SEC APPROVES FINAL AMENDMENTS MODERNIZING DISCLOSURE REQUIREMENTS OF REGULATION S-K

On August 26, 2020, the U.S. Securities and Exchange Commission (SEC) adopted amendments to modernize certain specific disclosure requirements applicable to public companies.^[1] The amendments address the following disclosures required by Regulation S-K:

• description of business (Item 101);
• legal proceedings (Item 103); and
• risk factor disclosure (Item 105).

The key changes include two new specific requirements: (1) a summary of risk factors where the risk factor section itself is longer than 15 pages; and (2) a description of the company’s human capital resources, measures and objectives.

The amendments are designed to provide companies with more flexibility in describing their business, legal proceedings and risk factors by shifting to principles-based disclosure. This allows companies to focus on describing material aspects of their particular business while avoiding prescriptive disclosure topics not meant for investors.

The amendments are part of a series of SEC rulemakings aimed at modernizing the disclosure regime for public companies by eliminating or updating disclosure requirements that have been long considered outdated and through formally adopting best practices and existing SEC interpretative guidance. See “Another Wave of Disclosure Simplification Rules Adopted by the SEC,” “SEC Disclosure Simplification Continues,” “SEC Adopts New Financial Statement Disclosure Requirements For Acquisitions and Dispositions” and “SEC Eliminates Consolidating Financial Information for SEC Registered Debt Securities.”

General Development of the Business (Item 101(a) of Regulation S-K)

Item 101(a) required a description of the general development of the business of the company, including certain specific disclosures for a five-year period or such shorter period as the company has been in business.

As amended, Item 101(a):

• replaces the five-year timeframe related to the development of the business with a materiality framework that allows a company to focus on those aspects of the development of its business that are material to investors (and Item 101(h) eliminates a three-year look back for smaller reporting companies);
• provides a non-exclusive list of topics that a company may address, if material, in describing the development of its business, which are (1) prior bankruptcy proceedings; (2) the impact of a merger on the development of the company; (3) the acquisition or sale of assets; and (4) changes to a company’s previously disclosed business strategy; and
• permits a company, in filings made after a company’s initial filing, to provide an update of the general development of the business rather than repeating the full prior discussion, which will be permitted to be incorporated by reference through a hyperlink to a single prior filing.

Narrative Description of Business (Item 101(c) of Regulation S-K)

Item 101(c) required a narrative description of the business of the company, focusing on its primary or dominant business segment or each reportable segment presented in the financial statements. Item 101(c) outlined 12 topics to be covered, to the extent material, in the description of the company’s business including disclosure of principal products and services, raw materials, intellectual property, seasonality and customers and competition, among others. In the adopting release, the SEC noted that many companies had considered these items as mandatory disclosure requirements.

As amended, Item 101(c):

• eliminates the 12 specific items and replaces it with a principles-based approach providing a non-exclusive list of disclosure topics drawn in part from what had previously been delineated in Item 101(c) such as revenue-generating activities, the status of development efforts for new or enhanced products, trends in market demand, competition, material resources, duration of intellectual property, material portions of the business subject to renegotiation at the election of the government, seasonality and regulations;
• requires a description of the company’s human capital, including any human capital measures or objectives that the company focuses on in managing the business (replacing the current requirement to disclose the number of employees); and
• expands the disclosure requirement of the impact of regulatory compliance on capital expenditures, earnings and competitive position to include material government regulations, not just environmental laws.

The final amendments do not define human capital resources and provide little guidance as to what such term means. They do provide examples of human capital measures and objectives that could be addressed including, but not limited to, attraction, development and retention of personnel, with the ultimate disclosure based on the nature of the company’s business and workforce.

Legal Proceedings (Item 103 of Regulation S-K)

Item 103 required detailed disclosure of any material pending legal proceedings and proceedings known to be contemplated by governmental authorities. This disclosure is based on a specified dollar amount (over $100,000 in potential monetary sanctions) for proceedings related to federal, state or local environmental protection laws.

