SEC Amends Regulation S-K to Modernize Business, Legal Proceedings and Risk Factor Disclosures

On August 26, 2020, the U.S. Securities and Exchange Commission (“SEC”) announced it had adopted a series of amendments (the “Amendments”) to Regulation S-K to modernize the description of business (Item 101), legal proceedings (Item 103) and risk factor (Item 105) disclosures that public companies (sometimes called “registrants”) are required to make.

In adopting the first significant revisions to these disclosure requirements in over 30 years, the SEC noted that the Amendments reflect its commitment to a principles-based, registrant-specific disclosure approach and that the disclosure requirements “are rooted in materiality and facilitate an understanding of a registrant’s business, financial condition and prospects through the lens through which management and the board of directors manage and assess the performance of the registrant.” The SEC also noted that the Amendments are intended to improve disclosures for investors by tailoring them to a registrant’s particular circumstances, reduce disclosure costs and burdens, and discourage repetitive and immaterial disclosures.

The Amendments become effective 30 days after publication in the Federal Register for all registration statements and reports filed thereafter. Accordingly, it is possible – depending on timing of publication in the Federal Register – that public companies with a December 31 fiscal year end will need to make third quarter Form 10-Q disclosures in compliance with the Amendments.

Summary of Amendments

The following is a summary of the revisions to Regulation S-K effected by the Amendments. The revisions are described in greater detail following this summary.

Changes to Item 101(a) and Item 101(h) – General Development of Business

Currently, a registrant must disclose a description of the general development of the registrant’s business throughout the past five years under Item 101(a), or such shorter period as the registrant may have been engaged in business. Smaller reporting companies must only disclose a description of the past three years under Item 101(h).

Item 101(a)(1) requires that such description of the general development of the business include (and Item 101(h) contains a similar list for smaller reporting companies):

• Form and year of organization;
• Nature and results of bankruptcy, receivership, or similar proceedings with respect to the registrant or any of its significant subsidiaries;
• Nature and results of any other material reclassification, merger, or consolidation of the registrant or any of its significant subsidiaries;
• Acquisition or disposition of any material amount of assets otherwise than in the ordinary course of business; and
• Material changes in the mode of conducting the business.

Elimination of Five-Year and Three-Year Disclosure Time Frames

The Amendments to Item 101(a) eliminate the five-year disclosure time frame and apply a materiality standard to the general development of business disclosure, irrespective of a specific time frame.

The Amendments to Item 101(h) eliminate the three-year disclosure time frame applicable to smaller reporting companies and provide that a smaller reporting company’s disclosure should describe the period of time material to an understanding of the general development of the business.

Nonexclusive List of Disclosure Topic Examples

The Amendments clarify that under Item 101(a) registrants need to disclose only information material to an understanding of the general development of the business. Under this principles-based approach, disclosure may include, but should not be limited to, the following topics:

• Material changes to a previously disclosed business strategy;
• Nature and effects of any material bankruptcy, receivership, or similar proceedings with respect to the registrant or any of its significant subsidiaries;
• Nature and effects of any material reclassification, merger or consolidation of the registrant or any of its significant subsidiaries; and
• Acquisition or disposition of any material amount of assets otherwise than in the ordinary course of business.

While the last three topics are not new and disclosures of the form and year of organization and material changes to the mode of conducting business are no longer specifically required, material changes to a previously disclosed business strategy is a new topic in Item 101(a). The Amendments do not require disclosure of a registrant’s business strategy, however, if it has not been previously disclosed. In the spirit of a principles-based approach, the SEC did not adopt a definition of the term “business strategy,” with the result that the registrant may focus disclosures on its specific facts and circumstances.

Disclosure in Subsequent Filings

The Amendments modify Item 101(a) such that, after a registrant’s initial registration statement, the registrant may limit disclosure of the general development of its business to only the material developments that have occurred since the most recent full discussion disclosed in a previously filed registration statement or report. If a registrant uses this approach, it must incorporate by reference its most recent full discussion of the general development of business with a hyperlink, but may not incorporate a full discussion from more than one previously filed document.

Alternatively, a registrant may choose to provide a complete discussion of its business development and material updates in each filing instead of incorporating by reference to a full discussion in a previously filed document.

