In April 2016, the SEC’s Division of Corporation Finance issued a 341-page concept release relating to the disclosure requirements of Regulation S-K.3 The release is part of the Division’s initiative to review the disclosure requirements that are applicable to SEC registrants, and to consider ways to improve these requirements for the benefit of investors and issuers.
Regulation S-K addresses a broad range of disclosures that apply to registration statements and periodic reports. In some cases, it has remarkably detailed and prescriptive disclosure requirements; in other cases, it is relatively “principlesbased,” and leaves considerable room to the judgment of the draftsperson. As we often point out, very few of Regulation S-K’s provisions were drafted with structured notes or other derivative securities in mind; accordingly, careful thought has been applied over the last decade to appropriate disclosures for these securities offerings, and certain norms of disclosure have taken root in the industry.
The concept release principally addresses the parts of Regulation S-K that relate to a registrant’s business and financial results.4 Accordingly, most of its discussion is not specifically relevant to structured note product supplements or pricing supplements; these documents mainly discuss the terms of the relevant securities and the risks that arise from those terms.5 However, a variety of the issues raised in the concept release address issues that practitioners in our sector must address every day.
Who Is Reading This Document? Addressing the Informational Needs of Different Investors
Pages 45 to 52 of the concept release discuss the fact that there are considerable differences among the recipients of offering documents in terms of their understanding of the material presented. Accordingly, the concept release seeks comment on, for example, whether disclosures should be tailored to facilitate their use by different types of investors. A subsequent discussion in the concept release (beginning on page 324) discusses the possibility of “layered disclosure,” in which summary disclosures are used in order to highlight key information for less sophisticated investors.
Practitioners in the structured product market have devoted substantial attention in recent years to the needs of retail investors, especially (of course) for products that are principally targeted at retail investors. Issuers have organized their offering documents with a view to enhancing the ability of retail investors to understand the products, and the risks that they entail, including hypothetical performance diagrams and tables, and emphasizing the key risks that are inherent to a structure, such as potential loss of principal, or capped returns.
The SEC’s discussion in the concept release of presenting information in graphic form, such as charts and tables, and standardized disclosure formats, is reminiscent to some extent of the KIID rules enacted in the European Union, particularly if the SEC begins to extend these concepts to the description of securities in prospectuses.
Perhaps surprising, but true: Item 503(c)’s guidance for risk factors is extremely limited. The very few words used in this part of Regulation S-K in fact generate a significant amount of text in offering documents. Additionally, Item 503(c) really says nothing specific about structured notes, underlying assets or even “estimated initial value.” In fact, of the five examples of material risks set forth in Item 503, only one, relating to “limited liquidity,” directly relates to these types of securities.
Accordingly, practitioners have devoted substantial time to creating today’s structured note risk factors, giving careful consideration to the terms of the notes, the nature of the underlying asset and (beginning in 2012) the SEC’s guidance as to estimated initial value. Many would say that the risk factors presented by different issuers in the market for similar products is strikingly similar.
The concept release notes the SEC’s historic concern about “generic” risk factors, and about boilerplate text that could apply to any offering. The concept release repeats the SEC’s prior guidance that risk factors should be as specific as possible.
Structured note issuers tend to be specific about risks where known — for example, a document with a “10% buffer” will clearly state that the investor is subject to a potential loss of 90% of principal (subject to credit risk). For other items, such as the potential profit from the issuer’s hedging activities and the related conflict of interest that arises, issuers tend to be unable to place precise figures (since the future is unknown), and instead discuss the nature of the risk in qualitative terms.
The concept release is also concerned as to whether issuers are appropriately stressing the key risk factors. In the structured note market, issuers principally address this with careful placement. For example, issuer credit risk and potential loss of principal (where applicable) are typically addressed not only by placing these risk factors in a prominent part of the risk factors section, but also by including appropriate disclosures on the cover page and the summary section. The goal here is to ensure that investors, particularly retail investors, won’t miss the point, and will consider it prior to making an investment.
Avoiding Duplicative Disclosures
The concept release expresses a concern that, due to the length and complexity of disclosure documents, key messages might be missed. The release is interested in the possibility of shortening documents, whether through avoiding duplicative disclosures, or by using features such as hyperlinks. In the area of structured products, for example, many detailed provisions about the terms of the notes are sometimes repeated verbatim in different parts of the document, such as the “summary section” and the “description of the notes.” The concept release suggests that the SEC may take rulemaking action at some point to avoid this type of repetition.
OK, we admit it. We’re somewhat fascinated by the SEC’s exhibit requirements, and somewhat pleased that the concept release requests comments about Regulation S-K’s exhibit requirements. However, to the extent that this is not a burning issue for most market participants, and that the concept release is principally concerned with the filing requirements for “material contracts,” we will keep our remarks brief.
- Only a few exhibit requirements relate directly to structured notes: principally, filing underwriting agreements and related documents, indentures and forms of notes, and “enforceability opinions” and “tax opinions.”
- We are aware of few situations in which the filing of underwriting agreements, indentures and forms of notes have provided meaningful benefit to investors, as these documents are principally understandable only by securities lawyers. However, filing these documents does involve a cost for issuers, principally in the form of printer fees, and legal fees for reviewing the filing and supervising the filing process. The principal benefit of these filings seems to be to enable lawyers to compare their work to that of other firms. (That being said, as new TLAC and other requirements are implemented, regulators may take an interest in indentures and similar documents to understand whether covenants and other provisions comply with the applicable regulatory requirements.)
- As an alternative to requiring the filing of these documents, perhaps the SEC could consider rules that would enable issuers, instead of filing these documents, to (a) make them available to investors and the SEC upon request, or (b) post them (in whatever reasonable electronic format they choose) on a company website?