United States: SEC Proposes Changes To Business, Legal Proceeding And Risk Factor Disclosure Requirements

The SEC has proposed amendments to the description of business, legal proceeding and risk factor disclosures that are required pursuant to Regulation S-K. The SEC intends to update the rules to account for developments in capital markets and the economy that have occurred over time; to improve disclosure for investors; and to reduce compliance burdens for issuers. The proposals are part of the SEC's disclosure effectiveness initiative and reflect the SEC's consideration of this topic in its 2013 Regulation S-K study and 2016 concept release.1

Item 101(a) of Regulation S-K – General Development of Business

The SEC is proposing amendments to Item 101(a)(1) of Regulation S-K that "would provide more flexibility to tailor disclosures to the unique circumstances of each registrant, which in turn could result in improved disclosures for investors."  The SEC proposes to require only material updates to this disclosure for filings other than initial registration statements.

Item 101(a) requires a description of the general development of the issuer's business during the past five years, or such shorter period as the issuer may have engaged in business. The SEC notes that it does not think it is necessary to prescribe a timeframe, and the currently required five-year timeframe may not elicit the most relevant disclosure for every issuer. For this reason, the SEC is proposing to revise Item 101(a) to eliminate the five-year disclosure timeframe and require issuers to focus on the information material to an understanding of the development of their business, without focusing on a specific timeframe. The SEC also proposes to revise Item 101(h) of Regulation S-K to eliminate the provision that currently requires smaller reporting companies to describe the development of their business during the last three years.

Disclosure regarding the general development of the business is currently required in registration statements and annual reports for all issuers. The SEC proposes to retain the requirement for initial registration statements under the Securities Act of 1933, as amended and the Securities Exchange Act of 1934, as amended. In filings subsequent to an issuer's initial registration statement, an issuer would be required to provide an update of this disclosure, focusing on material developments (if any) during the reporting period, including whether the issuer's business strategy has changed. The SEC also proposes to require that an issuer incorporate by reference, and include an active hyperlink to, the most recently filed disclosure that, together with the update, would present a full discussion of the general development of its business.

The SEC is proposing to amend Item 101(a)(1) to be more principles-based by providing a non-exclusive list of the types of information that a registrant may need to disclose, and by requiring disclosure of a topic only to the extent such information is material to an understanding of the general development of an issuer's business. The four matters proposed to be included in the non-exclusive list are (i) material bankruptcy, receivership, or any similar proceeding; (ii) the nature and effects of any material reclassification, merger or consolidation of the issuer or any of its significant subsidiaries; (iii) the acquisition or disposition on an material amount of assets otherwise than in the ordinary course of business; and (iv) to the extent material to an understanding of an issuer's business, transactions and events that affect or may affect the issuer's operations, including material changes to an issuer's previously disclosed business strategy.

Item 101(c) of Regulation S-K – Narrative Description of Business

Item 101(c) of Regulation S-K requires a narrative description of the business done and intended to be done by an issuer and its subsidiaries, focusing upon the registrant's dominant segment or each reportable segment about which financial information is presented in the financial statements. Further, to the extent material to an understanding of the issuer's business taken as a whole, the description of each such segment must include 10 specific items listed in Item 101(c). Item 101(c) specifies two other items that must be discussed with respect to the issuer's business in general, although, where material, the registrant must also identify the segments to which those matters are significant. In the proposing release, the SEC notes that, because the 12 items may not be relevant to all issuers, the disclosure requirement can elicit disclosure that is not material to a particular issuer. The SEC proposes to shift the requirements in Item 101(c) to an "updated and more principles-based disclosure framework" that encourages issuers to "exercise judgment in evaluating what disclosure to provide, which would result in disclosure more appropriately tailored to a registrant's specific facts and circumstances."

The SEC proposes to include in Item 101(c) a non-exclusive list of disclosure topics that would likely be material to many issuers. The SEC notes that these proposed topics would not be line-item requirements; however, to the extent that a topic is material to an understanding of an issuer's business, disclosure would be required. Current topics such as working capital practices, disclosure about new segments and the dollar amount of backlog orders believed to be firm would not be included in the non-exclusive list, but issuers still would have to provide disclosure about these topics if they are material to an understanding of their business.

The SEC's proposed rule amendments would retain the distinction between those disclosure topics for which segment disclosure should be the primary focus, and those disclosure topics for which the focus should be on the issuer's business as a whole.  The proposed amendments clarify that, for any listed topic, disclosure is required only to the extent that it is material to an understanding of the issuer's business as a whole.

