In December 2017, the American Bar Association (“ABA”) submitted its fourth comment letter to the SEC related to the financial and business disclosure requirements in Regulation S-K. Like the SEC’s ongoing Disclosure Effectiveness Initiative, the ABA has a Disclosure Effectiveness Working Group as part of its Federal Regulation of Securities Committee (of which I am a member) and its Law and Accounting Committee.
The ABA comment letter begins with a general discussion of the materiality concept, which is the underlying basis of disclosure, and then provides input on various specific areas of disclosure under Regulation S-K. The ABA comment letter specifically responded to the SEC concept release and request for public comment on sweeping changes to certain business and financial disclosure requirements issued on April 15, 2016.
I’ve been writing about Regulation S-K and the SEC Disclosure Initiative since at least early 2015. Although consistently a priority, with the finalization of proposed rule changes on the SEC short-term agenda, a complete overhaul of Regulation S-K (and Regulation S-X) is a fluid, ongoing process that will likely continue for years to come.
Materiality is a concept I’ve written about several times. Regulation S-K and Regulation S-X provide specific disclosure requirements that are measured and supplanted by the materiality concept. Specific disclosure requirements generally involve objective quantitative or bright-line-rule-based standards. In addition, to those specific disclosure requirements, a company must disclose any other material information necessary to make required disclosures not misleading. Materiality requires a facts-and-circumstances analysis. In TSC Industries, Inc. v. Northway, Inc., the U.S. Supreme Court defined materiality as information that would have a substantial likelihood of being viewed by a reasonable investor as having significantly altered the total mix of information available.
The ABA comment letter discusses the materiality standard’s application to specific Regulation S-K disclosure requirements. As noted by the ABA, the SEC recognizes that it has “adopted different approaches to guide registrants in evaluating materiality for purposes of disclosure, including in some cases using quantitative thresholds to address uncertainty in the application of materiality.” In some cases, Regulation S-K is “principles-based” in that it directs the company to apply the materiality standard directly to the facts at hand. A principles-based approach requires the company to “rely on a registrant’s management to evaluate the significance of information in the context of the registrant’s overall business and financial circumstances” and to “exercise judgment” in determining whether disclosure is required.
The ABA comment letter notes the necessity of balancing rule-based disclosures with those that require a materiality analysis. There is a degree of uncertainty in a materiality analysis and coupled with situations with a potential conflict of interest, such as disclosures related to officers and directors, or those that have a social application such as conflict minerals, the SEC leans towards a more specific rule-based approach. However, with ever-lengthening disclosure documents filled with irrelevant and non-material information, the principles-based materiality standard is gaining favor.
To balance the approaches, the ABA suggests subjecting almost all Regulation S-K disclosure items to a materiality analysis. A company would be required to evaluate each Item in Regulation S-K , thereby preserving the rigor of a rules-based system, but would be permitted to omit information, even if disclosure would otherwise be specifically required, if such information is not material and the inclusion of the information is not necessary to make any required statements not materially misleading. Exceptions to this approach would include disclosures involving conflicts of interest such as related party transactions and executive compensation.
The ABA specifically recommend amending Item 10 of Regulation S-K to add the following subsection (g):
(g) In addition to the information expressly required to be disclosed, the registrant shall disclose such additional material information, if any, as may be necessary to make the required statements in the light of the circumstances under which they are made not misleading. Issuers may omit information otherwise called for by a line item, except for Items 402 and 404, if such information is not material, as long as the effect of omitting the information would not be materially misleading. It shall be presumed, in the absence of facts to the contrary, that the omission of any disclosure called for by a Regulation S-K line item was an intentional omission by the registrant in reliance upon this sub-section (g) and not a failure to provide the disclosure called for by such line item.
Known Trends or Uncertainties
Known trends and uncertainties is a category of discussion included in Management Discussion and Analysis of Financial Conditions (MD&A). Item 303(a) requires a company to discuss their financial condition, changes in financial condition, and results of operations using year-to-year comparisons. The discussion is required to cover the period of the financial statements in the report (i.e., 2 years for smaller reporting companies and emerging growth companies and 3 years for others). The SEC proposed rule change published on October 11, 2017 would allow a company to eliminate the earliest year in its discussion as long as (1) the discussion is not material to an understanding of the current financial condition; and (ii) the company has filed a prior Form 10-K with an MD&A discussion of the omitted year. The proposed amendment would also eliminate the reference to a five-year look-back in the instructions, but rather a company would be able to use any presentation or information that it believes will enhance a reader’s understanding. The amendments will flow through to foreign private issuers as well with conforming changes to the instructions for Item 5 of Form 20-F.
