SEC Continues Effort to Modernize Disclosure Requirements
Continuing its ongoing effort to modernize and simplify disclosure obligations applicable to public companies, the Securities and Exchange Commission (SEC) recently adopted amendments to certain requirements set forth in Regulation S-K. These amendments impact the description of business (Item 101), disclosure of legal proceedings (Item 103) and disclosure of risk factors (Item 105), areas that have not undergone significant modification in over 30 years. These amendments are intended to improve the readability of the disclosure while discouraging repetition and eliminating disclosure of immaterial information. In light of these amendments, public companies are encouraged to carefully review their current disclosure, as significant modifications to existing disclosure may be warranted in future filings and registration statements. These amendments will become effective 30 days following publication in the Federal Register and are expected to have the most immediate impact on companies with fiscal years ending on September 30, 2020.
Among other things, these amendments implement the following key changes:
- Description of Business (Item 101(a))
- Eliminates the requirement to disclose the general development of the registrant’s business over a 5-year period (3 years for smaller reporting companies) and replaces it with an obligation to disclose the information material to an understanding of the general development of the registrant’s business, without a specified timeframe.
- Authorizes registrants, in filings made after their initial registration statement, to provide an update of the material developments to their business as opposed to a full discussion. However, a registrant utilizing this approach must provide a hyperlink to and incorporate by reference the full discussion from a single previous filing that, together with the update, provides the full overview of its business.
- Filings Impacted: Form S-1, Form S-4, Form 10-K, Form 10, Schedule 14A
- Description of Business (Item 101(c))
- Replaces the list of disclosure topics in Item 101(c) with a non-exhaustive list of disclosure topic examples.
- Adds a disclosure topic related to the registrant’s human capital resources and human capital measures and objectives used in managing its business.
- Expands the previously required disclosure related to the material effects of environmental laws to include the material effects of all applicable government regulations.
- Filings Impacted: Form S-1, Form S-4, Form 10-K, Form 10, Schedule 14A.
- Legal Proceedings (Item 103)
- Increases from $100,000 to $300,000 the disclosure threshold in connection with environmental proceedings involving a governmental authority. Permits registrants to utilize an alternative threshold so long as the increased threshold is properly disclosed and does not exceed the lesser of $1 million or 1% of the registrant’s consolidated current assets.
- Authorizes and encourages companies to include a hyperlink or cross-reference to legal proceedings disclosure included elsewhere in the filing, such as the notes to the financial statements.
- Filings Impacted: Form S-1, Form S-4, S-11, Form 10-Q, Form 10-K, Form 10, Schedule 14A.
- Risk Factors (Item 105)
- Requires risk factors to be organized under relevant headings (in addition to the subcaptions currently required). In addition, registrants will be required to group risk factors that may generally apply to any company or investment at the end of the risk factor section under a separate “General Risk Factors” heading.
- Alters the risk factor disclosure standard from “most significant” to “material” risks.
- Obligates registrants with risk factor sections exceeding 15 pages to prepare a series of concise, bulleted or numbered statements, no longer than two pages, of the principal risk factors at the forefront of the applicable filing.
- Filings Impacted: Form S-1, Form S-3, Form S-4, S-11, Form F-1, Form F-3, Form F-4, Form 10-K, Form 10.
Current requirements and amendments as well as practical takeaways in this alert are covered in detail below:
Item 101(a) – General Business Description
Current Requirements:
Item 101(a) of Regulation S-K currently requires a registrant to describe in certain registration statements and annual reports the general development of its business during the past five years (three years for smaller reporting companies) or such shorter period as the registrant may have been engaged in business. When providing this narrative, registrants are currently required to provide certain disclosures, including (i) the year in which the registrant was organized and its form of organization; (ii) the nature and results of any bankruptcy, receivership or similar proceedings with respect to the registrant or any of its significant subsidiaries; (iii) the nature and results of any other material reclassification, merger or consolidation of the registrant or any of its significant subsidiaries; (iv) the acquisition or disposition of any material amount of assets otherwise than in the ordinary course of business; and (v) any material changes in the mode of conducting business.
Amendments:
The five-year disclosure timeframe (and three-year timeframe for smaller reporting companies) is eliminated and disclosure of the general development of the registrant’s business is replaced with a materiality standard. The SEC believes that these changes will improve the quality of disclosure by affording registrants additional flexibility to tailor their disclosure and provide information material to an understanding of their business. In adopting the final amendments, the SEC acknowledged that some registrants may prefer to describe the development of their business over a longer period in order to provide helpful context to investors making investment decisions, while others may conclude the material aspects of their business can be described over a shorter timeframe
The amendments retain existing disclosure topics related to (i) the results of any bankruptcy, receivership or similar proceedings; (ii) the nature and results of any other material reclassification, merger or consolidation of the registrant or any of its significant subsidiaries; and (iii) the acquisition or disposition of any material amount of assets otherwise than in the ordinary course of business. Registrants will no longer be required to disclose transactions and events that affect or may affect their operations, as the SEC was persuaded that such disclosure is duplicative since it is already required in the MD&A section. To the extent registrants have previously disclosed their business strategy, the amendments add a requirement that such registrants discuss any changes to such previously disclosed strategy if material to an understanding of the development of the registrant’s business. The SEC declined to define “business strategy” and emphasized that, under the principles-based approach, registrants have flexibility to determine the appropriate level of detail related to such disclosure. In addition, the SEC clarified that registrants will not be required to disclose their business strategies annually and that such updated disclosure will only be required to the extent material to an understanding of a registrant’s business.
