Continuing its disclosure effectiveness initiative, on January 30, 2020, the SEC proposed amendments to Management’s Discussion & Analysis of Financial Conditions and Operations (MD&A) required by Item 303 of Regulation S-K. In addition, to eliminate duplicative disclosures, the SEC also proposed to eliminate Item 301 – Selected Financial Data and Item 302 – Supplementary Financial Information. Like all recent disclosure effectiveness rule amendments and proposals, the rule changes are meant to modernize and take a more principles based approach to disclosure requirements. In addition, the proposed rule changes are intended to reduce repetition and disclosure of information that is not material.
On the same day the SEC issued an Interpretive Release on MD&A. A week earlier the SEC issued three new compliance and disclosure interpretations on the subject.
Among the proposed changes, the new rule would add a new Item 303(a) to state the principal objectives of MD&A, replace the specific requirement to disclose off-balance-sheet arrangements with a directive to disclose the arrangements in the broader context of the MD&A discussion, eliminate the need for a tabular disclosure of contractual obligations as the information is already in the financial statements, add a requirement to discuss critical accounting estimates and add the flexibility to choose whether to compare the same quarter from the prior year, or the immediately preceding quarter. On the same day as the proposed rule release, the SEC issued guidance on the disclosure of key performance metrics in MD&A.
SEC Chairs Jay Clayton and Commissioners Allison Herren Lee and Hester Peirce issued statements on the changes. Allison Herren Lee again expressed her disappointment that the SEC is not requiring additional environment- and climate-related disclosures. Chair Clayton touched on the subject, noting that the issues are complex, changing and multi-national and investor and company capital allocation decisions that are influenced by climate and environmental factors are forward-looking and likewise complex. Furthermore, disclosure requirements are generally historical in nature with limited forward-looking statement requirements, for the obvious reason that the future is impossible to predict. With that said, all companies are required to disclose material risks, expenditures and factors that affect their business, including climate change and environmental issues where relevant.
Climate and environmental disclosures are an evolving topic. The SEC continues to review and study the issue but is hesitant to spend other people’s money on matters that are personal and social, as opposed to clear material business metrics. It is this exact concern Commissioner Hester Peirce spoke about in her statement noting, “[T]hanks in part to an elite crowd pledging loudly to spend virtuously other people’s money, the concept of materiality is at risk of degradation.” With that said, Commissioner Peirce supports the proposed rule changes as written, and is pleased they do not go further into environmental, social and governance (ESG) matters. For more on ESG in general, see HERE.
Proposed New Rules
The proposed new rules would completely eliminate Item 301 – Selected Financial Data; Item 302 – Supplementary Financial Information; and Item 303(a)(5) requiring tabular disclosure of contractual obligations. The proposed rules will also (i) add a new Item 303(a) to state the principal objectives of MD&A; (ii) update capital resource disclosures to require disclosure of material cash requirements including commitments for capital expenditures as of the latest fiscal period, the anticipated source of funds needed to satisfy cash requirements and the general purpose of such requirements; (iii) update the results of operations disclosure to require disclosure of known events that are reasonably likely to cause a material change in the relationship between costs and revenues; (iv) update the results of operations disclosure to require a discussion of the reasons underlying material changes in net sales or revenues; (v) replace the specific requirement to disclose off-balance-sheet arrangements with a directive to disclose the arrangements in the broader context of the MD&A discussion, (vi) add a requirement to discuss critical accounting estimates, and (vii) add the flexibility to choose whether to compare the same quarter from the prior year, or the immediately preceding quarter.
The proposed new rules also apply to foreign private issuers (FPIs). Finally, the proposed amendments would make numerous cross-reference clean-up amendments including to various registration statement forms under the Securities Act and periodic reports and proxy statements under the Exchange Act.
Elimination of Item 301 – Selected Financial Data
Item 301 generally requires a company to provide selected financial data in a comparative tabular form for the last five years. Smaller reporting companies (SRCs) are not required to provide this information and emerging growth companies (EGCs) that are not also SRCs are not required to provide information for any period prior to the earliest audited financial statements in the company’s initial registration statement.
When Item 301 was developed, prior financial information was not available on EDGAR and financial statements were not tagged with XBRL. Also, the purpose behind Item 301 is to illustrate trends but Item 303 requires a discussion of material trends. Accordingly, Item 301 is not useful and the SEC proposed to eliminate it.
Elimination of Item 302 – Supplementary Financial Information
Item 302 requires selected disclosures of quarterly results and variances in operating results. SRCs and FPIs are not required to provide the information (note FPIs are not required to report quarterly results or file quarterly reports at all). Also, Item 302 only applies to companies that are registered under the Exchange Act and accordingly does not apply to voluntary or Section 15(d) reporting companies (for more on voluntary and Section 15(d) reporting, see HERE).
