Who reads those things? It is a common refrain that I have thought to myself when clicking through an electronic agreement for my latest iOS update or tossing in the trash the latest terms and conditions update for my auto insurance. However, as much as it pains me to say as a securities attorney, I know that is the same reaction many investors have when they receive a proxy statement or annual report in the mail from a company in which they have made an investment. It is not that the investor does not care how the company is performing, but rather I think in many instances the volume of information is so overwhelming that a typical investor has a difficult time locating the information that might really be important, or as a securities attorney might say, the information that is actually material.
This is an issue that the U.S. Securities and Exchange Commission (SEC) has attempted to balance throughout its existence. As the SEC states on its website, the mission of the SEC is to protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation. The primary statutes through which the SEC carries out this mission are the Securities Act of 1933, as amended (Securities Act) and the Securities Exchange Act of 1934, as amended (Exchange Act). As the U.S. Supreme Court summarized in one of its seminal securities law cases, the design of the Securities Act is to protect investors by promoting full disclosure of information thought necessary to make informed investment decisions.[1] It is the investor protection part of the SEC’s mission that this article will explore. More particularly, we will explore the premise that too much required disclosure actually has a counterproductive effect. If the volume and depth of disclosure has become so much that the average investor does not even bother reading the materials provided, is this not a disservice to the exact category of investor that the securities laws were put in place to protect? After all, it is not the institutional investor or registered investment advisor for whom the securities laws are designed to protect. Rather, it is the average investor; or as the U.S. Supreme Court has stated, those investors that cannot fend for themselves.[2]
Recent SEC Efforts on Disclosure Improvement and Simplification
In December 2013, staff of the SEC produced its Report on Review of Disclosure Requirements in Regulation S-K (hereinafter referred to as the SEC Disclosure Report), which, among other things, included a comprehensive analysis of Regulation S-K and how the regulation could be updated to modernize and simplify the SEC registration process and reduce the costs and other burdens associated with registration.[3] Regulation S-K sets forth requirements for disclosure (other than financial statement disclosure) under both the Securities Act and the Exchange Act and is applicable to both public offerings and ongoing reporting requirements.[4] It is a key part of the SEC’s “integrated disclosure system,” which was created in 1982 following many years of analysis of the disclosure rules under the Securities Act and the Exchange Act.[5] Under the integrated disclosure system, most registration and reporting forms under the Securities Act and the Exchange Act refer to Regulation S-K for many of their substantive disclosure requirements.[6] The “goal of the [SEC’s] integrated disclosure program has been to revise or eliminate overlapping or unnecessary disclosure and dissemination requirements wherever possible, thereby reducing burdens on registrants while at the same time ensuring that security holders, investors and the marketplace have been provided with meaningful nonduplicative information upon which to base investment decisions.” (emphasis added).[7]
The SEC’s efforts at modernizing disclosure requirements for public reporting companies and registered securities offerings continued with publication of a concept release in 2016.[8] The release, which we refer to as the Concept Release, sought to assess whether the disclosure requirements in Regulation S-K continue to provide the information that investors need to make informed investment and voting decisions and whether any of the SEC’s rules have become outdated or unnecessary. The Concept Release again noted the SEC Disclosure Report’s recommendation that any review of disclosure requirements should consider ways to present information that would improve the readability and navigability of disclosure documents and explore methods for discouraging repetition and the disclosure of immaterial information.[9]
The SEC has taken recent action modifying the SEC’s disclosure requirements under Regulation S-K. On August 26, 2020, the SEC adopted amendments[10] to modernize the description of business (Item 101), legal proceedings (Item 103), and risk factor disclosures (Item 105) that registrants are required to make pursuant to Regulation S-K. We previously summarized these amendments in a prior client alert.[11] Then, on November 19, 2020, the SEC adopted amendments[12] eliminating the requirement for Selected Financial Data (Item 301), streamlining the requirement to disclose Supplementary Financial Information (Item 302), and amending Management’s Discussion & Analysis of Financial Condition and Results of Operations (MD&A) (Item 303). These amendments are intended to eliminate duplicative disclosures and modernize and enhance MD&A disclosures for the benefit of investors, while simplifying compliance efforts for registrants.