Item 303(a) also requires a discussion of known trends or uncertainties that have had or that the company reasonably expects will have a material effect, either positive or negative, on its liquidity, capital resources or results of operations. A discussion of trends is forward-looking, related to potential future performance. Although the ABA believes the information is relevant and important, it expresses concerns about the SEC’s interpretations and guidance on the disclosure requirement.
The SEC guidance on trends (SEC Release 33-6385, published in 1989) states that where a trend, demand, commitment, event or uncertainty is known, management must: (i) assess whether the trend is reasonably likely to come to fruition, and if not disclosure is not required; (ii) if unsure, management should assume it is reasonably likely and then determine the impact on the company financial condition and if such impact is material. Unless the impact is not material, disclosure is required.
The ABA advocates replacing the SEC’s current guidance with an analysis based on the Supreme Court case of Basic, Inc. v. Levinson, which created a probability vs. magnitude test for materiality. In Basic the Supreme Court set the standard as “Under such circumstances, materiality ‘will depend at any given time upon a balancing of both the indicated probability that the event will occur and the anticipated magnitude of the event in light of the totality of the company activity.’”
The ABA also notes recent uncertainty in the law on the question of whether a failure to disclose is necessarily a violation of the antifraud provisions under Section 10(b) and Rule 10(b)(5). In particular, different federal circuit courts have reached different conclusions on the subject, and the U.S. Supreme Court has recently refused to review the matter to provide clarity. The ABA would like the SEC to address this discrepancy in rule making by affirmatively asserting that whether a failure to disclose is a violation of antifraud provisions depends on a facts-and-circumstances analysis.
Critical Accounting Estimates
MD&A also requires a discussion of critical accounting estimates. The ABA suggests that the SEC amend Item 303 to specifically require a discussion of the judgements and assumptions that management must make in order to prepare, and that have the most significant impact on, the company financial statements. The ABA suggests that the SEC clarify that the discussion should not just be a cut-and-paste of the critical accounting footnote in the financial statements, as is often the case now. Rather, the MD&A discussion should supplement the more technical footnote disclosure to help investors have a better understanding of the impact these assumptions have on the company’s financial disclosure. The discussion could even provide examples of what the financial statements might contain if different assumptions were made.
The SEC has made inroads into eliminating duplicative disclosure, including requesting comment and raising the issue of whether items duplicated in financial statement footnotes and other parts of a report should be maintained in only one or the other section or incorporated by reference from the footnotes to another section such as MD&A. Several important factors affect this dialogue, including that (i) an auditor must audit and therefore has responsibility for the contents in the financial statement footnotes, including any related discussion in the audit report which could increase audit costs and burdens; and (ii) items in the financial statement footnotes are not protected by the forward-looking statements’ safe harbors. As such, the ABA recommends any enhanced disclosure related to accounting estimates and judgments only be included in the MD&A section of a report.
Although SEC rules do not require a disclosure of business strategy, many companies include a stand-alone discussion, especially in an IPO context. The ABA suggests adding business strategy as a required category under Item 101 Description of Business. The ABA also suggests leaving the category undefined instead letting companies look to generally accepted understandings and their own business ideas. I do not agree with this suggestion from the ABA. I am generally not an advocate of additional requirements and would suggest leaving it as is with voluntary discussion where appropriate.
Intellectual Property Rights
The SEC has discussed expanding the intellectual property disclosures in Item 101. The ABA advocates protection of intellectual property and trade secret information. Among many issues is the loss of protection afforded trade secret or confidential information once published and in the public, the ability to identify copyright information created by employees, and identifying which distinctive marks are subject to common law trademark protection. As such, it recommends that the SEC not expand its current requirements.
The topic of social disclosure has been much debated over the past few years. In a report issued in October 2017, the U.S. Department of the Treasury recommended eliminating special interest and social disclosure from the SEC disclosure rules, including those related to conflict minerals, mine safety, resource extraction and pay ratio. The Financial Choice Act would eliminate these provisions as well. Climate change disclosure is another area of debate. On the other hand, institutional investors have asserted a social agenda, and disclosure of same, in the proxy process and voting on directors. The power of these funds and investors is not one a company can ignore.
