by Cydney Posner
The SEC has issued a new concept release, as part of its Disclosure Effectiveness Initiative, seeking comment on modernizing certain business and financial disclosure requirements in Reg S-K. The release, which weighs in at a hefty 341 pages, focuses on business and financial disclosures in periodic reports “because many of them have changed little since they were first adopted.” That Reg S-K was adopted more than 30 years ago certainly becomes apparent as the release marches through each technical requirement in the rules, asking whether there is any reason to retain it or modify it and whether it even addresses issues that are important to investors in light of the way companies currently operate their businesses. At the open meeting called to vote on issuing the concept release, Chair Mary Jo White said that a review of compensation and governance requirements is also on the SEC’s agenda.
SoapBox: Surprisingly, notwithstanding the implications of a couple of the questions, the release does not seem to be animated by any fundamental or pervasive “re-imagining” of the disclosure system as a whole, such as the “company profile” approach that Chair Mary Jo White had floated back in 2013. That approach would have included a “filing and delivery framework based on the nature and frequency of the disclosures, including a ‘core document’ or ‘company profile’ with information that changes infrequently. Companies could then be required to update the core filings with information about securities offerings, financial statements, and significant events.” (See this News Brief.) The same concept was recommended for further study and consideration in the staff’s 2013 S-K Study, the Report on Review of Disclosure Requirements in Regulation S-K, required by Section 108 of the JOBS Act. It was later discussed, along with some countervailing considerations, by Corp Fin Director Keith Higgins in 2014 (see this PubCo post). Even though the release notes briefly that there were several commenters on the S-K Study that favored consideration of the concept of a “company profile,” the release seems to devote almost no space to batting this concept around. Instead, for the most part, the release seems to take a more granular or incremental approach, exhaustively examining each particular current requirement to see whether it can be improved or even remains viable. (And that review is quite comprehensive. Anyone who has practiced in the area for a while will recognize and have faced, perhaps with some frustration, a significant number of the issues raised.) One of the few allusions to anything resembling a “company profile” regime may be implicit in one of the questions in the release, which asks whether, “[o]nce a registrant has disclosed this [core business] information in a registration statement should we allow registrants to omit this disclosure from subsequent periodic reports unless material changes occur?” Is this what the “company profile” concept has morphed into?
Although there are questions specific to each section, as a general matter, the release seeks comment across the board on a number of topics as applicable to various disclosure requirements: the importance of various disclosures in making investment and voting decisions, how the requirements could be enhanced, whether the current requirements appropriately balance costs and benefits, and whether technology could be used to lower costs, increase benefits and facilitate investor access. In addition, the release asks about the challenges arising out of the current and potential new disclosure requirements, and whether the requirements could be revised to adapt to future changes in market conditions and advancements in technology. The release also takes into account that different types of investors may have different types of information needs, that the value of some types of disclosures may not be uniform across companies and industries, and that the costs of disclosure may impose a disproportionate burden on smaller companies.
SideBar: Although undoubtedly not the intent of the release, the encyclopedic nature of the discussions makes it a great resource for understanding the background and guidance surrounding the current rules, as well as the staff’s interpretation of the current requirements (which, I would guess, would still be in place for quite a while). Attorneys performing “S-K checks” should take note. For example, the release includes a very useful table showing the scaled disclosure requirements for EGCs and SRCs. The release could also be useful in crafting responsive disclosures. For example, someone who finds Item 305 related to derivatives and other market-risk sensitive instruments to be somewhat impenetrable might find helpful the guiding principles behind the rules that are laid out in the release. Similarly, the release reminds us about SEC guidance in some areas. For example, in the discussion regarding disclosure related to employees, the release reminds us that there is a CDI specifying that, in “industries where registrants’ general practice is to hire independent contractors…rather than ‘employees’ to perform the work of the company, this disclosure should indicate the number of persons retained as independent contractors, as well as the number of regular employees.”
The release addresses three basic topics: disclosure framework, line items and presentation and delivery. The summaries below are far from comprehensive, but are rather intended to provide a flavor of the discussions in the release.
- Temporary rules. The release observes that the current rules have developed as a result of statutory mandates, new legislation and SEC responses to business and market developments. The release considers whether “temporary” rules with automatic sunset provisions or some other type of sunset review would be useful.