What the Recent Regulation S-K Amendments Demonstrate
The recent Regulation S-K amendments demonstrate a couple of common recurring themes. First, while the integrated disclosure framework was intended to reduce duplicative disclosure, there still remains a lot of information that a company repetitively discloses, whether in the same filing or in subsequent filings after initial disclosure. For example, the recent amendments deleted in its entirety Item 301, which previously required a registrant to furnish selected financial data in comparative tabular form for each of the registrant’s last five fiscal years and any additional fiscal years necessary to keep the information from being misleading. Due to advances in technology (see EDGAR), this prior financial information was easily accessible to an investor and so the disclosure was entirely unnecessary. Advances like these are the type of changes that can really benefit the average investor, as it will help to curtail the volume of information that is in a disclosure document and, hopefully, concentrate on new, material changes to the company’s business.
A second theme is the SEC’s return to the use of a summary section as a solution to an over-disclosure problem – specifically, in this instance, with respect to risk factor disclosure. In its Concept Release, the SEC described the problem with existing risk factor disclosure as follows:
Although Item 503(c) instructs registrants not to present risks that could apply to any registrant, risk factor disclosure typically includes generic risk factors. Registrants often use risk factors that are similar to those used by others in their industry or circumstances as the starting point for risk disclosure, and the disclosure is not always tailored to each registrant’s particular risk profile. Examples of generic disclosures include risk factors about a registrant’s failure to compete successfully, the effect of general economic conditions on a registrant’s business, changes in regulation, and dependence upon a registrant’s management team.[13]
Despite the SEC’s repeated attempts to encourage registrants to focus on the most significant or principal risks, to avoid “boiler plate” risk factors, and to keep risk factors concise, the Concept Release noted the risk factors section continues to expand in length, with one study citing an average of 22 risk factors per registrant.[14] The SEC’s solution to the over-disclosure problem was to add a summary risk factor section (limited to two pages) summarizing the principal factors that make an investment in the registrant or offering risky. Per the SEC, the use of a risk factor summary, when the full risk factor discussion exceeds 15 pages, should make the disclosure more user friendly and improve its readability.[15] Personally, I find a solution that adds content, even if in summary form, to a disclosure problem relating to excessive, generic content to be a somewhat paradoxical solution.
This is not the first time that use of a summary has been encouraged or mandated by the SEC to make disclosure more concise, material, and relevant to investors. The SEC has previously suggested use of an executive-level overview at the start of the MD&A, and, more recently, it added an optional 10-K summary that a registrant can provide in its annual report on Form 10-K.[16] I think the desire for a summary is the SEC’s attempt to get the registrant to focus on what is really material, so that the average investor can have concise, readable disclosure about the performance of the registrant.
Implementing Meaningful Disclosure Change
If the SEC desires to see significant simplification of registrants’ disclosure for the benefit and protection of the average investor, it is going to require significant change to the SEC’s current rulemaking philosophy. That is not to say that the SEC should abandon its preference for “principles-based disclosure” over the more prescriptive, rule-based disclosure. The SEC has described principles-based disclosure in the following way:
Many of our rules require disclosure when information is material to investors. These 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 determine whether disclosure is necessary. The requirements are often referred to as “principles-based” because they articulate a disclosure objective and look to management to exercise judgment in satisfying that objective.[17]
The problem with principles-based disclosure is that it requires significant effort from management. Unlike prescriptive disclosure, where management often looks to its legal counsel to provide a shell of the disclosure based on what the rule requires, principles-based disclosure requires analysis from the people closest to the business – management. That is not to say management is not “up-to-the-task.” Companies’ earnings releases already do a very effective job at providing management’s analysis of its most recent quarterly or year-end results. There is no prescriptive rule-based regime about what should be included in a company’s earnings’ release. Yet, management effectively describes the company’s most recent financial results and often includes commentary, in plain English, about how the company is performing. Earnings releases are not overly complex, yet the market often responds based on these releases. In fact, many companies’ blackout policies allow insiders to begin trading two-business days after earnings are released, whether or not the more extensive quarterly or annual report has been filed. The reason for that is the market has already been provided, via the earnings release, with the information that is material to an investment decision – i.e., the information that the average investor actually considers to be important.
