At the end of last week, the SEC voted, without an open meeting, to propose amendments to modernize the descriptions of business, legal proceedings and risk factors in Reg S-K. The proposal is another component of the SEC’s “Disclosure Effectiveness Initiative.” In crafting the proposal, the SEC took into account comments received on the 2016 Concept Release on disclosure simplification and modernization (see this PubCo post), as well as Corp Fin staff experience in review of disclosures. The changes to the rules were proposed “in light of the many changes that have occurred in our capital markets and the domestic and global economy in the more than 30 years since their adoption, including changes in the mix of businesses that participate in our public markets, changes in the way businesses operate, which may affect the relevance of current disclosure requirements, changes in technology (in particular the availability of information), and changes such as inflation that have occurred simply with the passage of time.” There is a 60-day comment period.
SEC Chair Jay Clayton has previously described his framework for disclosure rules as “rooted in the principles of: (1) materiality; (2) comparability; (3) flexibility; (4) efficiency; and (5) responsibility.” Consistent with that framework, he has observed, disclosure requirements must evolve over time to reflect changes in markets and industries. Many of the provisions of Reg S-K originated when the most valuable assets reflected on companies’ balance sheets were primarily fixed assets, such as property, plant and equipment. Now, many companies’ most valuable assets are human capital, intellectual property and other intangible assets. While Clayton continued to view the lynch pins of the current materiality disclosure framework as the right ones, the SEC must, he has said, recognize when the drivers of value have changed and reconsider the nature of the information to be assessed under the framework. In part, this proposal reflects that effort.
To be sure, the approach taken in the proposal is certainly an incremental one. The most significant change is the addition of “human capital” as one of the topics be disclosed, to the extent material, as part of the business narrative, a change that Clayton has been foreshadowing for months. (See, e.g., this PubCo post.) And while there is no fundamental “re-imagining” of the disclosure system as a whole, such as the “company profile” approach that former SEC Chair Mary Jo White had floated back in 2013, there are some mild telltale signs. (If you recall, the company profile approach would have included a “filing and delivery framework based on the nature and frequency of the disclosures, including a ‘core document’ or ‘company profile’ with information that changes infrequently. Companies would then be required to update the core filings with information about securities offerings, financial statements, and significant events.” See this News Brief.) Here, with regard to descriptions of the development of the business, the SEC is proposing to eliminate repetition by permitting companies to simply update to reflect material developments in the reporting period and include a link to incorporate by reference more complete prior disclosure regarding development.
As described in the proposing release, to enable each business to focus on the matters that are material to that business, the proposed amendments take a more principles-based approach to the business and risk factor disclosure requirements. With regard to legal proceedings, the proposal would continue the current prescriptive approach because that requirement is less dependent the specific attributes of companies.
The Concept Release raised the question of whether the disclosure rules should be more principles-based or more prescriptive. As discussed, both of these approaches are based on the concept of “materiality” as defined in TSC Industries, Inc. v. Northway, Inc., specifically, whether there is a substantial likelihood that a reasonable investor would consider the information important in decision-making and whether a reasonable investor would view the information to significantly alter the “total mix” of information available. “Principles-based” rules “articulate a disclosure objective and look to management to exercise judgment in satisfying that objective.” On the other hand, some requirements “prescribe” quantitative thresholds to minimize uncertainty in determining materiality and to identify when disclosure is required. While principle-based rules are necessarily imprecise, may be difficult to apply and can result in a loss of comparability among reporting entities, they can help to eliminate irrelevant information by permitting tailored responses that focus on information that is material to the particular business and are more flexible and adaptable as circumstances change. Prescriptive standards can help promote comparability, consistency and completeness of disclosure, but they can sometimes be circumvented and may not address or capture all the important information. An earlier S-K Study conducted by the staff pursuant to the JOBS Act recommended that revisions emphasize an overarching principles-based approach while preserving the benefits of a rules-based system.
The proposed changes are summarized below:
Development of business (Item 101(a))
This item requires a description of the general development of the business during the past five years, or any shorter period the company may have been in business.
