[This post revises and updates my earlier post primarily to reflect the contents of the adopting release.]
By a vote of three to two, on Wednesday, the SEC voted to adopt amendments, substantially as proposed with some modifications, to modernize the Reg S-K disclosure requirements related to the descriptions of business, legal proceedings and risk factors. As Chair Jay Clayton observed in his Statement, these Reg S-K disclosure items “essentially have not changed in over 30 years,” but much has changed in our economy since that time, making these updates well warranted. The changes are a component of the SEC’s Disclosure Effectiveness Initiative and reflect public comments on the SEC’s 2016 Concept Release (see this PubCo post) and the 2019 Reg S-K proposal (see this PubCo post), as well as experience from the staff’s disclosure review process. In devising the final amendments, the SEC considered the “many changes that have occurred in our capital markets and the domestic and global economy” since the requirements were adopted. The amendments largely reflect the SEC’s historic “commitment to a principles-based, registrant-specific approach to disclosure” that, although “prescriptive in some respects,” is “rooted in materiality” and designed to provide an understanding of a company’s business through the lens that management and the board apply in managing and assessing the company’s performance. While there are changes throughout, the most significant change is the enhancement of the disclosure requirement for human capital, a topic that has been front-burnered by the impact of COVID-19 on the workforce. The amendments will become effective 30 days after publication in the Federal Register.
To enable each business to focus on the matters that are material to that business, the final amendments take a pronounced turn toward a principles-based approach to the business and risk factor disclosure requirements. With regard to legal proceedings, the rules largely continue the current prescriptive approach, although in a change from the proposal, an element of flexibility in the disclosure threshold has been introduced. To be sure, the approach taken in the proposal is certainly an incremental one. The most significant change is the addition of “human capital” as one of the topics to be disclosed, to the extent material, as part of the business narrative, a change that Clayton has been foreshadowing for well over a year. (See, e.g., this PubCo post.) And while there is no fundamental “re-imagining” of the disclosure system as a whole, such as the “company profile” approach that former SEC Chair Mary Jo White had floated back in 2013, there are some mild telltale signs. (If you recall, the company profile approach would have included a “filing and delivery framework based on the nature and frequency of the disclosures, including a ‘core document’ or ‘company profile’ with information that changes infrequently. Companies would then be required to update the core filings with information about securities offerings, financial statements, and significant events.” See this News Brief.) Here, with regard to descriptions of the development of the business, the SEC is eliminating repetition by permitting companies to simply update to reflect material developments in the reporting period and include a link to more complete prior disclosure regarding development.
There was considerable divergence of opinion expressed at the open meeting to consider the new rules—less about what was in the new rules than what wasn’t. Notably, Commissioners Allison Lee and, in her debut open meeting, Commissioner Caroline Crenshaw were dismayed at the silence of the new rules on two issues they viewed to be critical—diversity and climate risk. Those omissions were enough to lead to their dissents. Not that the other Commissioners were necessarily opposed to disclosure about those topics (although some may have been— see this PubCo post.) Rather, they preferred not to include prescriptive requirements that would have specifically mandated diversity and climate risk disclosure, opting instead for a principles-based disclosure system that would elicit discussion of those items only to the extent that the company viewed the information as material, including disclosure of metrics that the company and its board use in managing the company’s business. According to Clayton, the SEC’s principles-based disclosure
“framework in providing the public with the information necessary to make informed investment decisions has proven its merit time and again as markets have evolved when we have faced unanticipated events. This has been widely demonstrated in registrant disclosures regarding the effects of COVID-19. We have seen disclosures shift to emphasize matters such as liquidity, cash needs, supply chain risks, and the health and safety of employees and customers. This has served as a reminder that our rigorous, principles-based, flexible disclosure system, where companies are required to communicate regularly and consistently with market participants, provides countless benefits to our markets, our investors and our economy more generally.”
Lee and Crenshaw argued for a more balanced approach with some prescriptive regulation that would have provided more certainty in eliciting disclosure that investors were seeking. According to Lee, the SEC
“received thousands of comments seeking disclosure on workforce development, diversity, and climate risk. There were letters explaining why principles-based disclosure requirements, without at least some specifics, would not produce the disclosures investors need. Letters explaining what metrics were most important in terms of building long-term value for investors. Letters explaining what metrics cut across industries and what companies were already tracking.”
