September 09, 2020

Living in a Material(ity) World: SEC Adopts Regulation S-K Amendments Rooted in Materiality

Continuing a trend favoring a principles-based, materiality-driven disclosure regime, on August 26, 2020, the Securities and Exchange Commission (SEC) adopted amendments to the description of business (Item 101), legal proceedings (Item 103) and risk factors (Item 105) disclosures required under Regulation S-K. These amendments largely follow the SEC’s proposed rule changes from August 2019 and represent the first significant updates to these items in over 30 years. The amendments primarily affect reports on Form 10-K and registration statements. 

The amendments represent a shift from prescriptive disclosures to a more principles-based, or company-specific, approach. In other words, the amendments emphasize a more fluid discussion of what a company believes is material to its business over a more standardized disclosure rubric. For example, the amendments to Item 101 eliminate the required five-year lookback period for business descriptions in favor of a materiality-based discussion of business developments. Perhaps the most significant change is the expansion of the non-exhaustive list of discussion topics to include a description of human capital resources and human capital measures or objectives. The addition of the human capital topic acknowledges that a company’s people is now often a key asset– as opposed to the property, plant and equipment that were key assets many years ago – and human capital has been a key focus area for initiatives requesting more disclosure of environmental, social and political topics. The SEC emphasized in the adopting release that, with respect to human capital resources and all other subjects included in the SEC’s list of examples, “these are examples of potentially relevant subjects, not mandates.”

The amendments to risk factor disclosure are similarly focused on materiality and improving readability. Among other changes, companies with risk factor disclosure of more than 15 pages will now be required to provide an accompanying risk factor summary of no more than two pages. This reform, intended to help investors navigate lengthy disclosure, was also viewed by Commissioner Peirce as somewhat of an “experiment” to encourage companies to “overcome the fear of litigation that pushes companies to disclose many pages of risks.”

The final amendments will be effective 30 days after being published in the Federal Register, and therefore will be effective for the 2021 annual reporting season and near-term securities offering registration statements. Although the amendments will primarily impact preparation of upcoming reports on Form 10-K, they are likely to be in effect when calendar year-end companies file their third quarter Forms 10-Q and may impact legal proceedings or risk factor disclosure in those reports.

Description of Business

Summary of Changes – General Development of Business

  • Adopts a principles-based approach, requiring disclosure of information material to an understanding of the general development of the business.
  • Replaces the previously prescribed five-year timeframe with a materiality framework.
  • Permits a company, in filings made after a company’s initial filing, to provide only an update of the general development of the business focused on material developments that have occurred since its most recent full discussion of the development of its business, which will be incorporated by reference.

Summary of Changes – Narrative Description of Business

  • Clarifies and expands the principles-based approach, with a non-exclusive list of disclosure topic examples drawn in part from current prescribed topics.
  • Includes a description of the company’s human capital resources among the list of disclosure topics to be considered.
  • Refocuses the regulatory compliance disclosure requirement by including as a topic all material government regulations, not just environmental laws.

Recommended Actions

  • First, acknowledge that very few disclosure changes are required by the amendments. Rather, many of the changes give companies more flexibility to tailor disclosure to current, material matters. Accordingly, changes to the Business section may evolve over time and need not change significantly in the first year.
  • Start early. Compare your last Business description to the new rules to identify potential areas for change. Consider whether this is a good year to devote time and resources to a wholesale revision of the Business section, taking to heart the spirit of the amendments.
  • Review your latest investor decks and other materials that are actually used by the company in discussions with investors to identify the items truly material to the company. Similarly, review analyst reports to identify the key areas of interest among analysts and investors in understanding the business.
  • As it relates specifically to the new requirement to describe human capital resources and human capital measures or objectives to the extent material to the company:
    • If you have a corporate social responsibility (CSR) report, review the report for information already provided about human capital resources.
    • Regardless of whether you have a CSR report, review peer companies’ CSR reports to identify the type of information they consider significant enough to report.
    • Consider the key human capital measures and objectives you focus on in managing your organization, including consideration of recruitment, attraction, development and retention of talent.
    • There is no express requirement to report any quantitative information or report information based on any particular reporting framework.
      • Examples of measures companies may focus on include the level of employee participation in training and development programs, level of employee engagement assessed through surveys, diversity and inclusion performance, regrettable turnover/attrition metrics, occupational health and safety data, participation in employee wellness programs, data on recruiting lead times, etc.

* As a threshold matter, we expect that very few operating companies will conclude that their human capital resources are not material to the company.

  • After making any revisions, carefully form check your revised Business disclosure to ensure it aligns with the amended requirements. The table below highlights representative examples of the key changes in disclosure requirements and topics.