The Amendments also modify Item 101(h) such that, after the filing of an initial registration statement, a smaller reporting company may provide updates to the general development of its business disclosure, instead of a full discussion, in accordance with Item 101(a). The Amendments clarify that a smaller reporting company also may use the hyperlink option for incorporation by reference.

Changes to Item 101(c) – Narrative Description of Business

Currently, Item 101(c) requires a narrative description of the business done and intended to be done by the registrant and its subsidiaries, with a focus on the registrant’s dominant segment or each reportable segment for which financial information is presented in the financial statements. Item 101(c) also requires, generally to the extent material to an understanding of the registrant’s business taken as a whole, that the description of each segment must include each of the following 12 disclosure items:

• Principal products produced and services rendered (including quantitative disclosure threshold);
• New products or segments;
• Sources and availability of raw materials;
• Intellectual property;
• Seasonality of the business;
• Working capital practices;
• Dependence on certain customers (including quantitative disclosure threshold);
• Dollar amount of backlog orders believed to be firm;
• Business subject to renegotiation or termination of government contracts;
• Competitive conditions;
• Material effects of compliance with environmental laws; and
• Number of persons employed.

Nonexclusive List of Disclosure Topic Examples

The Amendments provide for a principles-based approach by replacing the current list of specific disclosure items with the following nonexclusive list of disclosure topic examples that a registrant may need to disclose pursuant to Item 101(c). Amended Item 101(c) continues to focus on disclosure by reportable segment, but clarifies that only information material to an understanding of the business taken as a whole is required, including but not limited to the following disclosure topics:

• Revenue-generating activities, products and/or services, and any dependence on 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 (i) sources and availability of raw materials; and (ii) the duration and effect of patents, trademarks, licenses, franchises, and concessions held;
• 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
• Extent to which the business of the segment is or may be seasonal.

While these disclosure topics retain or revise items from the current, longer, list, the Amendments eliminate explicit references to disclosure requirements regarding disclosure of working capital practices, new segments and the dollar amount of backlog orders believed to be firm. The SEC noted that, under the principles-based approach, a registrant would need to provide disclosure about these topics, in addition to any other topics regarding its business, if material to an understanding of its business and not otherwise disclosed.

Revised Regulatory Compliance Disclosure

The Amendments revise Item 101(c) to require a discussion, to the extent material to an understanding of the registrant’s business taken as a whole, of 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. This expands the existing disclosure requirement, which expressly applied only to compliance with environmental regulations. When Regulation S-K was originally adopted, environmental regulation was at its zenith and the manufacturing sector of the American economy accounted for a larger percentage of registrants than today. Since then, the service sector has expanded and, with it, other kinds of regulation. Registrants must also continue to include the estimated capital expenditures for environmental control facilities for the current fiscal year and any other subsequent period that is material. If the foregoing information is material to a particular segment, then that segment must be identified.

New Human Capital Resources Disclosure

The Amendments introduce a new Item 101(c) disclosure requirement – description of the registrant’s human capital resources, to the extent material to an understanding of its business taken as a whole. The Amendments list nonexclusive examples of potentially relevant subjects, which include human capital measures and objectives that the registrant focuses on in managing the business, such as those that address the attraction, development and retention of personnel. If the foregoing information is material to a particular segment, then that segment must be identified.

The SEC noted that each registrant’s disclosure must be specific to its business, workforce and facts and circumstances. The SEC did not define the term “human capital,” opting instead for wording whose meaning can evolve over time and may be defined by different companies in industry-specific ways.

As part of the human capital resources disclosure, registrants must continue to disclose the number of persons employed by the registrant, to the extent material to an understanding of its business taken as a whole. The SEC did not expand this disclosure item to include required disclosure of additional metrics, such as the number of full-time, part-time, and contingent workers, and employee turnover. Nevertheless, the SEC noted that under its principles-based approach, to the extent that such metrics, for example, are material to an understanding of the registrant’s business, then the registrant must disclose this information.

Changes to Item 103 – Legal Proceedings

Currently, Item 103 requires disclosure of any material pending legal proceedings, excluding ordinary routine litigation incidental to the business, to which the registrant or any of its subsidiaries is a party or of which their property is the subject. Item 103 also requires disclosure of the following information regarding material pending legal proceedings: the name of the court or agency in which the proceedings are pending; the date instituted; the principal parties thereto; a description of the factual basis alleged to underlie the proceeding; and a description of the relief sought. If proceedings are known to be contemplated by governmental authorities, then registrants must include similar information for such proceedings.

