On August 26, 2020, the Securities and Exchange Commission (SEC or Commission) decided in a 3-2 vote to adopt amendments to modernize the disclosure required under Item 101, Description of Business; Item 103, Legal Proceedings; and Item 105, Risk Factors, of Regulation S-K.

As described in the SEC’s final rule release, the amendments reflect the Commission’s “long-standing commitment to a principles-based, registrant-specific approach to disclosure” that is “rooted in materiality [to] facilitate an understanding of a registrant’s business, financial condition and prospects through the lens through which management and the board of directors manage and assess the performance of the registrant.” Specifically, the modernization of Items 101, 103 and 105 is tailored to reflect companies’ particular circumstances, improve readability of disclosure documents and reduce disclosure of immaterial information. The amendments to Item 101 also notably add a requirement for a company to describe its human capital resources, including any human capital measures or objectives the company focuses on in managing its business, to the extent material to an understanding of the business taken as a whole.

The amendments will become effective 30 days after publication in the Federal Register.

Background

These changes were developed through the Commission’s Disclosure Effectiveness Initiative, pursuant to which the SEC reviewed the disclosure requirements of Regulation S-K and Regulation S-X to facilitate more timely disclosure of material information to investors. In 2016, the SEC issued a concept release providing a broad overview of, and requesting comment on, business and financial disclosure requirements under Regulation S-K. Since that time, amendments have been made to several provisions, including to eliminate requirements the SEC believed were duplicative of other disclosure requirements or outdated or overly burdensome, and to further shift to a principles-based approach.[1] In developing the proposed amendments, the SEC considered input from comment letters received in response to these modernization efforts. It also took into account its staff’s experience with Regulation S-K arising from the Division of Corporation Finance’s disclosure review program and the changes in the business landscape since adoption of the regulation.

Summary of Amendments

Item 101(a) of Regulation S-K: General Development of Business

Item 101(a) currently requires a description of the general development of a company’s business during the past five years or such shorter period as the company may have been engaged in its business. The amendments to Item 101(a) are intended to provide a company with additional flexibility to tailor its disclosures to its unique circumstances and thus provide more informative disclosures to investors. In particular, the amendments to Item 101(a):

• Replace the previously prescribed five-year time frame with a requirement to disclose information material to an understanding of the general development of the company’s business.
• Permit a company, after the filing of its initial registration statement under the Securities Act or the Securities Exchange Act, to provide only an update to the general development of the company’s business, focusing on material developments, if any, during the reporting period, and require the company to provide a hyperlink to, and incorporate by reference, the company’s most recently filed disclosure that, together with the update, would provide a full discussion of the general development of the company’s business.
• Provide a nonexclusive list of topics that a company may need to disclose if such information would be material to an understanding of the general development of the company’s business. The list includes three topics currently covered by Item 101(a)(1) – disclosure of material bankruptcy proceedings, disclosure of the effects of any material merger or consolidation of the company, and disclosure of the acquisition or disposition of any material amount of assets – and a new topic, requiring disclosure of material changes to the company’s previously disclosed business strategy, but only if such disclosure is material to the understanding of the company’s business.

Item 101(c): Narrative Description of Business

Item 101(c) currently requires a company to provide a narrative description of the business conducted and intended to be conducted by the company and its subsidiaries and provides 12 specific topics that must be discussed by the company, to the extent they are material to an understanding of its business. These 12 topics do not generally apply to all companies; however, some companies have interpreted Item 101(c) to require disclosure of each such topic, regardless of applicability and materiality, resulting in immaterial disclosures. To enable disclosure more appropriately tailored to a company’s specific circumstances, the amendments to Item 101(c) also adopt a more principles-based framework that encourages companies to exercise judgment in determining what disclosures to provide. In particular, the amendments to Item 101(c):

• Provide as examples the following six disclosure topics, which are derived from a subset of the disclosure topics currently included in Item 101(c) and clarify that disclosure of such topics would be required only if the information is material to an understanding of the general development of the company’s business: (1) revenue-generating activities and dependence on certain products, services or customers, (2) development efforts for new or enhanced products, trends in demand and competitive conditions, (3) sources and availability of resources material to a company’s business, including raw materials and certain intellectual property rights, (4) business subject to renegotiation or termination of government contracts, (5) seasonality of the business and (6) the number of persons employed.
• Refocus the regulatory compliance disclosure requirement by including all material government regulations and not just environmental laws to require, to the extent material to an understanding of the business taken as a whole, disclosure of the material effects that compliance with government regulations may have on the capital expenditures, earnings and competitive position of the company and continue to require estimated capital expenditures for environmental control facilities for the current fiscal year and any subsequent period that is material.
• Include a requirement to describe the company’s human capital resources, including any human capital measures or objectives that management focuses on in managing the company’s business (such as measures or objectives that address the development, attraction and retention of personnel), to the extent such disclosures are material to understanding the business.