I believe one of the reasons earnings releases are effective disclosure tools is that they naturally have a limit on word count. I do not mean that literally, but rather the limit is imposed by custom and what the market expects. Most earnings releases are three to five pages, when you do not include any summary financial tables included with the release. That is one area where I believe the SEC should be more prescriptive – the use of page limitations in its rule-based regime. Below are some suggestions on where page limitations may be useful in producing disclosure that is simple, non-repetitive and meaningful.
Risk Factors. I did like the SEC’s recent risk factor rule changes. But they did not go far enough. Instead of limiting the summary to two pages, let’s limit the entire risk factor section to three pages. This will require management to determine which risks are most material and specific to its business and to describe them succinctly, in bullet or number list form. Revise Regulation S-K such that it allows registrants to automatically incorporate by reference the generic risk factors that are commonly included in SEC filings. The list of generic risk factors can be hyperlinked into the disclosure document by reference to a generic risk factors list maintained by the SEC and publicly available through hyperlink in the filing. I would also suggest creation of standard, industry specific risk factors. For example, there could be a standard set of risk factors for financial institutions – after all, do we really need a bank to warn us that if loans go bad, it will affect financial results? These risks could also be hyperlinked into the filing. The SEC could establish a task force of relevant industry participants that periodically (annually or less frequently) update the standard risk factors. That way, the identification of these more common risk factors would still be available to investors, but in a way that does not unnecessarily add to the length of disclosure documents.
MD&A. The SEC has long recognized the need for a narrative explanation of the financial statements, as a numerical presentation and accompanying footnotes alone may be insufficient for an investor to assess the quality of the earnings and the likelihood that past performance is indicative of future performance.[18] The SEC has focused on improving the analysis in MD&A for many years. Yet, despite specific instructions in former Item 303(a) that “the discussion shall not merely repeat numerical data contained in the consolidated financial statements,” the SEC has previously observed that many registrants simply recite the amounts of changes from year to year that are readily computable from their financial statements.[19] I would suggest again implementing a page count limit on the MD&A. Using the earnings release example discussed above, I would suggest a five-page limit to the MD&A. This will discourage the recital of comparative financial information that is already available in the financial statements, particularly with respect to quarterly and annual reports. I would also encourage the SEC’s continued analysis of financial disclosures that appear both in the MD&A and then again in the notes to financial statements, as potential areas where duplicative disclosure can be eliminated.
While the use of page limitations does feel like a prescriptive limitation, registrants that desire to disclose additional information certainly have avenues to do so. Some of the most user-friendly documents that SEC registrants voluntarily file or furnish with the SEC are investor presentations, such as those that are given by management at investor or industry conferences. These presentations are typically graphical and tabular in nature and summarize material information succinctly in a readable format. Registrants can also distribute material information to the market via the filing of current reports on Form 8-K, to the extent any page limitation is content prohibitive. In any event, I do not believe that a page limitation on disclosure items would force companies to omit information that would otherwise be material to investors. Rather, it will force them to do what the SEC has asked companies to do for years, provide concise, nonduplicative disclosure that focuses on material information specific to the disclosing company.
