The SEC issued new rules yesterday which affect the business description, litigation disclosure, and risk factor disclosure of SEC-reporting companies in their annual and quarterly reports (10-K and 10-Q), registration statements (S-1 and S-3), and M&A disclosure filings (S-4 and 14A) filed with the SEC.[1] These provisions had not been significantly revised for more than 30 years.
One or another of these rules could affect some of the disclosure of virtually every US public company, and we recommend that public companies review their existing disclosures in light of the new rules, particularly their risk factors. The new rules will become effective in about 1 month.
Described below are the key changes adopted by the SEC and how they impact company disclosures.
Risk Factors
Summary of Risk Factors
If the risk factor section exceeds 15 pages (which is often the case for many companies), the company must include a 2-page summary of the risk factors using “concise, bulleted or numbered statements” in the forepart of the prospectus or annual report. This will require a change for many companies - the SEC estimates that 40% of companies have risk factor sections which exceed 15 pages.
Headings
The risk factors should be organized under relevant headings for groups of risk factors. Most companies already organize their risk factors under separate headings, but those that do not will need to reorganize their risk factors to reflect this.
General Risk Factors
Any generic risk factors should be included together at the end of the risk factor section under the caption “General Risk Factors.” Many companies will need to review their risk factors to determine which describe generic risks broadly applicable to all companies and move these risk factors under a separate heading at the end of the risk factors section.
Litigation
Environmental Regulatory Actions
The $100,000 threshold for environmental regulatory actions has been increased to $300,000, but a company also has the option of selecting another threshold that it determines is reasonably designed to result in disclosure of material environmental proceedings, so long as this threshold does not exceed the lesser of $1 million and 1% of current assets. Companies will need to evaluate their disclosure of environmental regulatory actions to determine whether this will result in reduced required disclosure.
Hyperlink
The new rules expressly permit the litigation disclosure to be included by cross referencing or hyperlink to another place in the document where the disclosure is made. Many companies already include a cross reference but others may consider a cross reference or hyperlink.
Business
Optional List of Disclosure Topics
The old list of required items in the business section, such as products, raw materials, intellectual property, seasonality, backlog, customers, working capital practices, and competition, which must be disclosed if material, has been eliminated. As revised, the new rules require only information material to the business as a whole to be disclosed. A non-exhaustive list of disclosure topics that “may” be disclosed include:
- Revenue-generating activities, products or services, and any dependence on revenue-generating activities, key products, services, product families or customers including government customers
- Status of development efforts for new or enhanced products, trends in market demand and competitive conditions
- Resources material to the business, such as sources and availability of raw materials and duration and effect of intellectual property
- Any material portion of the business subject to renegotiation or termination by the government
- Seasonality
Companies will need to evaluate their business section and the new list of “optional” disclosures. Some disclosure may no longer be needed due to the new principles-based approach, but new disclosures may be needed.
Human Capital Resources
A new required disclosure item is added – if material to the business as a whole, a description of the company’s human capital resources (which should include the number of employees) and any human capital measures or objectives that the company focuses on in managing its business (such as measures that address the development, attraction and retention of personnel) is required. While some companies have been increasingly adding human capital management information to their disclosures, this will require a change by many companies.
Governmental Regulation
The requirement to disclose environmental regulation is expanded to require, if material to the business as a whole, a description of material effects of governmental regulation including environmental regulation. Many companies already do this but this could require a change by some companies.
General Development of Business
Rather than requiring a description of the general development of the business over the prior 5 years as is currently required, the revisions require disclosure of only information that is material to an understanding of the general development of the business and eliminates the 5-year timeframe. After a company’s initial SEC filing, companies are only required to update this description with material developments since the latest full description and incorporate by reference the earlier complete description.
- Business Strategy: When describing the general development of the company’s business, one new item listed that “may” be disclosed is material changes to a previously disclosed business strategy.
- Other: Other items that may be disclosed include material bankruptcies, material mergers, and the acquisition or disposition of a material amount of assets.
Companies should evaluate their business development disclosure and whether any changes should be made to their first filing due to the new principles-based approach. For many companies this first filing would be their annual report on Form 10-K. Future filings will be able to incorporate by reference this disclosure and supplement it only with material developments.
[1] The new rules also affect the risk factor disclosure of foreign private issuers in their registration statements on Form F-1, F-3 and F-4.
