United States: Two SEC Commissioners: Is The Reg S-K Modernization Proposal Too Principles-Based? And Why No Climate Change Disclosure?

Last Updated: August 30 2019
Article by Cydney Posner

Yesterday, Commissioners Robert Jackson and Allison Lee published a joint statement to encourage public comment about two aspects of the proposal to modernize Reg S-K (see this PubCo post), released on August 8, about which they had some, uh, reservations. They both indicated their support for release of the proposal, particularly its focus on adding "human capital" as a disclosure topic, but—and it's a significant "but"— they took issue with the proposal's "shift toward a principles-based approach to disclosure and the absence of the topic of climate risk."

First, they viewed as problematic the proposal's tilt toward "a principles-based approach to disclosure rather than balancing the use of principles with line-item disclosures as investors—the consumers of this information—have advocated." They note here that, while issuers "prefer the discretion afforded to them by principles-based disclosure," investors "favor a balanced approach using some line-item disclosure rules."

Although a principles-based approach offers flexibility and "makes sense in some cases," they believe that the proposal did not adequately weigh the costs of that approach against the benefits. One cost that they believe was not adequately considered was the level of discretion "that it gives company executives...over what they tell investors. Another is that it can produce inconsistent information that investors cannot easily compare, making investment analysis—and, thus, capital—more expensive." Under a principles-based approach, can the SEC be sure that investors will be given the information they need?


The SEC's 2016 Concept Release on disclosure simplification and modernization (see this PubCo post) raised the question of whether the disclosure rules should be more principles-based or more prescriptive. Both of these approaches are based on the concept of "materiality" as defined in TSC Industries, Inc. v. Northway, Inc., specifically, whether there is a substantial likelihood that a reasonable investor would consider the information important in decision-making and whether a reasonable investor would view the information to significantly alter the "total mix" of information available. "Principles-based" rules "articulate a disclosure objective and look to management to exercise judgment in satisfying that objective." On the other hand, some requirements "prescribe" quantitative thresholds to minimize uncertainty in determining materiality and to identify when disclosure is required. While principle-based rules are necessarily imprecise, may be difficult to apply and can result in a loss of comparability among reporting entities, they can help to eliminate irrelevant information by permitting tailored responses that focus on information that is material to the particular business and are more flexible and adaptable as circumstances change. Prescriptive standards can help promote comparability, consistency and completeness of disclosure, but they can sometimes be circumvented and may not address or capture all the important information. An earlier S-K Study conducted by the staff pursuant to the JOBS Act recommended that revisions emphasize an overarching principles-based approach while preserving the benefits of a rules-based system.

For example, they believe that the proposal "takes a crucial step forward" with regard to the mandate for human capital disclosure, which they viewed as recognition that "companies that invest in their workers perform better over time." But, because the proposal "favors flexibility over bright-line rules, the proposal may give management too much discretion—sacrificing important comparability—when describing a company's investments in its workers."


The SEC's proposal would replace the existing requirement to disclose only the number of employees with a principles-based requirement to disclose, to the extent material, a "description of the registrant's human capital resources, including in such description any human capital measures or objectives that management focuses on in managing the business (such as, depending on the nature of the registrant's business and workforce, measures or objectives that address the attraction, development, and retention of personnel)." The exact measures or objectives discussed in a company's disclosure could change over time and vary with the industry. Instead of specific line item disclosures, the proposal provides non-exclusive examples of potentially material human capital measures and objectives. The release asked for comment on whether the SEC should add more examples of measures or objectives that may be material, such as the number of full-time, part-time, seasonal and temporary workers; voluntary and involuntary turnover rates; measures regarding average hours of training per employee per year; information regarding human capital trends, such as competitive conditions and internal rates of hiring and promotion; measures regarding worker productivity; and the progress that management has made with respect to any objectives it has set regarding its human capital resources.

Although the two commissioners appreciated the language in the proposal suggesting potential disclosure regarding the "attraction, retention, and development of personnel," they were looking for comment on "more specific metrics that are important to investors. For example, commenters might consider whether measures of the company's use of independent contractors and temporary workers as opposed to full-time employees would be useful..... Commenters might also consider whether the final rule should retain our current requirement to disclose the number of employees, which research has shown is a valuable data point." To that end, they cited a study showing that "'abnormal reductions in the number of employees' are useful in predicting financial misstatements and 'reductions in the number of employees' may be an indicator of declining demand for a firm's product."