The ABA supports the SEC’s guidance related to social issues, which is principles-based and generally would be included in MD&A or risk factor disclosures. The ABA includes sustainability, public policy, environmental, social and governance matters in this broad category. The comment letter supports a materiality analysis related to disclosure. However, I note that materiality would require an analysis as to whether such disclosure is important to a “reasonable investor.” As noted above, many institutional investors push their own social agenda, and thus disclosures related to same, even if a reasonable investor may not find the information material.
Disclosure of these social issues breeds emotional arguments and extreme viewpoints. Those that advocate for eliminating the disclosure requirements do so strongly, and those that believe there is not enough disclosure or enforcement in the area, believe so fervently. The ABA comment letter suggests adding rules that will assist companies in determining the level of disclosure, but qualifying those rules with a materiality standard. However, the ABA notes the complexity in this area and the need for careful evaluation, as well as the probability of a fluid, changing investor environment and thus a changing view of the “reasonable investor.”
Item 103 requires disclosure of material pending private civil and governmental regulatory legal proceedings and certain other specified pending or contemplated legal proceedings to which an issuer or its property is subject. Legal proceeding disclosures may also be appropriate in MD&A, risk factors and financial footnotes. Although Item 103 puts all matters in one location, it often does not include any important information beyond factual information about the proceedings. The ABA suggests even further reducing the disclosure in Item 103 to a catalogue with cross-references to more robust disclosures in other sections of a report. Finally, the ABA recommends reevaluating the requirement related to disclosure of “contemplated” governmental proceedings to those that have been asserted or have a probability of being asserted.
The disclosure of risk factors is complex enough that I once wrote a blog on just that topic. Almost all SEC guidance on disclosure matters includes a discussion of risk factors, such as the recent guidance on cybersecurity disclosure.
Risk factor disclosures are entirely principles-based. That is, there are no bright-line prescriptive rules that require a specific risk disclosure. Although the SEC consistently suggests only including risk factors that actually impact a company, and not boilerplate disclosures that could impact all businesses, most companies include the boilerplate disclosures. Companies are more concerned with the plaintiff’s bar and potential shareholder lawsuits for the failure to include a risk factor than the SEC guidance in this regard. Likewise, an SEC suggestion to limit the number of risk factor disclosures, or to order these disclosures in terms of management’s view of their priority or assessment of probability and magnitude of the potential impact, was met with strong issuer opposition—again, likely from a fear of shareholder litigation.
The ABA comment letter makes a number of specific recommendations related to risk factor disclosures. Despite opposition, the ABA suggests that the SEC consider limiting the number of risk factors and require that they be listed in order of priority. Similarly, the ABA suggests a specific requirement that companies omit generic risk factors from their reports and registration statements. Although it does not suggest disclosing the probability of a particular risk, the ABA does advise that companies conduct a probability/magnitude assessment in its risk factor disclosures.
Further Background on SEC Disclosure Effectiveness Initiative
I have been keeping an ongoing summary of the SEC ongoing Disclosure Effectiveness Initiative. The following is a recap of such initiative and proposed and actual changes.
In October, 2017 the U.S. Department of the Treasury issued a report to President Trump entitled “A Financial System That Creates Economic Opportunities; Capital Markets” (the “Treasury Report”). The Treasury Report made specific recommendations for change to the disclosure rules and regulations, including those related to special interest and social issues and duplicative disclosures.
On October 11, 2017, the SEC published proposed rule amendments to modernize and simplify disclosure requirements for public companies, investment advisers, and investment companies. The proposed rule amendments implement a mandate under the Fixing America’s Surface Transportation Act (“FAST Act”). The proposed amendments would: (i) revise forms to update, streamline and improve disclosures including eliminating risk factor examples in form instructions and revising the description of property requirement to emphasize a materiality threshold; (ii) eliminate certain requirements for undertakings in registration statements; (iii) amend exhibit filing requirements and related confidential treatment requests; (iv) amend Management Discussion and Analysis requirements to allow for more flexibility in discussing historical periods; and (v) incorporate more technology in filings through data tagging of items and hyperlinks.
On March 1, 2017, the SEC passed final rule amendments to Item 601 of Regulation S-K to require hyperlinks to exhibits in filings made with the SEC. The amendments require any company filing registration statements or reports with the SEC to include a hyperlink to all exhibits listed on the exhibit list. In addition, because ASCII cannot support hyperlinks, the amendment also requires that all exhibits be filed in HTML format. The new Rule goes into effect on September 1, 2017, provided however that non-accelerated filers and smaller reporting companies that submit filings in ASCII may delay compliance through September 1, 2018.