On August 26, 2020, the Securities and Exchange Commission adopted sweeping changes to the disclosures regarding the description of business, legal proceedings and risk factors that reporting companies are required to provide in registration statements and periodic reports pursuant to Regulation S-K (the “Final Rules”).1 The targeted disclosure items have not undergone significant revision in over 30 years and the changes will impact many of the most commonly filed registration statements and periodic reports, including Forms S-1, S-3, 10-K and 10-Q. Beyond the specific amendments, the Final Rules reflect a larger conceptual shift from a rigid prescriptive disclosure regime to a more flexible principles-based approach that encourages registrants to eliminate redundant and immaterial disclosure and tailor discussions to their particular business.
The rule amendments were proposed on August 8, 2019 and were largely adopted as proposed. The Final Rules will go into effect 30 days after publication in the Federal Register, and therefore will affect the next 10-K and 10-Q filings for many registrants.
Item 101(a) – General Development of Business
Item 101(a) of Regulation S-K currently requires a registrant to describe the general development of its business during the past five years. The Final Rules eliminate this specific timeframe and instead require registrants to disclose information material to an understanding of the general development of the business.2 In addition, in filings subsequent to the initial registration statement, registrants will no longer be required to provide information that has already been disclosed. Instead, registrants will be permitted to disclose only material developments since the prior filing if they include a hyperlink to (and incorporate by reference) the previous disclosure that, together with the update, would present a full discussion of the general development of their business.
The Final Rules also replace the list of prescribed disclosure topics related to business strategy in Item 101(a)(1) with a non-exhaustive list of the types of information that a registrant may need to disclose to the extent material. However, this new list is largely the same as the prior list, except that this item no longer mandates disclosure of the registrant’s year of organization and form of business entity, or disclosure of material changes in the mode of conducting the registrant’s business.3
The Final Rules further amend Item 101(a) by requiring registrants to disclose material changes to a previously disclosed business strategy to the extent material to an understanding of their business. Due to concerns regarding disclosure of proprietary information, the SEC has limited this disclosure to only changes to business strategies that have previously been disclosed. This change will not require registrants to disclose their business strategies if they have not already done so.
Item 101(c) – Narrative Description of Business
Item 101(c) currently requires a narrative discussion of a registrant’s business and explicitly includes 12 topics of discussion. Although the current rule only requires a discussion of most of these topics to the extent material to an understanding of the registrant’s business taken as a whole, the SEC noted in the Proposing Release for the amendments that many registrants nonetheless interpret this provision to require discussion of each topic, even if immaterial.4 Although the Final Rules’ changes to the actual text of this item are relatively incremental, the Final Rules are meant to encourage registrants to exercise more judgment in deciding what to disclose and to tailor such disclosure to their specific facts and circumstances. The SEC also hopes that this principles-based approach will elicit more meaningful disclosures and discourage the disclosure of immaterial information by registrants rigidly adhering to the enumerated discussion topics even as businesses, markets and technology continue to change over time.5
In terms of specific changes to Item 101(c), the Final Rules eliminate explicit reference to the disclosure of working capital practices,6 new business segments and the dollar amount of firm backlog. However, the Adopting Release cautions that a registrant would still need to provide disclosure regarding these topics (and any other topics) to the extent material to an understanding of its business.7 In this regard, note that this information is also required to be disclosed in the Management’s Discussion & Analysis sections of registration statements and periodic reports to the extent relevant.8
The Final Rules also broaden the current requirement to disclose the number of employees of the registrant to also include a description of the registrant’s “human capital resources,” including any human capital measures or objectives that management focuses on in managing the business, to the extent material to an understanding of the registrant’s business. Although the SEC declined to include a definition of “human capital resources,”9 the Final Rules state that a discussion of “human capital measures” could include measures or objectives that address the development, attraction and retention of personnel.10 In addition, the Final Rules broaden the current disclosure topic that covers environmental law compliance to include disclosure of the material effects of compliance with government regulations, not just environmental regulations.
Item 103 – Legal Proceedings
The Final Rules make two modest changes to Item 103, which requires egistrants to disclose any material pending legal proceedings, other than ordinary routine litigation incidental to the business.
First, the Final Rules explicitly allow registrants to include cross-references or hyperlinks to legal-proceeding disclosure elsewhere in the document (for example, in the notes to the financial statements).
Second, the Final Rules increase the threshold to disclose certain environmental proceedings. Instruction 5.C. to Item 103 currently requires disclosure of any proceeding under environmental laws to which a governmental authority is a party unless the registrant reasonably believes it will not result in sanctions of $100,000 or more. The Final Rules increase the threshold to $300,000 and, as an alternative, allow the registrant to elect a different threshold so long as (i) the threshold does not exceed the lesser of (a) $1,000,000 or (b) 1% of the current assets of the registrant and its subsidiaries on a consolidated basis, (ii) the registrant determines that the threshold is reasonably designed to result in disclosure of any environmental proceeding that is material to its business or financial condition, and (iii) the registrant discloses the threshold, and any subsequent change, in each annual and quarterly report.