- Principles-Based v. Prescriptive Disclosure Requirements. Both of these approaches are based on the concept of “materiality” as defined in TSC Industries, Inc. v. Northway, Inc., specifically, whether there is a substantial likelihood that a reasonable investor would consider the information important in decision-making and whether a reasonable investor would view the information to significantly alter the “total mix” of information available. “Principles-based” rules “articulate a disclosure objective and look to management to exercise judgment in satisfying that objective.” On the other hand, some requirements “prescribe” quantitative thresholds to minimize uncertainty in determining materiality and to identify when disclosure is required. While principle-based rules are necessarily imprecise, may be difficult to apply and can result in a loss of comparability among reporting entities, they can help to eliminate irrelevant information by permitting tailored responses and are more flexible and adaptable as circumstances change. Prescriptive standards can help promote comparability, consistency and completeness of disclosure, but they can sometimes be circumvented and may not address or capture all the important information. The S-K Study recommended that revisions emphasize an overarching principles-based approach while preserving the benefits of a rules-based system. A study on accounting standards recommended an “objectives-oriented” approach under which new rules would be developed “by clearly articulating the accounting objective of the standard and providing sufficient detail and structure so that the standard can be applied on a consistent basis,” minimizing exceptions and bright lines. The question is whether that approach would be appropriate in this context.
- Different audience profiles. The release observes that, while annual reports are intended for shareholders making voting decisions, 10-Ks are read primarily by institutional investors, professional security analysts and sophisticated individual investors, who “may be relatively more interested in standardized disclosure formats well-suited for large-scale processing and analysis.” Other types of investors may seek disclosure emphasizing the information that management believes is most important. The question is what level of sophistication should be assumed. Should disclosure be targeted based on the extent to which investors rely on market prices or third-party analyses, rather than using disclosure directly? Variants of this question are repeated throughout the release in connection with different disclosure requirements.
- Compliance and competitive costs. An appropriate level of disclosure is critical to a well-functioning capital market, but may entail administrative and compliance costs, as well as competitive or other economic costs, which are addressed to some extent through scaled disclosure requirements. Comment is requested on ways to reduce costs, as well as on the effectiveness of scaled disclosure requirements. Information regarding the costs and benefits of each disclosure requirement is requested throughout the release.
Information for Investment and Voting Decisions (Line Item Disclosures)
- Core Company Business Information. Under review here are the disclosures required by Item 101(a)(1) and (c)and Item 102 to determine whether they continue to provide information necessary to understand the nature of a company’s business and properties, whether any requirements should be added, such as strategy, and whether any requirements can be modified or eliminated, such as by using summaries in lieu of detailed discussion of the development of the business. With regard to the narrative description of business and related line items, in light of changes in the way businesses operate, the release asks whether other disclosures are now relevant. For example, what other disclosures would be appropriate in the context of a business that relies heavily on intellectual property owned by a third party or relies on a service agreement with third parties to perform necessary business functions? Should a general description of the company’s industry be required, and should there be additional industry-specific requirements for some companies, such as manufacturing or technology companies? Should all of the disclosure requirements be conditioned on materiality? Should they all be restructured to be principles-based? Should more information about intellectual property be required for companies in industries that depend heavily on it? Should the disclosure requirements regarding government contracts, environmental compliance and costs be amplified? Should disclosure regarding regulation be mandated? Which requirements should be further scaled or eliminated for smaller issuers? Should additional information be required about contract employees, outsourcing or subcontracting arrangements? The property disclosure requirements have been around in some form or other since 1935, but should they even be retained for all companies?
- Company Performance, Financial Information and Future Prospects. This section addresses selected (5-year) financial data (Item 301), supplementary quarterly financial data (Item 302) and MD&A (Item 303). Given the overlap with the financial statements and prior reports, do the selecteds or quarterlies add anything to the mix or should they be limited or eliminated? Do they enable investors to see retrospective changes and short-term and other trends not otherwise easily available? Certainly, no one is suggesting that MD&A be eliminated, but is there a way to “encourage” registrants to do more than just recite the amounts of changes from year to year which are readily computable from their financial statements, instructions to the contrary notwithstanding? Should a high-level executive overview be required that is not just duplicative, but addresses the most important themes, opportunities and challenges? Should the two-step test for forward-looking information be retained? (Is the event likely to occur? If not reasonably likely, no disclosure is required. If undeterminable, disclosure is required unless management determines that, if it were to come to fruition, it would not be reasonably likely to have a material effect.) Should the “reasonably likely” standard that applies to MD&A be revised in favor of the probability/magnitude standard of Basic v. Levinson? Should discussion of performance metrics and other key variables important to particular industries be required? Is there a reason to continue to include a discussion of prior period results? Is there a presentation other than year-to-year comparisons of results that would facilitate better analysis? How can the analysis of liquidity and capital resources be made more meaningful? In light of the increased use by non-financial companies of short-term borrowings to, among other things, buy back stock and pay off long-term debt, should the rules include a specific requirement to discuss short-term borrowings? Is the information required about off-balance sheet arrangements duplicative of the financial statement notes or should it be retained and even expanded to require an analysis of the associated risks? Should narrative disclosure or additional categories of obligations be added to the table of contractual obligations? Should disclosure be required regarding management’s significant judgments and assumptions underlying its use of critical accounting estimates?
