August 22, 2019Client Alert

In Continuing Push Toward “Principles-Based” Disclosure, SEC Proposes Additional Amendments to Regulation S-K

The SEC has proposed amendments to required public company disclosure of descriptions of business, legal proceedings, and risk factors. These disclosures are required both in prospectuses used in an offering and in public companies’ periodic filings. The SEC voted to propose the amendments on Thursday, August 8, as part of its continuing “Disclosure Effectiveness Initiative” that seeks to simplify and modernize public company disclosure. The proposed rules arrive on the heels of the effectiveness of this year’s earlier Regulation S-K final rules that addressed, among other matters, MD&A, disclosure of material contracts, incorporation by reference, hyperlinking, and confidential treatment. Read Michael Best’s alert on the last set of Regulation S-K amendments here.

The proposed rules continue the SEC’s movement toward “principles-based disclosure,” a phrase the SEC uses to refer to providing a public company registrant more flexibility in determining what information is material for disclosure in the context of the registrant’s business, rather than “prescriptive disclosure,” or providing bright-line rules, sometimes with quantitative thresholds, that generally require all registrants to disclose the same types of information. The SEC hopes that contextual, principles-based disclosure will limit irrelevant, outdated, or immaterial information in favor of tailored disclosure that is more helpful to the public. In connection with the release, however, SEC Commissioner Jay Clayton acknowledged that balancing the two philosophies is delicate, that registrants may prefer prescriptive disclosure that provides the certainty of knowing when disclosure is necessary, and that prescriptive disclosure provides the public with comparability and consistency. According to the SEC, some commenters to the earlier Concept Release supported a more principles-based approach, while others supported some combination of both principles-based and prescriptive disclosure.

The newly proposed rules focus on four disclosure Items: 101(a), regarding developments in a registrant’s business; 101(c), regarding narrative description of a registrant’s business; 103, regarding description of legal proceedings; and 105, regarding risk factors.

General Development of Business (Item 101(a))

The SEC’s proposed changes to Item 101(a) are primarily principles-based and focus on materiality and timeliness of disclosure while attempting to bring the information most relevant to investors to the forefront.

Four Non-Exclusive Discussion Topics. The proposed rule offers a non-exclusive list of four discussion topics that a registrant would be required to include in disclosure to the extent that the information would be material to an understanding of the general development of the registrant’s business. The topics include three disclosure topics currently listed in Item 101(a)(1): material bankruptcy, receivership, or similar proceedings, the nature and effects of any material reclassification, merger or consolidation of the registrant 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. The fourth topic is a discussion of material changes to a registrant’s business strategy, a topic never before included in Regulation S-K.

The discussion factors provide some structure and guidance but are required only to the extent material, allowing the registrant flexibility to decide which topics are material to understanding developments in its business. Because the factors are non-exclusive, they require discussion of developments that are essential to understanding the registrant’s business development, but that do not fit into one of the topic categories.

Eliminate Five Year Timeline. Item 101(a) currently requires a discussion of the general development of a registrant’s business over the past five years. The SEC noted in its release of the proposed rules that registrants often duplicate this discussion year-over-year, providing information that is unhelpful to investors and that obscures new developments in a registrant’s business that it would be useful for an investor to know. The proposed regulations are less mechanical, requiring a registrant to disclose information material to an understanding of the general development of its business, regardless of the timeframe. The SEC notes in the release that some material developments may make more sense to investors in the context of a discussion of a longer period that highlights a material change, while some registrants “may conclude that material aspects of their business development can be described over a shorter timeframe.”

Updates Only, With References or Hyperlinks. In filings after a registrant’s initial filing, a registrant need only update developments material to an understanding of the general development of its business, focusing on those developments that occurred during the relevant reporting period. Registrants are then expressly allowed to include a hyperlink to discussion in another filing which, when taken together with the updated discussion, would contain the full discussion of the general development of the registrant’s business. The SEC noted that many registrants as a practice duplicate disclosure year-over-year, and that new developments since Regulation S-K was adopted in 1970s, including the availability of business information via EDGAR and company websites, make general development of business info more accessible to investors, and duplication less important in periodic reports.

Business Strategy Disclosure. As mentioned, the proposed regulations add discussion of material changes to a registrant’s business strategy to the nonexclusive list of topics that a registrant may need to disclose. Disclosure of business strategy has not to this point been required under Regulation S-K. The SEC noted that this requirement is most relevant to a registrant that disclosed a business strategy in an initial filing, and that a registrant with no previously-disclosed strategy need not begin disclosing that strategy. The SEC is specifically seeking comments in this area, including whether disclosure of business strategy should be affirmatively required, and, if so, how the SEC can require that disclosure without causing registrants competitive harm.