What’s more, she added, “recent events have provided a real-time case study on the need for many of these disclosures.” However, she observed, the SEC “takes the position that it does not need to require or specify these types of disclosures because our principles-based disclosure regime is on the job and will produce any disclosures on these topics that are material. Investors are asked to trust that each individual company has gauged materiality on these complex issues with flawless precision and objectivity.” But hundreds of companies don’t include disclosure on diversity—should we assume that it is therefore not material, she asks? Similarly, she argues, by “some estimates, over 90% of U.S. equities by market capitalization are exposed to material financial impact from climate change. We are long past the point at which it can be credibly asserted that climate risk is not material. We also know today that investors are not getting this material information.” For a more extensive discussion of the open meeting debate, see this PubCo post.
Included at the end of this post is a copy of the SEC’s table of changes to the rules.The final amendments are summarized below:
Development of business (Item 101(a))
Currently, this item requires a description of the general development of the business during the past five years, or any shorter period the company may have been in business. The changes in the final amendments are designed to make the requirements more principles-based and more flexible.
- Non-exclusive list of topics. As adopted, the rule will now provide a non-exclusive list of four topics, and companies will need to include disclosure regarding any of the topics only to the extent the information would be material to an understanding of the general development of the business. The SEC believes that the approach will provide flexibility, while focusing on materiality. To the extent there is material information beyond the four topics, the company would be required to disclose that information as well. The identified topics are:
“(i) Any material changes to a previously disclosed business strategy;
(ii) The nature and effects of any material bankruptcy, receivership, or any similar proceeding with respect to the registrant or any of its significant subsidiaries;
(iii) The nature and effects of any material reclassification, merger or consolidation of the registrant or any of its significant subsidiaries; and
(iv) The acquisition or disposition of any material amount of assets otherwise than in the ordinary course of business.”
- Material changes to strategy. Material changes to strategy, the first bullet point above, is an addition to the current rule. Because many companies discuss their strategies as part of their IPO registration statements, the SEC believes that material changes to a strategy that has previously been disclosed may be material to investors, notwithstanding objections from some commenters that the rule would result in disparate treatment for those companies that had not disclosed their strategies.
- Eliminate prescribed timeframes. Instead of the currently required five-year timeframe (three years for smaller reporting companies), companies will need to focus on the period over which information would be material. The SEC thought that the current timeframe “may not always elicit the most relevant disclosure” for every company. In some cases, a period longer than five years might be appropriate, and in other cases, a shorter period would make the most sense.
- Update only. Companies will be permitted, in filings after the initial registration statement, to provide only an update focused on material developments that have occurred since the most recent full discussion of the development of the business in a prior filing, including changes in the business strategy. Companies choosing this approach would need to provide an active hyperlink to incorporate the most recent filing that contains the full discussion of the general development, so that together the disclosure would provide the full discussion of the general development of the business. Only a single prior filing may be linked. The proposal is intended to eliminate repetitive disclosures to help investors focus on material developments.
Business narrative (Item 101(c))
Reg S-K requires a narrative description of the business done and intended to be done, focusing on the dominant segment or each reportable segment (if financial information is presented in the financial statements for those segments). Currently, the rule includes a long list of enumerated disclosure topics, many of which were adopted in 1973. Time to update perhaps? While the current rule invokes a materiality standard, the SEC observes that many companies treat the list as mandatory. The SEC believes that shifting to a more principles-based framework might do the trick, encouraging companies to use their judgment to tailor the disclosure.
The more principles-based requirements include a list of disclosure topics, drawn from those in current Item 101(c), that are likely to be material to many companies, retaining the current distinction between segment disclosure topics (most of the topics) and topics to be discussed in the context of the business as a whole. The list excludes from the current list topics such as disclosure about working capital practices, new segments and dollar amount of firm backlog, although, if those topics were material, the company would still need to provide disclosure about them. To illustrate, a discussion of working capital practices would typically be more appropriate in MD&A unless, for example, supply chain finance arrangements were material to understanding a company’s commercial relationships, in which case disclosure in the business narrative would be appropriate.
- Principles-based list of disclosure topics—segments. The topics to be discussed by segment include:
- Products and services—“Revenue-generating activities, products and/or services, and any dependence on revenue-generating activities, key products, services, product families or customers, including governmental customers.”
The SEC viewed these elements as “key to how reasonable investors often evaluate the future prospects of a registrant’s business.”
- Development and competition—“Status of development efforts for new or enhanced products, trends in market demand and competitive conditions.”
This topic, although flexible and principles-based, will likely elicit more granular information than the current topic.
- Resources—“Resources material to a registrant’s business, such as:
- (A) Sources and availability of raw materials; and
- (B) The duration and effect of all patents, trademarks, licenses, franchises and concessions held.”