By contrast, in his opening remarks to a meeting of the SEC's Investor Advisory Committee, SEC Chair Jay Clayton made clear to the Committee that, in his view, " to move our framework forward we should not attempt to impose rigid standards or metrics for human capital on all public companies." And, in prior comments to the Committee on this topic (see this PubCo post), Clayton cautioned that it will not be easy to develop standardized disclosure requirements for "human capital." Given that disclosure requirements should elicit information that is material to making investment decisions, Clayton observed, those requirements may need to differ significantly, depending on the industry and even the company. It may not be possible, Clayton maintained, to identify metrics that offer market-wide comparability and perhaps not even industry-wide comparability:

"Each industry, and even each company within a specific industry, has its own human capital circumstances. For example, I would expect that the material human capital information for a manufacturing company will be different from that of a biotech startup, and different from that of a large healthcare provider. Further, the human capital considerations for a car manufacturer will be different from that of a home manufacturer. Because of those differences and the principles of materiality, comparability, and efficiency, I am wary of jumping in with rules or guidance that would mandate rigid standards or metrics for all public companies."

In support of their argument, Jackson and Lee cite the petition for rulemaking regarding human capital management disclosure submitted in 2017 by the Human Capital Management Coalition, a group of 25 institutional investors with more than $2.8 trillion in assets under management (see this PubCo post), and the recommendations of the SEC's Investor Advisory Committee, which, they maintain, "have urged the SEC to require specific, detailed disclosures reflecting the importance of human capital management to the bottom line." (See this PubCo post.) The two commissioners welcomed feedback about the "specific measures" that investors would find useful.


The recommendations of the SEC's Investor Advisory Committee were adopted by a vote of 14 to 6, and, with a significant bloc of votes against, the debate about the recommendation was quite contentious. The recommendation advised the SEC to consider mandating human capital management disclosure as part of its Disclosure Effectiveness Initiative. The disclosure requirements might be limited to the most basic, purely principles-based disclosure, asking companies to "detail their HCM policies and strategies for competitive advantage and comment on their progress in meeting their corporate objectives." Alternatively, the requirements could be more prescriptive, mandating use of specific metrics, some of which companies already use to measure

"the success of their HCM strategies and investments. Development of specific metrics should depend on the outcome of standard regulatory processes, and should be adopted only after due consideration for how they might have unintended consequences, such as 'managing to the metric.' Any requirements should be crafted so as to reflect the varied circumstances of different businesses, and to eschew simple 'one-size-fits-all' approaches that obscure more than they add. For example, workplace safety metrics may be crucial for mining companies, but immaterial for software companies. Nonetheless, the fact that board and managers routinely rely on a number of similar metrics suggests that they can add value for investors, at least within a given sector, similar to the 'view from management' approach to MD&A disclosure."

Based on research, the recommendation then offered some examples of specific metrics that "could be considered in rule-making or as part of routine disclosure reviews by Commission staff. " For example, the recommendation suggests that Reg S-K, Item 101, could be expanded to require more information about the breakdown of workers into full-time, part-time and contingent categories, as well as key performance indicators, such as rates of turnover, internal hire and promotion, safety, training, diversity and standard survey measures of worker satisfaction. Discussion of applicable company policies on these topics might be included. Item 101 also requests information about competitive conditions, which could be interpreted to apply to "productivity and competitive advantages of the issuer's employee population, relative to competitors and available pools of labor."

Through the SEC comment process, the staff could seek to elicit data about the education, experience and training of the workforce. In addition, proxy disclosure could address how human capital is being "incentivized and managed" by augmenting executive comp disclosure with summaries of material information about broader workforce compensation and incentives, such as factors considered in pay and promotion decisions and organizational structures related to HCM. The recommendation suggested that the SEC work with FASB "to consider the evolving role of HCM in value creation and update Generally Accepted Accounting Principles accordingly."

For a summary of the specific comments of Committee members objecting to and in favor of the recommendation, see this PubCo post.

