On August 8, 2019, the Securities and Exchange Commission (“SEC”) proposed amendments1 to crucial disclosure requirements under Regulation S-K, including Item 101 (Description of Business), Item 103 (Legal Proceedings) and Item 105 (Risk Factors) as part of its ongoing initiative to update and modernize its disclosure. The proposal, which follows two sets of adopted rule amendments that became effective in recent months and are applicable for companies’ upcoming 10-K filings2, continues a shift towards a more principles-based disclosure framework that places the onus on the reporting companies to exercise greater judgment in evaluating what disclosures to provide. If implemented, these amendments would reduce duplicative disclosures and lead to disclosure more appropriately tailored to a reporting company’s specific facts and circumstances. Of particular note, the SEC reiterated its belief, expressed by Chairman Clayton in a number of his recent speeches3, that human capital can be an important driver of performance for many companies, and therefore proposed to require disclosure of human capital measures that management focuses on, if material to understand the business.
All proposed amendments would apply to domestic issuers. The proposed amendments to Item 105 (Risk Factors) would apply to foreign private issuers because Forms F-1, F-3 and F-4 specifically refer to that Item of Regulation S-K while the amendments to Item 101 (Description of Business) and Item 103 (Legal Proceedings) would not.
Item 101 (Description of Business)
Item 101(a) (General Development of Business)
Item 101(a) currently requires a description of the general development of the company’s business during the past five years. The proposed changes are designed to provide companies with the flexibility to tailor their disclosures to their individual circumstances, and make it easier for investors to focus on material updates to the business. The proposed amendments to Item 101(a) would introduce the following changes:
- Eliminate Prescribed Timeframe. Require disclosure of information that is material to an understanding of the general development of the company’s business and eliminate a prescribed five-year timeframe for this disclosure.4 The SEC noted that some companies might prefer to describe the development of their business over a longer period in order to provide the information that may be material to an investment decision, while others may conclude that the material aspects of their business development can be described over a shorter timeframe.5
- Require Only Updated Disclosure in Subsequent Filings. In filings made after a company’s initial Securities Act of 1933 or Securities Exchange Act of 1934 registration statement, permit a company to provide only an update of the general development of the business with a focus on material developments, if any, in the reporting period, and a hyperlink to the company’s most recently filed disclosure that, together with the update, set forth the full discussion of the general development of the company’s business. The SEC believes this would avoid duplicative disclosure and would allow investors to focus on material developments during the reporting period.6
- Include Material Changes to Business Strategy as Potential Disclosure Topic. Make disclosure largely principles-based by providing a non-exclusive list of topics, which the company would be required to disclose, and by requiring disclosure only to the extent any particular topic is material to an understanding of the general development of the company’s business.7 The SEC is also proposing to include, as a listed disclosure item, to the extent material to an understanding of the company’s business, “transactions and events that affect or may affect the company’s operations, including material changes to a registrant’s previously disclosed business strategy” (emphasis added). Importantly, if a company has not previously disclosed its business strategy, the SEC is not proposing to require disclosure of that strategy out of concern that this could force companies to disclose proprietary information that could be harmful to their competitive position.
Item 101(c) (Narrative Description of Business, Including Human Capital Resources Disclosure)
Item 101(c) currently requires a narrative description of the business conducted and intended to be conducted by the company and its subsidiaries, focusing upon the company’s dominant segment or each reportable segment about which financial information is presented in the financial statements, and includes twelve specific items that must be discussed, to the extent material to an understanding of the company’s business.8 Because the twelve items may not be relevant to all companies, they can elicit disclosure that is not material to a particular company. The SEC is proposing to amend Item 101(c) to be more principles-based by encouraging companies to exercise judgment with respect to the matters on which they focus their disclosures. The proposed amendments to Item 101(c) are as follows:
- Non-Exclusive List of Possible Disclosure Topics. Provide a non-exclusive list of topics that a company may need to disclose, which is derived from a subset of topics included in Item 101(c) (disclosure about new segments and dollar amount of backlog orders believed to be firm would no longer be listed as potential disclosure topics under this Item). Disclosure would be required only to the extent such information is material to an understanding of the general development of a registrant’s business taken as a whole.
