By George Wilson

 

Principles-based disclosure guidance is a major theme in current SEC rulemaking.  Recent changes to Regulation S-K business, risk factor and MD&A disclosures rarely prescribe specific disclosures and frequently require materiality judgments.  For example, the business description disclosures in the new S-K Item 101 include this overall requirement:

 

When describing each segment, only information material to an understanding of the business taken as a whole is required. Disclosure may include, but should not be limited to, the information specified in paragraphs (c)(1)(i) through (v) of this section.

 

These kinds of judgments are never simple.  The old business description guidance had more prescriptive rules.  One such rule was a requirement to disclose the name of a customer who accounted for over 10% of consolidated revenues.  This was a more objective and simpler disclosure decision.  Now we must use judgment to decide if a customer relationship is material information to an investor rather than relying on this kind of “bright-line.”

 

The new human capital resources disclosure in S-K Item 101 demonstrates the complexity in principles-based disclosure requirements.  First, the provision above – “only information material to an understanding of the business taken as a whole is required” applies to this disclosure.   Second, it requires us to make some very subjective judgments:

 

(ii) A description of the registrant's human capital resources, including the number of persons employed by the registrant, and any human capital measures or objectives that the registrant 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 development, attraction and retention of personnel).

 

It would be much simpler if the rule provided a list of areas such as retention practices, training programs and compensation plans.  Instead, we must first determine what management focuses on in the realm of human capital resources and then determine what information is material and hence required to be disclosed.  This will be much more time consuming and challenging!

 

It is reasonable to ask why the SEC is moving from objective, rule-based, disclosures to a more principles-based regimen.  On November 18, 2020, CorpFin Division Director William Hinman addressed this issue in a speech at the eighteenth annual PLI Directors’ Institute on Corporate Governance titled “The Regulation of Corporation Finance – A Principles-Based Approach.”  His perspective about the importance of principles-based requirements is clear:

 

“However, I believe that our principles-based requirements, which articulate an objective and allow companies to satisfy the objective by providing disclosure appropriately tailored to their facts and circumstances, in most cases are the ones that provide investors with the most meaningful information.  These requirements can be highly effective in eliciting disclosure about complex and evolving areas like climate change, Brexit, cybersecurity and the LIBOR transition.”

 

Later in this speech he says:

 

“There are many different approaches that companies can take when preparing disclosure.  I encourage an approach that does not begin with the question “What must I disclose?”  Rather, for the good corporate citizen, the question is better framed as “What should I disclose?”  Companies should disclose the information that investors and the markets will find useful and important, regardless of whether there is some technical argument that compliance with specific disclosure requirements can be met with less illuminating disclosure.” 

 

Yes, these principles-based requirements present more challenges than prescriptive, rules-based requirements.  But the message here is clear.  With this movement to a more principles-based disclosure regimen, we must carefully address these judgments and make them with investors in mind.

 

As always, your thoughts and comments are welcome.

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