After the registrant’s initial registration statement, the amendments provide registrants with an option to disclose only the material developments, if any, to its business development since the previously provided full discussion. However, registrants electing to provide only an update of their general business must incorporate by reference, and include an active hyperlink to, the most recently filed SEC disclosure that, together with the interim material update, would provide the full discussion of the general development of the registrant’s business. Importantly, registrants are only permitted to incorporate the full discussion of the general development of their business from a single, previously filed document (i.e., registrants may only include one hyperlink). Utilization of this approach is optional, and registrants are still permitted to provide the complete discussion if so desired.
Narrative Description of Business (Item 101(c))
Current:
Item 101(c) of Regulation S-K currently requires a narrative description of the registrant’s business, with a focus on the registrant’s dominant segment or each reportable segment about which financial information is presented in the financial statements. Item 101(c) further specifies certain items that must be described by the registrant, to the extent material.[1] The SEC has observed that many registrants provide disclosure related to each specified item, even when they are not relevant, which results in immaterial disclosure.
Amendment:
The amendments replace the current list of specific items with a non-exclusive list of disclosure topic examples and clarifies that disclosure is only required to the extent material to an understanding of the registrant’s business taken as a whole. These topics are intended to facilitate application of the SEC’s principles-based approach, and the topics include (i) revenue-generating activities, products and/or services, and any dependence on key products, services, product families or customers, including governmental customers, to the extent the information is material to an understanding of the registrant’s business; (ii) the status of development efforts for new or enhanced products, trends in market demand, and competitive conditions; (iii) the resources material to the registrant’s business (i.e., raw materials, durations of intellectual property); (iv) any material portion of the business that may be subject to renegotiation of profits or termination of contracts or subcontracts at the election of the government; (v) the extent to which the business is or may be seasonal; (vi) compliance with material government regulations, including environmental regulations; and (vii) human capital disclosure.
An important new disclosure topic relates to the registrant’s human capital resources. This topic, if material to understanding the registrant’s business taken as a whole, will require registrants to provide a description of its human capital resources, including the number of persons employed by the registrant and any human capital measures or objectives the registrant focuses on in managing its business (e.g., measures or objectives that address the development, attraction and retention of personnel). The SEC did not impose prescriptive requirements, recognizing that exact measures and objectives included in human capital management disclosure may evolve over time and vary across industries and regions. In addition, registrants must disclose the material effects that compliance with governmental regulations, including environmental regulations, may have upon their capital expenditures, earnings and competitive position. This requirement expands the disclosure required under the current rules, which was limited to environmental laws.
In an effort to streamline and reduce repetitive disclosure, the amendments delete explicit references in the current rules to (i) disclosure about new segments; (ii) the dollar amount of backlog orders; and (iii) working capital practices, since some of those topics, such as working capital, are often discussed in the MD&A section.
Item 103 – Legal Proceedings
Current:
Item 103 of Regulation S-K currently requires disclosure of any material pending legal proceedings to which the registrant or any of its subsidiaries is a party. Registrants must also provide disclosure of the name of the court or agency, the date instituted, the principal parties involved and a description of the alleged factual basis underlying the proceeding and the relief sought.
The instructions to Item 103 currently impose a $100,000 disclosure threshold for environmental proceedings in which the government is a party. The SEC implemented this requirement in 1982 and the monetary threshold had not subsequently been adjusted.
Amendment:
Given the substantial overlap between Item 103 and the disclosure of loss contingencies required under U.S. GAAP, it is fairly common practice for registrants to simply repeat some or all of the disclosures provided in the notes to the financial statements. Therefore, in an effort to reduce duplicative disclosures, the amendments expressly authorize, and even encourage, registrants to provide hyperlinks or cross-references to legal proceedings disclosure located elsewhere in the document.
The amendments also adjust the quantitative threshold related to certain governmental environmental proceedings from $100,000 to $300,000 to account for inflation. A registrant may adopt an alternative threshold so long as (i) it reasonably believes the alternative threshold is designed to result in disclosure that is material to the registrant’s business; (ii) it discloses use of an alternative threshold (including any changes thereto) in each annual and quarterly report; and (iii) the alternative threshold does not exceed the lesser of $1 million or 1% of the registrant’s consolidated current assets.[2]
Item 105 – Risk Factors
Current:
Item 105 of Regulation S-K currently requires registrants to discuss the “most significant” factors that make an investment in the registrant’s securities speculative or risky. The SEC has encouraged registrants to avoid boilerplate language applicable to all companies and instead focus on the “most significant” risks specific to the company. The current rules require that each risk factor be set forth under a subcaption that describes the risk.