- Discussion of Compliance With Material Government Regulations (Not Just Environmental Regulation). Propose to refocus the regulatory compliance requirement by including material government regulations not just environmental laws as a topic. The proposed approach would codify what has already become common practice regarding government regulation disclosure and would ensure that investors have access to information about a company’s compliance with government regulations that materially affect the company’s business.
- Requirement to Include Human Capital Disclosure. Include human capital resources as a separate disclosure topic, to the extent such disclosure would be material to an understanding of the company’s business. Currently, the only required disclosure with respect to human capital is the number of employees, which dates back to a time when companies relied significantly on plant, property and equipment to drive value. The SEC recognizes that today intangible assets, including human capital, represent an essential resource and driver of performance for certain companies. Therefore, as part of the SEC’s efforts to modernize disclosure, it is proposing to replace the current requirement to disclose the number of employees with a requirement to describe the company’s human capital resources, including any human capital measures or objectives that management focuses on in managing the business, to the extent such disclosure would be material to an understanding of the company’s business. The proposed amendment provides non-exclusive examples of human capital measures and objectives that may be material, depending on the nature of the company’s business and workforce, such as measures or objectives that address the attraction, development, and retention of personnel. In this context, the SEC specifically noted that each industry and company has its own human capital considerations, which may evolve over time. The intent of the proposed amendment is to elicit, to the extent material, disclosures about human capital that would enable investors to better understand and evaluate this company resource and to see through the eyes of management how each company manages its workforce.
The SEC’s expansion of Item 101 to require human capital management disclosure is significant and follows increasing pressure on the SEC from investors to take action with respect to such disclosure. In particular, the SEC cited to a rulemaking petition, which it received in 2017 from a group of 25 institutional investors representing over $2.8 trillion in assets, calling on the SEC to require registrants to disclose information about their human capital management policies, practices and performance.9 In addition, the Investor Advisory Committee recently recommended that the SEC take measures to improve the disclosure of a registrant’s human capital management and, in line with the SEC’s proposal, suggested that “any requirements should be crafted so as to reflect the varied circumstances of different businesses, and to eschew simple ‘one-size-fits-all’ approaches that obscure more than they add.”10
Similar to current Item 101(c), most of the listed disclosure topics would fall into the category for which segment disclosure would be required to the extent the topic is material to an understanding of the company’s business taken as a whole. The SEC believes that, for the topic regarding the material effects of compliance with government regulation, including environmental regulation, and the topic regarding human capital resources, the appropriate primary focus should be the company’s business taken as a whole. Similar to the current rule, however, if the information elicited regarding these two topics is material to a particular segment, the company would additionally be required to identify that segment.
Item 103 (Legal Proceedings)
Item 103 requires disclosure of any material pending legal proceedings, other than ordinary routine litigation incidental to the business, to which the company or any of its subsidiaries is a party. Although Item 103 and US GAAP differ in certain respects, they also have overlapping disclosure requirements. As a result, in order to comply with Item 103 by providing disclosure under the legal proceedings section header of a Form 10-K or 10-Q, companies commonly repeat some or all of the disclosures that are also provided in the notes to the financial statements under US GAAP, the MD&A, and the Risk Factors sections. The proposed amendments to Item 103 would include the following requirements:
- Hyperlinks and Cross-References for Legal Proceedings Disclosure. Expressly state that the required information may be provided by including hyperlinks or cross-references to legal proceedings disclosure located elsewhere in the document (a practice already followed by a large number of reporting companies), in an effort to encourage companies to avoid duplicative disclosure.
- Increased Threshold for Environmental Proceedings Disclosure. Increase the threshold for disclosure of environmental proceedings to which the government is a party from $100,000 to $300,000 to adjust for inflation. The SEC chose to maintain a bright-line threshold based on its determination that the imposition of a governmental fine may be important for investors in assessing a company’s environmental compliance.
