Risk Factor Disclosures For Reporting Public Companies 

by Laura Anthony, Esq. on November 18, 2014 in Regulation S-K, Risk Factors, Safe Harbors, Uncategorized

 A risk factor disclosure involves a discussion of circumstances, trends, or issues that may affect a company’s business, prospects, operating results, or financial condition.  Risk factors must be disclosed in registration statements under the Securities Act and registration statements and reports under the Exchange Act.  In addition, risk factors must be included in private offering documents where the exemption relied upon requires the delivery of a disclosure document, and is highly recommended even when such disclosure is not statutorily required.

The Importance of Risk Factors

Risk factors are one of the most often commented on sections of a registration statement.  The careful crafting of pertinent risk factors can provide leeway for more robust discussion on business plans and future operations, and can satisfy a wide arrange of SEC concerns regarding existing financial and non-financial matters (such as potential default provisions in debt, dilution matters, inadvertent rule violations, etc.).

Although smaller reporting companies are not required to include risk factors in their annual Form 10-K and quarterly Form 10-Q, they may do so voluntarily and we recommend that such risk factors be included in their annual Form 10-K.  As a reminder, a “smaller reporting company” is an issuer that is not an investment company or asset-backed issuer or majority-owned subsidiary and that (i) had a public float of less than $75 million as of the last business day of its most recently completed second fiscal quarter; or (ii) in the case of an initial registration statement, had a public float of less than $75 million as of a date within days of the filing of the registration statement; or (iii) in the case of an issuer whose public float as calculated by (i) or (ii) is zero, had annual revenues of less than $75 million during the most recently completed fiscal year for which audited financial statements are available.

Risk factors, together with safe harbor language regarding forward-looking statements, can provide protection for forward-looking information contained in a document, such as plans and expectations,  that do not pan out as expected or intended.  Risk factors warn current and potential investors as to the risks of either purchasing or continuing to own the company’s stock.   As the securities of smaller reporting companies are often high-risk penny stocks or thinly traded, and such companies tend to be in the business development and growth stage of their corporate life cycle, protections against failed or changed plans is fundamental.

By providing proper disclosure of the material risks associated with investing in a company’s securities, a company can mitigate the risk of liability to its shareholders should that risk come to pass.  Risk factors act as an insurance policy and strong defense in the face of shareholder litigation.

The “bespeaks caution” doctrine refers to a line of judicial case law holding that statements of future forecasts, projections and expectations in an offering or other disclosure document are not misleading as long as they contain adequate cautionary language disclosing specific risks.  Section 21E of the Exchange Act, enacted as part of the Private Securities Litigation Reform Act of 1995, codifies this doctrine for qualifying issuers.  Section 21E provides a public company with a safe harbor defense in securities litigation challenging forward-looking statements.  Among other exclusions, companies that issue penny stocks may not rely on Section 21E, but may rely on the “bespeaks caution” line of case law. 

To avail itself of the safe harbor protection, the forward-looking statements must be identified and be accompanied by meaningful, cautionary language that identifies important factors that could cause actual results to differ materially from those projected—i.e., risk factors.   To provide protection, the risk disclosure must be specific, not just boilerplate.

SEC Rules and Guidance on Risk Factors

Regulation S-K sets forth the non-financial statement disclosure requirements for both the Securities Act of 1933 (“Securities Act”) and the Securities Exchange Act of 1934 (“Exchange Act”) and is applicable to both registration statements and ongoing reporting requirements.  In addition, Regulation S-K serves as a guide in the preparation of private placement disclosure documents.  Items 501 and 503 of Regulation S-K include the requirements for the disclosure of risk factors. 

Risk factors must be disclosed in registration statements under the Securities Act and registration statements and reports under the Exchange Act.  Item 503 of Regulation S-K requires concise, logically organized statements of the particular risks involving either the company, industry or the offering being made by the company.  The statements should be categorized and appear in order of importance under each category. Item 503 requires that the disclosure of risk factors in a registration statement be included in the beginning immediately following the summary section, or if there is no summary section, immediately following the cover page. 

Item 501 requires that the risk factor section must be prominently cross-referenced by page number, on the cover page of a registration statement.  Most companies comply with this rule by using bold, italics, larger font size or a combination thereof to comply with this rule.

Risk factor disclosures cannot contain countervailing or offsetting language.  That is, a company cannot explain away the risk.

Like many areas of securities laws, the SEC gives broad guidance on disclosure, trying to avoid boilerplate language.  The SEC requires the reporting company to make relevant risk factor disclosures that are germane, concise and written in plain English.  The risk factors should be written as of the date of the report in which they are contained regardless of the period of the financial statements contained in such report.  Each risk must have a heading that adequately describes the risk being disclosed and such heading should be bolded, italicized or both.  Each risk must be concise and focused on a single material risk.  The risks must be easy to read and written in such a way to highlight the most important information. 