In addition to the same reasons for eliminating Item 301, including duplication, the SEC has been considering the costs and benefits of requiring quarterly financial information at all.
Elimination of Item 303(a)(5) – Contractual Obligations Table
Under Item 303(a)(5) companies, other than SRCs, must disclose known contractual obligations in tabular format. There is no materiality threshold for the disclosure. The SEC proposes to eliminate the table consistent with its objective of promoting a principals based MD&A disclosure and to streamline disclosures and reduce redundancy.
Item 303 – Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A)
Currently MD&A is broken down into 4 parts. Item 303(a) requires full-year disclosures on liquidity, capital resources, results of operations, off-balance-sheet arrangements, and contractual obligations. Item 303(b) covers interim periods and requires a disclosure of any material changes to the Item 303(a) information. Item 303(c) acknowledges the application of a statutory safe harbor for forward-looking information provided in off-balance-sheet arrangements and contractual obligations disclosures. Item 303(d) provides scaled back disclosure accommodations for SRCs. The proposed rules would substantially change this structure.
The new Item 303 will (i) add a new Item 303(a) to state the principal objectives of MD&A including as to full fiscal years and interim periods; (ii) eliminate unnecessary cross-references, clarify and remove outdated and duplicative language; (iii) update capital resource disclosures to require disclosure of material cash requirements including commitments for capital expenditures as of the latest fiscal period, the anticipated source of funds needed to satisfy cash requirements and the general purpose of such requirements; (iv) update the results of operations disclosure to require disclosure of known events that are reasonably likely to cause a material change in the relationship between costs and revenues; (v) update the results of operations disclosure to require a discussion of the reasons underlying material changes in nets sales or revenues; (vi) eliminate the requirement to discuss the impact of inflation; (vii) replace the specific requirement to disclose off balance sheet arrangements with a directive to disclose the arrangements in the broader context of the MD&A discussion, (viii) add a requirement to discuss critical accounting estimates, and (ix) add the flexibility to choose whether to compare the same quarter from the prior year, or the immediately preceding quarter.
The proposed new Item 303(a) instruction paragraph will be revised to set forth the principal objectives of MD&A. The instructions will codify guidance that requires a narrative explanation of financial statements to allow a reader to see a company “through the eyes of management.” Also, the instructions will emphasize providing disclosure on:
(i) Material information relevant to an assessment of the financial condition and results of operations of the company, including an evaluation of the amounts and certainty of cash flows from operations and outside sources;
(ii) The material financial and statistical data that the company believes will enhance a reader’s understanding of its financial condition, changes in financial condition and results of operations; and
(iii) Material events and uncertainties known to management that would cause reported financial information not to be necessarily indicative of future operating results or of future financial condition, including descriptions and amounts of matters that (a) would have a material impact on future operations and have not had an impact in the past and (b) have had a material impact on reported operations and are not expected to have an impact on future operations.
On January 30, 2020, the SEC issued an interpretive release providing guidance on key performance indicators and metrics in MD&A. Current Item 303(a) requires disclosure of information not specifically referenced in the item that the company believes is necessary to an understanding of its financial condition, changes in financial condition and results of operations. The item also requires discussion and analysis of other statistical data that, in the company’s judgment, enhances a reader’s understanding of MD&A.
Keeping in line with the SEC’s efforts to streamline disclosures to those that are specifically material to each company, the SEC has stated that companies should identify and address those key variables and other qualitative and quantitative factors that are peculiar to and necessary for an understanding and evaluation of the individual company. The interpretive guidance reminds companies to consider whether the information they are disclosing is GAAP or non-GAAP (and thus requires compliance with Regulation G or Item 10 of Regulation S-K – see HERE).
In addition, the company should consider what additional information may be necessary to provide adequate context for an investor to understand the metric presented. The SEC expects that the following information will be provided regarding a metric: (i) a clear definition of the metric and how it was calculated; (ii) a statement indicating the reasons why the metric provides useful information to investors; and (iii) a statement indicating how management uses the metric in managing or monitoring the business. Changes in the method of calculating the metric from one year to another must also be disclosed including the reasons for and impact of the change.
On January 24, 2020, the SEC issued three new C&DI on MD&A disclosures. The new C&DI clarifies the ability to incorporate prior financial years’ MD&A by reference from a previous SEC filing. In particular, the instructions to Item 303 allow a company to incorporate an MD&A discussion from a prior report for financial statements that are more than two years old. The C&DI clarifies that to properly incorporate by reference specific language must be provided together with a hyperlink to the incorporated information. For more on incorporation by reference, see HERE.
Furthermore, if incorporation by reference is not used for discussion of a third year of financial statements, the company must assess whether the discussion is relevant and necessary for a proper disclosure of its financial condition. No discussion can be omitted that is material to an understanding of results of operations.
