On November 9, 2020, amendments to key provisions of long-standing corporate disclosure requirements became effective. Adopted by a 3-2 vote on August 26, 2020, and published in the Federal Register on October 8, 2020, the Securities and Exchange Commission (SEC or Commission) completed its Modernization of Regulation S-K Items 101, 103, and 105 (Amendments or Final Rule). These items are, respectively, the description of business, legal proceedings, and risk factors disclosures that registrants make in SEC filings such as quarterly and annual reports and registration statements. Not having undergone substantial revision in more than thirty years, Regulation S-K has been improved with a streamlined disclosure process and a more readable style for certain filings.
The Amendments to Regulation S-K
The Amendments modernize certain disclosure requirements in Regulation S-K, including description of the business (Item 101–17 C.F.R. 229.101), legal proceedings (Item 103–17 C.F.R. 229.103), and risk factors (Item 105–17 C.F.R. 229.105). The details follow.
Items 101(a) and (h) (Description of the general development of the business, including smaller companies)
- Applies a largely principles-based approach requiring disclosures that are material to an understanding of the general development of the business.
- Substitutes a materiality framework for the previous five-year reporting time frame and eliminates the three-year time frame for smaller reporting companies.
- Allows for an update as to material developments rather than a full discussion, following a registrant’s initial filing or the most recent filing containing a full discussion, provided that the prior discussion is incorporated by reference.
Item 101(c) (Narrative description of the business)
- Implements a principles-based approach by offering a revised, condensed, and non-exclusive list of disclosure topic examples, drawn in part from previously listed topics.
- Requires, to the extent material to an understanding of the business taken as a whole, disclosure of the material effects of compliance with material government regulations, not just environmental laws.
- Includes, as a disclosure topic, a description of the registrant’s human capital resources to the extent such disclosures would be material to understanding the registrant’s business. The new paragraph calls for 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).”
Item 103 (Legal proceedings)
- Left largely intact but streamlined to avoid duplicative disclosures in a filing, by allowing for hyperlinks or cross-references to legal proceedings located elsewhere in the document.
- Implements a modified disclosure threshold increasing the existing quantitative threshold for disclosure of environmental proceedings to which the government is a party from $100,000 to $300,000. Registrants are given flexibility, however, to select a different threshold reasonably designed to result in disclosure of material environmental proceedings, provided the threshold does not exceed the lesser of $1 million or 1 percent of the current assets of the registrant and its subsidiaries on a consolidated basis.
Item 105 (Risk factors)
- Clarifies that risk factors must be “material” instead of “the most significant” and requires that they be concise.
- Makes changes to the risk factor discussion to make the presentation more reader-friendly, such as utilizing summaries for risk factor sections exceeding 15 pages and a logical organization to the discussion using relevant headings.
- Separates risk factors that may generally apply to investments in securities to the end of the section, and under a separate caption.
It should be noted that the amendments to Items 101 and 103 affect domestic registrants and, to the extent they have elected to file on domestic forms subject to Regulation S-K disclosure requirements, foreign private issuers as well. In contrast, the amendment to Item 105 affects both domestic and foreign registrants.
Human Capital Resources
The previous Item 101(c)(1)(xiii) required disclosure of the number of persons employed by the registrant. The 2016 Concept Release solicited input on this disclosure requirement, requesting feedback as to, among other things, whether this numeric disclosure was still important to investors. The SEC subsequently received a rulemaking petition favoring the disclosure of additional information about human capital management policies, practices, and performance. In light of feedback received from the Concept Release and the rulemaking petition, the SEC more recently proposed to amend Item 101(c) to replace the number of persons employed by a registrant with a description of the registrants’ human capital resources. Many commentators expressed general support for the proposed change, with varying views as to the appropriate roles of a principals-based approach or prescriptive approach and the extent to which each method would elicit meaningful information.
After considering public comments on these and other issues raised in the proposal with respect to human capital, the SEC issued its final changes. According to the Final Rule’s preamble, Item 101(c) “will require, to the extent such disclosure is material to an understanding of the registrant’s business taken as a whole, a description of a registrant’s human capital resources, including any human capital measures or objectives that the registrant focuses on in managing the business.” Non-exclusive examples of measures and objectives that address the attraction, development, and retention of personnel are identified, but the Final Rule is clear that these are only examples of potentially relevant subjects and that each registrant’s human capital disclosure “must be tailored to its unique business, workforce, and facts and circumstances.”