- Risk and risk management. This section discusses risk factors (Item 503(c)) and market risk (Item 305). In general, the release asks how to make risk factors more specific, more meaningful and how to avoid boilerplate. Previous commenters advised the SEC that, because of liability concerns and, specifically, the PSLRA, “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.” Moreover, the SEC acknowledges that “academic studies find that risk factor disclosure is informative and that the public availability of this information decreases information asymmetry among investors.” Nevertheless, the release persists in grumbling about the length of risk factors and the continued inclusion of more generic risks. But, at the same time, the release asks whether the disclosure should be further expanded to describe the probability of occurrence and how the risk is being addressed; should disclosure of the company’s strategy for managing risk exposure be required, notwithstanding staff comments requiring the elimination from risk factors of any mitigating language? In connection with quantitative and qualitative disclosure regarding market risk sensitive instruments, such as derivatives, do changes in GAAP make the information now redundant and, if not, does it elicit useful information for investors? Should the three prescribed disclosure alternatives (tabular disclosure, sensitivity analysis and value at risk) be eliminated or replaced with different approaches? Should all risk-related disclosures be consolidated?
- Securities of the registrant. This section concerns the number of holders (Item 201(b)), description of securities (Item 202), sales of unregistered securities and use of proceeds (Item 701) and repurchases (Item 703). The release asks whether the number of record holders has any value to investors and whether the number of beneficial owners would be more valuable. Would a comprehensive discussion of registered securities in periodic reports facilitate access to important disclosure for investors in the secondary market? Is the disclosure under this item of sales of unregistered securities redundant of other disclosures? Does the disclosure of the use of IPO proceeds provide information that is useful to investors? Should more frequent or more granular information about repurchases be required? Should the impact of stock buybacks be analyzed in MD&A, for example, if debt is incurred to fund repurchases or if the buyback has had an impact on performance measures such as EPS?
- Industry guides. Do they provide useful guidance that improves disclosure, and should they be codified in Reg S-K?
- Public policy and sustainability matters. Some investors and interest groups have requested more disclosure of a variety of public policy and sustainability matters, including climate change, resource scarcity, corporate social responsibility and good corporate citizenship, contending that this information is significant to their voting and investment decisions. The release asks which disclosures, if any, are important to informed voting and investment decisions. The question is whether this disclosure is important to the general population of “reasonable investors” or only to a narrow segment of investors. The release cites one study showing that “investors are more likely to engage registrants on sustainability issues than on financial results or transactions and corporate strategy.” However, some commenters have expressed concern “that adopting sustainability or policy-driven disclosure requirements may have the goal of altering corporate behavior, rather than producing information that is important to voting and investment decisions.” What are the cost and challenges of providing ESG disclosures?
SideBar: At the SEC open meeting to vote on issuance of the concept release (see this PubCo post), Commissioner Stein contended that “[s]ustainability disclosure differentiates companies and it may foster investor confidence, trust, and employee loyalty. More importantly for investors, companies that adopt certain environmental, social, and corporate governance or ESG measures may perform better than those that do not.” She expressed concern, however, that the release did not specifically address many of these ESG topics, such as diversity and inclusion measures. Commissioner Piwowar had quite a different view. He emphasized that both the JOBS Act and FAST Act required the SEC to study Reg S-K to simplify reporting and reduce costs to companies. In that light, he took issue with any effort to expand the nature of disclosure to cover items that were not strictly “material,” as opposed to merely useful or interesting to some shareholders, or, as he put it, allowing these shareholders to “hijack corporate resources to serve their own agendas.” Presumably, he was taking direct aim at this aspect of the release regarding sustainability and ESG disclosures.
