Disclosure Simplification (New Rules in Place). In March 2019, the Securities and Exchange Commission (“SEC”) adopted certain amendments as part of its continuing efforts to modernize and simplify provisions of Regulation S-K. Many of these changes will be relevant when preparing this year’s annual reports on Form 10-K.

General Changes to Regulation S-K Provisions

• Disclosure about a company’s physical properties is now required under Item 102 only to the extent material to the registrant.
• In light of its emphasis on principles-based requirements, the SEC has eliminated the list of specific risk factor examples in Item 105.
• Pursuant to amended Item 303, registrants will generally be able to exclude discussion of the earliest of three years in the management discussion and analysis if the discussion is already included in a prior filing and the location in the prior filing is identified. In addition, Item 303 will no longer expressly require a year-to-year comparison. Although a year-to-year comparison may continue to be the preferred method of discussion, registrants may use any presentation that enhances a reader’s understanding of the financial condition, changes in financial condition and results of operation of the registrant.
• Pursuant to an amendment to Item 401, disclosure about executive officers of a registrant that is included in its Form 10-K in lieu of the proxy statement must now be under a required caption “Information about our Executive Officers” instead of “Executive officers of the registrant.”
• The new rules eliminate the checkbox on the cover page of Form 10-K that indicates whether disclosure of delinquent filers of reports under Section 16(a) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), are included or anticipated. In addition, amendments to Item 405 of Regulation S-K (a) revise the requirements as to what information concerning delinquencies can be relied on and (b) change the disclosure heading to “Delinquent Section 16(a) Reports” instead of “Section 16(a) Beneficial Ownership Reporting Compliance.”
• The reference to AU section 380, Communication with Audit Committees, in the audit committee report required by Item 407(d)(3)(i)(B) has been updated to refer more broadly to the applicable requirements of the Public Company Accounting Oversight Board and the SEC.
• With respect to incorporation by reference, the SEC has eliminated the five-year limitation in prior Item 10(d) and has revised other requirements to modernize procedures for such incorporation.
• The rules also require registrants to disclose on the cover pages of the various forms, information regarding the title of each class of securities registered pursuant to Section 12(b) of the Exchange Act, each exchange on which such securities are registered and the trading symbol for each such class.

Requirement for New Exhibit Containing a Description of Capital Stock and Other Registered Securities. New Item 601(b)(4)(vi) requires the filing of a new exhibit containing a description of each class of the registrant’s securities that is registered under Section 12 of the Exchange Act as of the end of the period covered by the report being filed. The requirement applies to any Form 10-K filed after May 1, 2019.

Other Amendments to Exhibit Requirements

• A company will be able to omit confidential information in material contracts and certain other exhibits without concurrently submitting a confidential treatment request if it meets certain conditions. These conditions include the same substantive requirements as before the amendments. Exhibits must be clearly marked to indicate where information has been omitted and contain other specified disclosures. The exhibit index would also need to reflect that a portion of the exhibit has been omitted. Upon request, registrants would have to provide materials to the SEC staff similar to those currently required in a confidential treatment request, including an analysis of why the redacted information is not material and would likely cause competitive harm to the company if publicly disclosed.
• Only newly reporting registrants will be required to file material contracts entered into within the two years prior to filing that have been fully performed.
• Registrants do not need to file schedules or attachments to exhibits if the schedules and attachments do not contain material information and are not otherwise disclosed in the exhibit or disclosure document. The filed exhibit must contain a list briefly identifying the contents of omitted schedules and attachments. Personally identifiable information such as bank account numbers, social security numbers, home addresses and the like can be omitted where the disclosure of such information would constitute a clearly unwarranted invasion of personal privacy.

Disclosure Simplification (Continued). In August 2019, in furtherance of its broad and ongoing project to simplify periodic report disclosures, the SEC proposed principles-based amendments to three items of Regulation S-K, 101 (Description of Business), 103 (Legal Proceedings) and 105 (Risk Factors).

