August 28, 2020
On August 26th, the Securities and Exchange Commission (SEC) adopted amendments to Item 101 (Description of Business), Item 103 (Legal Proceedings), and Item 105 (Risk Factors) of Regulation S-K as part of its overall initiative to modernize and improve disclosures that companies are required to include in their SEC filings. This initiative, known as the Disclosure Effectiveness Initiative — which stems from the SEC’s comprehensive evaluation of Regulation S-K mandated by the JOBS Act — is intended to update the SEC’s disclosure regime by modernizing and simplifying disclosure requirements for companies at all stages of development.
The SEC cited public comments, staff experience, changes in the regulatory and business landscape, and changes in capital markets and the domestic and global economy that have occurred since the adoption of Regulation S-K over 30 years ago as the driving factors behind these amendments. The changes reflect ongoing changes in the mix of businesses that participate in public markets, the way businesses operate, technology, and the ease of access to information. In addition to modernizing the regulations, the SEC focused on amending disclosure requirements that may elicit repetitive or boilerplate disclosures – which generally lengthen disclosures – to improve the readability and quality of disclosures for investors and simplify compliance for companies.
Overall, these amendments underscore the SEC’s preference for a principles-based, company-specific approach to disclosure. Although simplification is a key element of the Disclosure Effectiveness Initiative, these amendments, in effect, elevate the disclosure standards under these Items by placing more responsibility on companies to craft individualized, meaningful disclosures that will facilitate investors’ understanding of the company’s business, financial condition, and prospects.
The amendments, which are summarized below, will be effective 30 days after their publication in the Federal Register. For calendar year companies, this means that these amendments likely will be in effect and, therefore, must be considered by companies as early as the next Quarterly Report on Form 10-Q.
Elimination of the Five-Year and the Three-Year Disclosure Periods. The amendments to Item 101(a) and 101(h) eliminate the existing three-year disclosure period for smaller reporting companies and the five-year disclosure period for all other companies and replace them with a principles-based disclosure standard for all companies. As amended, the rules require companies to disclose information that is material to an understanding of the general development of the business, irrespective of a specific timeframe. This gives companies flexibility to tailor disclosures to their unique circumstances. The amended framework creates an increased responsibility of companies to thoughtfully, comprehensively, and timely satisfy the disclosure requirements set forth in Item 101.
Disclosure About Business Strategy. Under the existing rule, Item 101(a)(1) sets forth a list of disclosure topics that a company must include in its discussion of the development of its business. The amendment replaces this list with a non-exclusive list of the types of information that a company should consider in its disclosures under Item 101 and clarifies that disclosure of a topic is only required to the extent the information is material to an understanding of the general development of the company’s business.
The most notable change to the rule is the adoption of a new topic: material changes to the company’s previously disclosed business strategy. While not every company may choose to disclose its business strategy, the amended rule requires a company that has previously disclosed its business strategy to discuss changes to that strategy to the extent material to an understanding of the development of the company’s business. The final rule emphasized that this principles-based approach will provide companies with the flexibility to determine the appropriate level of detail for these disclosures and should mitigate any disincentives the amendments create for companies to disclose their business strategy.
The amended rule retains (with minor modifications) the existing topics addressing:
The amended rule eliminates the requirement to disclose (unless material to an understanding of the general development of the business):
Updated Disclosure in Subsequent Filings Permitted. Under the existing rules, companies are required to include a discussion regarding the general development of the business in certain registration statements and reports. The amendments to Items 101(a)(2) and 101(h) permit companies to provide only an update (rather than a full discussion) of the general development of the business, disclosing all material developments that have occurred since the most recent full discussion of the development of its business disclosed in a previously filed registration statement or report. The intent of this amendment is to give companies the opportunity to focus investor attention on material developments and reduce repetitive disclosures that may obscure important developments about the company’s business. For companies choosing this approach, the disclosure must incorporate by reference to a single previously-filed document the most recent full discussion of the development of the company’s business.
Revised List of Disclosure Topics. The amendment to Item 101(c) — which requires a company to include in its disclosures a narrative description of the company’s business, with a focus on the company’s dominant segments — updates the list of disclosure topics set forth in Item 101(c)(1). Under the existing and amended rule, companies must discuss the disclosure topics listed in Item 101(c)(1) to the extent they are material to the company’s business as a whole, in addition to any other topics that are material to the company’s business as a whole. In its release, the SEC stated its intent to clarify and emphasize the principles-based nature of this disclosure item and elicit disclosures that are material to companies’ individual circumstances. It also considered changes in business markets and technology since the rule’s adoption, which may render existing topics irrelevant to some companies.