Although one commenter suggested that companies be required to discuss how climate change will affect access to raw materials, the SEC rejected that idea, contending that a climate-change requirement was inconsistent with the principles-based nature of the regulation. Another commenter questioned the continuing relevance of disclosure regarding raw materials given the shift in the U.S. economy away from manufacturing; nevertheless, the SEC elected to retain the requirement as proposed, explaining that companies need only discuss raw materials to the extent material. Even though intellectual property has become increasingly important to many businesses, the SEC elected not to expand the topic to add copyrights or trade secrets, largely because of competitive concerns and the substantial time and cost that might be involved in systematically identifying and cataloguing these types of intellectual property.
- Government contracts—“A description of any material portion of the business that may be subject to renegotiation of profits or termination of contracts or subcontracts at the election of the Government.”
The adopting release noted that companies with U.S. government contracts tend to also disclose that the “funding of these contracts is subject to the availability of Congressional appropriations and that, as a result, long-term government contracts are partially funded initially with additional funds committed only as Congress makes further appropriations.” In addition, the release observed that these companies disclose “that they may be required to maintain security clearances for facilities and personnel in order to protect classified information. Additionally, these registrants state that they may be subject to routine government audits and investigations, and any deficiencies or illegal activities identified during the audits or investigations may result in the forfeiture or suspension of payments and civil or criminal penalties.”
- Seasonality—“The extent to which the business is or may be seasonal.”
The SEC decided to retain this topic to avoid a potential loss of information about seasonality in the fourth quarter because GAAP may not elicit this disclosure. In response to a comment suggesting that this topic require disclosure about the impact of climate change on seasonal businesses, the SEC once again rejected the idea “to avoid undermining the principles-based nature of Item 101(c),” noting that the “principles-based approach to this disclosure affords registrants sufficient flexibility to address relevant factors that may affect seasonality to the extent material to an understanding of the registrant’s business.”
- Principles-based list of disclosure topics—company as a whole. The two topics identified below are intended to be discussed in the context of the company as a whole, unless material to a particular segment, in which case, the discussion should be extended to that segment as well.
- Governmental regulation—“The material effects that compliance with government regulations, including environmental regulations, may have upon the capital expenditures, earnings and competitive position of the registrant and its subsidiaries, including the estimated capital expenditures for environmental control facilities for the current fiscal year and any other material subsequent period.”
As amended, the item will expand the current topic mandating disclosure regarding the material impact of environmental regulations to cover all “material government regulations.” The SEC observed that, although there is no separate requirement for disclosure about material government regulations, many companies do provide that disclosure. Accordingly, the extension of the topic seemed consistent with current practice and will help provide investors with information material to an investment decision. The SEC emphasized, however, that the item “does not call for, or require, a recitation of every regulation that affects a registrant’s business and operations.”
- Human Capital—“A description of the registrant’s human capital resources, including the number of persons employed by the registrant, and any human capital measures or objectives that the registrant focuses on in managing the business (such as, depending on the nature of the registrant’s business and workforce, measures or objectives that address the development, attraction and retention of personnel).”
The amended rule replaces the existing requirement to disclose only the number of employees with a requirement to disclose, to the extent material, information about human capital resources, including any human capital measures or objectives that the company focuses on in managing the business.
In particular, the final amendments identify as non-exclusive examples of potentially relevant subjects that may be material, depending on the nature of the registrant’s business and workforce, “measures and objectives that address the attraction, development, and retention of personnel.” Even these measures, the SEC emphasized, are not a mandate. In his statement, however, Clayton remarked that, while the SEC is not prescribing “specific, rigid metrics,” under the principles-based approach, he did “expect to see meaningful qualitative and quantitative disclosure, including, as appropriate, disclosure of metrics that companies actually use in managing their affairs.”
In the proposing release, the SEC had asked for comment on whether it should add more examples of measures or objectives that may be material, such as the number of full-time, part-time, seasonal and temporary workers; voluntary and involuntary turnover rates; measures regarding average hours of training per employee per year; information regarding human capital trends, such as competitive conditions and internal rates of hiring and promotion; measures regarding worker productivity; and the progress that management has made with respect to any objectives it has set regarding its human capital resources.
