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SEC Adopts Changes to Modernize Certain Disclosures Under Regulation S-K
On August 26, 2020, the Securities and Exchange Commission adopted amendments to modernize Regulation S-K's description of business, legal proceedings and risk factor disclosure requirements in documents registrants file with the SEC, including periodic reports and registration statements. Prior to the adoption of these amendments, these disclosure items had not undergone significant revisions in more than 30 years. In adopting the amendments, SEC Chairman Jay Clayton noted that the new rules "are rooted in materiality and seek to elicit information that will allow today's investors to make more informed investment decisions."
Some of the more notable disclosure changes include: making the description of business disclosure requirements more principles-based, permitting a hyperlink to cross-reference disclosure for legal proceedings included elsewhere, such as the financial statement footnotes, and requiring a summary of risk factors if the risk factors section exceeds 15 pages. In addition, disclosure in the Business section of applicable periodic reports and registration statements under Item 101(c) of Regulation S-K will now require, to the extent material to an understanding of the registrant's business taken as a whole, a description of a registrant's human capital resources, including any human capital measures or objectives that the registrant focuses on in managing the business.
The SEC's adopting release is available here. The amendments come one year after the SEC's proposed amendments in August 2019 (described in our previous client alert, available here) and are part of a comprehensive evaluation of the SEC's disclosure requirements that was recommended in the SEC staff's "Report on Review of Disclosure Requirements in Regulation S-K" mandated by the JOBS Act.
Below is a table briefly summarizing the final Regulation S-K amendments adopted by the SEC, which is immediately followed by a more detailed discussion of the amendments:
Regulation S-K Item
Impacted Registration Statements and Periodic Reports
Summary of Amendments
Item 101(a), Description of Business
Forms S-1, S-4, 10, 10-K
Eliminates the previously prescribed five-year disclosure timeframe for describing the general development of the registrant's business (three years for smaller reporting companies), and replaces it with a requirement to disclose information material to an understanding of the general development of the registrant's business without reference to a specified timeframe.
In filings made after a registrant's initial filing, permits registrants to provide an update of the general development of the business rather than a full discussion. If this approach is used, the registrant must provide a hyperlink to and incorporate by reference only one recent filing that, together with the discussion in the current filing, will contain a full discussion of the general development of its business.
Item 101(c), Description of Business
Clarifies the principles-based approach of Item 101(c)'s requirement to describe the registrant's business by replacing the disclosure topics previously required by Item 101(c) (if material to an understanding of the registrant's business taken as a whole) with a non-exhaustive list of disclosure topic examples (drawn, in large part, from the topics previously required by Item 101(c)).
Newly includes, as an additional disclosure topic (if material to an understanding of the registrant's business taken as a whole or a particular business segment), a description of the registrant's human capital resources.
Expands the previous requirement to disclose the material effects of environmental regulations to now include the material effects of all applicable government regulations.
Item 103, Legal Proceedings
Forms S-1, S-4, S-11, 10, 10-K, 10-Q
Expressly states that the required disclosure of material legal proceedings may be provided by hyperlink or a cross-reference to legal proceedings disclosure located elsewhere in the document (e.g., the financial statement footnotes).
Increases the disclosure threshold for the disclosure of environmental proceedings to which the government is a party from $100,000 to $300,000 (or such higher amount disclosed by the registrant not to exceed $1 million or 1% of consolidated assets).
Item 105, Risk Factors
Forms S-1, S-3, S-4, S-11, F-1, F-3, F-4, 10, 10-K
If the risk factor section exceeds 15 pages, requires a summary risk factor disclosure of no more than two pages. This summary must appear at the forefront of the applicable report or registration statement/prospectus.
Replaces the disclosure standard to require discussion of the "material" risks instead of the "most significant" risks.
Requires risk factors to be organized under relevant headings in addition to the subcaptions previously required, with any risk factors that may generally apply to any company or investment disclosed at the end of the risk factor section under a separate "General Risk Factors" heading.
Description of Business (Item 101 of Regulation S-K)
Item 101(a) of Regulation S-K previously required a registrant to describe the general development of its business during the past five years (three years for a smaller reporting company), and Item 101(c) required a registrant to provide a narrative description of its business based on specified topics if material to an understanding of the registrant's business as a whole. The disclosure timeframe and the business topics to be discussed were prescriptive in nature. In an effort to move to a more principles-based disclosure framework, the SEC, as part of its amendments, is encouraging registrants to exercise judgment in evaluating what disclosure to provide, which the SEC hopes will result in disclosures more appropriately tailored to a registrant's specific facts and circumstances.