- Non-exclusive list of topics. As proposed, the rule would now provide a non-exclusive list of four topics, and companies would need to include disclosure regarding any of the topics only to the extent the information would be material to an understanding of the general development of the business. The SEC believes that the approach would provide flexibility, while focusing on materiality. To the extent there is material information beyond the four topics, the company would be required to disclose that information as well. The identified topics are:
“(i) Transactions and events that affect or may affect the company’s operations, including material changes to a previously disclosed business strategy;
(ii) Bankruptcy, receivership, or any similar proceeding;
(iii) The nature and effects of any material reclassification, merger or consolidation of the registrant or any of its significant subsidiaries; and
(iv) The acquisition or disposition of any material amount of assets otherwise than in the ordinary course of business.”
- Material changes to strategy. Material changes to strategy, the first bullet point above, would be an addition to the current rule. Because many companies discuss their strategies as part of their IPO registration statements, the SEC believes that material changes to a strategy that has previously been disclosed may be material to investors.
- Eliminate prescribed timeframe. Instead of the currently required five-year timeframe, companies would need to focus on the period over which information would be material. The SEC thought that the current timeframe “may not elicit the most relevant disclosure for every registrant.” In some cases, a period longer than five years might be appropriate, and in other cases, a shorter period would make the most sense.
- Update only. Permits the company, in filings after the initial registration statement, to provide only an update focused on material developments in the reporting period, including changes in the business strategy. Companies would need to provide an active hyperlink to incorporate the most recent filing, so that together the disclosure would provide the full discussion of the general development of the business. The proposal is intended to eliminate repetitive disclosures while also minimizing the burden on investors because they will need to click on only one hyperlink.
Business narrative (Item 101(c))
Reg S-K requires a narrative description of the business done and intended to be done, focusing on the dominant segment or each reportable segment (if financial information is presented in the financial statements for those segments). Currently the rule includes a long list of enumerated disclosure topics, many of which were adopted in 1973. Time to update perhaps? While the current rule invokes a materiality standard, the SEC observes that many companies treat the list as mandatory. The SEC believes that shifting to a more principles-based framework might do the trick, encouraging companies to use their judgment to tailor the disclosure.
The more principles-based requirements would include a list of disclosure topics, drawn from those in current Item 101(c), that are likely to be material to many companies, retaining the current distinction between segment disclosure topics (most of the topics) and topics to be discussed in the context of the business as a whole. The proposed list would exclude from the current list topics such as disclosure about working capital practices (more appropriate in MD&A), new segments and dollar amount of firm backlog, although, if those topics were material, the company would still need to provide disclosure about them.
- Principles-based list of disclosure topics—segments. The topics to be discussed by segment include:
- “Revenue-generating activities, products and/or services, and any dependence on revenue-generating activities, key products, services, product families or customers, including governmental customers.”
The SEC viewed these elements as “key to how reasonable investors often evaluate the future prospects of a registrant’s business.”
- “Status of development efforts for new or enhanced products, trends in market demand and competitive conditions.”
Rather than prescribe additional disclosures about competition, as some commenters had advocated, the SEC opted for a more flexible, principles-based approach here.
- “Resources material to a registrant’s business, such as:
- (A) Sources and availability of raw materials; and
- (B) The duration and effect of all patents, trademarks, licenses, franchises and concessions held.”
- “Resources material to a registrant’s business, such as:
Even though intellectual property has become increasingly important to many businesses, the SEC elected not to expand the topic to add copyrights or trade secrets, largely because of competitive concerns and the substantial time and cost that might be involved in systematically identifying and cataloguing these types of intellectual property. The SEC noted in the discussion the significantly different approaches to IP disclosure among companies in different industries; for example, among biotechs and pharmas, the discussion often involves detailed patent disclosure, but among IT and services companies, the discussion is more often at a high-level.
- “A description of 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.”
The proposing release noted here that companies with U.S. government contracts tend to also disclose that the “funding of these contracts is subject to the availability of Congressional appropriations and that, as a result, long-term government contracts are partially funded initially with additional funds committed only as Congress makes further appropriations. These registrants disclose that they may be required to maintain security clearances for facilities and personnel in order to protect classified information. Additionally, these registrants state that they may be subject to routine government audits and investigations, and any deficiencies or illegal activities identified during the audits or investigations may result in the forfeiture or suspension of payments and civil or criminal penalties.”
- “The extent to which the business is or may be seasonal.”
The SEC decided to retain this topic to avoid a potential loss of information about seasonality in the fourth quarter because GAAP may not elicit this disclosure.
- Principles-based list of disclosure topics—company as a whole. The two topics identified below are intended to be discussed in the context of the company as a whole, unless material to a particular segment, in which case, the discussion should be extended to that segment as well.
