On August 26th, 2020, the SEC announced that it adopted amendments to modernize Regulation S-K Items 101 (business description), 103 (legal proceedings), and 105 (risk factors).  SEC Chairman, Jay Clayton, stated that this is a step towards modernizing “public company business disclosure rules for essentially the first time in over 30 years”.  

Principals-Based or Rules-Based?

The rules adopted are anchored on principles-based, materiality assessments that drive disclosures and, as suggested by the SEC, “seek to elicit information that will allow today's investors to make more informed investment decisions”.  This suggests that companies, themselves, through the lens of management and board of directors get to determine what is deemed material.

In a public statement, Commissioner Allison Herren Lee questioned the efficacy of these amendments.  Based on the responses of nearly 3,000 comment letters submitted to the SEC by the public, over 90% of respondents requested that the SEC consider requiring more rules-based disclosures on workforce development, climate change and diversity and inclusion rather than overly emphasize principles-based requirements.

Standardized Disclosures Are Essential for Comparability

As companies continue to evolve from more industrial-focused to more technology and service-based organizations, the companies’ workforces become a crucial source of driving firm value and growth.  Arguably, reliance on the company’s workforce to help it navigate the difficulties faced during this significant uncertainty period is all the more critical.  Since the company’s labor workforce is potentially one of its most valuable assets (and some would say the most valuable), investors need to be able to contextualize human capital management and identify human capital risks and opportunities.

Some investors, for instance, the California State Teachers’ Retirement System suggest that the SEC requires universal mandatory disclosure. For example (1) the number of people employed; (2) the total cost of the company’s workforce; (3) turnover; and (4) workforce diversity. While recognizing that principles-based disclosures allow companies to tell their own stories, some investors like CalPERS are also concerned that this can lead to a lack of standardized information being disclosed across companies and therefore prohibits cross-sectional company comparability.

Should Materiality be Viewed Through the Lens of the Company OR Investors

A study conducted by Harvard University professors found that institutional investors perceive climate risks to have financial implications for the portfolios that they manage.  Therefore, reliance on a principles-based disclosure framework anchored on materiality would mean that there would be less, not more, standardized data surrounding climate risks and its impact on a company.  Without a structured framework, it would be very difficult for investors to access the data they need on this risk to make informed decisions.

"Materiality is entity-specific. The omission or misstatement of an item in a financial report is material if, in light of surrounding circumstances, the magnitude of the item is such that it is probable that the judgment of a reasonable person relying upon the report would have been changed or influenced by the inclusion or correction of the item."
FASB Conceptual Statement No. 8, QC11

This notion of materiality leaves the judgment of whether to disclose or not disclose to management and the board of directors, who may not have the same perspective as investors who are managing a portfolio of investments.  It raises the question of how materiality, as viewed through a single company’s lens, intersects with investors’ objectives who have to assess many companies.