Nonfinancial Risk Disclosure and the Costs of Private Ordering

• Published date: 01 September 2018
• Date: 01 September 2018
• Author: Virginia Harper Ho
• DOI: http://doi.org/10.1111/ablj.12123

American Business Law Journal

Volume 55, Issue 3, 407–474, Fall 2018

Nonfinancial Risk Disclosure and the

Costs of Private Ordering

Virginia Harper Ho*

In 2016 the Securities and Exchange Commission (SEC) considered for the first

time whether financial disclosure reform should address information on

sustainability matters and other sources of nonfinancial risk. The resulting debate

over these issues raised fundamental questions about how well the federal disclosure

regime addresses emerging risks and about how well private ordering, through

shareholder engagement, the work of private standard-setters, and corporate

voluntary disclosure, can fill the gaps. This article argues that the current model of nonfi-

nancial risk disclosure, based largely on private ordering, is ineffective and undermines

the SEC’s mission to protect investors, facilitate capital formation, and promote fair,

orderly, and efficient markets. This conclusion rests on evidence that the current state of

sustainability disclosure is inadequate for investment analysis and that these deficiencies

are largely problems of comparability and quality that cannot readily be addressed by pri-

vate ordering. This article also highlights the costs of agency inaction to investors and to

public companies, which have been largely ignored in the debate over the future of finan-

cial reporting. It concludes by proposing avenues for disclosure reform.

*

Professor of Law, University of Kansas. The author is grateful for the opportunity to

engage with members of several committees of the American Bar Association’s (ABA)

Section of Business Law on initiatives related to the issues explored in this article,

including the SEC’s Regulation S-K reforms and the work of the Financial Stability

Board’s Task Force on Climate-related Financial Disclosure (TCFD). However, the views

expressed herein are solely those of the author and do not reflect the views of the ABA

or any of its working groups. Special thanksisowedtoDonLangevoort,JillFisch,Tom

Lin, Hilary Allen, Arthur Laby, Michael Vandenbergh, Stephen Park, Josephine Sandler

Nelson, James Coburn, and Veena Ramani, as well as participants at the 2016 Lewis &

Clark Business Law Forum, the 2017 J.B. & Maurice C. Shapiro Environmental Law

Symposium at the George Washington University School of Law, the 2017 National Busi-

ness Law Conference, the 2017 University of Sheffield Conference on Law, Finance, and

Sustainability, and faculty workshops at Washington & Lee, Villanova, and the Chicago-

Kent College of Law for their insights on the issues addressed here.

©2018 The Author

American Business Law Journal ©2018 Academy of Legal Studies in Business

407

Every investment analyst should be able to identify and properly eval-

uate investment risks, and ESG issuesareapartofthisevaluation.

—Paul Smith, CFA, President and CEO of the Certified Financial Analysts

Institute

1

Certain areas of reform, most notably in the … ESG space, are better

addressed by ongoing engagement with … investors, rather than

through SEC mandates.

—Shearman & Sterling LLP

2

INTRODUCTION

Since 2013 the Securities and Exchange Commission (SEC) has been

engaged in the first comprehensive overhaul in decades of the disclosure

requirements that apply to public companies, a “Disclosure Effective-

ness” project that will define public reporting under the federal securities

laws for the twenty-first century.

3

As part of that review, the SEC issued

an ambitious Concept Release in 2016—over 300 pages long and con-

taining 340 multipart questions—seeking public comment on how best to

modernize and simplify the business and financial disclosure rules con-

tained in Regulation S-K.

4

The SEC’s initial recommendations and sub-

sequent proposed rules to reform Regulation S-K address only a small

1

CFA INST., ENVIRONMENTAL,SOCIAL,AND GOVERNANCE ISSUES IN INVESTING:AGUIDE FOR

INVESTMENT PROFESSIONALS 3 (2015).

2

Comment of Shearman & Sterling LLP on Regulation S-K Concept Release to Brent

J. Fields, Sec’y, U.S. Sec. & Exch. Comm’n (Aug. 31, 2016), https://www.sec.gov/comments/

s7-06-16/s70616-367.pdf.