In this regard, the Amendments maintain a largely principles-based, registrant-specific approach to human capital disclosures, although a registrant must also disclose the number of persons employed, to the extent that it would be material to understanding the registrant’s business. In keeping with the principles-based approach, the Commission declined to require the use of available disclosure standards or frameworks. This approach was recommended by certain stakeholders such as the Sustainability Accounting Standards Board (SASB), which submitted comments to the SEC generally supporting the rulemaking initiative but seeking a more structured approach to human capital disclosures and recommending the use of the organization’s set of financially material ESG standards.
Climate Change and Diversity
Comments made by Thomas Riesenberg, director of Legal Policy at SASB, illustrate some of the reactions within the ESG community to the Final Rule. Notwithstanding some positive changes with respect to human capital, Riesenberg also notes that the SEC “stopped short” of addressing other ESG issues, leading to the two Democratic SEC Commissioners, Allison Herren Lee and Caroline A. Crenshaw, to vote against the Amendments.
The two dissenting commissioners made statements during the SEC’s August 26, 2020, meeting, focusing on ESG factors such as climate change and diversity. Expressing concern that these topics were not addressed in the Final Rule adopted by the majority, Commissioners Lee and Crenshaw illustrated the relevancy of these issues to investors, especially given the rise of ESG data considered to be material to financial performance. In particular, Commissioner Lee’s statement recounted how the SEC issued a climate risk guidance in 2010 related to Items 101 and 103, suggesting that the Amendments presented a lost opportunity to revisit the guidance. Furthermore, Commissioner Crenshaw’s statement recommended that the SEC should form an internal task force and an external advisory committee related to ESG.
Other U.S. financial regulators have already begun to address ESG issues such as climate risk. The Federal Reserve recently requested membership to the Network for Greening the Financial System, a network of central banks focused on better understanding the risks that climate change poses to their respective economies. In September 2020, the Commodity Futures Trading Commission released a report titled “Managing Climate Risk in the U.S. Financial System” that presents 53 recommendations for mitigating the risks to financial markets posed by climate change. State regulators, including utility regulators the New York Public Service Commission and the California Public Utilities Commission, and insurance regulator the New York State Department of Financial Services, have also moved to either adopt or start proceedings regarding a mandate.
With respect to a future SEC rulemaking involving ESG disclosure requirements, the legal basis for a regulatory change would be found in existing securities laws, or pursuant to new federal legislation. The outcomes of the two pending Senate runoff races in Georgia on January 5, 2021, would influence which path the Commission takes.
Under one scenario in which one or more of the candidates lose, Republicans will maintain control of the Senate and it is unlikely that any ESG disclosure legislation received from the House would move forward. In that situation, the SEC would have to develop ESG disclosure rules based on and within the parameters of existing securities laws. Depending on the scope and reach of the rules, this approach could be vulnerable to legal challenges alleging that the ESG disclosure rules exceed the SEC’s authority under the current statutory structure.
Under another scenario, in which both candidates win, Democrats would have a 50-50 split in the Senate with Vice President-Elect Kamala Harris casting tie-breaking votes. In that case, legislation amending the securities laws to explicitly authorize a more robust SEC disclosure program could pass more easily through both houses and become law. We probably would see several bills introduced in the 117th Congress, and at least one successfully moving forward, similar to those introduced in the 116th Congress, such as Massachusetts Senator Elizabeth Warren’s Climate Risk Disclosure Act of 2019 (S. 2075), Illinois Representative Sean Casten’s Climate Risk Disclosure Act of 2019 (H.R. 3623), and California Representative Juan Vargas’s ESG Disclosure Simplification Act of 2019 (H.R. 4329). An ESG disclosure rulemaking developed pursuant to newly amended securities laws would be less vulnerable to legal challenges.
With the recent election of a democratic presidential administration, the chance of the SEC also focusing more on ESG, especially climate change disclosures, is highly probable. With Jay Clayton set to step down as chairman at the end of 2020 (although urging regulators on his way out to think carefully before mandating environmental-related disclosures), the Biden administration will get a chance to appoint a new leader, giving the SEC a new 3-2 democratic majority. Given that the vote to adopt the Modernization to Regulation S-K with minimal ESG requirements was along party lines, as well as the various statements by Commissioners Crenshaw and Lee surrounding ESG and climate risk, it is likely that an SEC with a democratic majority will focus on releasing––at a minimum––guidance, and will attempt to amend or promulgate new rules.