- Regulatory compliance. The proposal would expand the current topic mandating disclosure regarding the material impact of environmental regulations to cover all “material government regulations.” As proposed, this topic would require disclosure of the “material effects that compliance with material government regulations, including environmental regulations, may have upon the capital expenditures, earnings and competitive position of the registrant and its subsidiaries,” including “material estimated capital expenditures for environmental control facilities.” The SEC observed that, although there is no separate requirement for disclosure about material government regulations, many companies do provide that disclosure. For example, healthcare and insurance companies often discuss HIPAA compliance. Accordingly, the extension of the topic seemed consistent with current practice and would help provide investors with information material to an investment decision.
- Human Capital. The proposal seeks to refocus the current disclosure by replacing the existing requirement to disclose only the number of employees with a requirement to disclose, to the extent material, a “description of the registrant’s human capital resources, including in such description any human capital measures or objectives that management 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 attraction, development, and retention of personnel).” The exact measures or objectives discussed in a company’s disclosure may change over time and vary with the industry. The objective, according to the SEC, is to allow investors “to better understand and evaluate this company resource and to see through the eyes of management how this resource is managed.”
What is human capital management? According to SASB, human capital management “addresses the management of a company’s human resources (employees and individual contractors) as key assets to delivering long-term value. It includes issues—such as labor practices, employee health and safety and employee engagement, diversity and inclusion—that affect the productivity of employees, management of labor relations, and management of the health and safety of employees and the ability to create a safety culture.” (See this PubCo post.)
Instead of specific line item disclosures, the proposed amendment provides non-exclusive examples of potentially material human capital measures and objectives. The release asked for comment on whether the SEC should add more examples of measures or objectives that may be material, such as the number of full-time, part-time, seasonal and temporary workers; voluntary and involuntary turnover rates; measures regarding average hours of training per employee per year; information regarding human capital trends, such as competitive conditions and internal rates of hiring and promotion; measures regarding worker productivity; and the progress that management has made with respect to any objectives it has set regarding its human capital resources. Whether or not they become part of the final rule, the additional list helps to identify some of the issues that companies could consider in crafting their own disclosures.
The release notes that there has been growing interest in human capital disclosure, including a petition for rulemaking regarding human capital management disclosure that was submitted in 2017 by, wait for it, the Human Capital Management Coalition, a group of 25 institutional investors with more than $2.8 trillion in assets under management. The petition asked the SEC to adopt rules requiring “issuers to disclose information about their human capital management policies, practices and performance.” Although the petition was short on prescriptive recommendations, it did identify the broad categories of information that the proponents viewed as “fundamental to human capital analysis.” (See this PubCo post.)
In remarks in March to the SEC’s Investor Advisory Committee, which was considering whether to recommend that the SEC adopt human capital management disclosure requirements, SEC Chair Jay Clayton reminded the Committee that the requirements for human capital disclosure were adopted back when human capital was primarily viewed as a cost on the income statement. But increasingly, human capital has become the source of economic strength and, for some companies,
“human capital is a mission-critical asset. Disclosure should focus on the material information that a reasonable investor needs to make informed investment and voting decisions; yet, applying this and the other principles [of the framework] to human capital in the way businesses assess and disclose, and investors evaluate, for example, revenue or costs of goods sold, is not a simple task. That said, the historical approach of disclosing only the costs of compensation and benefits often is not enough to fully understand the value and impact of human capital on the performance and future prospects of an organization. With that as context, my view is that to move our framework forward we should not attempt to impose rigid standards or metrics for human capital on all public companies. Rather, I think investors would be better served by understanding the lens through which each company looks at its human capital. In this regard, I ask: what questions do boards ask their management teams about human capital and what questions do investors—those who are making investment decisions—ask about human capital? For example, how do investors use human capital information to make relative capital allocations among similar organizations? Armed with general and sector-specific answers to these questions, we can better craft rules and guidance.”