Regulation S-K, Item 101(a) currently requires a description of the general development of the company’s business during the past five years. The proposed rules would eliminate the reference to the five-year prescribed timeframe (three years for smaller reporting companies). The proposed rules would also limit disclosure to recent material developments and allow for a hyperlink to the full description to a prior filing (e.g., initial registration statement or prior Form 10-K). Regulation S-K, Item 101(c) currently requires a generally principles-based narrative description of the company’s business, including 12 topics of discussion (e.g., principal products or services; availability of raw materials; intellectual property; dependence on a single or few customers; backlog; competition; etc.). The proposed rules would clarify that the enumerated disclosure topics do not need to be addressed if they are not material to an understanding of the company’s business taken as a whole. The proposed rules would also eliminate certain of the enumerated topics (e.g., backlog, which the SEC indicated in the proposing release is better located in management’s discussion and analysis (“MD&A”)) and refresh the coverage points of others. For example, Item 101(c) currently requires disclosures of the number of employees and the proposed rules would refresh this item to provide a description of the company’s human capital resources. Also, Item 101(c) currently calls for a discussion of the material effects of compliance with environmental laws. This item would be refreshed to cover all material governmental regulations.

Regulation S-K, Item 103 currently requires disclosure of pending legal proceedings, including governmental investigations. The proposed rules would expressly permit some or all of the required information to be incorporated by reference or hyperlinked. In addition, the current monetary threshold for disclosure of environmental claims of $100,000 would be increased to $300,000.

Regulation S-K, Item 105 currently requires the most significant risk factors that make an investment in the company risky or speculative. In response to concerns that risk factor disclosures have become longwinded, the SEC is proposing to add a requirement that companies include a risk factor summary if the risk factor disclosure exceeds 15 pages. Also, the proposed rules replace the requirement to disclose the “most significant” risks with the “material” risks.

Inline XBRL Reminder. Most large accelerated filers have already adopted^[1] the SEC’s requirement to submit financial statements and certain other information using Inline XBRL format. As a reminder, accelerated filers are required to adopt Inline XBRL beginning with their first Form 10-Q for the fiscal period ending on or after June 15, 2020 (for calendar year companies, the 2020 second quarter Form 10-Q).

SEC Comment Letter Trends. During the 12 months ended June 30, 2019, the most common comment area by the SEC was revenue recognition (number 5 in the prior year), followed by non-GAAP financial measures.^[2] In the prior year, MD&A was the top comment area, also followed by non-GAAP financial measures. Also of note, segment reporting slipped from number 4 to number 8. According to Ernst & Young, other common comment areas included fair value measurements, intangible assets and goodwill, and income taxes.^[3]

For revenue recognition, comments focused on identification of performance obligations, proper classification as agent or principal, variable consideration estimates, criteria for using the residual approach for estimating sales prices and disaggregation of revenue in the footnotes.^[4] When commenting about MD&A, common themes included: information about known trends and uncertainties and results of operations (including, for example, requests that companies explain their results of operations in greater detail, including identifying and discussing the underlying factors driving significant changes and details about significant components of, and changes in, revenue and expense categories).^[5] For comments about non-GAAP financial measures, the SEC continued its focus on a wide variety of issues, including the use of individually tailored accounting principles (especially relating to alternative revenue measures), presentation of GAAP measures with equal or greater prominence, reconciliation calculations, appropriateness of adjustments that exclude or smooth items identified as non-recurring, infrequent or unusual and discussion about why management believes presentation of non-GAAP measure(s) is useful information to investors.^[6]

Enforcement Action for Failure to Timely Disclose Loss Contingency. In September 2019, the SEC and Mylan N.V. (“Mylan”) settled a complaint that Mylan violated accounting and disclosure rules by failing to timely disclose a confidential investigation by the United States Department of Justice ("DOJ") into Mylan’s pricing and classification of its popular EpiPen product.

As background, Mylan acquired the rights to the EpiPen in 2007 from Merck KGaA. Upon acquisition, Mylan continued to classify the EpiPen for purposes of Medicare and Medicaid reimbursement as a “generic” drug, as opposed to the alternative classification as a “branded” drug. The distinction is important because as a generic drug, Mylan was required to remit much smaller rebates to the government than it would have if the EpiPen was classified as a branded product. In 2014, the Centers for Medicare and Medicaid Services (“CMS”) asked Mylan to change its definition of the EpiPen to branded, which Mylan declined. Shortly thereafter, the DOJ opened a civil investigation of Mylan’s classification as it related to possible violation of the False Claims Act. Ultimately, in October 2016, Mylan disclosed that it had settled the DOJ investigation for $465 million.

Subsequently, the SEC commenced an investigation into Mylan’s disclosures relating to the DOJ investigation. The SEC’s complaint was based on violation of two distinct rules, Regulation S-K, Item 303, which requires companies to disclose any known trends or uncertainties, and SEC Regulation S-X, which requires companies to comply with GAAP, which in turn requires companies to (1) disclose “reasonable possible” losses, and (2) accrue “probable” losses.

