Securities Law Blog

On April 13, 2016, the U.S. Securities and Exchange Commission published an extensive concept release requesting public comment on whether its business and financial disclosure requirements contained in Regulation S-K — the integrated disclosure regime for registration statements for public offerings and ongoing periodic reports and other filings — continue to elicit the most important and relevant information for investors to make informed investment and voting decisions, and how public companies can most effectively and economically present this information through advancements in technology. The concept release, available here, is part of a multiyear evaluation of the SEC’s disclosure requirements originally mandated by the 2012 Jobs Act and prepared on the basis of initial comments gathered in response to an earlier SEC staff study and disclosure initiative. The concept release, at 341 pages with 340 specific requests for comment, is a major work by the SEC’s staff and traces the statutory and regulatory evolution of corporate disclosure and its objectives (i.e., protecting investors, facilitating capital formation and maintaining orderly markets) using a combination of principles-based and prescriptive disclosure requirements aimed at different types of public companies and their stockholders and investors. The concept release would serve as an excellent text book for a law school course on securities regulation.

Disclosure Principles and Considerations

As a starting point, the concept release describes the following general considerations that it follows in connection with Regulation S-K disclosure rule-making:

• whether the rule should be adopted on a temporary basis with automatic sunset provisions to better assess the effect of or necessity for a particular rule before adopting it on a permanent basis;
• whether the rule should require disclosure based on materiality principles, which rely on a company’s management to evaluate the significance of information in the context of its overall business and financial circumstances, or based on objective, quantitative line-item thresholds to identify when disclosure is required;  
• whether the rule should assume a certain level of sophistication by the investor or other user of the information so as to elicit disclosure suitable for the “everyday person” or an institutional investor with industry-specific foundational knowledge; and  
• whether the rule should be adopted if the expected administrative and compliance costs of preparing and disseminating the disclosure outweighs its perceived (though largely unquantifiable) usefulness, and whether scaled disclosure for smaller registrants to minimize those costs jeopardizes investor protection.

Possible Regulation S-K Amendments

The following discussion sets out the areas where the SEC has identified disclosure requirements that should be eliminated or modified, or new disclosure requirements should be added.

Core Company Business Information

Item 101(a)(1) — General Development of Business: The SEC noted that where a Form 8-K disclosure requirement, in cases such as acquisitions and dispositions, would be repetitive with a Form 10-K disclosure requirement, it would consider not requiring disclosure in any report subsequent to the original Form 8-K disclosure. The SEC additionally questioned the appropriateness of the five-year time frame for describing the general development of a registrant’s business.

Item 101(c) — Narrative Description of Business: The SEC noted that disclosure of the amount of backlog orders may no longer be a meaningful metric for most nonindustrial companies and, if eliminated, whether there is some other measure of committed revenue that is not yet reflected in the financial statements such as bookings. The SEC also noted that this disclosure may be more appropriate for the management discussion and analysis (MD&A) section.

Item 101(c)(1)(iv) — Technology and Intellectual Property Rights: The SEC noted that requirements could be more specific as to disclosure involving intellectual property, which appears to vary significantly among registrants and across industries, highlighting in particular the practices in the biotechnology and pharmaceutical industries (which tend to provide detailed patent disclosure) and the information technologies and services industry (which tends to provide only high-level discussions of their IP portfolios).

Items 101(c)(1)(ix) and (c)(1)(xii) — Government Contracts and Regulation, including Environmental Laws: The SEC observed that government contracts, because they are subject to renegotiation of profit and to termination for the convenience of the government, are typically described in a way that is responsive to this item in the notes to the financial statements. Cross-references should be considered to avoid duplicative disclosure. The SEC also noted that there is no separate line-item requirement to discuss government regulation that may be material to a registrant’s business (though it is common to see in regulated industries such as health care, insurance, biotechnology, public utilities and financial services) and asked whether such a requirement should be added.

Item 101(c)(1)(xiii) — Number of Employees: The SEC noted a possible disclosure requirement update for registrants to distinguish among the total number of persons employed between those who are full-time and part-time or seasonal employees, those who are employees and independent contractors, and those who are domestic and foreign employees. In addition, the SEC asked whether disclosure on outsourcing and subcontracting arrangements should be required.

Item 102 — Description of Property: The SEC questioned this item’s continuing relevance given that many businesses (particularly in services and information technology) no longer require or depend on physical properties. Where the properties are significant to the business (such as in the retail, hotel and lodging, casino, restaurant and paper mill industries), more specific disclosures would be required.