Jackson and Lee also addressed what they perceived to be a major deficiency in the proposal: it did "not seek comment on whether to include the topic of climate risk in the Description of Business under Item 101. Estimates of the scale of that risk vary, but what is clear is that investors of all kinds view the risk as an important factor in their decision-making process. Yet it remains tough for investors to obtain useful climate-related disclosure. One argument against mandating such disclosure is that climate risk is too difficult to quantify with acceptable accuracy. Whatever one thinks about disclosure of climate risk, research shows that we are long past the point of being unable to meaningfully measure a company's sustainability profile."


As reported by BNA, then-Director of Corp Fin, Keith Higgins, indicated that the highest proportion of comments received on the 2016 Concept Release related to better environmental and social responsibility disclosure. He observed that, of the 360 "unique" comment letters (i.e., non-form letters) received on the Concept Release, about 80% "were looking for improved sustainability disclosure." The problem, he believed, was that those types of sustainability disclosures were not necessarily amenable to one-size-fits-all rulemaking. According to Higgins, "[c]limate change tops the list of issues...." However, he acknowledged, the issues involved in sustainability "cut across 79 different industries and aren't suited to a constant set of rules....'Everyone recognizes that one-size-fits-all disclosure is likely not to be so effective in the sustainability area—others recognize the enormity of that task.'" Nevertheless, many commenters wanted the SEC to at least come up with "a framework for sustainability disclosure." (See this PubCo post.)

According to this recent study from consulting firm McKinsey, however, investors want to see more standardized sustainability reporting. The authors observe that, in light of mounting evidence "that the financial performance of companies corresponds to how well they contend with environmental, social, governance (ESG), and other non-financial matters, more investors are seeking to determine whether executives are running their businesses with such issues in mind."

Although there has been an increase in sustainability reporting, McKinsey's survey revealed that investors believe that "they cannot readily use companies' sustainability disclosures to inform investment decisions and advice accurately." Why not? Because, unlike regular SEC-mandated financial disclosures, ESG disclosures don't conform to a common set of standards—in fact, they may well conform to any of a dozen major reporting frameworks and many more standards, selected at the discretion of the company. That leaves investors to try to sort things out before they can make any side-by-side comparisons—if that's even possible. According to McKinsey, investors would really like to see some type of legal mandate around sustainability reporting. (See this PubCo post.)

In addition, this October 2018 rulemaking petition, which advocated that the SEC mandate ESG disclosure under a standardized comprehensive framework, indicated that companies often provide ESG information on a voluntary basis, but struggle to provide information that is adequate and useful for investors, often providing information that is "episodic, incomplete, incomparable, and inconsistent," even when included in SEC filings. Moreover, the variety of approaches adopted, along with the proliferation of voluntary disclosure frameworks, have led to inconsistency and lack of comparability. SEC rulemaking, they maintained, would reduce the burden on companies by providing clearer standards that offer more consistency and comparability for investors and other consumers of the information. (See this PubCo post.)

The two commissioners refer to various studies showing the value of material sustainability measures, particularly the work of the independent standard-setting organization, the Sustainability Accounting Standards Board, or SASB, "which has carefully refined its measures through extensive engagement with investors and issuers alike in order to emphasize metrics most material to investors." The two commissioners invite more public comment on "whether and how this topic should be included in a final rule," including "data and analysis to help guide that important work."


In November 2018, SASB announced that it had published a series of sustainability accounting standards specifically tailored for 77 industries. According to the SASB Chair, the publication of these standards represented an "important milestone" because they provide "codified, market-based standards for measuring, managing, and reporting on sustainability factors that drive value and affect financial performance."

The SASB standards—according to SASB, "the world's first set of industry-specific sustainability accounting standards covering financially material issues"— were published after six years of study and market consultation (see this News Brief from 2013 describing the release of the SASB standards for the health care sector). By focusing on development of standards and associated metrics specific to particular industries, SASB sought to identify a "subset of sustainability factors most likely to have financially material impacts on the typical company in an industry." Each standard provides accounting metrics for disclosure topics, technical protocols for compiling data and activity metrics for normalization. SASB then elaborates on each metric with detailed directions as to the precise information that should be disclosed. The objective was to provide investors and companies "decision-useful" information, information that can help them make more informed decisions. (See this PubCo post.)

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