Clayton has previously also observed that the disclosure may need to vary significantly, depending on the industry and even the company. It may not be possible, Clayton noted, to identify metrics that offer market-wide comparability and perhaps not even industry-wide comparability: “Each industry, and even each company within a specific industry, has its own human capital circumstances. For example, I would expect that the material human capital information for a manufacturing company will be different from that of a biotech startup, and different from that of a large healthcare provider. Further, the human capital considerations for a car manufacturer will be different from that of a home manufacturer.” While the rules should be principles-based, “it is important that the metrics allow for period-to-period comparability for the company.” Importantly, Clayton believed that human capital should be viewed through the eyes of management, whether the focus is on turnover rates, education or experience of the workforce, availability of workers to fill open positions or other factors. Commissioner Robert Jackson also noted that the economy is changing to be more of a “human-centric model,” and that the role of workers is likewise changing, as more companies look to “contingent workers.” Disclosure should reflect these changes. In the end, the Committee voted—14 to 6—to recommend that the SEC consider imposing human capital management disclosure requirements as a part of its Disclosure Effectiveness Initiative. (See this PubCo post and this PubCo post.)
Smaller reporting companies (Item 101(h))
The SEC is not proposing to amend the more prescriptive alternative disclosure standards regarding business development, description of business, and other information specified under Item 101(h)(1) through (6). This approach allows SRCs to provide a less detailed description of their business, consistent with the current scaled disclosure requirements for these companies. However, the SEC is proposing a couple of conforming changes.
- Eliminate timeframe. The SEC is proposing to revise Item 101(h) to eliminate the three-year timeframe for SRCs to describe the development of their businesses. The SEC is proposing to retain the requirement that SRCs that have not been in business for three years must provide the same information for its predecessors if there are any.
- Updates. As proposed above, for filings other than the initial registration statement, SRCs would be permitted to provide an update to the general development of the business disclosure, instead of a full discussion, along with an active hyperlink to the most recent filing.
Legal proceedings (Item 103)
This item requires disclosure of any material pending legal proceedings, other than ordinary routine litigation, to which the company or any of its subsidiaries is a party or to which any of their property is the subject. Similar information is to be included for such proceedings known to be contemplated by governmental authorities.
- Hyperlinks permitted. To discourage duplication, the proposal would expressly permit hyperlinks or cross-references to legal proceedings disclosure located elsewhere in the document. The proposing release noted that much of the legal proceedings disclosure is often included in the notes to the financial statements or elsewhere in the document.
- Disclosure threshold. The proposal would raise the disclosure threshold for environmental proceedings to which a governmental authority is a party to $300,000. Currently, companies are not required to disclose environmental proceedings to which the government is a party if they reasonably believe that monetary sanctions will be less than $100,000, a threshold that dates back to 1982. The SEC views the monetary threshold to be appropriate because it may help investors to assess the company’s level of environmental compliance and provides a useful benchmark for companies to determine the need for disclosure. The proposed increase was based on the CPI Inflation Calculator.
Risk Factors (Item 105)
This principles-based item requires disclosure of the most significant factors that make the investment speculative or risky. The comments that the SEC received in response to the Concept Release were “wide-ranging and no consensus emerged.” In this proposal, the SEC is addressing “the lengthy and generic nature of the risk factor disclosure presented by many registrants,” which, studies have shown, has recently increased. For example, “one study found that registrants increased the length of risk factor disclosures from 2006 to 2014 by more than 50 percent in terms of word count, compared to the word count in other sections of Form 10-K that increased only by about 10 percent, and that this increase in risk factor word count may not be associated with better disclosure.” The SEC considers the inclusion of untailored, boilerplate risks to be a contributing factor, which practice continues, notwithstanding SEC and staff guidance to limit risks to those that are “most significant.” Commenters indicated, however, that companies would continue to disclose generic risks because of the “risk of litigation associated with failing to disclose risks if events turn negative.”
- Mandatory summary as an incentive. The proposal would require, if the risk factor section exceeded 15 pages, a summary of the risk factors to be included in the forepart of the prospectus or annual report, as applicable, under an appropriate caption. The summary would “consist of a series of short, concise, bulleted or numbered statements summarizing the principal factors that make an investment in the registrant or offering speculative or risky.” A summary would not only “enhance the readability and usefulness of this disclosure,” it would also serve as an “incentive to limit the length of [the] risk factor disclosure.” The SEC estimates that about 40% of current filers would be affected.
- Materiality standard. The proposal would change the current disclosure standard from “most significant” factors to “material” factors, with the goal of focusing companies on “disclosing the risks to which reasonable investors would attach importance in making investment decisions” and encouraging companies to tailor their risks.
- Organization. The SEC is proposing to requires companies to organize the risk factors under relevant headings, an already common practice, with risks applicable generally to an investment in securities—where the company does not explain how it is “specifically relevant to an investor in its securities”—to be located at the end under a separate caption, “General Risk Factors.”