General Development of Business (Item 101(a) of Regulation S-K)
Timeframe for Description of General Development of Business. The SEC's amendments eliminate the prescribed five-year timeframe (three years for smaller reporting companies) for providing the disclosure regarding the general development of a registrant's business. Registrants are now instructed to focus on information material to an understanding of the general development of their businesses, irrespective of a specific timeframe.
Subsequent SEC Filings. Disclosure of the general development of a registrant's business was previously required to be disclosed for the full five or three-year timeframe in all applicable registration statements and reports. The SEC's amendments preserve the disclosure requirement in initial registration statements under the Securities Act and Exchange Act. However, for subsequent filings, a registrant is permitted to disclose only material developments, if any, since the most recent full discussion of the general development of the registrant's business disclosed in a previously filed registration statement or report. For subsequent filings, a registrant choosing to provide only an update of the general development of its business must incorporate by reference, and include an active hyperlink to, the most recently filed SEC disclosure that, together with the update, would present a full discussion of the general development of the registrant's business. Significantly, a registrant is permitted to include only one hyperlink to limit the burden on investors caused by the discussion being located in multiple documents. If a registrant does not choose this approach, it must provide a complete discussion of its business development, including material updates, in which case a hyperlink will not be required.
Non-Exclusive List of Required Disclosure Items, Including Material Changes to Business Strategy. As part of its amendments, the SEC also amended Item 101(a)(1) to create a more principles-based framework for a registrant's business development disclosure by providing a non-exclusive list of the types of information that a registrant may need to disclose and to only require disclosure of a topic to the extent such information is material to an understanding of the general development of a registrant's business. As amended, Item 101(a)(1) includes the following non-exclusive disclosure topics:
material changes to a registrant's previously disclosed business strategy;
the nature and effects of any material bankruptcy, receivership, or any similar proceeding of the registrant or any of its significant subsidiaries;
the nature and effects of any material reclassification, merger or consolidation of the registrant or any of its significant subsidiaries; and
the acquisition or disposition of any material amount of assets otherwise than in ordinary course of business.
The last three topics were previously required and the first topic is new. With respect to the first topic, the SEC is not requiring that the registrant disclose its business strategy. However, to the extent a registrant has previously disclosed its business strategy, any material changes to such previously disclosed business strategy must be disclosed.
Additionally, as amended, Item 101(a)(1) no longer requires disclosure of the year the registrant was organized and the form of its organization, although such disclosure would continue to be required if material to an understanding of the general development of the registrant's business.
Impact of S-K 101(a) Amendments on Form 10-K Disclosures. Registrants will need to consider the interplay of amended Item 101(a) with the existing instruction in Part I, Item 1 of Form 10-K, which requires a discussion of the development of the registrant's business only since the beginning of the fiscal year for which the 10-K is filed. The SEC did not acknowledge the Form 10-K disclosure requirement, or its interplay with the new Item 101(a) amendments, in the proposing or adopting releases describing the Regulation S-K amendments, nor did the SEC amend the existing requirement in Part I, Item 1 of Form 10-K.
Narrative Description of Business (Item 101(c) of Regulation S-K)
Non-Exclusive Disclosure Topics. Item 101(c) requires a narrative description of the business done and intended to be done by the registrant and its subsidiaries, focusing upon the registrant's dominant segment or each reportable segment about which financial information is presented in the financial statements. Item 101(c) previously set forth 10 specific items required to be disclosed to the extent material to an understanding of the registrant's business taken as a whole, and two other items required to be disclosed with respect to the registrant's business in general. These items included, but were not limited to, principal products produced and services rendered, new products or segments, sources and availability of raw materials, seasonality of the business, working capital practices, backlog, dependence on certain customers, competitive conditions and the material effects of compliance with environmental laws.
The SEC is amending Item 101(c) to be more principles-based by replacing the list of specific disclosure items with a non-exclusive list of disclosure topic examples. Revised Item 101(c) no longer explicitly requires disclosure with respect to working capital practices, new segments, and dollar amounts of backlog orders believed to be firm. However, under the SEC's new principles-based approach, disclosure regarding these topics, and any other topics regarding the registrant's business, will still need to be provided if material to an understanding of the registrant's business. As amended, Item 101(c) now provides that when describing the business done and intended to be done by the registrant, disclosure may include, but should not be limited to, the following:
Revenue-generating activities, products and/or services, and any dependence on revenue-generating activities, key products, services, product families or customers, including governmental customers;
Status of development efforts for new or enhanced products, trends in market demand and competitive conditions;
Resources material to a registrant's business, such as:
Sources and availability of raw materials; and
The duration and effect of all patents, trademarks, licenses, franchises, and concessions held;
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; and
The extent to which the business is or may be seasonal.