As amended, Item 103:

• allows disclosure of required information in the “Business” section by hyperlink or cross-reference to other legal proceedings disclosure, such as the notes to the financial statements; and
• modifies the disclosure threshold for governmental environmental proceedings by increasing the existing quantitative threshold to $300,000, but affords a company with the flexibility to elect to apply 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 1% of the company’s current assets.

Risk Factors (Item 105 of Regulation S-K)

Item 105 required disclosure of the most significant factors that make an investment in the company or offering speculative, specifying that the discussion should be concise, organized logically and furnished in plain English. Companies were directed to explain how each risk affects it or the securities being offered.

As amended, Item 105:

• requires summary risk factor disclosure of no more than two pages if the risk factor section exceeds 15 pages, which is required to be in concise, bulleted or numbered statements summarizing the principal factors that make an investment in the company or offering speculative or risky;
• refines the principles-based approach by requiring disclosure of “material” risk factors over the previous standard of “most significant;” and
• requires companies to organize risk factors under relevant headings (in addition to the subcaptions currently mandated), with any risk factors that may generally apply to an investment in securities disclosed at the end of the risk factor section under a separate heading.

The SEC noted in the adopting release that “although [current] Item 105 instructs registrants not to present risks that could apply generically to any registrant, and despite longstanding Commission and staff guidance stating that risk factors should be focused on the ‘most significant’ risks and should not be boilerplate, it is not uncommon for companies to include generic risks.”

Foreign Private Issuers

The final amendments to Items 101 and 103 affect only domestic companies and “foreign private issuers” that have elected to file on domestic forms. Regulation S-K does not apply to foreign private issuers unless a form reserved for foreign private issuers specifically refers to Regulation S-K. Instead of Items 101 and 103 of Regulation S-K, the foreign private issuer forms refer to Part I, Item 4 and Item 8.A.7., respectively, of Form 20-F. In contrast, the amendment to risk factors will affect both domestic and foreign companies because Forms F-1, F-3 and F-4, like their domestic counterparts, all refer to Item 105.

Our Take

These amendments are not likely to cause significant changes to public company disclosure practices.

Risk Factors. Although designed as an incentive for companies to reduce risk factor disclosures, it is unlikely that companies are going to reduce the length of risk factor disclosures in an effort to not have to provide a summary risk factor section. For many large, complex companies, risk factor disclosures easily surpass 15-pages and many of these companies have already been practicing many of the risk factor principles recommended in the adopting release. It is unclear at this time what the SEC will expect to see as summary risk factor disclosure for companies that exceed the 15-page limit. In prospectuses for initial public offerings, the “Summary” section includes a subsection devoted to a summary discussion of risk factors. This subsection is often simply a bullet list of key risk factors prepared by lifting the headings (or subcaptions) of each of these risk factors included in the “Risk Factors” section of the prospectus. This may be all that is necessary to satisfy the new requirement.

Human Capital Disclosures. One amendment that could accelerate real change in disclosure is the requirement that companies describe, to the extent material, their human capital resources, measures and objectives. The perspective that broader workforce policies, practices and strategies beyond the executive ranks are material to shareholders has been an area of ongoing discussion. While some companies have been disclosing human capital matters in varying degrees in CSR reports and other publications, these disclosures have largely only been posted on the company’s website and used as part of shareholder engagement efforts. All companies, including those that have been providing human capital disclosures, will need to review their approach to such disclosures in light of the new requirement.

Each company should consider the specific areas identified by the SEC—recruitment, development and retention—as well as other areas not identified by the SEC, such as diversity, in light of its particular business and human capital risks and exposures. The discussion of what to report on should involve individuals focused on SEC disclosures, financial reporting and employee relations, which should then be reviewed by the executive team. As these disclosures are receiving increasing focus by investors and other stakeholders, individuals responsible for investor engagement and public relations should also be part of the discussion. Finally, a critically important consideration for companies is to evaluate whether adequate disclosure controls are in place to report on these new disclosures.

Effectiveness

The amendments will be effective 30 days after publication in the Federal Register.