The third new C&DI illustrates how incorporation by reference can be used in a Section 10(a)(3) prospectus update to a registration statement that allows forward incorporation by reference. In particular, if a year of MD&A is omitted from a Form 10-K, that year will not be deemed included in the updated registration statement unless it is specifically incorporated by reference from a prior year’s filing.
Further Background on SEC Disclosure Effectiveness Initiative
I have been keeping an ongoing summary of the SEC ongoing Disclosure Effectiveness Initiative. The following is a recap of such initiative and proposed and actual changes. I have scaled down this recap from prior versions to focus on the most material items.
On August 8, 2019, the SEC proposed changes to disclosures related to business descriptions, legal proceedings and risk factors under Regulation S-K. See my blog HERE.
In May 2019 the SEC proposed amendments to the financial statements and other disclosure requirements related to the acquisitions and dispositions of businesses. See my blog HERE on the proposed amendments. This was a follow-on to the September 2015 request for public comment related to disclosure requirements for entities other than the reporting company itself, including subsidiaries, acquired businesses, issuers of guaranteed securities and affiliates listed further below.
On March 20, 2019, the SEC adopted amendments to modernize and simplify disclosure requirements for public companies, investment advisers, and investment companies. The amendments: (i) revise forms to update, streamline and improve disclosures including eliminating risk-factor examples in form instructions and revising the description of property requirement to emphasize a materiality threshold; (ii) eliminate certain requirements for undertakings in registration statements; (iii) amend exhibit filing requirements and related confidential treatment requests; (iv) amend Management Discussion and Analysis requirements to allow for more flexibility in discussing historical periods; and (v) incorporate more technology in filings through data tagging of items and hyperlinks. See HERE. Some of the amendments had initially been discussed in an August 2016 request for comment – see HERE, and the proposed rule changes were published in October 2017 – see HERE illustrating how lengthy rule change processes can be.
In December 2018 the SEC approved final rules to require companies to disclose practices or policies regarding the ability of employees or directors to engage in certain hedging transactions, in proxy and information statements for the election of directors. To review my blog on the final rules, see HERE and on the proposed rules, see HERE.
In the fourth quarter of 2018, the SEC finalized amendments to the disclosure requirements for mining companies under the Securities Act and the Securities Exchange. The proposed rule amendments were originally published in June 2016. In addition to providing better information to investors about a company’s mining properties, the amendments are intended to more closely align the SEC rules with current industry and global regulatory practices and standards as set out in by the Committee for Reserves International Reporting Standards (CRIRSCO). In addition, the amendments rescinded Industry Guide 7 and consolidated the disclosure requirements for registrants with material mining operations in a new subpart of Regulation S-K. See HERE.
On June 28, 2018, the SEC adopted amendments to the definition of a “smaller reporting company” as contained in Securities Act Rule 405, Exchange Act Rule 12b-2 and Item 10(f) of Regulation S-K. See HERE and later issued updated C&DI on the new rules – see HERE. The initial proposed amendments were published on June 27, 2016 (see HERE).
On March 1, 2017, the SEC passed final rule amendments to Item 601 of Regulation S-K to require hyperlinks to exhibits in filings made with the SEC. The amendments require any company filing registration statements or reports with the SEC to include a hyperlink to all exhibits listed on the exhibit list. In addition, because ASCII cannot support hyperlinks, the amendment also requires that all exhibits be filed in HTML format. The new Rule went into effect on September 1, 2017 for most companies and on September 1, 2018 for smaller reporting companies and non-accelerated filers. See my blog HERE on the Item 601 rule changes and HERE related to SEC guidance on same.
On July 13, 2016, the SEC issued a proposed rule change on Regulation S-K and Regulation S-X to amend disclosures that are redundant, duplicative, overlapping, outdated or superseded (S-K and S-X Amendments). See my blog on the proposed rule change HERE. Final amendments were approved on August 17, 2018 – see HERE.
The July 2016 proposed rule change and request for comments followed the concept release and request for public comment on sweeping changes to certain business and financial disclosure requirements issued on April 15, 2016. See my two-part blog on the S-K Concept Release HERE and HERE.
In September 2015, the SEC issued a request for public comment related to disclosure requirements for entities other than the reporting company itself, including subsidiaries, acquired businesses, issuers of guaranteed securities and affiliates. See my blog HERE. Taking into account responses to portions of that request for comment, in the summer of 2018, the SEC adopted final rules to simplify the disclosure requirements applicable to registered debt offerings for guarantors and issuers of guaranteed securities, and for affiliates whose securities collateralize a company’s securities. See my blog HERE.
In early December 2015, the FAST Act was passed into law. The FAST Act required the SEC to adopt or amend rules to: (i) allow issuers to include a summary page to Form 10-K; and (ii) scale or eliminate duplicative, antiquated or unnecessary requirements for emerging growth companies, accelerated filers, smaller reporting companies and other smaller issuers in Regulation S-K. See my blog HERE.