In apparent response to the Regulation S-K, Item 303 requirement to describe known trends and uncertainties that have had or that the company reasonably expects will have a material favorable or unfavorable impact on net sales, revenues or income, Mylan disclosed in its 2014 and 2015 annual reports that CMS “may” take the position that its EpiPen classification (and thus its reimbursement submissions to the government) were wrong. But, at the time Mylan filed its 2014 and 2015 annual reports, CMS “had” taken the position that Mylan’s classification was wrong, which the SEC alleged in its complaint was misleading.

In its complaint, the SEC also alleged that Mylan violated Regulation S-X (i.e., GAAP) in two instances. First, the SEC alleged that Mylan should have disclosed the DOJ investigation as a material loss contingency when it became “reasonably possible,” which the SEC said was triggered in the third quarter of 2015 when Mylan (1) presented its case to the DOJ, but the DOJ refused to close the investigation, and (2) signed a tolling agreement. Second, the SEC alleged that Mylan should have accrued a loss in the second quarter of 2016 when it became probable and reasonably estimable, which the SEC said occurred when Mylan provided the DOJ with its damage estimate (non-trebled) of $114 to $260 million. Importantly, this was Mylan’s estimate only in the event its classification (and resulting reimbursements) were wrong, which at that time Mylan maintained were correct.

It is worth noting that around the time of the DOJ and SEC investigations, Mylan was under significant public and political scrutiny for dramatically raising the price of its EpiPen products from 2007 to 2016, which may have put some pressure or incentive on the DOJ and SEC to investigate and prosecute.

Practitioners have echoed some concern over the case because there is no absolute requirement to disclose otherwise confidential investigations, even at the Wells Notice stage. The Mylan complaint/settlement, at least on some level, illustrates the SEC’s view that there might be bright-line events that trigger disclosure and/or accrual of loss contingencies. That is, by alleging that (1) the mere refusal of the government to close an investigation and signing of a tolling agreement resulted in a “reasonably possible” loss contingency and (2) that the submission of damage estimate for settlement purposes, while still maintaining a position of no violation, resulted in a “probable” loss contingency.

Enforcement Action for Failing to Disclose Revenue Management Scheme. On September 16, 2019, the SEC announced that Marvell Technology Group (“Marvell”) agreed to settle charges that it misled investors by engaging in an undisclosed revenue management scheme in order to meet publicly issued revenue guidance. According to the SEC, Marvell orchestrated a scheme to accelerate, or “pull-in”, sales to a current quarter that were scheduled or forecasted to occur in a subsequent quarter. It is important to note that the SEC’s order does not allege that the scheme itself or Marvell’s accounting or revenue recognition principles were fraudulent or incorrect. Rather, the SEC charged that Marvell failed to publicly disclose the revenue management scheme in its periodic reports, thus concealing a substantial decline in customer demand, a loss in market share and ultimately reduced future sales (as future forecasted sales were “pulled-in” to the current quarter).

Faced with a persistent decline in customer demand and concern about continuing to miss guidance, the highest levels of Marvell management implemented a top-down process to establish sales targets, apparently notwithstanding protests from Marvell’s sales group that those targets were unrealistic. To persuade customers to agree to accelerate sales, Marvell offered various incentives, such as discounts, rebates, free products and relaxed payment terms. As the accelerated revenue scheme continued, the gap between actual sales and forecasted sales continued to grow in part because of deteriorating market conditions, but also in significant part because the “pull-in” sales were cannibalizing sales forecasted for future quarters. As a result, the SEC charged that Marvell failed to disclose in MD&A the revenue acceleration scheme and that a significant portion of its quarterly revenue represented pulled-in sales previously forecasted for future quarters. In addition, the SEC alleged that by failing to disclose the revenue acceleration scheme, Marvell also failed to advise investors of a material trend—that accelerating sales to the current quarter would likely adversely impact future sales and company performance, as required to be discussed pursuant to Regulation S-K, Item 303.

Notes:

¹ For calendar year companies, this was required for fiscal periods ending on or after June 15, 2019.

² See Ernst & Young LLP, SEC Comments and Trends, An Analysis of Current Reporting Issues (Sept. 2019).

³ See id.

⁴ See id.

⁵ See id.

⁶ See id.; see also, pwc, SEC comment letter trends (Sept. 6, 2019).