The proposed list of disclosure topics in Item 101(c) would retain information regarding revenue-generating activities, products and/or services, and any dependence on key products, services, product families or customers, including governmental customers, to the extent this information is material to an understanding of an issuer's business. The list of disclosure topic would also retain information regarding development efforts for new or enhanced products, and trends in market demand and competition would generally be material to an investment decision. With respect to raw materials, the SEC proposes to modernize the disclosure requirements to refocus disclosure on all resources material to an issuer's business, and to facilitate application of this standard, the SEC proposes including as examples of resources that may be material: (i) raw materials; and (ii) patents, trademarks, licenses, franchises and concessions held. The proposing release notes that the SEC chose not to expand the requirement to include copyrights and trade secrets.

The SEC proposes to retain renegotiation or termination of government contracts as an enumerated disclosure topic in Item 101(c), as well as the extent to which the business is or may be seasonal. The SEC also proposes including the material effects of compliance with material government regulations, not just environmental laws, as a listed disclosure topic in Item 101(c). The SEC expects that this disclosure topic would focus on the material effects that compliance with material governmental regulations, both foreign and domestic, may have upon the capital expenditures, earnings and competitive position of the issuer and its subsidiaries.

The SEC proposes to retain the requirement that an issuer disclose material estimated capital expenditures for environmental control facilities for the current fiscal year and any other subsequent period that the issuer deems material, while not proposing to require the disclosure of additional specific expenditures related to environmental compliance.

The SEC proposes to amend Item 101(c) to refocus requirements regarding human capital resources disclosures. The SEC proposes to replace the current requirement to disclose the number of employees with a requirement to provide information regarding the issuer's "human capital resources," including in such description 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 issuer's business. The proposed amendment provides a non-exclusive list of examples of human capital measures and objectives that the SEC believes may be material, depending on the nature of the issuer's business and workforce, including measures or objectives that address the attraction, development, and retention of personnel.

Item 103 of Regulation S-K – Legal Proceedings

In the proposing release, the SEC notes that while Item 103 of Regulation S-K and U.S. GAAP differ in certain respects with respect to disclosure of legal proceedings and contingences, these provisions also have overlapping disclosure requirements. In an effort to encourage issuers to avoid duplicative disclosure, the SEC proposes to revise Item 103 to expressly state that some or all of the required information may be provided by including hyperlinks or cross-references to legal proceeding disclosures located elsewhere in the document.

The SEC also proposes to amend Instruction 5.C. to Item 103, which specifically requires disclosure of any proceeding under environmental laws to which a governmental authority is a party, unless the issuer reasonably believes it will not result in sanctions of $100,000 or more. The proposed amendment would increase the $100,000 threshold to $300,000 to adjust for inflation.

Item 105 of Regulation S-K – Risk Factors

Item 105 of Regulation S-K "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." The SEC proposes to amend Item 105 to address what the SEC considers to be the lengthy and generic nature of the risk factor disclosure presented by issuers.

The SEC proposes to require summary risk factor disclosure in the forepart of the prospectus or annual report when issuers provide risk disclosure that exceeds 15 pages. The summary would consist of a series of short, concise, bulleted or numbered statements summarizing the principal factors that make an investment in the issuer or offering speculative or risky. The SEC also proposes to update Item 105 to replace the requirement to discuss the "most significant" risks with "material" risks.

The SEC also proposes to require that issuers organize their risk factor disclosure under relevant headings. Further, under the SEC's proposed amendments, if an issuer chooses to disclose a risk that could apply to other issuers or securities offerings, and the disclosure does not provide an explanation of why the identified risk is specifically relevant to an investor in its securities, an issuer would be required to disclose such risk factors at the end of the risk factor section, under the caption "General Risk Factors."

Next Steps

These latest proposals in the SEC's Disclosure Effectiveness initiative will be subject to comment for 60 days following publication in the Federal Register. The SEC has a number of other proposals seeking to make disclosure more effective that remain outstanding, including significant changes to Regulation S-X. While the SEC's Concept Release dealt with a very wide variety of topics, these latest proposals represent a more measured approach toward modernizing and simplifying the business description, legal proceeding and risk factors disclosure requirements.


[1] See Report on Review of Disclosure Requirements in Regulation S-K (Dec. 2013), available at https://www.sec.gov/news/studies/2013/reg-sk-disclosure-requirements-review.pdf, and Business and Financial Disclosure Required by Regulation S-K, Rel. No. 33-10064 (Apr. 13, 2016), available at https://www.sec.gov/rules/concept/2016/33-10064.pdf (the "Concept Release").

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Morrison & Foerster LLP. All rights reserved

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