The U.S. Securities and Exchange Commission (SEC) recently adopted amendments to the rules modifying the disclosures that public companies are required to make in their periodic reports. The regulations impacted by the amendments—Items 101, 103 and 105 of Regulation S-K—relate to the description of the company’s business, legal proceedings as they relate to environmental disclosures, and risk factors. A public company’s Annual Reports on Form 10-K and Quarterly Reports on Form 10-Q incorporate the disclosures required by these Items, as do some registration statements and certain other SEC filing forms. The amendments will be effective November 9, 2020. This article describes the material changes made by the amendments, and the steps that public companies may desire to take to prepare for the new disclosure requirements.
Item 101: Description of business
Item 101 currently calls for a description of the general development of the company’s business over the last five years and a narrative description of the business done and intended to be done by the company, focusing on the company’s “dominant” segment, or each segment for which information is presented in the financial statements.
With regard to the description of general development, the amendment eliminates the strict five-year time frame, and instead asks for disclosure only of information that would be material to understanding such development. Additionally, the SEC states that this disclosure may include, but should not be limited to: (i) material changes to business strategy; (ii) the nature and effects of any material bankruptcy, receivership or similar proceeding; (iii) the nature and effects of any material reclassification, merger or consolidation; and (iv) the acquisition or disposition of any material amount of assets outside the ordinary course of business. Furthermore, once a company has disclosed the general development of its business in this manner, future disclosures can be limited to material changes during the reporting period, if the full original disclosure is incorporated by reference including a hyperlink.
With regard to the narrative description of the business, the amendment replaces a list of specific items required with a more “principles-based” list, stating that the disclosure may include, but should not be limited to: (i) revenue-gathering activities, products and services the company provides; (ii) status of the development of new products and trends in market conditions; (iii) resources material to the company’s business; (iv) material portions of the business that may be subject to renegotiation or termination by the government; and (v) the seasonality of the business. Item 101, as amended, will also require, where material to an understanding of the business, a description of the company’s material human capital resources (i.e., employees, contractors and other sources of human capital), measures and objectives, along with disclosure of the material effects of the company’s regulatory compliance.
Item 101 disclosures are required in Form 10-K, to be updated by Form 10-Q, as needed. So, for companies with a fiscal year ending December 31, the first periodic filing to incorporate the changes will likely be the Form 10-K for the year ended December 31, 2020. In order to prepare for compliance with these changes, companies should review their existing Description of Business disclosures for relevant updates. Such updates may include addressing the topics in the non-exclusive list the SEC provided, eliminating any immaterial five-year lookback disclosures, and developing human capital and regulatory compliance disclosures.
Item 103: Legal proceedings
As currently in effect, Item 103 requires disclosure of the company’s material pending legal proceedings. Such proceedings explicitly exclude disclosure of governmental environmental proceedings with monetary sanctions that the company reasonable believes will be less than $100,000.
The amendment to this Item adds a provision specifically permitting companies to incorporate information about proceedings elsewhere in the filing by hyperlink. Some companies already do this, but the amendment makes it expressly permissible. The amendment also increases the threshold for governmental environmental proceedings from $100,000 to $300,000, or a higher threshold that the company reasonably believes will result in a disclosure of any proceeding material to its business or financial condition. However, in no event may this alternate threshold be higher than $1 million.
Both Form 10-K and Form 10-Q require Item 103 disclosures. To prepare for the change, companies should review their current disclosures, and may add hyperlinked cross-references internally within the filing, if applicable. Additionally, they should determine whether any environmental proceedings currently disclosed could be omitted under the new rules.
Item 105: Risk factors
The current version of Item 105 calls for a concise discussion of the most significant risk factors involved in an investment in the public company, organized logically, with a sub-caption adequately describing each risk.
The amendment seeks to limit overlong and non-specific risk factor disclosures by adding some specific requirements. One such requirement is that risk factors be set forth under specific headings. The use of generic risk factors that could apply to any company is discouraged, but if they are included, they must be included under a heading at the end of the risk factor section titled “General Risk Factors.” Additionally, if the risk factor discussion is more than 15 pages long, the company must include a bulleted or numbered outline of no more than two pages, summarizing the principal factors that make an investment in the public company risky. The language in the Item is also changed from disclosure of the “most significant” risks to the “material” risks—those that would be important to a reasonable investor. This is intended to make disclosures more specifically tailored to the particular public company.
Form 10-K requires disclosures of risk factors under Item 105, but Form 10-Q also requires disclosure of any material changes since the last Form 10-K (for all companies other than smaller reporting companies). In anticipation of these changes, public companies should review their risk factor current disclosures and organize them into logical categories with headings, and include a 2-page summary of the principal risks if required. Any generic risk factors should be eliminated, tailored more specifically to the company, or relegated to the “General Risk Factors” heading at the end.