Item 105 (Risk Factors)
Item 105 (which was previously included in Item 503(c) prior to the FAST Act Modernization and Simplification amendments) currently requires concise and logically organized disclosure of the most significant factors that make an investment in the company or offering speculative or risky. Item 105 further instructs that risk factors should not be boilerplate. However, the SEC has found that many companies’ risk factor disclosure has progressively become longer and often includes generic, boilerplate risks that could apply to any offering or registrant. To balance the need to provide more focused disclosure about the company’s risk profile with concerns about imposing specific limits on disclosure length, the proposed amendments to Item 105 would include the following requirements:
- Summary Risk Factors Disclosure. Include summary risk factor disclosure if the risk factor section exceeds 15 pages, which would include a series of short, concise, bulleted or numbered statements summarizing the principal risk factors. The SEC believes that this presentation would enhance the readability and usefulness of this disclosure for investors and may also incentivize companies to limit the length of their risk factor disclosure.
- Change of Disclosure Threshold from “Most Significant” to “Material”. Change the disclosure standard from “most significant” risks to “material” risks.11 The SEC believes that this could result in risk factor disclosure that is more tailored to the particular facts and circumstances of each company and reduce the amount of risk factor disclosure that is not material.
- Group Risk Factors Under Relevant Headings. Require risk factors to be grouped under relevant headings in an effort to help readers comprehend lengthy risk factor disclosures (which is already a best practice currently followed by many companies).
- New “General Risk Factors” Section. Require any risk factors that could apply generally to an investment in securities and which are included without an explanation as to why the risk is specifically relevant to an investor in the company’s securities to be disclosed at the end of the risk factor section under the heading “General Risk Factors.”
The proposed amendments will have a 60-day public comment period following their publication in the Federal Register.
1 Available here.
2 The two recent rule amendments that are already applicable for companies’ upcoming Form 10-Ks are: (1) the FAST Act Modernization and Simplification of Regulation S-K, Release No. 33-10618 (Mar. 20, 2019), summarized at the White & Case memo available here; and (2) the Disclosure Update and Simplification, Release No. 33-10532 (August 17, 2018), summarized at the White & Case memo available here.
3 See, for example, his remarks for telephone call with SEC Investor Advisory committee members (Feb. 6, 2019), available here, his remarks to the SEC Investor Advisory Committee (Mar. 28, 2019), available here.
4 We note that the Form 10-K already includes a one-year time frame for Item 101 disclosure under Part I, Item 1 (which states that “the discussion of the development of the registrant’s business need only include developments since the beginning of the fiscal year for which this report is filed”). As drafted, the rule proposal does not impact this language in the Form 10-K.
5 For similar reasons, the SEC is also proposing to revise Item 101(h) to eliminate the provision that currently requires smaller reporting companies to describe the development of their business during the last three years.
6 The SEC is also proposing to permit smaller reporting companies, for filings other than initial registration statements, to provide an update to the general development of the business disclosure, instead of a full discussion, that complies with proposed Item 101(a)(2), including the proposed hyperlink requirement.
7 Three of the four matters that the SEC is proposing to list as disclosure topics are currently covered in Item 101(a)(1): material bankruptcy, receivership, or any similar proceeding; the nature and effects of any material reclassification, merger or consolidation of the company or any of its significant subsidiaries; and the acquisition or disposition of any material amount of assets otherwise than in the ordinary course of business.
8 Items specified in Item 101(c) include: (i) Principal products produced and services rendered; (ii) New products or segments; (iii) Sources and availability of raw materials; (iv) Intellectual property; (v) Seasonality of the business; (vi) Working capital practices; (vii) Dependence on certain customers; (viii) Dollar amount of backlog orders believed to be firm; (ix) Business subject to renegotiation or termination of government contracts; (x) Competitive conditions; (xi) The material effects of compliance with environmental laws; and (xii) Number of employees.
9 The SEC also cited to comment letters it received in support of this petition from a number of investors. See the rulemaking petition to require registrants to disclose information about their human capital management policies, practices and performance, File No. 4-711 (July 6, 2017), available at here and related comments available at here. Also see the press release related to this petition, available here.
10 See the Recommendation of the Investor Advisory Committee Human Capital Management Disclosure (March 28, 2019), available here.
11 Rule 405 under Securities Act of 1933, the term “material” as follows: The term material, when used to qualify a requirement for the furnishing of information as to any subject, limits the information required to those matters to which there is a substantial likelihood that a reasonable investor would attach importance in determining whether to purchase the security.