Consistent with the prior rule, the disclosure topics above require disclosure that focuses on the registrant's dominant segment or each reportable segment. While the disclosure topics above generally mirror a subset of the items that were previously required to be disclosed under Item 101(c), one notable addition is the requirement in the second topic to describe "trends in market demand and competitive conditions." The SEC noted that it proposed this disclosure topic to elicit more granular information of the type previously required under Item 101(c) in response to comments received on the SEC's 2016 concept release. As part of that comment process, commenters had recommended more disclosure of a registrant's competitive position, especially the market share of its products and industry trends shaping the nature of competition.
Governmental Regulations. As amended, Item 101(c) now requires, to the extent material to an understanding of the registrant's business taken as a whole, disclosure about the material effects that compliance with government regulations, including environmental regulations, may have upon the capital expenditures, earnings and competitive position of the registrant and its subsidiaries, including the estimated capital expenditures for environmental control facilities for the current fiscal year and any other material subsequent period. Previously, Item 101(c) only required disclosure with respect to material environmental regulations instead of all material government regulations. In amending Item 101(c), the SEC considered and rejected a comment to define "environmental regulations" to include, among other things, regulations related to climate change.
In expanding the existing disclosure topic regarding environmental regulations to include the material effects of compliance with government regulations more generally, the SEC noted that it is already common practice for registrants to provide business section disclosures regarding government regulations that are material to their business. The SEC also noted that it believes disclosure of this information will provide important information to investors, but emphasized that the disclosure should discuss only those governmental regulations that are of particular importance and is not required to recite every regulation that affects the registrant's business.
Human Capital Resources. A notable new disclosure topic added to Item 101(c) as part of the SEC's amendments is a requirement to describe, to the extent material to an understanding of the registrant's business taken as a whole, the registrant's human capital resources, including the number of persons employed by the registrant, and any human capital measures or objectives that the registrant focuses on in managing the business (such as, depending on the nature of the registrant's business and workforce, measures or objectives that address the development, attraction and retention of personnel).
The new human capital resources disclosure topic is an effort to modernize the SEC's disclosure requirements after considering feedback from the SEC's 2016 concept release, as well as comments in response to a 2017 human capital rulemaking petition. Contrary to the SEC's August 2019 proposing release, the final rule adopted by the SEC retains the current requirement to disclose the number of persons employed by the registrant, provided this information is material to an understanding of the registrant's business taken as a whole. Also, while Item 101(c), as amended, identifies measures or objectives addressing the development, attraction and retention of personnel as subjects related to a registrant's human capital resources that may be material and warrant disclosure, the SEC emphasized that these are examples only of potentially relevant subjects, depending on the nature of the registrant's business and workforce, and are not disclosure mandates.
In its adopting release, the SEC recognized that the exact measures and objectives included in human capital management disclosure may evolve over time and may depend, and vary significantly, based on factors such as the industry, the various regions or jurisdictions in which the registrant operates, the general strategic posture of the registrant, including whether and the extent to which the registrant is vertically integrated, as well as the then-current macro-economic and other conditions that affect human capital resources, such as national or global health matters. In addition, in his public statement issued as part of the adoption of these amendments, Chairman Clayton also noted that disclosure of human capital metrics will vary widely from industry to industry and issuer to issuer, though he went on to state that he "expects to see meaningful qualitative and quantitative disclosure, including, as appropriate, disclosure of metrics that companies actually use in managing their affairs."
Legal Proceedings (Item 103 of Regulation S-K)
Item 103 of Regulation S-K requires applicable registration statements and reports to disclose any material pending legal proceedings, other than ordinary routine litigation incidental to the business, which the registrant or any of its subsidiaries is a party to or of which any of their property is subject.
To reduce duplicative disclosures appearing in the notes to a registrant's financial statements and other parts of its filings (i.e., risk factors and MD&A), the final rules adopted by the SEC amend Item 103 to expressly state that some or all of the required information may be provided by including hyperlinks or cross-references to legal proceedings disclosure located elsewhere in the document. The SEC noted in its adopting release that this amendment is intended to reduce duplicative disclosure that distracts investors from other important information.