Amendment:
In an attempt to enhance the readability and utility of the risk factor disclosure, the SEC has revised the disclosure standard from the “most significant” to “material” risk factors. In addition, registrants will now be required to organize the risk factors under relevant headings, in addition to the subcaptions currently required. To the extent that the registrant includes risk factors that apply generically to any company or offering, the amendments will require those risks to be disclosed at the end of the risk factor section under the caption “General Risk Factors”.
An important new requirement relates to the length of the risk factor disclosure. While the SEC has avoided imposing page limits, the amendments do impose additional requirements on registrants if their risk factor disclosure exceeds 15 pages. Motivated in part by attempts to reduce the registrant’s potential liability, the amount of risk factor disclosure by companies has significantly increased in recent years. One study cited by the SEC found that between 2006 and 2014, the number of words used in the “Risk Factors” section increased by more than 50%.
The SEC estimates that approximately 40% of registrants currently have risk factor disclosure that exceeds 15 pages. Under the new rules, if the risk factor disclosure exceeds 15 pages, the registrant will be required to prepare a series of concise, bulleted or numbered statements, no longer than two pages, at the forefront of the applicable filing that summarizes the principal factors that make an investment in the registrant or offering speculative or risky. The SEC acknowledged that this new rule may incentivize some companies to streamline and reduce their risk factor disclosure in order to avoid triggering the new summary disclosure requirement.
Practical Takeaways
Although these amendments will not drastically change a public company’s disclosure practices, registrants should consider allocating additional time to review and draft upcoming reports in light of these changes, including with respect to the following.
Business
Revised Regulation S-K Item 101 focuses on materiality and elimination of prescriptive requirements that are not material to investors. We recommend that public companies take a holistic view of their business section to assess what information can be removed, what information should be expanded or highlighted and whether corresponding changes should be made in other sections of their filings (e.g., MD&A). Consistent with the principles-based nature of the revisions to Item 101, a registrant should seek to identify the key principles or themes that are material to its investors in understanding its business and revise its disclosures to better articulate and contextualize those principles and themes. In many cases, there may not be significant changes, but the SEC’s revised requirements give companies the opportunity—and the obligation—to focus their disclosure on the aspects of their business that matter the most.
Human Capital Disclosures
Investors are increasingly focused on human capital disclosure, and public companies should evaluate the materiality of their human capital resources to their business. If material, companies should include disclosure around those resources in upcoming filings. The SEC did not impose prescriptive requirements, but registrants are encouraged to carefully evaluate their measures related to the development, attraction and retention of personnel, along with other metrics such as diversity, and consider disclosure as appropriate.
Risk Factors
As mentioned above, the amount of risk factor disclosure has significantly increased in recent years. Many companies have spent a substantial amount of time drafting and refining risk factor disclosure that is intended to adequately communicate potential risks and to help protect the company from potential liability. We would not recommend eliminating risk factor disclosures just to come in under the 15-page limit, but a company close to that limit may want to consider whether there are any opportunities to streamline and/or fine tune the existing disclosure, without impacting the quality of the disclosure. In general, we recommend that companies focus on appropriately reorganizing and clarifying, instead of reducing, their existing risk factor disclosures.
Market practice regarding the summary risk factor disclosure will likely evolve over time. It is currently unclear exactly what the SEC expects this summary to look like, but it could be similar to the discussion of risk factors included in the box “Summary” of prospectuses often included in registered offerings.
Disclosure Controls and Procedures
In light of these changes and as new information is included in future public filings, we encourage public companies to evaluate their disclosure controls and procedures and make any necessary updates to ensure compliance with these updated rules. As a reminder, the chief executive officer and chief financial officer are required to certify that the company maintains appropriate disclosure controls and procedures. In addition, since these filings may also be automatically incorporated by reference into Securities Act registration statements, the information and disclosures made by the registrant in these filings are potentially subject to additional liability under Sections 11, 12 and 17 of the Securities Act.
If you have any questions related to this alert, please do not hesitate to contact any member of the Public Companies group or your regular Smith Anderson lawyer.
[1] Item 101(c) currently requires the disclosure of (i) principal products produced and services rendered; (ii) new products or segments; (iii) sources and availability of raw materials; (iv) intellectual property; (v) seasonality of the business; (vi) working capital practices; (vii) dependence of certain customers; (viii) dollar amount of backlog orders believed to be firm; (ix) business subject to renegotiation or termination of government contracts; (x) competitive conditions; (xi) the material effects of compliance with environmental laws; and (xii) number of persons employed.
[2] The release notes that, based on current asset data for fiscal year 2019 from Standard & Poor’s Compustat Daily Updates database, the $1 million threshold represents approximately 0.01% of the mean current assets of companies in the S&P 500.
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