The amended rule retains as disclosure topics:
The amended rule modifies and expands on certain existing disclosure topics; specifically, it:
The amended rule eliminates specific disclosure requirements pertaining to:
Under the principles-based framework of the rule, however, a company must still discuss these topics to the extent they are material to an understanding of the company’s business as a whole.
Cross-references and Hyperlinks Permitted. To encourage companies to avoid duplicative disclosures, Item 103 includes a new provision that expressly permits disclosure of the required information by cross-reference or hyperlink to legal proceedings disclosures located elsewhere in the document (such as Management’s Discussion & Analysis, Risk Factors, or notes to the financial statements).
Increased Disclosure Threshold for Environmental Proceedings. The amendment to Item 103 increases the existing quantitative threshold for disclosure of environmental proceedings to which the government is a party from $100,000 to $300,000, to account for inflation, and adds a new component that allows a company 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 company and its subsidiaries. This hybrid, principles-based approach was adopted to elicit disclosures that are important to investors in assessing a company’s environmental compliance while allowing companies to apply a disclosure threshold that is more indicative of materiality on a company-specific basis.
Addition of Risk Factor Summary. As a way of addressing the ever-growing length of risk factor disclosures, the SEC has previously considered instituting a page limit for risk factors. Dissuaded by comments received in response to prior initiatives, the SEC has instead adopted an amendment that requires companies whose risk factor disclosure exceeds 15 pages to also include a risk factor summary. This amendment is designed to encourage companies to limit their risk factor disclosures to those that are material and improve the readability and usefulness of lengthy disclosures for investors.
The risk factor summary should be included near the beginning of the document and must be presented as concise, bulleted or numbered statements summarizing the principal factors that make an investment in the company speculative or risky. The risk factor summary can be no longer than 2 pages, and it does not need to include all risk factors identified in the full risk factor discussion. In the risk factor summary, companies are free to prioritize certain risks and omit others. If a company is required to include this summary, consideration should be given to synthesizing the summary with any “safe harbor” language that is included pursuant to the Private Securities Litigation Reform Act.
Disclosure of “Material” Risks. The amendment changes the standard of disclosure under Rule 105 from the “most significant” factors to the “material” factors that make a company’s securities speculative or risky. The term “material”, as used in this context (as well as in the amendments to Items 101 and 103), is defined in Rule 12b-2 of the Exchange Act and Rule 405 of the Securities Act. The guidance set forth in the release indicates that the materiality standard for risk factor disclosure aligns with the broad concept of materiality used throughout federal securities laws, referencing the Supreme Court’s holdings that:
The SEC emphasized its intent to reduce the disclosure of generic risk factors (which companies are instructed not to include under the existing rules) and focus companies on disclosing the risks that investors would consider important in making voting and investment decisions.
Addition of Subheadings. Under the amended rules, companies are directed to organize risk factor disclosures under relevant subheadings, in addition to the subcaptions that are already required. The SEC has periodically emphasized the importance of organizing risk factors in a manner that will help investors better navigate the disclosures. The final rule highlights the SEC’s intent to improve readability and usefulness of the disclosures for investors and curtail the lengthy and generic nature of risk factor disclosures that is frequently presented.
Companies are afforded the flexibility to determine the order that most efficiently presents the disclosures, consistent with the SEC’s goal of making Item 105 more principles-based. The amended rules do not prescribe specific subheadings that companies must include, with one exception — risk factors that could apply generally to any company or offering must be presented at the end of the risk factor section under the caption “General Risk Factors." Consistent with existing rules that require a company to explain how each risk factor disclosed affects it, the SEC encourages companies to tailor their risk factor disclosures to emphasize the specific relationship of the risk to the company or offering, therefore avoiding the need to include risks under the “General Risk Factors” subheading.
These materials have been prepared for informational purposes only and are not legal advice. This information is not intended to create, and receipt of it does not constitute, an attorney-client relationship. Internet subscribers and online readers should not act upon this information without seeking professional counsel.