being made by ESG providers, the committee contended that “the SEC is best-placed to set the framework for Issuers to disclose material information upon which investors can rely to make investment and voting decisions.” Accordingly, the committee recommended that the SEC “begin in earnest an effort to update the reporting requirements of Issuers to include material, decision-useful, ESG factors.” According to the committee, investors require ESG information to make investment and voting decisions, but are not served “by the piecemeal, ad-hoc, inconsistent information currently in the mix.” Instead, the committee advocated, investors and third-party data providers should have “accurate, comparable and material Issuer primary-source information upon which to base their analysis,” which information should be governed by “consistent standards and oversight.”
In the view of the committee, action by the SEC would
“(a) provide investors with the material, comparable, consistent information they need to make investment and voting decisions,
(b) provide Issuers with a framework to disclose material, decision-useful, comparable and consistent information in respect of their own businesses, rather than the current situation where investors largely rely on third party ESG data providers, which may not always be reliable, consistent, or necessarily material,
(c) level the playing field among all US Issuers regardless of market cap size or capital resources,
(d) ensure the continued flow of capital to US Issuers, and
(e) enable the SEC to take control of ESG disclosure for the US capital markets before other jurisdictions impose disclosure regimes on US Issuers and investors alike.”
While recognizing the difficulties, the committee contended that “well-constructed, principles-based reporting that enables each Issuer, regardless of industry or business line, to set out its risks, strategies and opportunities in relation to material ESG factors should be no different than current disclosure of business risk, strategy and opportunity. ESG matters are part and parcel of the business of every Issuer and are unique to every Issuer.”
While a majority of committee members supported the recommendation, there were several naysayers. They argued that ESG was best addressed by private parties rather than through a central mandate, that there was no broad consensus on the topic, that a mandate would result in just massive boilerplate disclosure and that a mandate was incongruent with the concept of materiality as reflected in SAB 99 and under the securities laws. There was also some concern expressed regarding the implications for FASB and its independence. A few other members, while favoring the proposal, indicated that they did not support line item prescriptive disclosure, but rather a reference by the SEC to an external framework, such as the SASB framework. The example given was the successful reference to the COSO framework for internal controls.
At the meeting, SEC Chair Jay Clayton reiterated his views on ESG disclosure. In his statement, he reminded the committee that his “views and support for effective disclosure on ‘decision useful’ information, including the modernization of financial disclosures and my views on disclosures about ‘E’ matters, ‘S’ matters and ‘G’ matters (I believe E, S and G are quite different baskets of disclosure matters and that lumping them together diminishes the usefulness, including investor understanding, of such disclosures), are not new to you.”
Commissioner Hester Peirce also issued a statement at the meeting. Of course, Peirce previously conveyed her attitude without mincing words when she indicated at a prior committee meeting that “ESG” stands for “enabling shareholder graft.” (See this PubCo post.) Here, she was a bit more politic, arguing instead that, although she was “concerned about multiple ESG data providers bombarding issuers with questionnaire after questionnaire in order to produce assessments of questionable value,” she viewed a new SEC disclosure framework for ESG information as “an unnecessary response when our existing securities disclosure framework is very good at handling all types of material information.” In her view “stakeholders want to see their priorities classified as ESG and embedded in disclosure mandates so they can shift companies’ attention away from shareholder priorities and toward stakeholder priorities.” As to the recommendation, she viewed the committee’s approach as wrong-headed: if the committee were
“able to focus our attention on discrete pieces of information for which disclosure mandates are necessary, perhaps a substantive discussion could follow. A more general call to develop a new ESG reporting regime—without a clear explanation of why the past fifty years of discussion on the topic has not crystallized into a universally applicable set of material ESG items, but now is the magic moment—may not be as helpful. Otherwise, let’s keep using our tried and true disclosure framework, which is rooted in materiality and is flexible enough to accommodate a wide range of issuers, each with its unique and ever-evolving set of risks.”
Given the views expressed by at least half the commissioners, it seems unlikely that the SEC would move forward on any disclosure mandate for ESG, at least in the near term. (For more on the SEC’s internal debate regarding ESG disclosure requirements, see this PubCo post.)
Disclosure effectiveness
How to design disclosures that the retail investor can understand was the issue addressed by the committee in its recommendation on disclosure effectiveness. Investment decisions are complicated, a problem compounded by legal requirements and liability concerns. Not to mention that many investors are lacking in the knowledge necessary to understand many of the disclosures. As a result, “the challenge the SEC faces is a daunting one: designing comprehensible disclosures about complex topics for individuals who lack expertise in the topic and are uncomfortable with the vocabulary of finance.” For example, in a financial literacy study conducted on behalf of the SEC in 2012, after survey respondents reviewed “a sample disclosure that begins as follows, ‘In addition to sales loads and 12b-1 fees described in the prospectus, we receive other compensation…,’ just over half (54.8 percent) correctly answered a question about whether the firm gets compensation other than sales loads and 12b-1 fees.”
Although “investors want disclosures that are brief, readable and delivered before they have to make an investment decision,” that’s often not what they receive. Although the SEC has adopted numerous improvements, investors still often “end up feeling overwhelmed by the volume and complexity of the information they receive,” obviously undermining disclosure effectiveness. What’s more, studies have shown that
“providing more information, even when that information is accurate and relevant, may actually cause investors to make less use of the information. This creates a tension between the various purposes served by disclosure. Market transparency, accountability, and regulatory oversight depend on the full and fair disclosure of all material information that has characterized the Commission’s traditional approach. Moreover, investors may benefit from disclosures they do not read, if, for example, independent analysts and reporting services digest and summarize the material, thereby enabling investors to focus on key insights they might have otherwise missed. In some cases, the information required to be disclosed causes entities to avoid conduct that would be embarrassing if revealed. Similarly, comprehensive [10-K] disclosures by issuers lead to more accurate pricing of their securities, benefiting even those investors who do not review the [10-K].”
Despite the potential for information overload, the committee observes, “disclosure experts have learned a lot in recent years about how to design disclosures to increase the likelihood both that they will be read and that they will be understood.” To achieve that goal, however, basic principles of effective disclosure must be “built in on the front end.”
The committee recommended the following steps for developing disclosure regulation:
- “In developing new disclosures intended primarily for retail investors, the SEC should, to the extent possible, adopt an iterative process that includes research, design, testing, and refinement of proposed disclosures. In addition to incorporating this process into its own work, the Commission could provide incentives to registrants who employ these best practices in their disclosure development.
- Disclosure design experts should work hand-in-hand with legal experts throughout the disclosure development process to provide input into decisions about content, language, presentation, and delivery. In developing disclosures, they should seek to balance the benefits of standardization against the risks of one-size-fits-none disclosures.
- In addition to using this process for development of new disclosures, the Commission should, as resources allow, review existing retail disclosures (such as various mutual fund disclosures, the new variable product summary, the CRS and ADV, and possibly IAPD and BrokerCheck reports) to determine their effectiveness and, as necessary, make improvements.
- In deciding which disclosures to review, the Commission should prioritize those disclosures or sections of disclosures that its research shows are of greatest significance to retail investors and/or least likely to be read or understood by such investors. The Office of Investor Advocate can play a valuable role in helping to set those priorities.”
Although the SEC has used recommended approaches such as consumer research to develop disclosure requirements and promotion of layered disclosure, it has not adopted an iterative approach, which suggests that procedural changes to adoption of disclosure regulation may be warranted.
