The SEC recently proposed amendments to Regulation S-K related to a registrant's required disclosures concerning the description of its business (Items 101(a),(c) and (h)), legal proceedings (Item 103), and risk factors (Item 105.) The proposed amendments are intended to update the rules to improve disclosures for investors and to simplify compliance efforts for registrants. The proposed amendments can be found here. Comments on the proposed amendments are due by October 22, 2019.
The SEC has invited comment on the proposed amendments as well as on "any other areas where [its] approach to ensuring investors have the appropriate mix of information to make investment decisions can be improved." The proposing release includes specific questions seeking comment on various aspects of the SEC's approach for disclosure under the amendments.
In this alert, we review the SEC's approach to the proposed amendments, provide a high-level summary of the changes, and briefly present our thoughts on topics board members and senior management should consider before the rules are finalized.
These proposals are part of a comprehensive evaluation of the SEC's disclosure requirements that was recommended in the Report on Review of Disclosure Requirements in Regulation S-K (the S-K Study). The report was mandated by Section 108 of the Jumpstart Our Business Startups Act (the JOBS Act). Based on the S-K Study's recommendation, the SEC staff initiated an evaluation of the information registrants are required to disclose, how this information is presented, where this information is disclosed, and how the SEC staff could better leverage technology as part of its efforts. According to the SEC, the overall goal of these efforts "is to improve our disclosure regime for both investors and registrants."
Certain line-item requirements in Regulation S-K employ bright-line, quantitative thresholds to specify when disclosure is required, or require all registrants to disclose the same type of information. These "prescriptive" disclosure requirements do not rely on management's judgment to determine whether disclosure is required under certain circumstances. In contrast, some requirements in Regulation S-K are designed to elicit disclosure within broad categories of information material to an investment decision. In making such disclosures, registrants have the flexibility to determine whether the disclosure could be material to an investment decision.
These "principles-based" disclosure requirements describe a disclosure concept, as opposed to requiring disclosure under a specific line-item requirement. The SEC has explained that "[p]rinciples-based rules rely on a registrant's management to evaluate the significance of information in the context of the registrant's overall business and financial circumstances and to determine whether disclosure is necessary." The SEC has also indicated that "emphasizing principles-based disclosure may allow a registrant to more effectively tailor its disclosure to provide the information about its specific business and financial condition that is material to an investment decision and in turn may reduce the amount of disclosure that may be irrelevant, outdated or immaterial." Chairman Jay Clayton noted that the proposed rule changes "reflect a thoughtful mix of prescriptive and principles-based requirements that should result in improved disclosures and the elimination of unnecessary costs and burdens."
The revisions to Items 101(a), 101(c) and 105 are principles-based, and the SEC noted that these changes "may result in more or less detail than prescriptive requirements, which set forth explicit criteria for disclosure." The SEC explained that "[t]he economic effects of replacing a prescriptive requirement with a more principles-based disclosure standard based on materiality depend on a variety of factors, including the preferences of investors, the compliance costs of producing the disclosure and the nature of the information to be disclosed." In contrast, the proposed disclosure requirements for Item 103 are more prescriptive because that disclosure is less dependent on a registrant's individual characteristics.
ITEM 101 – DESCRIPTION OF BUSINESS
The SEC is proposing to revise Item 101(a), re-designate paragraph (a)(2) as paragraph (a)(3), and revise paragraphs (c) and the introductory text to paragraph (h). Outlined below are the key areas where these disclosures would change.
Eliminate prescribed time frames
In the proposed revision to Item 101(a), the SEC would eliminate the five-year disclosure time frame and, instead, require registrants to focus on information material to an understanding of the development of their business, irrespective of a specific time frame. Interestingly, the SEC noted that in certain circumstances, a registrant may prefer to describe its business over a longer period in order to provide information material to an investment decision.
The proposed revisions to Item 101(h) would delete the provision requiring smaller reporting companies (SRC) to describe their business during the last three years. If, however, an SRC has not been in business for three years, it is required to provide the same information for its predecessors, if any.
Non-exclusive list; material changes to business strategy
The SEC is proposing to amend Item 101(a)(1) to be more "principles based by providing a non-exclusive list of the types of information that a registrant may need to disclose" where the information is "material" to understanding the registrant's business. The SEC noted that its approach is designed to provide flexibility "to tailor the disclosure to reflect the circumstances of each registrant."
The current disclosure regime does not require disclosure of material changes to a registrant's previously disclosed business strategy. The SEC proposes, to the extent material to an understanding of a registrant's business, a disclosure topic relating to transactions and events that affect or may affect the registrant's operations, including material changes to a registrant's previously disclosed business strategy. The SEC indicated that while many commentators were concerned about proprietary strategy disclosure that could cause competitive harm, the proposed amendments require a registrant only "to include material changes to [its] previously disclosed business strategy." The term "business strategy" is not defined in the proposed rules. Three of the other four disclosure topics have not changed and relate to:
- Material bankruptcy, receivership, or any similar proceeding
- Nature and effects of any material reclassification, merger or consolidation of the registrant or any of its significant subsidiaries and
- Acquisition of disposition of any material amount of assets otherwise than in the ordinary course of business.
Require only updated disclosure in subsequent filings
Currently, registrants are required to provide disclosure regarding the general development of the business in registration statements and annual reports. Under the proposed amended rules, a registrant would be required to include a full discussion of the general developments of its business only in its initial registration statement. For subsequent filings, instead of a repetition of the full discussion, the registrant would (a) provide an update of the general developments of the business with a "focus on the material developments in the reporting period," including disclosure of material changes in the registrant's business strategy, and (b) include one active hyperlink to the registrant's most recent filing that, together with the update, would contain the full discussion of the general development of the registrant's business.