In addition, Instruction 5.C of Item 103 previously included a $100,000 disclosure threshold for disclosing environmental proceedings in which the government is a party. This bright-line threshold had not been amended since it was originally adopted in 1982. As part of its amendments to Item 103, the SEC adopted a two-prong approach for disclosure of such proceedings that includes a minimum quantitative threshold, while also providing registrants with flexibility to apply a more tailored disclosure threshold within a range that has an upper limit of the lesser of $1 million or 1% of the registrant's consolidated current assets. Under the amended rule, a registrant is not required to disclose any such environmental proceedings unless it reasonably believes that the proceeding will result in no monetary sanctions, or in monetary sanctions, exclusive of interest and costs, of less than $300,000 or, at the election of the registrant, such other threshold that (i) the registrant determines is reasonably designed to result in disclosure of any such proceeding that is material to the registrant's business or financial condition, (ii) the registrant discloses (including any change thereto) in each annual and quarterly report, and (iii) does not exceed the lesser of $1 million or 1% of the current assets of the registrant and its subsidiaries on a consolidated basis. Item 103, as amended, also notes that such proceedings that are similar in nature may be grouped and described generically.
Risk Factors (Item 105 of Regulation S-K)
Item 105 of Regulation S-K previously required a discussion of the most significant factors that make an investment in the registrant or offering speculative or risky. The SEC believes this existing requirement has resulted in lengthy risk factor disclosures by many registrants, with generic, boilerplate risks contributing to the increased length of these disclosures. In an effort to enhance the readability and usefulness of the risk factor disclosures and to create an incentive for some registrants to reduce the length of their risk factor discussion, the SEC adopted the following amendments to Item 105:
Summary Risk Factor Disclosure. Summary risk factor disclosure will be required if the risk factor section exceeds 15 pages. According to the SEC, this 15-page threshold is estimated to affect approximately 40% of registrants. If the risk factor discussion exceeds 15 pages, registrants must include in the forepart of the applicable filing a series of concise, bulleted or numbered statements summarizing the principal factors that make an investment in the registrant or offering speculative or risky.1 This summary cannot exceed two pages. In its adopting release, the SEC confirmed that the risk summary is not required to contain all of the risk factors identified in the full risk factor discussion (i.e., the risk factor summary can prioritize certain risks and omit others).
Require Only Material Risk Factors. The requirement to discuss the "most significant" risks is replaced by a requirement to discuss "material" risks. For purposes of this requirement, "material" is defined in Exchange Act Rule 12b-2 and Securities Act Rule 405, and the SEC intends the new disclosure standard will focus registrants on disclosing the risks to which reasonable investors would attach importance in making investment or voting decisions. The SEC believes its clarification of a materiality standard for risk factor disclosures will result in risk factors that are more tailored to a registrant's particular facts and circumstances and will reduce generic risk factor disclosures.
Organize Risk Factors Under Relevant Headings. Registrants will now be required to organize their risk factor disclosure logically and under relevant headings. Risk factors must continue to include a subcaption that adequately describes the disclosed risk. In addition, if a registrant chooses to disclose a risk that could apply generically to any company or any offering, the amendments require that such risks be disclosed at the end of the risk factor section under the caption "General Risk Factors."
While not required by the current rules, many registrants organize their risk factors based on relative importance or significance. Under the amended rules, the SEC similarly will not require registrants to prioritize its risk factor disclosures, but registrants will continue to be permitted to prepare their risk factor disclosures to emphasize the relative importance of certain risks. Such organization, however, will need to be secondary to the new requirement to organize the risk factors under relevant headings.
These amendments are effective 30 days after publication in the federal register. Accordingly, the changes above are likely to have the most immediate impact on existing registrants with fiscal years ending on September 30, 2020. These registrants, in particular, and all registrants, in general, will want to take a fresh look at the Business and Risk Factor sections of their upcoming 10-Ks to determine how and to what extent these amendments will impact existing disclosures. In addition, companies that restate their risk factors in full in each 10-Q should consider whether and to what extent to comply with the new requirements of Item 105 of Regulation S-K in their next 10-Q.
[1] This is similar to the requirement currently contained in Item 3(b) to Form S-11, which requires an introductory statement to be made in the forepart of the prospectus, in a series of short, concise paragraphs, summarizing the principal factors which make the offering speculative.
This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. John-Paul Motley, an O'Melveny partner licensed to practice law in California, Shelly Heyduk, an O'Melveny partner licensed to practice law in California, Robert Plesnarski, an O'Melveny partner licensed to practice law in the District of Columbia, and Sarah Levesque, an O'Melveny counsel licensed to practice law in California, contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.
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