- Exhibits. This section concerns exhibits required for periodic and current reports under Item 601. Other than acquisition agreements, exhibits must be filed as complete documents, including any schedules or attachments, but should immaterial attachments and schedules still be required? Should all amendments be required to be filed, even if immaterial? The release also asks whether the standards for material contracts – both “not made in the ordinary course of business” and contracts “entered into not more than two years before such filing” – are still appropriate. Similarly, are the exceptions to “ordinary course,” including the clause related to agreements upon which the registrant’s business is “substantially dependent, as in the case of contracts to sell the major part of registrant’s products or services” well understood and still appropriate or should the requirement be more prescriptive by establishing a dollar amount or percentage threshold? For example, the release floats the idea of “a requirement for registrants to file all ordinary course contracts entered into (i) since the beginning of the last fiscal year, (ii) that exceed a percent of some measure, such as revenue or net income and (iii) where the registrant has a direct or indirect material interest.” Should the requirement regarding related-party exhibits be revised “to require registrants to file as exhibits all contracts involving related party transactions disclosed pursuant to Item 404(a)?” Alternatively, should there be a principles-based standard that just requires filing of “all contracts that are material to an understanding of the registrant or its business”? The release also points out inconsistencies between Form 8-K and the exhibit requirements that warrant further attention, such as with respect to acquisitions and dispositions of assets. Does it still make sense to require auditor’s preferability letters relating to voluntary changes in accounting principles? And what about that list of significant subsidiaries – do investors really need that? Notably, some commenters asked for more information about subsidiaries, such as revenues and LEIs (legal entity identifiers), to help understand a registrant’s corporate structure and tax strategy. Should companies still be allowed to omit insignificant subsidiaries that are located in countries regarded as tax havens?
- Scaled requirements. There are lots of different categories used by the SEC – SRCs, EGCs, accelerated filers, non-accelerated filers, large accelerated filers. Should the eligibility criteria be rationalized and the disclosure requirements harmonized? (For a discussion of recommendations on this topic from the SEC’s Advisory Committee on Small and Emerging Companies, see this PubCo post.) Are there requirements that could be further scaled without risk to investors? Should SRCs be exempt from XBRL?
- Frequency of interim reporting. The value of quarterly financial reporting has been the subject of some recent debate, particularly to the extent it encourages “short-termism.” On the other hand, some are skeptical of the benefits of semi-annual reporting, i.e., whether delaying a report by a few months would make a difference. Should quarterly reporting be revised for smaller or for all companies?
Presentation and Delivery of Important Information
In this section, the release seeks input on how to improve readability and navigability, including through use of tools such as cross-referencing, incorporation by reference, hyperlinks and company websites.
- Cross-referencing. Cross-references could be used to reduce redundancies and improve the navigability of lengthy documents, but they could also impair readability and introduce challenges with respect to comparative analyses or large-scale automated processing of disclosure. With regard to financial statements, the release suggests that cross-referencing from the financial statements to MD&A may confuse users about what is covered by the auditor’s report. Moreover, while the financial statements are not covered by the PSLRA safe harbor from liability for forward-looking statements, the safe harbor does cover MD&A. Concerns have been voiced as to whether cross-referencing in the financial statements to forward-looking statements in the MD&A could cause those statements to “lose” their PSLRA safe-harbor protection, exposing the registrant to liability. The release asks whether cross-referencing should be expanded or required in some areas.
- Incorporation by reference. Advancements in technology encourage increasing use of incorporation by reference. The question is whether it’s helpful or confusing, whether it should be limited, expanded or prescribed in certain instances, and whether new information needs to highlighted.
- Hyperlinks. Currently, companies assume liability for hyperlinked material as if it were part of the filing. The SEC has imposed some limits on hyperlinks, and the question is whether technology and usage have advanced sufficiently to eliminate concerns regarding disaggregated disclosure.
- Company websites. Companies are not permitted to satisfy disclosure requirements by incorporating by reference to information on their own websites, but should they be? What about from other sources? Some rules require that information be posted on company websites. Do investors benefit from requiring disclosure in a filing when the information is readily available on the registrant’s website? If information posted on websites were to be excluded from filings, what protections, such as duration of availability, should be required?
- Specific formatting requirements. Companies generally have wide latitude in how they present the required disclosures, but some disclosure has a prescribed format. Do the current disclosure requirements appropriately consider the need for both standardization and flexibility? Should more standardized tabular or graphic presentations be required?
- Layered disclosure. Generally, in the staff’s view, a “layered” approach would highlight, in an overview, the information that management believes is the most important information, while still providing detailed data and analysis further into the filing. But are there other approaches to layering that should be considered?
- Structured disclosures. Structured disclosures include disclosures made machine-readable through XBRL. Many sophisticated investors and analysts contend that structured disclosures facilitate analysis of information; however, preparation of the structured data is costly and time-consuming. (But see this News Brief reporting on a study that showed that the investors and analysts who were supposed to benefit from XBRL “don’t seem to be using it. According to the report’s authors,… analysts and investors remain skeptical about XBRL and have many concerns about its utility.”) The release asks whether there are ways to improve structured data while reducing costs.
At the open meeting, Chair White said that a review of compensation and governance requirements is also on the SEC’s agenda. Meanwhile, comments on this concept release are due 90 days after publication of the concept release in the Federal Register.