Disclosures No Longer Required, Unless Material

Disclosures Converted From Required to Non-Exclusive Examples (With or Without Modest Changes)

Added as Non-Exclusive Examples

General Development of Business

  • Disclosure of the year the company was organized
  • Form of company’s organization
  • Disclosure of any material changes in the company’s mode of conducting its business
  • Nature and effects of any material bankruptcy, merger or consolidation
  • Acquisition or disposition of any material amount of assets other than in the ordinary course of business
  • Material changes to a previously disclosed business strategy

Description of Business

  • New segments
  • Working capital resources
  • Dollar amount of firm backlog orders
  • Revenue-generating activities, products and/or services, and any dependence on certain activities, key products, services, product families or customers, including governmental customers
  • Status of development efforts for new or enhanced products, trends in market demand and competitive conditions
  • Material resources, including sources and availability of raw materials and the duration and effect of patents, trademark, licenses and franchises
  • A description of any material portion of business that may be subject to renegotiation of profits or termination of contracts at the election of the government
  • The extent to which the business is or may be seasonal
  • Material effects that compliance with all government regulations (including environmental regulations, as already required) may have upon the capital expenditures, earnings and competitive position of the company, including estimated capital expenditures for environmental control facilities
  • Human capital resources (including the number of employees, as already required) and human capital measures or objectives that the company focuses on in managing the business, such as measures or objectives that address the development, attraction and retention of personnel

Legal Proceedings

Summary of Changes

  • Expressly states that the required information may be provided by hyperlink or cross-reference to legal proceedings disclosure located elsewhere in the document to avoid duplicative disclosure.
  • Implements a modified disclosure threshold for certain governmental environmental proceedings resulting in monetary sanctions that increases the existing quantitative threshold for disclosure of those proceedings from $100,000 to $300,000, but that also affords a company some flexibility by allowing the company, at its election, to select a different threshold that it determines is reasonably designed to result in disclosure of material environmental proceedings, provided that the threshold is disclosed in each annual and quarterly report and does not exceed the lesser of $1 million or 1% of the current assets of the company.

Recommended Actions

  • Revisit the substantive differences in the standards for disclosure of legal proceedings under Item 103 of Regulation S-K and disclosure of contingencies under ASC 450. While the amendments permit hyperlink and cross-references to eliminate redundant disclosure, they do not conform the standards for disclosure between the two regimes. Where the same disclosure is appropriate in multiple places, consider use of hyperlinks or cross-references to eliminate redundant disclosure.
  • Consider whether the flexibility to select an alternative threshold is attractive to the company and how to assess an appropriate threshold. It is not currently common practice for companies to disclose company-determined quantitative materiality thresholds, which would be required to make use of this alternative.

Risk Factors

Summary of Changes

  • Requires summary risk factor disclosure of no more than two pages if the risk factor section exceeds 15 pages.
  • Refines the principles-based approach of Item 105 by requiring disclosure of “material” risk factors rather than “most significant” risk factors.
  • Requires risk factors to be organized under relevant headings in addition to the subcaptions currently required, 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.

Recommended Actions

  • If the risk factors currently exceed 15 pages, review them with an eye toward reducing duplication, streamlining the narrative and removing unnecessary or outdated risk factors. Risk factors often suffer from a “Hotel California” phenomenon where risk factors check in, but they never check out.
  • If any of the narrative in your risk factor repeats disclosure elsewhere, consider replacing it with a cross-reference. For example, if a risk factor on regulatory compliance describes the many regulations applicable to the company, and that description is also included in the Business section, refer to the description in the Business section and focus the risk factors on the risks related to compliance or non-compliance.
  • If the risk factors must exceed 15 pages, start preparing a brief summary of the risk factors, which may be a listing of the risk factors’ titles (the typical approach to summary risk factors in prospectus summaries). These are often already complete sentences identifying the key risk. Alternatively, consider using a two- to three-word description of the risk, followed by a brief clause detailing the risk. For example, a risk factor regarding raw material costs could be summarized as follows: “Economic Environment ― We operate a global business and our operations may be impacted by changes in industrial, economic or political conditions in the geographies and markets we serve.”
  • Organize your risk factors by subtype and by order of significance of the subtypes and risks within the subtypes. Examples of subcaptions could include “Business Environment and Competition Risks,” “Operational Risks,” “Legal, Regulatory and Compliance Risks,” and “Credit and Liquidity Risks.” Many companies already organize their risk factors by subtype, so reviewing peer company filings may be helpful in identifying potential subcaptions.

We expect that disclosure practices will evolve over time as companies adapt to the new rules, market practices develop and the SEC issues interpretive guidance. In connection with considering changes to disclosure, and as those disclosures then evolve over time, we also recommend you review, assess and potentially adjust disclosure controls and procedures to keep pace with the rigors of the principles-based system.

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