3

This review was mandated by Congress in 2012 under the Jumpstart Our Business Start-

ups Act, Pub. L. No. 112-106, 126 Stat. 306 (2012) [hereinafter the JOBS Act] and again in

2015 under the Fixing America’s Surface Transportation (FAST) Act, Pub. L. No. 114-94,

129 Stat. 1312 (2015) [hereinafter the FAST Act]. The first stages of the Disclosure Effec-

tiveness review included a report to Congress on its disclosure rules and a review of the

rules governing financial statements under Regulation S-X and a review of the rules gov-

erning the business and financial disclosure outside the financial statements under Regula-

tion S-K. See generally Disclosure Effectiveness, SEC, https://www.sec.gov/spotlight/disclosure-

effectiveness.shtml (last visited Jan. 21, 2018); see also U.S. SEC.&EXCH.COMM’N,REPORT ON

REVIEW OF DISCLOSURE REQUIREMENTS IN REGULATION S-K (2013), https://www.sec.gov/news/

studies/2013/reg-sk-disclosure-requirements-review.pdf (reviewing the history and scope of

the current framework) [hereinafter SEC REPORT ON REVIEW].

4

Business and Financial Disclosure Required by Regulation S-K: Concept Release, 81 Fed.

Reg. 23,916 (Apr. 22, 2016) [hereinafter Concept Release].

408 Vol. 55 / American Business Law Journal

subset of the issues the SEC raised in the Concept Release and the next

steps of the Disclosure Effectiveness review are still pending.

5

Taking stock of the current reporting regime for public companies has

reopened fundamental questions about the purpose of mandatory disclo-

sure and how much flexibility companies should have in determining

what information is material to investors under the standard set by the

U.S. Supreme Court in TSC Industries, Inc. v. Northway, Inc.

6

Nowhere is

this more obvious than in the responses the SEC received to questions in

the Concept Release, which, for the first time, formally sought input on

whether financial reporting should address nonfinancial indicators of firm

risk and performance related to sustainability and other environmental,

social, and governance (ESG) matters.

7

Although these eight questions

accounted for only a fraction of the questions in the C oncept Release , they

attracted responses from over two-thirds of the more than 300 unique

comment submissions.

8

Over eighty percent of all Concept Release com-

ments urged the agency to improve the level of sustainability disclosure in

5

In response to its mandate under the FAST Act, the SEC issued proposed rules in 2017 to

amend select provisions of Regulation S-K that do not pertain to nonfinancial disclosure.

FAST Act Modernization and Simplification of Regulation S-K, 82 Fed. Reg. 50,988 (Nov.

2, 2017) [hereinafter Regulation S-K Proposed Rules]; see also U.S. SEC.&EXCH.COMM’N,

REPORT ON MODERNIZATION AND SIMPLIFICATION OF REGULATION S-K(2016), https://www.sec.gov/

reportspubs/sec-fast-act-report-2016.pdf [hereinafter REG ULATION S-K RECOMMENDATIONS]. A

future phase of the review will cover executive compensation and governance. Concept

Release, supra note 4, at 23,917.

6

426 U.S. 438, 449 (1976).

7

Concept Release, supra note 4, at 23,969–73 (“Disclosure of Information Relating to Public

Policy and Sustainability Matters”). As the Concept Release explains, “[s]ustainability disclo-

sure encompasses a range of topics, including climate change, resource scarcity, corporate

social responsibility, and good corporate citizenship. These topics often are characterized

broadly as environmental, social, or governance (‘ESG’) concerns.” Concept Release, supra

note 4, at 23,970. The terms “ESG” and “nonfinancial” are used interchangeably through-

out this article. The term “sustainability reporting” refers to a corporate responsibility or

other voluntary report separate from the company’s annual report.

8

The SEC received over 300 unique comments, in addition to over 25,000 form letters dis-

tributed by two investor advocacy groups. See Comments on Concept Release: Business and

Financial Disclosure Required by Regulation S-K, U.S. SEC.&EXCH.COMM’N, https://www.sec.

gov/comments/s7-06-16/s70616.htm (last visited Jan. 20, 2018). Many of the comments

focused exclusively on these questions, but most responded more broadly and linked sus-

tainability responses to other parts of Regulation S-K that cover risk disclosure. See generally

Virginia Harper Ho, Comments on the Regulation S-K Concept Release: An Analysis of

Reform Proposals on Materiality, Risk, and Sustainability (2018) (unpublished manuscript)

(on file with author).

2018 / Nonfinancial Risk Disclosure 409