Company Performance, Financial Information and Future Prospects

Item 301 — Selected Financial Data: The SEC noted that there have been suggestions to eliminate this item entirely inasmuch as readers can discern trends from a registrant’s annual financial statements and MD&A or from readily accessible independent sources. It has also been suggested to limit the required disclosure to the last three (versus five) fiscal years, unless all five years are necessary to illustrate a material trend in the registrant’s business. If this item is retained, the SEC has asked whether the rule is sufficiently flexible to permit registrants to select the data that best indicates performance, including operating data (e.g., number of subscribers) and non-GAAP (generally accepted accounting principles) financial measures.

Item 302 — Supplementary Financial Information: The SEC noted the possibility of eliminating Item 302(a)(1), which requires disclosure of quarterly financial data of selected operating results, because the required data has already been reported in prior quarterly reports. Although the fourth fiscal quarter is not covered, U.S. GAAP allows investors to infer that data.

Item 303 — Management’s Discussion and Analysis Generally: The SEC noted that MD&A requirements must balance a materiality-based (e.g., known material trends and uncertainties) and quantitative-based (e.g., commitments for capital expenditures) approach to disclosure to improve the quality of analysis in MD&A. It has been suggested that a new separately captioned section be added requiring registrants to provide an executive-level overview of their performance in the most recent year, as well as expectations and concerns for the coming year, similar to what a CEO might report to the board of directors. The SEC also noted duplicative disclosure in MD&A and the notes to financial statements, commonly in critical accounting policies and estimates and recent accounting pronouncements. Additionally, the SEC asked whether its two-step test for assessing the need to disclose forward-looking trends, commitments, events and uncertainties in MD&A results in the most meaningful disclosure.

Item 303(a)(3) — Results of Operations: The SEC noted that there have been recommendations to amend this item, which is required to cover a three-year period, to eliminate prior period results in MD&A as this information is readily available in previous filings. In other words, only the most recently completed annual or quarterly period would be provided on a comparative basis to allow users to focus on new, material information about the latest fiscal period.

Item 303(a)(1) and (a)(2) — Liquidity and Capital Resources: The SEC asked whether current disclosure requirements under this item elicit adequate disclosure of a registrant’s reliance on short-term borrowings and potential liquidity funding gaps.

Item 303(a)(4) — Off-Balance Sheet Arrangements: The SEC noted that disclosure of off-balance sheet arrangements may be potentially redundant with disclosure in financial statements, and asked whether additional disclosure should be required for registrants to analyze the risks and financial costs associated with those arrangements.

Item 303(a)(5) — Contractual Obligations: The SEC asked if additional guidance or instructions about how to treat certain types of contractual obligations, such as interest payments, repurchase agreements and tax liabilities, would be helpful to registrants preparing the tabular disclosure.

Item 303 — Critical Accounting Estimates: The SEC asked whether this item should be revised to require disclosure about management’s significant judgments and assumptions underlying its use of critical accounting estimates.

Risk and Risk Management

Item 503(c) – Risk Factors: The SEC noted the suggestion that there should be a comprehensive default framework for risk factor disclosure that would classify risk factors based on relative likelihood and relative impact into one of three tiers based on the risk’s probable occurrence and the relative seriousness of the consequences if a risk materializes. The SEC noted that any such requirement should be grounded in the principle of materiality from management’s viewpoint. As to additional risk-related disclosure on specific topics, the SEC indicated that risks associated with cybersecurity and oil and gas exploration may be encouraged. Additionally, the SEC highlighted the growing length of risk factor disclosure attributing it to liability concerns and noted suggestions that any efforts to reduce risk factor disclosure, without concomitant changes to the relevant rules or the protection of a safe harbor, are unlikely to be effective because there is little incentive for registrants to scale back risk factor disclosure.

Item 305 — Quantitative and Qualitative Disclosures about Market Risk: The SEC noted, in light of current U.S. GAAP requirements, it has been suggested that this item should be eliminated or, alternatively, refocused to permit principles-based disclosure of market risks associated with derivatives and other market-sensitive instruments. The SEC also asked how this item could be improved to elicit better disclosure about market risks and risk management practices, and whether there should be more standardized disclosure in this item to enhance comparability among registrants.

