SEC Adopts Amendments To Business Descriptions, Risk Factors And Legal Proceedings
Just eight months following the rule proposal (see HERE), on August 26, 2020, the SEC adopted final amendments to Item 101 – description of business, Item 103 – legal proceedings, and Item 105 – Risk Factors of Regulation S-K. The amendments make a more principles-based approach to business descriptions and risk factors, recognizing the significant changes in business models since the rule was adopted 30 years ago. The amendments to disclosures related to legal proceedings continue the current prescriptive approach. In addition, the rule changes are intended to improve the readability of disclosure documents, as well as discourage repetition and disclosure of information that is not material.
The Item 101 and Item 103 amendments only apply to domestic companies and foreign private issuer that elect to file using domestic company forms. The forms generally used by foreign private issuers (F-1, F-3, 20-F, etc.) do not have references to Items 101 and 103 of Regulation S-K but rather refer to specific disclosure provisions in Form 20-F. However, the Item 105 (Risk Factor) amendments will apply across the board to both domestic and foreign issuers as the foreign issuer forms specifically refer to that section of Regulation S-K.
The effective date of the new rules is November 9, 2020 and as such, compliance with the new rules will need to be included in any filings made after 5:30 EST on Friday, November 6.
Item 101 – Description of Business
Item 101(a) of Regulation S-K requires a description of the general development of the business of the company during the past five years (or three years for smaller reporting companies) and lists five specific categories of information to include in the disclosure, including, for example, the year the company was formed and a description of any acquisitions or dispositions of businesses.
The SEC has amended Item 101(a) related to a company’s description of its business, to:
(i) Make it largely principles-based by providing a non-exclusive list of the types of information that could be disclosed and only requiring that disclosure to the extent it is material to an understanding of the general development of the business. The non-exclusive list includes: (a) material bankruptcy, receivership or similar proceeding; (b) nature and effects of any material reclassifications, merger or consolidation; (c) the acquisition or disposition of any material amount of assets otherwise than in the ordinary course of business; and (d) material changes to a company’s previously disclosed business strategy (note the proposed rule was more expansive on this topic but was determined to be repetitive to MD&A disclosures);
(ii) Eliminate a prescribed time frame for the disclosure. The SEC would rather require companies to focus on the information material to an understanding of the development of their business, irrespective of a specific time frame; and
(iii) Permit a company, in filings made after a its initial filing, to provide only an update of the general development of the business that focuses on material developments in the reporting period. A company must incorporate the previous discussion by reference and can only incorporate from a single previously filed document.
Item 101(c) of Regulation S-K requires a narrative description of the business done and intended to be done by the company, focusing on the segments that are reported in the company’s financial statements. Item 101(c) currently includes a list of 12 topics to cover. Like Item 101(a), the amendments make the rule largely principles-based and encourage a company to exercise judgment in evaluating what disclosure to provide. Only material information need be provided. The rule also provides a list of topics for a company to consider, and maintains the focus on providing company segment information.
The new list of topics include: (i) revenue generating activities, products or services, and any dependence on key products, services, product families, or customers, including governmental customers; (ii) status of development efforts for new or enhanced products, trends in market demand and competitive conditions; (iii) resources material to a company’s business, including raw materials; (iv) the duration and effect of all patents, trademarks, licenses, franchises, and concessions held; (v) a description of any material portion of the business that may be subject to renegotiation of profits or termination of contracts or subcontracts at the election of the government; (vi) the extent to which the business is or may be seasonal; (vii) compliance with material government regulations, including environmental regulations (the prior list only included environmental regulations) to the extent they impact capital expenditures, earnings and competitive position; and (viii) human capital disclosure.
The human capital category is completely new and would include any material human capital measures or objectives that management focuses on in managing the business, and the attraction, development and retention of personnel (such as in a gig economy). The final rule includes non-exclusive examples of subjects that may be material, depending on the nature of the registrant’s business and workforce. The SEC declined to define “human capital” allowing a company to tailor the concept to its circumstances and objectives.
The human capital category is a win for advocates of environmental, social and governance (ESG) disclosures which have advocated for increased rule requirements related to these disclosure topics. For more on ESG, see HERE). It is unlikely we will see more than minor incremental increases in ESG disclosures beyond human capital under the current SEC regime. 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.
Item 103 – Legal Proceedings
requires disclosure of any material pending legal proceedings, other than ordinary routine litigation incidental to the business, to which the company or any of its subsidiaries is a party or of which any of their property is the subject. Item 103 also requires disclosure of the name of the court or agency in which the proceedings are pending, the date instituted, the principal parties thereto, and a description of the factual basis alleged to underlie the proceeding and the relief sought.
The SEC has amended Item 103 to: (i) expressly state that the required information about material legal proceedings may be provided by including hyperlinks or cross-references to legal proceedings disclosure located elsewhere in the document in an effort to encourage companies to avoid duplicative disclosure; and (ii) revise the $100,000 threshold for disclosure of environmental proceedings to which the government is a party to either $300,000 or a threshold determined by the company as material but in no event greater than the lesser of $1 million or 1% of the current assets of the company.
Item 105 – Risk Factors
Item 105 of Regulation S-K requires disclosure of the most significant factors that make an investment in the company or offering speculative or risky and specifies that the discussion should be concise and organized logically. The disclosure of risk factors has always been principles-based with the SEC consistently discouraging the use of boilerplate items. However, despite this guidance, most companies include a lengthy laundry list of boilerplate risks.
The SEC has amended Item 105 to: (i) require summary risk factor disclosure of no more than two pages if the risk factor section exceeds 15 pages; (ii) refine the principles-based approach of that rule by changing the disclosure standard from the “most significant” factors to the “material” factors required to be disclosed; and (iii) require risk factors to be organized under relevant headings, 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 caption.
A company rarely requires more than 15 pages of risk factors, and as such, the new rule should be a good lesson in brevity and pointedness.
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.
As discussed in this blog, on August 26, 2020, the SEC adopted final amendments to Item 101 – description of business, Item 103 – legal proceedings, and Item 105 – Risk Factors of Regulation S-K.
In May 2020, the SEC adopted 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. My blog on the final amendments will be published after this blog.
In March 2020, the SEC adopted amendments to the definitions of an “accelerated filer” and “large accelerated filer” to enlarge the number of smaller reporting companies that can be exempt from those definitions and therefore not required to comply with SOX Rule 404(b) requiring auditor attestation of management’s assessment on internal controls. See HERE.
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. See HERE.
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 HERE 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. In March 2020, 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.