But the SEC elected not to include more prescriptive requirements—or even these additional non-exclusive examples—because of its belief
“that the exact measures and objectives included in human capital management disclosure may evolve over time and may depend, and vary significantly, based on factors such as the industry, the various regions or jurisdictions in which the registrant operates, the general strategic posture of the registrant, including whether and the extent to which the registrant is vertically integrated, as well as the then-current macro-economic and other conditions that affect human capital resources, such as national or global health matters…. Although many commenters recommended that we expand this disclosure topic to include additional metrics, such as the number of full-time, part-time, and contingent workers, and employee turnover, we are not adopting these prescriptive elements because we believe that they would be inconsistent with our objective to make Item 101(c) more principles-based.”
Even though the final amendments do not identify these examples, the list may help identify some of the issues that companies could consider in crafting their own disclosures.
Smaller reporting companies (Item 101(h))
Currently, Item 101(h) provides alternative disclosure requirements for smaller reporting companies, applying a three-year timeframe. The SEC is not amending the more prescriptive alternative disclosure standards regarding business development, description of business, and other information specified under Item 101(h)(1) through (6). This approach allows SRCs to provide a less detailed description of their business, consistent with the current scaled disclosure requirements for these companies. However, the SEC did make a couple of conforming changes.
- Eliminate timeframe. The SEC is eliminating the three-year timeframe for SRCs to describe the development of their businesses and directs SRCs to provide information for the period of time that is material to an understanding of the general development of the business. However, the SEC is retaining the requirement that SRCs that have not been in business for three years must provide the same information for its predecessors if there are any.
- Updates. As indicated above, for filings other than the initial registration statement, SRCs will be permitted to provide an update to the general development of the business disclosure, instead of a full discussion, along with an active hyperlink to the most recent filing containing the full discussion.
Legal proceedings (Item 103)
This item requires disclosure of any material pending legal proceedings, other than ordinary routine litigation, to which the company or any of its subsidiaries is a party or to which any of their property is the subject. Similar information is to be included for these proceedings known to be contemplated by governmental authorities.
- Hyperlinks permitted. Item 103 and GAAP have overlapping disclosure requirements. Although these requirements have different objectives and mandate different disclosure in some respects, much of the legal proceedings disclosure is often included in the notes to the financial statements or elsewhere in the document, such as in risk factors or MD&A. To discourage duplication, the final amendments expressly permit hyperlinks or cross-references to legal proceedings disclosure located elsewhere in the document.
- Disclosure threshold. Currently, companies are not required to disclose environmental proceedings to which the government is a party if they reasonably believe that monetary sanctions will be less than $100,000, a threshold that dates back to 1982. The final amendments raise the prescribed disclosure threshold, based on the CPI Inflation Calculator, to $300,000—sort of. However, the SEC also recognized that a single numerical threshold could lead to some disclosures that are not material, especially for larger companies. Accordingly, in a change from the proposal, the final amendments add flexibility by adopting a hybrid approach that allows the company to select a different threshold that it determines is reasonably designed to result in disclosure of material environmental proceedings—so long as the threshold selected does not exceed the lesser of $1 million or one percent of the current assets of the company and its subsidiaries on a consolidated basis. If a company chooses to use a threshold other than $300,000, it must disclose this threshold (including any changes) in each annual and quarterly report. The SEC believes that these “parameters, together with the bright-line $300,000 threshold, are intended to ensure that investors continue to receive relevant information about environmental sanctions while also realizing the benefits of a more principles-based approach.”
Risk Factors (Item 105)
This principles-based item requires disclosure of the most significant factors that make the investment speculative or risky and how the risk affects the company or the securities. In the proposal, the SEC was attempting to address “the lengthy and generic nature of the risk factor disclosure presented by many registrants,” which, studies have shown, has recently increased. For example, “one study found that registrants increased the length of risk factor disclosures from 2006 to 2014 by more than 50 percent in terms of word count, compared to the word count in other sections of Form 10-K that increased only by about 10 percent, and that this increase in risk factor word count may not be associated with better disclosure.” The SEC considers the inclusion of generic, boilerplate risks to be a contributing factor, but this practice has continued, notwithstanding SEC and staff guidance to limit risks to those that are “most significant.” Commenters in response to the Concept Release “attributed the growing length of risk factor disclosure to the fear of litigation for failing to disclose risks if events turn negative.”
