Securities Law Blog

The Securities and Exchange Commission recently issued a proposing release to amend various disclosure rules for SEC periodic reports, registration statements and certain proxy statements relating to how public companies describe their business, legal proceedings and investment risk factors. See Release Nos. 33-10688; 34-86614; File No. S7-11-19. The proposed amendments to Regulation S-K, the SEC’s central disclosure resource, depart philosophically from what one might expect from the SEC’s decades-old rule-based series of line-item disclosure requirements. According to the SEC release, existing rules are structurally inflexible and have increasingly led to disclosure that does “not reflect what is material to every business” and is frequently outdated in these main disclosure areas. The SEC release further indicates that no new amendments to continually adjust existing line-item disclosures and quantitative thresholds will solve this ongoing problem and instead proposes to establish a principles-based disclosure solution – one that articulates a disclosure “concept” rather than a hard rule. Interestingly, this new concept relies on a company’s management to evaluate the significance of information in the context of the company’s overall business and financial circumstances and to determine whether disclosure is necessary.

The SEC’s proposed principles-based rule amendments are aimed at the following disclosure requirements in Regulation S-K Items 101(a) – description of the general development of the business, 101(c) – narrative description of the business, and 105 – risk factors.

• Item 101(a), which requires a description of the general development of the business of the registrant during the past five years (or such shorter period as the registrant may have been engaged in business), would be revised to permit companies to disclose only information material to an understanding of the general development of the business and eliminate the prescribed timeframe for this disclosure. In filings made after a registrant’s initial filing, only an update of the general development of the business would be required with a focus on material developments in the reporting period with a hyperlink to the registrant’s most recent filing (e.g., initial registration statement or more recent periodic report or other filing if one exists) that, together with the update, would contain the full discussion of the general development of the registrant’s business.
• Item 101(c), which requires a narrative description of the business done and intended to be done by the registrant and its subsidiaries, focused upon the registrant’s dominant segment or each reportable segment about which financial information is presented in the financial statements, would be revised to clarify and expand disclosure of topics drawn from a subset of the 12 mandatory topics currently contained in Item 101(c), and include, as a disclosure topic, human capital resources, including any human capital measures or objectives that management focuses on in managing the business, to the extent such disclosures would be material to an understanding of the registrant’s business. The revisions would also refocus the regulatory compliance requirement by including material government regulations, not just environmental laws, as a topic.
• Item 105, which requires disclosure of the most significant factors that make an investment in the registrant or offering speculative or risky, and specifies that the discussion should be concise and organized logically, would be revised to require summary risk factor disclosure if the risk factor section exceeds 15 pages, and to refine the approach of Item 105 by changing the disclosure standard from the “most significant” factors to the “material” factors. The proposals would also 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.

In its recent release, the SEC acknowledged that there are both benefits and costs involved in a shift toward a more principles-based approach to disclosure with the proposed amendments. The benefits, according to the SEC, include elimination of disclosure that is not material which may lead to a reduction in the compliance burdens by registrants and potentially benefit investors to the extent it improves the readability and conciseness of the information provided. As a result, registrants may be encouraged to present more tailored information to investors.

On the other hand, the SEC states that “a more principles-based approach may result in the elimination of disclosure material to an investment decision if issuers misjudge what information is material (emphasis added).” This statement by the SEC leaves a lot of unanswered questions.  Who would “judge” whether the disclosure is adequate, accurate and complete, and when would that judgment be made? The concern is that the SEC’s Division of Corporation Finance, in its review of registration statements and other filings, would be put in the position of having to clear this nuanced disclosure and potentially making judgments about what aspects of the company’s business are material and should be disclosed. In drawing out these conclusions, SEC comment letters asking for supplemental responses to the applicability of a slew of potential business disclosures would seem to be a predictable side effect. Even worse, the SEC’s Division of Enforcement could potentially be put in the position of second guessing the adequacy of the disclosure months and years after the disclosure (or omission) is made, with an eye toward determining whether the public has been misled. The SEC suggests that the risks of such misjudgments are mitigated by accounting controls and the anti-fraud provisions of the securities laws, assuming a company’s auditors and lawyers will be policing the accuracy of issuer disclosures.

The SEC concludes that smaller, younger and/or resource-constrained issuers could benefit from reduced compliance costs by eliminating immaterial disclosure in their SEC filings. However, at these and other companies with less established reporting histories, the lack of management depth, board oversight and outside professional advisers to make broad, unbiased materiality assessments and prepare detailed non-standard disclosures could have the opposite effect on compliance costs.

The SEC’s proposing release, which is part of its continuing “Disclosure Effectiveness Initiative” that seeks to simplify and modernize public company disclosure, is aimed to solicit public comment. Comments are due to the SEC by October 22, 2019.

The opinions expressed are those of the author and do not necessarily reflect the views of the firm or its clients.