Item 105 – Risk Factors
The Final Rules make significant changes to risk factor disclosure to encourage registrants to eliminate lengthy and generic risk factors in favor of concise disclosure that is tailored to the specific risks facing the registrant.
First, registrants will be required to include a summary of the risk factors if their risk factor disclosure exceeds 15 pages. This summary may be no longer than two pages in length and must consist 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. Although prospectuses, especially those used in connection with IPOs, already typically include a summary of the most important risk factors, summaries of risk factors are less common in periodic reports. The SEC estimates that this change would affect approximately 40% of current filers, and intends that this threshold incentivize registrants to limit the length of their risk factor disclosure.11
Second, the Final Rules change the threshold for disclosing a risk factor by requiring the disclosure of “material” risks instead of a registrant’s “most significant” risks. This aligns the standard for disclosure with the general test of materiality used elsewhere in the securities laws (i.e., whether there is “a substantial likelihood that a reasonable investor would attach importance” to the information in determining whether to purchase or sell the security).12 The SEC believes that this change will potentially shorten risk factor disclosure by eliminating immaterial disclosure.
Lastly, the Final Rules change the organization of risk factors by requiring that risk factors be organized under relevant headings and by discouraging generic risk factor disclosure (i.e., a risk that could apply to other companies or securities offerings and that the disclosure does not provide an explanation of why such risk is specifically relevant to an investor in the registrant’s securities). However, to the extent that a registrant chooses to include generic risk factor disclosure, this would be required to be moved to the end of the risk factor section under the caption “General Risk Factors.”13
Next Steps
Public companies should begin updating their disclosures now given that the Final Rules will affect many registrants’ next periodic report filings. Although most of the amendments will not need to be implemented until the next Form 10-K, the changes to Item 103 will affect upcoming 10-Q filings. Accordingly, companies should consider whether the new $300,000 threshold for environmental proceedings with government entities is appropriate or whether to adopt an alternative threshold.
Before their next 10-K filing, companies should revise their business descriptions and consider how to address the new disclosure topics in the Final Rules, such as compliance with governmental regulations, human capital resources and changes to previously disclosed business strategies. They should also apprise whether a five-year timeframe for the discussion of the general development of its business is appropriate or whether a shorter (or longer) timeframe is more suitable for their business, as well as whether to use incorporation by reference to trim the length of this section.
Companies should also ensure that their risk factors are grouped under subheadings and consider tailoring any risk factors that would fall under the new “General” subheading to be more specific to the company. Registrants with risk factors sections that exceed 15 pages should start considering what risks should be described in the new two page risk factor summary section.
Aside from these specific updates in response to the Final Rules, companies should also consider updates to other areas of their existing disclosure in light of the principles-based approach that underpins these amendments. It is clear that the SEC expects registrants to avoid redundant, generic and immaterial disclosure and instead exercise more judgment in determining what information to include in SEC disclosures. Registrants should expect that this attitude towards disclosure will manifest itself in future rulemakings and SEC comment letters and should draft their filings with this approach in mind.
Footnotes
1) Modernization of Regulation S-K Items 101, 103, and 105, Release Nos. 33-10825; 34-89670 (August 26, 2020) (hereinafter, the “Adopting Release”).
2) Adopting Release, at 11-13, 15. Note that the Final Rule similarly eliminates the three-year timeframe that applies to smaller reporting companies pursuant to Item 101(h).
3) To be sure, however, under this principles-based approach, even these omitted items would nonetheless need to be disclosed if material to a particular registrant.
4) Modernization of Regulation S-K Items 101, 103, and 105, Release Nos. 33-10668; 34-86614 (August 8, 2019) (hereinafter, the “Proposing Release”), at 25.
5) Adopting Release, at 28.
6) Examples of “Working Capital Practices” include: where a registrant is required to carry significant amounts of inventory to meet rapid-delivery requirements or to assure itself of a continuous allotment of goods from suppliers; where the registrant provides rights to return merchandise; or where the registrant has provided extended payment terms to customers. Rule 101(c)(1)(vi).
7) Adopting Release, at 28-29.
8) Item 303 of Regulation S-K; Interpretation: Commission Guidance Regarding Management's Discussion and Analysis of Financial Condition and Results of Operations. Release Nos. 33-8350; 34-48960 (December 29, 2003).
9) While not mentioned in the Adopting Release, the Proposing Release (at 46, 47), listed the following as potential examples of “human capital resources”: worker recruitment, employment practices and hiring practices; employee benefits and grievance mechanisms; employee engagement or investment in employee training; workplace health and safety; strategies and goals related to human capital management and legal or regulatory proceedings related to employee management; whether employees are covered by collective bargaining agreements; and employee compensation or incentive structures.
10) Adopting Release, at 46-47, 52-54.
11) Adopting Release, at 107 n. 11.
12) Adopting Release, at 72-73. “Material” is defined similarly in Rule 405 of the Securities Act of 1933 and Rule 12b-2 of the Securities Exchange Act of 1934.
13) Adopting Release, at 75, 78.
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