As mentioned above, the SEC requires that the risks be written in plain English.  This requirement is codified in Rule 421(d) of Regulation C.  Over the years, the SEC has published and updated plain English handbooks.  The SEC plain English guidelines require that the risk factor section contain (i) short sentences; (ii) definitive, concrete, everyday words; (iii) active voice; (iv) tables or bullet point lists, whenever possible; (v) no legal jargon or highly technical business terms; and (vi) no multiple negatives.

Categories of Risk Factors

In general, risk factors pertain to the company, the industry, or the investment or offering.  Company risks are those specific to the reporting company such as particular restrictive covenant documents, reliance or dependence on a concentrated source, or a history of losses.  Industry risks are particular to the industry of the reporting company, such as technology, manufacturing, textile, or commonly in today’s market, cannabis.  Investment or offering risks are those specifically tied to the security or trading market for the company’s securities, such as illiquidity.  The risks included in each category should be organized in the order of materiality and importance.

The common broad areas of risk factor disclosure include:

    • Absence of an operating history;
    • Absence of revenues;
    • Absence of profits;
    • An accumulated deficit;
    • High degree of leverage (debt);
    • Dependence on a single or small number of products, suppliers, customers, manufacturers or markets;
    • Dependence on key personnel;
    • Dependence on particular financial resources or source of capital;
    • Early stage of product development;
    • Competition;
    • Adequacy of production and/or distribution;
    • Technological factors such as possible obsolescence;
    • Capital needs and the lack of adequate current or future funding;
    • A concentration of voting control in management or others;
    • The absence of a trading market or a thinly traded, low-priced market;
    • Litigation;
    • Governmental regulations;
    • Foreign operations and the effects of foreign regulations, export laws, and currency fluctuations;
    • Labor matters;
    • Intellectual property matters;
    • Restrictive covenants in contracts; and
    • Off-balance sheet arrangements

Risks that apply to any issuer or any offering should be avoided.  For example, a general statement that an economic downturn would negatively impact a business should not be included; however, a concise statement that a particular economic change, such as a reduction or increase in the federal interest rate (or whatever change impacts the reporting business), and the particular risk associated with that change, could be included.  Specific example are encouraged.

Typical SEC Comments on Risk Factors

Risk factors are one of the most often commented on sections of a registration statement or SEC report.  These common SEC comments illustrate the SEC’s focus in reviewing risk factor disclosures.

    • We suggest that you revise your risk factor captions to make your disclosure more meaningful to your investors and shareholders.  Some of your risk factors merely state a fact about your business. You should succinctly state in your captions the particular risk that results from the uncertainty.
    • Some of your risk factors are too vague and generic and do not adequately describe the risk that follows.  Readers should be able to read the risk factor heading and come away with a strong understanding of what the risk is and the result of the risk as it specifically applies to you.  Revise your subheadings accordingly.
    • In each risk factor, get to the risk as quickly as possible and provide only enough detail to place the risk in context.  In some of your risk factors, the actual risk you are trying to convey does not stand out from the rest of the information.
    • Avoid presenting risks that could apply to any issuer in your industry, do not reflect your current operations, are not material, or are generic, boilerplate disclosures.  Rather, tailor each risk factor to your specific facts and circumstances.
    • Revise each risk to remove mitigating information.
    • Consider including a risk factor that addresses XYZ.
    • Provide the information investors need to assess the magnitude of the risk.
    • Where possible, quantify the risk.
    • The introductory paragraph to your risk factors section is not complete, there may be risks that you do not consider material now but may become material, or there may be risks that you have not yet identified.  You must disclose all risks that you believe are material at this time.
    • You include more than one risk under one subheading.  Revise to include only one risk under each subheading.

As always, competent legal counsel should be utilized in crafting SEC reports and/or offering disclosure documents.

Click Here to Print Risk Factor Disclosures For Reporting Public Companies – L&C Risk Factor Disclosures For Reporting Public Companies

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com

Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded issuers as well as private companies going public on the NASDAQ, NYSE MKT or over-the-counter market, such as the OTCQB and OTCQX. For nearly two decades Legal & Compliance, LLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions as well as registration statements on Forms S-1, S-8 and S-4; compliance with the reporting requirements of the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; Regulation A/A+ offerings; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers, ; applications to and compliance with the corporate governance requirements of securities exchanges including NASDAQ and NYSE MKT; crowdfunding; corporate; and general contract and business transactions. Moreover, Ms. Anthony and her firm represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. Ms. Anthony’s legal team prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the OTC Market’s top source for industry news, and the producer and host of LawCast.com, the securities law network. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Las Vegas, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.

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