On August 8, 2019, the U.S. Securities and Exchange Commission (SEC) proposed amendments (the “Proposed Rule”) to modernize its existing requirements for how companies disclose risk factors and describe their business and developments in their business and legal (including environmental) proceedings in their periodic reports and registration statements filed with the SEC. The Proposed Rule would update Regulation S-K, which contains the line-item requirements for non-financial statement disclosures in SEC filings. The Proposed Rule is the latest in a series of SEC rulemakings (see “Another Wave of Disclosure Simplification Rules Adopted by the SEC” and “SEC Disclosure Simplification Continues”) aimed at modernizing the disclosure regime for public companies through following a more principles-based, as opposed to prescriptive, approach to disclosure and through formally adopting best practices and existing SEC interpretative guidance.
We summarize below the proposed rule changes and highlight in particular how these would affect foreign private issuers.
The deadline for submitting comments on the Proposed Rule is expected to be around mid-October. The SEC will consider the comments received from the public on the proposed amendments, and any changes will take effect only once the SEC publishes a final rule release.
The Proposed Rule seeks to alleviate the compliance burden on companies while making risk factor disclosure easier for investors to read and understand. In particular, the SEC notes that, over the years, risk factor disclosures have tended to become lengthier and include generic, boilerplate risks that are not specifically tailored to a particular company’s business. This trend has primarily been driven by the impulse that more risk disclosure equals more protection against liability when things go bad.
In an attempt to balance the protection risk factor disclosure provides against litigation with the aim of encouraging better disclosure—that is, disclosure that is clearer, better organized and that makes it easier for investors to understand a company’s risk profile—the Proposed Rule would require companies to:
- Include a risk factor summary if the risk factors section exceeds 15 pages—The summary, which would be located in the forepart of the document, would consist of a series of short, concise, bulleted or numbered statements summarizing the principal factors that make an investment in the company or offering speculative or risky.
- Disclose “material” risks—The current rule and SEC guidance requires companies to disclose in the risk factors section the “most significant” risks relating to an investment in the company’s securities. The Proposed Rule would amend this to instead refer to “material” risks, with the aim of encouraging companies to focus on risks to which reasonable investors would attach importance in making investment decisions.
- Organize risk factors under relevant headings—The Proposed Rule would codify a best practice already followed by many companies by requiring similar risk factors to be grouped together under relevant headings in an effort to help readers better comprehend lengthy risk factor disclosures. To the extent a company chooses to include generic risk factors that are not specifically tailored to the company’s risk profile, these would need to be grouped together at the end of the risk factors section under the heading “General Risk Factors.”
Relevance to Foreign Private Issuers
The Proposed Rule would amend the risk factor disclosure requirements for registration statements on Forms F 1, F 3 and F 4 (the forms used by foreign private issuers to make offerings of securities). While the SEC is not proposing to change Form 20 F (the form used by foreign private issuers to file annual reports), the Proposed Rule solicits comments on whether the Form 20 F rules should be similarly amended. Changes to the SEC disclosure standards applicable to foreign private issuers may also, by analogy, affect disclosure practice in exempt offerings under Securities Act Rule 144A.
Notably, the Proposed Rule would align U.S. risk factor disclosures more closely with the recent changes in Europe under the new EU Prospectus Regulation (Regulation (EU) 2017/1129) that took effect in July 2019. For example, the EU Prospectus Regulation requires a summary of the most material risks (not to exceed 15 risk factors) specific to the issuer and the securities to be included in the summary section of a prospectus. In the main risk factors section, the EU Prospectus Regulation requires that risk factors be specific to the issuer or the securities being offered—generic risks that serve only as disclaimers may not be included—and organized by category depending on their nature.
The Proposed Rule seeks to make the disclosure rules requiring companies to describe their businesses, and developments in their business, more flexible in light of the varied nature of modern businesses and therefore more useful to investors. The current rule (Item 101(c) of Regulation S-K) enumerates a list of items that must be included in the narrative description of the company’s business, discussed on a reporting segment level. The Proposed Rule would take a more principles-based approach by including a non-exhaustive list of topics and clarifying that disclosure responsive to each topic is required only to the extent material to an understanding of the company’s business.
The Proposed Rule would also make the following changes to Item 101(a) and (c) of Regulation S-K:
- Human capital—The current form requires disclosure of the number of employees. Recognizing that the size and profitability of modern enterprises is often not correlated to their number of employees, the Proposed Rule would replace this with a requirement to discuss the company’s human capital resources, including measures or objectives that address the attraction, development and retention of employees, contractors or other human capital relevant to the company.
- Updates only—After a company’s initial registration statement, the description of developments in the company’s business can be limited to material changes since the last filing containing the full description, with the prior filing (from an earlier year, or a registration statement) hyperlinked and incorporated by reference.
- Eliminate prescribed time period—The current form requirements specifically elicit disclosure of the development of the business over the last five years, or such shorter time as the company been in business. This prescriptive requirement dates back to 1935 and does not reflect the current wide range of SEC reporting companies, from those with many decades of track record to start-ups for which each month may be critical. The Proposed Rule would direct companies to provide information material to an understanding of the development of their business, irrespective of timeframe.
- Material changes to business strategy—While strategic transactions are captured by the current form requirements, the Proposed Rule would require disclosure of material changes to a company’s previously disclosed business strategy, even if they have yet to have a material impact on the company.
- Reducing overlap—The Proposed Rule recognizes that financial statement disclosure and the related management’s discussion and analysis (MD&A)/operating and financial review and prospects (OFR) disclosure has progressed since the existing requirements were adopted. In an effort to reduce overlapping disclosure, the Proposed Rule would remove items such as working capital practices and backlog orders believed to be firm from the narrative description of the business section, with the expectation that these will be addressed, to the extent material, in the MD&A.
Relevance to Foreign Private Issuers
The equivalent Form 20-F disclosure requirements, contained in Items 4.A and 4.B, are one area in which disclosure by foreign private issuers is already moderately less prescriptive than that required of U.S. domestic registrants, as Form 20-F was revised in 1999 to align more closely to international standards. The Proposed Rule would not affect these. There is some concern that updating Form 20-F to align to the Proposed Rule could result in foreign private issuers losing the ability to use the same disclosure in multiple jurisdictions.
- Bright-line environmental threshold—The current form requirements contain a bright-line rule requiring disclosure of environmental proceedings to which the government is a party if the potential monetary sanction is at least $100,000, with such level not having increased since it was set in 1982. While the Proposed Rule solicits comment on whether a materiality standard should be used for this disclosure, it proposes to retain the bright-line approach, albeit with an inflation-based increase to $300,000, in recognition of the factual and legal complexity of environmental proceedings.
- Cross-references—While the Proposed Rule acknowledges that litigation disclosure required to be disclosed in the financial statements under U.S. GAAP or IFRS or included in risk factors accomplishes different goals than the disclosure elicited by Item 103 of Regulation S-K, it recognizes that companies frequently make use of the same disclosures in order to satisfy both requirements, and so will explicitly allow cross-references and incorporation by reference of legal proceedings disclosure in response to Item 103.
Relevance to Foreign Private Issuers
The Proposed Rule would not affect foreign private issuers. While Form 20-F does not include a similar bright-line test with respect to environmental proceedings, it does include a requirement to disclose legal or arbitral proceedings (including governmental proceedings) which may have or have had a “significant effect” on the company’s financial position or profitability.