Key Takeaways
- The SEC proposes changes to Regulation S-K related to disclosures describing a registrant’s business, legal proceedings and risk factors.
- Among other changes, the proposed rules would:
- Eliminate the five-year timeframe in the discussion of the general development of business and allow registrants to incorporate the content of previous disclosure by hyperlink;
- Require registrants to include a summary risk factor section if the risk factor discussion exceeds 15 pages;
- Organize risk factors under headings and move any “generic” risk factor disclosure to the end of the risk factor section; and
- Increase the dollar threshold for reporting environmental proceedings.
- Even if the proposed rules are not implemented, they may provide insight into what the SEC considers to be best practices from reporting companies.
On August 8, 2019, the Securities and Exchange Commission proposed sweeping changes to the disclosures regarding the description of business, legal proceedings and risk factors that reporting companies are required to provide in registration statements and periodic reports pursuant to Regulation S-K.1 The targeted disclosure items have not undergone significant revision in over 30 years and the changes, if implemented, would impact many of the most commonly filed registration statements and periodic reports, including Forms S-1, S-3, 10-K and 10-Q.
The rule amendments were proposed in response to the mandates in the Jumpstart Our Business Startups Act (“JOBS Act”) and the Fixing America’s Surface Transportation Act (the “FAST Act”) that the SEC examine Regulation S-K to determine ways to modernize and simplify its disclosure requirements.2 In order to fulfil these mandates, the SEC issued a Concept Release in 2016 requesting public comment on the business and financial disclosure requirements in Regulation S-K. In response to the feedback received on the Concept Release, the SEC proposes specific amendments to Item 101 (Description of Business), Item 103 (Legal Proceedings) and Item 105 (Risk Factors) of Regulation S-K (the “Proposed Rules”), and requests public comment on the Proposed Rules on or before the date that is 60 days after the Proposed Rules have been published in the Federal Register.3
Item 101(a) – General Development of Business
Item 101(a) of Regulation S-K currently requires a registrant to describe the general development of its business during the past five years. The Proposed Rules would eliminate this specific timeframe and instead require registrants to disclose information material to an understanding of the general development of the business.4 In addition, in filings subsequent to the initial registration statement, registrants would not be required to provide information that has already been disclosed. Instead, registrants would be permitted to disclose only material developments since the prior filing if they include a hyperlink to (and incorporate by reference) the previous disclosure that, together with the update, would present a full discussion of the general development of their business.
The Proposed Rules would further amend Item 101(a) by requiring registrants to disclose material changes to a previously disclosed business strategy to the extent material to an understanding of their business. Due to concerns regarding disclosure of proprietary information, the SEC has limited this disclosure to only changes to business strategies that have previously been disclosed. This change would not require registrants to disclose their business strategies if they have not already done so.
Item 101(c) – Narrative Description of Business
Item 101(c) currently requires a narrative discussion of a registrant’s business and explicitly includes 12 topics of discussion. Although the current rule only requires a discussion of most of these topics to the extent material to an understanding of the registrant’s business taken as a whole, the SEC notes in the Proposing Release that many registrants nonetheless interpret this provision to require discussion of each topic, even if immaterial. Although the Proposed Rules’ changes to the actual text of this item are relatively incremental, the SEC hopes that the updated framework of the Proposed Rules would encourage registrants to exercise more judgment in deciding what to disclose and to tailor such disclosure to their specific facts and circumstances.
In terms of specific changes to Item 101(c), the Proposed Rules would eliminate explicit reference to the disclosure of working capital practices,5 new business segments and the dollar amount of firm backlog. However, the Proposing Release cautions that a registrant would still need to provide disclosure regarding these topics (and any other topics) to the extent material to an understanding of its business.6 In this regard, note that this information is also required to be disclosed in the Management’s Discussion & Analysis sections of registration statements and periodic reports to the extent relevant.7
The Proposed Rules would also replace the current requirement to disclose the number of employees of the registrant with a requirement to describe the registrant’s “human capital resources,” including any human capital measures or objectives that management focuses on in managing the business, to the extent material to an understanding of the registrant’s business.8 In addition, the Proposed Rules would broaden the current disclosure topic that covers environmental law compliance to include disclosure of compliance with all material government regulations, not just environmental regulations.
Item 103 – Legal Proceedings
The Proposed Rules would make two modest changes to Item 103, which requires registrants to disclose any material pending legal proceedings, other than ordinary routine litigation incidental to the business.
First, the Proposed Rules would explicitly allow registrants to include cross-references or hyperlinks to legal-proceeding disclosure elsewhere in the document (for example, in the notes to the financial statements).