Current instructions to Item 103 require disclosure of any proceeding to which a governmental authority is a party relating to environmental laws that involve potential monetary sanctions, unless the registrant reasonably believes such monetary sanctions will be less than $100,000.

Use of Hyperlinks or Cross-References to Avoid Repetitive Disclosure

The Amendments revise Item 103 to expressly allow disclosure of the required information by hyperlink or cross-reference to legal proceedings disclosure elsewhere in the document, including in MD&A, Risk Factors, or notes to the financial statements.

Increased Threshold for Environmental Proceedings in Which the Government is a Party

The Amendments reorganize Item 103 to eliminate the existing instructions to Item 103 and incorporate their contents in the text of amended Item 103, and increase and provide more flexibility with respect to the threshold for disclosure of environmental proceedings to which a governmental authority is a party. The $100,000 disclosure threshold for environmental proceedings that involve monetary sanctions is increased to $300,000 or, if the registrant chooses, such other amount that the registrant determines is reasonably designed to result in disclosure of any proceeding that is material to the registrant’s business or financial condition, provided that the threshold may not exceed the lesser of $1 million or 1% of the current assets of the registrant and its subsidiaries on a consolidated basis. A registrant that elects a threshold other than the $300,000 amount must disclose the threshold elected, and any change thereto, in each Form 10-K and Form 10-Q.

Changes to Item 105 – Risk Factors

Currently, Item 105 requires registrants to disclose the most significant risk factors that make an investment in the registrant or offering speculative or risky. The risk factors discussion should be concise and organized logically. Item 105 also requires registrants to explain how each factor affects the registrant or the offered securities, discourages the disclosure of risks that could apply to any registrant, and requires registrants to set forth each risk factor under a subcaption that adequately describes the risk.

Summary Risk Factor Disclosure if Risk Factors Section Exceeds 15 Pages

The Amendments add a requirement to Item 105(b) under which a summary of principal risk factors is required when a registrant’s risk factor disclosure exceeds 15 pages. The summary must consist of a series of concise, bulleted or numbered statements summarizing the principal factors that make an investment in the registrant or offering speculative or risky. The summary does not need to contain all of the risk factors identified in the full risk factor disclosure. The summary may not exceed two pages and must be included in the forepart of the prospectus or annual report.

Disclose “Material” Instead of “Most Significant” Factors

The Amendments change the standard for risk factor disclosure to require disclosure of “material” factors that make an investment in the registrant or offering speculative or risky instead of the “most significant” factors. The SEC noted that this change is intended to focus registrants on disclosing risks to which reasonable investors would attach importance in making investment or voting decisions.

Organize Risk Factors Under Relevant Headings

The Amendments revise Item 105 to require the organization of risk factors under relevant headings, in addition to the currently required subcaptions. Risks that could apply generically to any registrant or offering of securities must be disclosed at the end of the risk factor section under the caption “General Risk Factors.” The Amendments do not otherwise require registrants to prioritize the order of the risk factor discussion and do not specify any other risk factor headings.

Comments on the Amendments

Principles-based disclosure has the salutary effect of focusing management attention on what really matters in the business. Requiring a discussion of regulatory issues (beyond environmental regulation) and human capital needs is a wise updating of Item 101, reflecting the shift over the last four decades in the American economy from old-line manufacturing to service industries. Most companies already make such disclosures with respect to regulatory issues voluntarily or in response to SEC Staff comments.

This is not the first time that the SEC has imposed new disclosure requirements while discouraging unnecessary disclosure. Despite such exhortations, the length and complexity of periodic disclosures have steadily increased ever since the SEC adopted Regulation S-K in 1977. The ability to disclose litigation under Item 103 by cross-reference to litigation disclosures in footnotes to financial statements should have the beneficial effect of increasing review of the financials by securities lawyers, who should nonetheless be mindful that GAAP requirements and Regulation S-K requirements are not identical. Whether registrants will curtail excess disclosure because the SEC is inviting that again, or will instead retain and expand existing disclosures in a bid to fend off securities litigation, remains to be seen.