- Mandatory summary as an incentive. Under the final amendments, if the risk factor section exceeds 15 pages, the company must include, in the forepart of the document, a summary, not to exceed two pages, consisting of “a series of concise, bulleted or numbered statements summarizing the principal factors that make an investment in the registrant or offering speculative or risky.” The SEC believes the prescribed format “will avoid concerns that the requirement could lead to lengthy summaries or result in investors discounting the full risk factor presentation,” and that the page limitation will lessen the company’s burden and provide an incentive “to give due consideration to the risk factors that are material to investors.” A summary, the SEC contends, will not only “enhance the readability and usefulness of the disclosure for investors,” it may also serve as “an incentive for registrants to reduce the length of their risk factor discussion to avoid triggering the summary requirement, to the extent that such an incentive outweighs perceived litigation risks.” The SEC estimates that about 40% of current filers will be affected.
- Materiality standard. The final amendments change the current disclosure standard from “most significant” factors to “material” factors, with the goal of focusing companies “on disclosing the risks to which reasonable investors would attach importance in making investment or voting decisions” and encouraging companies to tailor their risks. The SEC observed that the term “material” as used in Item 105 is defined in Rule 12b-2 and Rule 405.
- Organization. The SEC will now require companies to organize the risk factors under relevant headings, an already common practice, with risks that could apply generally to any company or offering of securities—where the company does not explain the specific relationship of the risk to the company or the offering—to be located at the end under a separate caption, “General Risk Factors.” The final amendments do not require companies to prioritize the order in which they discuss their risk factors.
Copied below is the SEC’s table of changes to the rules:
||Regulation S-K Item
||Summary of Existing Item Requirements
||Summary of the Final Amendments
||Item 101(a) and (h)
||Requires a description of the general development of the business of the registrant during the past five years, or such shorter period as the registrant may have been engaged in business.
||Revises Item 101(a) to:
· Be largely principles-based, requiring disclosure of information material to an understanding of the general development of the business, and eliminating the previously prescribed five-year timeframe.
Revises Item 101(h) to:
· Eliminate the three-year timeframe with respect to smaller reporting companies.
Revises Items 101(a) and (h) to clarify that:
· Registrants, in filings made after a registrant’s initial filing, may provide an update of the general development of the business rather than a full discussion. The update must disclose all of the material developments that have occurred since the registrant’s most recent filing containing a full discussion of the general development of its business, and incorporate by reference that prior discussion.
||Requires a narrative description of the business done and intended to be done by the registrant and its subsidiaries, focusing upon the registrant’s dominant segment or each reportable segment about which financial information is presented in its financial statements. To the extent material to an understanding of the registrant’s business taken as a whole, the description of each such segment must include disclosure of several specific matters.
||Revises Item 101(c) to:
· Clarify and expand the principles-based approach of Item 101(c), with a non- exclusive list of disclosure topic examples (drawn in part from the topics currently contained in Item 101(c));
· Include, as a disclosure topic, a description of the registrant’s human capital resources to the extent such disclosures would be material to an understanding of the registrant’s business; and
· Refocus the regulatory compliance disclosure requirement by including as a topic all material government regulations, not just environmental laws.
||Requires disclosure of any material pending legal proceedings including the name of the court or agency in which the proceedings are pending, the date instituted, the principal parties thereto, a description of the factual basis alleged to underlie the proceeding and the relief sought. Similar information is to be included for any such proceedings known to be contemplated by governmental authorities.
Contains a threshold for disclosure based on a specified dollar amount ($100,000) for proceedings related to Federal, State, or local environmental protection laws.
|Revises Item 103 to:
· Expressly state that the required information may be provided by hyperlink or cross-reference to legal proceedings disclosure located elsewhere in the document to avoid duplicative disclosure; and
· Implements a modified disclosure threshold that increases the existing quantitative threshold for disclosure of environmental proceedings to which the government is a party from $100,000 to$300,000, but that also affords a registrant the flexibility to select a different threshold that it determines is reasonably designed to result in disclosure of material environmental proceedings, provided that the threshold does not exceed the lesser of $1 million or one percent of the current assets of the registrant and its subsidiaries on a consolidated basis.
||Requires disclosure of the most significant factors that make an investment in the registrant or offering speculative or risky and specifies that the discussion should be concise, organized logically, and furnished in plain English. The Item also states that registrants should set forth each risk factor under a subcaption that adequately describes the risk. Additionally, Item 105 directs registrants to explain how each risk affects the registrant or the securities being offered and discourages disclosure of risks that could apply to any registrant.
||Revises Item 105 to:
· Require summary risk factor disclosure of no more than two pages if the risk factor section exceeds 15 pages;
· Refine the principles-based approach of Item 105 by requiring disclosure of “material” risk factors; and
· Require risk factors to be organized under relevant headings in addition to the subcaptions currently required, with any risk factors that may generally apply to an investment in securities disclosed at the end of the risk factor section under a separate caption.