Second, the Proposed Rules would increase the threshold to disclose certain environmental proceedings. Instruction 5.C. to Item 103 currently requires disclosure of any proceeding under environmental laws to which a governmental authority is a party unless the registrant reasonably believes it will not result in sanctions of $100,000 or more. The Proposed Rules would increase this threshold, which was adopted in 1982 and has not been updated since, to $300,000.
Item 105 – Risk Factors
The Proposed Rules would make significant changes to risk factor disclosure. The Proposing Release acknowledges that it has been difficult to persuade registrants to eliminate lengthy and generic risk factor disclosure given registrants’ fear of litigation from failing to disclose all potential risks to investors.9 Nevertheless, the Proposed Rules aim to make the risk factor disclosure more relevant and comprehensible by proposing several changes to Item 105.
First, registrants would be required to include a summary of the risk factors if their risk factor disclosure exceeds 15 pages. This 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. Although prospectuses, especially those used in connection with IPOs, already typically include a summary of the most important risk factors, summaries of risk factors are less common in periodic reports. The SEC estimates that this change would affect approximately 40% of current filers, and intends that this threshold incentivize registrants to limit the length of their risk factor disclosure.10
Second, the Proposed Rules would change the threshold for disclosing a risk factor by requiring the disclosure of “material” risks instead of a registrant’s “most significant” risks. This would align the standard for disclosure with the general test of materiality used elsewhere in the securities laws (i.e., whether there is “a substantial likelihood that a reasonable investor would attach importance” to the information in determining whether to purchase or sell the security).11 The SEC believes that this change will potentially shorten risk factor disclosure by eliminating immaterial disclosure.
Lastly, the Proposed Rules would change the organization of risk factors by requiring that the risk factors be organized under relevant headings and by discouraging generic risk factor disclosure (i.e., a risk that could apply to other companies or securities offerings and that the disclosure does not provide an explanation of why such risk is specifically relevant to an investor in the registrant’s securities). However, to the extent that a registrant chooses to include generic risk factor disclosure, this would be required to be moved to the end of the risk factor section under the caption “General Risk Factors.”12
Implications
Even if they are not implemented, the Proposed Rules nonetheless provide insight into what the SEC considers to be best practices in terms of disclosure. It is clear that the SEC would like registrants to avoid redundant, generic and immaterial disclosure and instead exercise more judgment in determining what information to include in SEC disclosures.
In particular, registrants should examine their risk factor disclosure now to ensure that risks are organized logically and preceded by appropriate headings, and that generic risk factors are either eliminated or moved the end of the risk factor section. Registrants should also give thought to the potential new topics of disclosure in the Proposed Rules, such as compliance with governmental regulations, human capital resources and changes to previously disclosed business strategies, so that they are prepared to include these disclosures if the Proposed Rules are implemented.
Footnotes
1) Modernization of Regulation S-K Items 101, 103, and 105, Release Nos. 33-10668; 34-86614 (August 8, 2019) (hereinafter, the “Proposing Release”).
2) Proposing Release, at 4.
3) Proposing Release, at 1.
4) Proposing Release, at 15. Note that the Proposed Rule similarly eliminates the three-year timeframe that applies to smaller reporting companies pursuant to Item 101(h).
5) Examples of “Working Capital Practices” include: where a registrant is required to carry significant amounts of inventory to meet rapid-delivery requirements or to assure itself of a continuous allotment of goods from suppliers; where the registrant provides rights to return merchandise; or where the registrant has provided extended payment terms to customers. Rule 101(c)(1)(vi).
6) Id.
7) Item 303 of Regulation S-K; Interpretation: Commission Guidance Regarding Management's Discussion and Analysis of Financial Condition and Results of Operations. Release Nos. 33-8350; 34-48960 (December 29, 2003).
8) Proposing Release, at 48. Although “human capital resources” is not a defined term in the Proposed Rules, the Proposing Release (at 46-47) notes that commenters previously suggested topics such as:
- worker recruitment, employment practices and hiring practices;
- employee benefits and grievance mechanisms;
- employee engagement or investment in employee training;
- workplace health and safety;
- strategies and goals related to human capital management and legal or regulatory proceedings related to employee management;
- whether employees are covered by collective bargaining agreements; and
- employee compensation or incentive structures.
9) Proposing Release, at 67.
10) Proposing Release, at 69.
11) Proposing Release, at 70. “Material” is defined similarly in Rule 405 of the Securities Act of 1933 and Rule 12b-2 of the Securities Exchange Act of 1934.
12) Proposing Release, at 72.