Securities of the Registrant

Item 201(b) — Related Stockholder Matters — Number of Equity Holders: The SEC noted that the requirement to disclose the number of security holders under this item may not provide meaningful information since the vast majority of stockholders hold their securities as a beneficial owner (compared to a record holder) through a broker-dealer or bank as nominee. The SEC asked whether this rule should be amended to require registrants to disclose the amount of each class of equity securities held in “street name.”

Item 202 — Description of Capital Stock: The SEC noted that a description of the material terms and conditions of a registrant’s securities is not required in periodic reports and, to find this information, investors typically must locate this disclosure either in the registrant’s exhibits or in the registrant’s Form 8-A, which often incorporates by reference from a prior Form S-1. As a result, the SEC asked whether a comprehensive discussion of registered securities in periodic reports would facilitate access to important disclosure for investors in the secondary market.

Item 701(a)-(e) — Recent Sales of Unregistered Securities: The SEC noted the suggestion that the disclosure requirements of this item, which require disclosure of all unregistered sales of common equity, should be reconciled with those of Item 3.02 of Form 8-K, which does not require disclosure of sales of less than 1 percent (or 5 percent in the case of a smaller reporting company) of the number shares outstanding of the equity securities being sold. Further, the SEC noted that this item may not be required at all in the sense that material sales of securities are typically included in a registrant’s discussion of liquidity and capital resources under MD&A.

Item 701(f) — Use of Proceeds from Registered Securities: The SEC noted the suggestion to eliminate this requirement since companies cannot necessarily determine whether a dollar spent following its first registered offering was derived from cash generated from operating activities or from the net proceeds of the securities offering and, in any event, material uses of cash is already reflected in a company’s discussion of cash flow in MD&A.

Item 703 — Purchases of Equity Securities by the Issuer and Affiliated Purchasers: The SEC noted that it may be appropriate to require enhanced disclosure of the “pros” and “cons” of share repurchase programs by addressing the time period for each program, maximum number of shares authorized by the board to be repurchased, cash spent on repurchases compared to that spent on reinvestment, impact of repurchase programs on corporate indebtedness and sources of funds to finance stock buybacks.

Industry Guides

The SEC noted a general need to update the industry guides for changes in industry practices and technology. The SEC also asked whether the industry guides should be codified in Regulation S-K. While the current approach may allow registrants the flexibility to omit obsolete disclosures, the fact that the guidance is not a regulatory requirement may result in less comparability across an industry.

Disclosure of Information Relating to Public Policy and Sustainability Matters

The SEC noted a strong desire from some investors and interest groups for new line-item disclosure requirements on a variety of public policy and sustainability matters, including climate change, resource scarcity, political spending and corporate social responsibility, stating that these environmental, social and governance concerns are of increasing significance to voting and investment decisions. The SEC also acknowledged that these issues may not necessarily be material to an understanding of every company’s financial performance or appropriate for inclusion in Exchange Act reports. The SEC is seeking input on whether adoption of policy-driven disclosure requirements are important to investors’ voting and investment decisions and, if adopted, whether to scale or exempt those disclosure requirements for smaller reporting companies.

Exhibits

The SEC noted two suggestions for dealing with exhibits — registrants would be permitted to omit (1) schedules or similar attachments to filed exhibits, unless they contain material information that is not otherwise disclosed in the exhibit or in the public filing, and (2) personally identifiable and similar information in filed exhibits such as bank account numbers and home addresses, without having to apply for confidential treatment to redact that information. The SEC further noted a suggestion to exclude the requirement to file an amendment or modification to a previously filed material contract that does not affect the economics of such contract.

Item 601(b)(10) — Material Contracts: With regard to contracts not made in the ordinary cause, the SEC asked whether the term “not made in the ordinary course of business” is a clear enough standard for agreements covered by the rule and whether there is a need for quantitative or other thresholds to determine when such a contract is material to a registrant. As to certain contracts made in the ordinary course, the SEC asked whether the types of contracts that, although made in the ordinary course of business, are required to be filed should be expanded beyond related-party contracts and commercial agreements involving a majority of the registrant’s products or services sold or purchased.

Item 601(b)(18) — Preferability Letter: The SEC is seeking input, in light of the significant overlap with accounting requirements, on whether to eliminate the exhibit requirement of this item to file a letter from the registrant’s independent accountant indicating in its judgment if a voluntary change in accounting principles or practices is preferable under the circumstances.