Narrative description of business
The registrant's business generally
Currently, Item 101(c) requires a description of the business done and intended to be done by the registrant and its subsidiaries. The SEC noted that the bulk of these requirements were adopted in 1973, and that its proposed changes are designed to make these requirement more principles-based by including disclosure topics drawn from a subset of the topics currently contained in Item 101(c). The SEC observed that many registrants use the existing section of this Item as a checklist, and include disclosures related to each topic even if the information is not material.
The SEC's proposed change to a principles-based approach is meant to "encourage registrants to exercise judgment in evaluating what disclosure to provide, which [will] result in disclosure more appropriately tailored to a registrant's specific facts and circumstances."
Segment disclosures vs. general business disclosures
Proposed Item 101(c) still retains the distinction between disclosure topics for which segment disclosure should be the primary focus, as compared to two items for which registrants should include disclosure material to an understanding of its business taken as a whole. For the following topics, the proposed rules require information about a registrant's dominant segment, or each reportable segment about which financial information is presented in the financial statements:
- revenue-generating activities, products and/or services, and any dependence on key products, services, product families, or customers, including governmental customers
- status of development efforts for new or enhanced products, trends in market demand and competitive conditions
- resources material to a registrant's business
- raw materials
- the duration and effect of all patents, trademarks, licenses, franchises, and concessions held
- 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 and
- the extent to which the business is or may be seasonal.
For the following topics, the registrant should focus primarily on its business as a whole, except in instances where the information elicited by these topics is material to a particular segment, in which case the registrant should also identify that segment:
- compliance with material government regulations, including environmental regulations: While there is no separate line item in Regulation S-K requiring disclosure of governmental regulations that may be material to a registrant's business, the SEC noted that it is "common practice" for many registrants to include this disclosure. The SEC explained that the proposed approach would codify this practice, and
- human capital disclosure: the SEC explained that this new topic is designed to elicit "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, to the extent such disclosures would be material to an understanding of the registrant's business."
The proposed rules do not address a few topics that were previously included in Item 101(c). Specifically, the SEC has deleted the provision addressing working capital, with the expectation that registrants will discuss working capital in their MD&A disclosures, to the extent material. In addition, disclosures about new segments and the dollar amount of backlog orders believed to be firm are deleted from this Item, with the caveat that registrants should still provide disclosures about these topics if they are material to an understanding of their business.
ITEM 103 – LEGAL PROCEEDINGS
The proposed rule would:
- allow the registrant to provide the required information about material legal proceedings by including hyperlinks or cross-references to legal proceedings disclosure located elsewhere in the document in an effort to encourage registrants to avoid duplicative disclosure and
- revise the $100,000 threshold for disclosure of environmental proceedings to which the government is a party to $300,000 to adjust for inflation.
ITEM 105 – RISK FACTORS
The proposed rule would:
- require summary risk factor disclosure if the risk factor section exceeds 15 pages
- refine the principles-based approach of that rule by changing the disclosure standard from the "most significant" factors to the "material" factors required to be disclosed and
- require risk factors to be organized under relevant headings, with any risk factors that may generally apply to an investment in securities disclosed at the end of the risk factor section under a separate caption.
The proposing release poses many questions regarding some of the proposed amendments as well as other conceptual questions. It has also drawn criticism. For example, Commissioners Robert Jackson and Allison Lee published a joint statement, available here, expressing their concern about the shift toward a principles-based approach to disclosure and the absence of the topic of climate risk. At this point, the proposal is simply that; no one knows which, if any, of the proposed rule revisions the SEC will adopt or how the proposals might change. There are, however, aspects of the release which are worth monitoring and on which registrants may wish to provide comments:
- Proposed disclosures of a company's business strategy (Proposed Item 101(a)(1)): The changes do not mean that a company needs to disclose its undisclosed proprietary strategy. Companies that have made business strategy disclosures, however, should consider the proposal and assess whether they are in a position to disclose transactions and events that may constitute a material change to their prior disclosure. Such registrants should consider whether such disclosure is practical.
- Reduction of repetitive information in registration statements and annual reports (Proposed Item 101(a)(2)): If adopted, this revision would enable registrants to present only the material developments to their business in the reporting period.Registrants should monitor whether strong opposition emerges to this common-sense proposal and assess their position accordingly.
- Proposed human capital disclosure (Item 101(c)): This is mostly new territory for public companies and will require some internal discussion and thought. Earlier this year, the Council of Institutional Investors called for action to be taken to improve issuers' reporting around human capital management and ESG matters. Many open questions remain about the contours of any such disclosure.
- Legal proceedings (Item 103): The proposed rule specifically contemplates the inclusion of hyperlinks or cross-references to avoid repetitive disclosure which may be found in the notes to the financial statements under US GAAP, the MD&A and Risk Factor section. Any such repetitive disclosure should be reviewed to assess whether it is consistent. In addition, due to the increase in the threshold amount, it may be possible to eliminate disclosure of certain environmental claims if this amendment is adopted.
- Risk factors (Item 105): The SEC noted that registrants often include lengthy and generic risk factors. Proposed Item 105 will require registrants to take a hard look at their risk factors and ensure that each factor is relevant and tailored to its circumstances. Whether or not the current rule is amended, registrants should consider evaluating existing risk factors with the SEC's comment in mind since the SEC's current view is that risk factors must be relevant and tailored to risks the registrant actually faces.
While the modernization of Regulation S-K disclosures is currently a proposal, the SEC's proposing release is a strong signal that disclosure changes are coming. The proposing release offers insight into the direction that the SEC will take as it moves to improve disclosures. Registrants should pay attention and assess how best to plan for the likely changes.