How a “Comply or Explain” Rule Would Improve Nonfinancial Disclosure

In 2016, the Securities and Exchange Commission (SEC) issued a Concept Release on Regulation S-K as part of its comprehensive review of the effectiveness of federal disclosure rules. The release included for the first time a request for comment on whether and how sustainability information should be incorporated into periodic reporting under federal securities law.  The SEC previously issued guidance in 2010 showing how information on material climate-related risks should be disclosed in companies’ financial reports. Other studies have also shown that nonfinancial information (referred to generally as “environmental, social, and governance” (ESG) disclosure) is material to firms, depending on their sector.  However, most ESG disclosure reaches investors and other interested parties not from the financial reports but from the voluntary sustainability reports that most listed companies now produce.

Because sustainability reports are written for different audiences, cover different timeframes, are often unaudited, and adopt different definitions of materiality than the TSC Industries standard that applies to financial reporting, ESG reporting remains inadequate for financial analysis, even though the quantity of publicly available ESG information has grown exponentially.  Many investors continue to express concern about the inadequacy of nonfinancial disclosure in companies’ annual reports and in proxy disclosures, even for areas like material climate-related risks that have been the subject of SEC guidance.  As I argue elsewhere, the most critical weaknesses of voluntary reporting – quality, reliability, and comparability – can’t be readily fixed by more voluntary reporting standards or other private governance efforts, suggesting that the SEC could play an important role.

At the same time, the lack of political support for new mandatory disclosure, and the strong reservations many firms and their advisors have about the potential costs and benefits of sustainability-related disclosure, mean that new prescriptive rules will not be the best way to fix the disclosure gaps for material ESG information either.

As investor demand for ESG information that can be used in financial analysis continues to grow, the SEC must decide whether to maintain the status quo or to actively promote better disclosure of material ESG information in some form.  Current debates over the future of financial (and nonfinancial) reporting seem to imply that the only choice is to ignore sustainability materiality and keep relying on voluntary disclosures that are poorly suited for investment purposes, or, on the other hand, to swing toward mandatory line-item disclosure rules that would apply to all reporting companies.  New approaches to ESG disclosure beyond this simplistic voluntary-mandatory choice are clearly necessary.

In a recent article, I argue that, if the SEC decides to address ESG disclosure as part of its ongoing disclosure reforms, it should consider a “comply or explain” approach to ESG reporting.   Under the comply-or-explain model, which has been widely adopted in the United Kingdom and other jurisdictions around the world, a securities regulator, stock exchange, or other authority adopts a code reflecting corporate best practices.  Companies can then elect to comply with the new rules in one of two ways: either by implementing the code provisions directly or by providing an explanation of why they have elected not to.  Under a comply-or-explain regime, only a firm that does neither would be noncompliant.

Based on a survey of empirical research across many of the jurisdictions that have implemented a comply-or-explain approach, I conclude that comply-or-explain principles have been an effective self-regulatory tool to improve corporate governance practices and enhance corporate transparency, particularly in markets that are most similar to the United States.  In fact, several provisions of current U.S. reporting requirements already follow a comply-or-explain approach, offering some precedent for a new model of ESG reporting.  My article concludes by drawing on this comparative experience to propose principles that could guide the SEC in incorporating a comply-or-explain approach to ESG reporting within the current financial reporting.  The argument here is not that comply-or-explain should be the SEC’s sole approach to ESG disclosure, but that as an important form of voluntary or self-regulation it should be one of the choices in the SEC’s toolkit.  The choice of a comply-or-explain model still leaves open a range of policy choices with regard to the appropriate scale and scope of disclosure, and I conclude by suggesting specific elements that could be incorporated in new ESG disclosure standards on a comply-or-explain basis.

This post comes to us from Virginia Harper Ho, a professor of lLaw at the University of Kansas School of Law and the co-director of the law school’s Polsinelli Transactional Law Center. It is based on her recent article, “‘Comply or Explain’ and the Future of Nonfinancial Reporting,” available here. It was originally presented at the 2016 Lewis and Clark Law Review symposium on “Innovating Corporate Social Responsibility: From the Local to the Global” and is forthcoming in a symposium volume.