Item 601(b)(21) — Subsidiaries: The SEC noted suggestions to require additional information in a registrant’s list of subsidiaries including profits earned, number of employees and countries of operation, to enable investors to better understand a registrant’s corporate structure and tax strategy. The SEC appears to be interested in the fact that registrants may be seeking to avoid disclosing subsidiaries located in countries regarded as tax havens by considering them insignificant at a time when government officials and academics are scrutinizing the use of offshore tax havens.

Scaled Disclosure Requirements for Smaller Registrants

Currently, registrants are eligible for scaled disclosure if they qualify as a smaller reporting company (SRC) or emerging growth company (EGC). The SEC has noted numerous suggestions with respect to revising the financial thresholds for defining these registrant categories eligible for scaled disclosure and, in particular, the public float tests that appear to create a compliance burden for companies with high valuations that would be considered “small” in terms of annual revenues by any reasonable observer. In this regard, the SEC asked whether it should tie eligibility for scaled disclosure to a certain proportion of public companies, such as those in the lowest 6 percent of total U.S. market capitalization, in order to determine whether the definitional thresholds are achieving their targeted objective. Additionally, the SEC asked whether there are any disclosure requirements for which scaling is not appropriate and if there are additional item requirements that the SEC should consider scaling for smaller registrants.

Frequency of Interim Reporting

The SEC acknowledged the ongoing debate about the value of quarterly financial reporting. Opponents of quarterly reporting argue that frequent financial reporting may lead management to focus on short-term results to meet or beat earnings targets rather than on long-term strategies. Others are skeptical of the benefits of eliminating these requirements, pointing to information asymmetry between managers and investors. Also, the value of quarterly reporting may vary by industry or by the size of the registrant. The SEC seeks input on the benefits and costs to investors, registrants and the market from quarterly reporting and whether to allow particular categories of registrants such as SRCs to file periodic reports on a less frequent basis, such as semiannually.

Presentation and Delivery of Important Information

The SEC stated that another critical element of effective disclosure is its presentation and delivery. The concept release seeks input on how the SEC could improve the readability and navigability of information because, while optimal content and scope requirements are critical, they mean little if the information provided is not reviewed or understood. The SEC seeks to take account of how various investors actually interact with companies’ disclosures, what matters most to them and what methods of delivery enhance the accessibility and intelligibility of the information provided. The concept release poses a range of questions, for example, about cross-referencing, hyperlinks, structured data, incorporation by reference, layered disclosure and the use of company websites.

In addition to broadly seeking input on the range of such options, the SEC is moving forward on other disclosure-related technology projects. The SEC staff, for instance, is preparing recommendations for a rule proposal for the SEC’s consideration to allow companies to file financial statements in inline XBRL, rather than as a separate exhibit to their annual and periodic reports, which has the potential to improve the quality of the structured data that is filed and investors’ access to the information. The SEC is also furthering efforts to modernize its EDGAR system by improving the machine-readability of forms and filings. Finally, the SEC noted that when it adopts new requirements under its rules, it is assessing not only whether the information is needed for informed decisions by investors, but also whether the information can be usefully structured, including in executive compensation proposals and new disclosure requirements for asset-backed securities.

Request for Comments

The concept release is requesting the public’s views on the matters discussed in this article, as well as any other aspect of the SEC’s disclosure requirements in Regulation S-K that investors, registrants and other market participants believe may be improved upon. Comments are due on or before 90 days after publication of the concept release in the Federal Register and should refer to File Number S7-06-16. Comments may be submitted electronically through the SEC’s website.

Conclusion

The SEC’s issuance of the concept release is not an unexpected development, but it likely portends a significant change in long-standing disclosure policy that has been in effect for more than 50 years. The specific questions on which comments are requested may also signal a new regulatory approach in mandating disclosure on the corporate sustainability efforts of public companies.

Based on our representation of a broad range of public companies, we believe the SEC has raised many good points in the concept release. Among these points are the possible elimination of disclosure previously included in a Form 8-K, the removal of prior years’ comparative MD&A disclosure and the reduction in the number of years required to be included in selected financial data. These changes, as well as others suggested in the concept release, should make issuer disclosure documents less cumbersome without impacting the materiality of the disclosure. Additionally, the elimination of the need to (1) file as an exhibit nonmaterial amendments to previously filed exhibits and (2) include schedules or similar attachments to filed exhibits will help issuers avoid losing Form S-3 eligibility over essentially a foot-fault and reduce the need for issuers to make time-consuming confidential treatment requests.