Returning to this article’s original premise, one central component of the SEC’s mission is investor protection. However, disclosure rules that result in a lengthy disclosure document that the average investor does not even bother reading can hardly be considered effective at fulfilling that mission. With the SEC’s advancements in XBRL and tagging of financial data, analysts and professional investors have more financial information than ever through which to analyze companies’ financial performance via their financial statements. These professional investors are not the category of investors that need the SEC’s protection, and such investors will analyze a registrant’s financial statements to spot trends in financial performance irrespective of what management may state in their reporting documents. Therefore, adding page limitations to certain sections of the Regulation S-K disclosure regime will not negatively impact these investors. What I believe more prescriptive page limitations will do is force companies to produce a more concise document that actually highlights the material information, which would benefit the average investor that SEC laws are designed to protect. In summary, I believe less is truly more in this instance.
[1] S.E.C. v. Ralston Purina Co., 346 U.S. 119 (1953).
[2] Id. at 125.
[3] See, Report on Review of Disclosure Requirements in Regulation S-K (Dec. 2013), available at https://www.sec.gov/news/studies/2013/reg-sk-disclosure-requirements-review.pdf (hereafter, the SEC Disclosure Report). The report was mandated by Section 108 of the Jumpstart Our Business Startups Act (“JOBS Act”). Pub. L. No. 112-106, Sec. 108, 126 Stat. 306 (2012).
[4] These ongoing reporting requirements under the Exchange Act include various periodic reports, such as current reports on Form 8-K, quarterly reports on Form 10-Q, and annual reports on Form 10-K.
[5] Id. at pg. 8.
[6] Id. Prior to the adoption of the integrated disclosure system, separate disclosure regimes applied to Securities Act registration statements and Exchange Act periodic reporting, which often resulted in overlapping and duplicative requirements. See, SEC Disclosure Report at pg. 8.
[7] Id. at pg. 11.
[8] Business and Financial Disclosure Required by Regulation S-K, Release No. 33-10064 (Apr. 13, 2016) [81 FR 23915 (Apr. 22, 2016)] (“Concept Release”), available at https://www.govinfo.gov/content/pkg/FR-2016-04-22/pdf/2016-09056.pdf.
[9] See, Concept Release at pg. 23921.
[10] Modernization of Regulation S-K Items 101, 103, and 105, Release No. 33-10825 (Aug. 26, 2020) [85 FR 64234 (Oct. 8, 2020)] (“Modernization Release”), available at https://www.govinfo.gov/content/pkg/FR-2020-10-08/pdf/2020-19182.pdf.
[11] SEC Adopts Amendments to Regulation S-K, available at https://www.wyrick.com/news-insights/sec-adopts-amendments-to-regulation-s-k.
[12] Management’s Discussion and Analysis, Selected Financial Data, and Supplementary Financial Information, Release No. 33-10890 (Nov. 19, 2020) [86 FR 2080 (Jan. 11, 2021)], available at https://www.govinfo.gov/content/pkg/FR-2021-01-11/pdf/2020-26090.pdf.
[13] Concept Release at pg. 23955.
[14] See, Id.
[15] See, Modernization Release at pg. 63754.
[16] See, Item 16 to Form 10-K. Anecdotally, I do not believe many registrants have elected to include a Form 10-K summary. This is not surprising, as summarizing is difficult work, and it would require a significant amount of original content.
[17] Concept Release a pg. 23925. The SEC further opined, “Limiting prescriptive disclosure requirements and emphasizing principles-based disclosure could improve disclosure by reducing the amount of information that may be irrelevant, outdated or immaterial. Because prescriptive disclosure requirements may result in disclosure that is not necessarily material or important to investors, greater use of principles-based disclosure requirements may allow registrants to more effectively tailor their disclosure to provide only the information about their specific business and financial condition that is important to investors. A principles-based approach also may allow registrants to readily adapt their disclosure to facts and circumstances that may change over time.” Id. at 23927.
[18] See, Concept Release at pg. 23937.
[19] Footnote 11, at pg. 2090.