Much commentary was received in response to the proposed rules on human capital disclosure, including to encourage more specific disclosure requirements. In the final rules, the Commission continued to favor flexibility to tailor disclosures to a company’s unique circumstances, which may evolve over time, rather than require companies to use a specific disclosure framework or adopt a definition of the term “human capital.” In his statement at the Open Meeting where the rules were adopted, Chairman Clayton noted that, under the principles-based approach, he expects to “see meaningful qualitative and quantitative disclosure, including, as appropriate, disclosure of metrics that companies actually use in managing their affairs.”

Item 103 of Regulation S-K: Legal Proceedings

Item 103 currently requires a company to disclose material pending legal proceedings, other than ordinary routine litigation incidental to the company’s business, to which the company or any of its subsidiaries is a party, and to disclose the name of the court or agency in which the proceedings are pending, the date the proceedings were instituted, the principal parties involved in the proceedings, and a description of the facts underlying the proceedings. The amendments to Item 103:

• Expressly state that required information may be provided by hyperlink or cross-reference to legal proceedings to avoid duplicative disclosure.
• Implement a modified disclosure threshold for certain governmental environmental proceedings resulting in monetary sanctions from the existing $100,000 to either (1) $300,000 or (2) if a company reasonably determines that a higher threshold would focus disclosure on material environmental proceedings, it may choose a higher threshold that does not exceed the lesser of $1 million or 1% of the company’s current assets. If a company chooses to use a higher threshold, it must disclose that threshold in each Form 10-K and 10-Q filing.

Item 105 of Regulation S-K: Risk Factors

Item 105 currently requires a company to provide a brief and logically organized discussion of the most significant factors that make an investment in the company or offering speculative or risky. Item 105 further requires a company to explain how each risk affects the company or the securities being offered and discourages disclosure of risks that may apply generically to any company. Notwithstanding these requirements, the SEC noted that risk factor disclosures have increased in recent years and cited “generic, boilerplate risks” that could apply to any company or offering as a contributing factor to this increase. To address these issues, the amendments to Item 105:

• Require summary risk factor disclosure of no more than two pages if the risk factor section exceeds 15 pages.
• Replace the requirement to disclose the “most significant” risk factors with “material” risk factors in order to focus a company’s disclosure on those risk factors to which investors would attach importance in making investment decisions.
• Require that risk factors be organized under relevant headings and that if a company discloses any generic risk factors that could apply to any company or offering, they appear under the caption “General Risk Factors” at the end of the risk factor section.

Companies may want to consider whether they can reduce their current risk factors below 15 pages to avoid the summary requirement and tailor their risk factor disclosures to identify specific risks to the company rather than include risks under the general risk heading.

Dissenting Votes

Differences of opinion within the Commission were expressed at the Open Meeting. According to Chairman Clayton, the adopted rules build upon the “materiality-based disclosure framework,” which is grounded in the need to provide the public with information necessary to make informed investment decisions. The rules, he continued, were designed to be tailored to a company’s industry and business models, so, for example, in crafting human capital disclosure, companies must incorporate the key human capital metrics used and focused on in managing the business to the extent it is material to an understanding of the company’s business. One Commissioner noted that while these amendments are “common sense reforms,” she would have preferred to eliminate “the remaining vestiges of a prescriptive approach, such as the requirement to disclose the number of employees.”

Two of the five Commissioners dissented on the basis that the rules should have included prescriptive requirements that include more ESG disclosures. The dissents specifically called for more disclosure regarding human capital – to include a company’s treatment of its employees and focus on diversity – and climate change, among other things.

Conclusion

There is long-standing debate over the appropriate balance between principles-based and prescriptive disclosure rules, as well as what kind of information should be deemed “material” and thus require public disclosure. Whether, as well as the extent to which, ESG matters should be deemed material for purposes of mandatory disclosure under the federal securities laws is an intensely debated topic, especially after the global health pandemic COVID-19 and the social unrest in the U.S. We anticipate that the SEC will continue to modernize its rules and regulations, and that ESG disclosure will continue to be revisited and debated.

[1] For example, see “SEC Finalizes Amendments To Simplify Financial Disclosures Regarding Acquisitions and Dispositions of Businesses” and “SEC Adopts Final Rules Modernizing Business and Financial Disclosure Requirements.”