Narrative Description of Business (Item 101(c))

The SEC also proposed principles-based disclosure amendments to the requirement under Item 101 that a registrant provide a narrative description of its present and future business. Similar to the changes to 101(a) business developments disclosure, the proposed rules emphasize materiality of disclosure rather than exhaustiveness.

Non-Exclusive Discussion Topics. Item 101(c) currently provides twelve items that a registrant is required to discuss if material to understanding the registrant’s business as a whole. The SEC maintains in the release that the current list does not require discussion of each item, but recognizes that most registrants currently feel as though an exhaustive discussion of each item is necessary both for the SEC’s purposes and to avoid potential lawsuits. The proposed rules amend the list of disclosure items to a shorter list of items that the SEC believes will be more likely to be material to a broader range of companies. And, the SEC has now made explicit that a registrant need only discuss an item on the list if the discussion is material to an understanding of the registrant’s business taken as a whole, encouraging registrants to omit wrote discussion of each item in the list if the discussion does not help an investor to understand its business.

Human Capital Resources. The SEC for the first time added human capital resources to the non-exclusive list of business narrative topics under the proposed rules. Human capital resources include any “human capital measures” or “objectives that management focuses on in managing the business.” This disclosure topic replaces the current 101(c) requirement that a registrant disclose its number of employees. The SEC is expressly seeking comment on this discussion item, including whether to include non-exclusive examples of human capital resource topics to discuss, and whether or not to retain the requirement that a registrant list its number of employees.

Regulatory Compliance. Item 101(c) currently requires a discussion of the material impact of any environmental regulations. The new rules update this factor to cover all “material government regulations.”

Legal Proceedings (Item 103)

Item 103, which requires a discussion of legal proceedings, is one area where the SEC sought to provide stronger prescriptive disclosure rather than a shift to principles-based disclosure. The SEC noted that it used a prescriptive approach for this item because the topic is by its nature less sensitive to differences in the characteristics of individual registrants.

Hyperlinks or Cross-References. The proposed rules specifically allow a registrant to provide required information about legal proceedings via a hyperlink or cross reference to legal proceedings located elsewhere in a filing. Registrants currently discuss legal proceedings repetitively in several different places in certain filings, and this change encourages registrants to avoid duplicative disclosure.

Environmental Proceeding Disclosure Threshold. Item 103 currently requires a registrant to disclose any environmental proceedings to which it is subject and to which the government is a party if it believes that the monetary sanctions involved are likely to be more than $100,000. This threshold was enacted in 1982, and the new rules increase the threshold to $300,000 to adjust for inflation since that original enactment.

Risk Factors (Item 105)

The SEC also took a principles-based approach to amending disclosure requirements for risk factors. The SEC acknowledges in the proposing release that a registrant has a strong incentive to exhaustively include risk factors to shield itself from potential litigation, but also observes that risk factor disclosure is becoming increasingly lengthy, and that many registrants use boilerplate generic risk factors that take attention away from registrant-specific risk factors that may be more important to investors. The proposed rules attempt to balance those two competing concerns by attempting to draw attention to material, registrant-specific information.

Summary Risk Factor Disclosure. Though the SEC seems to recognize that it may not be able to stop registrants from including lengthy risk factor disclosures, it splits the difference by requiring a registrant to provide a summary to its risk factor disclosures if the risk factor disclosures exceed 15 pages, an amount that it estimates currently includes about 40% of registrants. Under the proposed rules, if a registrant is required to prepare a summary, the summary should “enhance the readability and usefulness” of the disclosure for the investor.

“Material” Over “Most Significant.” Item 105 currently requires a registrant to discuss the “most significant” risk factors. Recognizing that the “most-significant” standard has not led registrants to limit risk factor disclosures, the SEC proposes to apply the materiality standard familiar from its proposed amendments to Items 101(a) and 101(c). Under the newly proposed rules, a registrant should disclose “material” risk factors, which are defined as “those matters to which there is a substantial likelihood that a reasonable investor would attach importance in determining whether to purchase the security.”

Generic Risk Factors Appear Last. Where a registrant does feel compelled to make a generic disclosure that does not provide an explanation of why the identified risk is specifically relevant to an investor in its securities, the new rules require the registrant to disclose the generic risk at the end of the risk factor section in a section captioned “General Risk Factors”

Michael Best has experts in public company disclosure that can help you adapt your company’s public disclosures to the evolving requirements in Regulation S-K. Contact an expert if you have a question about what might or might not be required under the final rules, or if you would like to submit a comment to the proposed rules.

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