SEC adopts final disclosure update and simplification amendments

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In her statement at the SEC open meeting held in 2016 to vote on issuing the proposing release for the SEC’s “Disclosure Update and Simplification,” SEC Commissioner Kara Stein protested that the proposal was, as she euphemistically framed it, so “hyper-technical” that many potential commenters may not be able “to truly access and understand what is being proposed.”  Apparently, even in its final state, the release was so hyper-technical that none of SEC Commissioners could even bear to talk about it. Could that be why there was no open meeting to discuss adoption of the final rules? Just guessing, of course.  What we saw instead was a Friday afternoon drop of this announcement and this 314-page release on the final rules. The SEC has also kindly provided this “demonstration version” of the rule amendments, essentially a blacklined version of the amendments. The final rules represent a component of the SEC’s disclosure effectiveness project, as well as an effort to implement one of the mandates of the FAST Act.  The final rules become effective 30 days after publication in the Federal Register, and the staff will review the impact of the amendments within five years thereafter.

The final rules amend certain disclosure requirements that have become redundant, duplicative, overlapping, outdated or superseded, in light of other SEC disclosure requirements, U.S. GAAP, or “changes in the information environment.”  Some of the disclosure requirements that overlap with GAAP, but require incremental information, were referred to FASB for potential incorporation into GAAP. The SEC is requesting that FASB determine whether to add these items to its agenda within 18 months after publication of the adopting release in the Federal Register. In a statement to Bloomberg BNA, FASB indicated that it was “reviewing the SEC’s recommendations, and that board members will discuss the request at an upcoming public meeting.” Although the final rules address Reg A issuers, investment companies and others, this post will address only the provisions applicable to public companies.

And speaking of “hyper-technical,”  the adopting release is also too hyper-technical to discuss at any length here, but below are some examples of the types of modifications the SEC adopted. Please note that the lists below are not complete.

Disclosure Location Considerations

The SEC identifies two broad themes here.  The first, “disclosure location considerations,” raises two issues: if streamlining of disclosure results in relocation, the disclosures could be more or less prominent or could be relocated in the financial statements, subjecting this information to audit or review, internal control over financial reporting and XBRL requirements.  In addition, the safe harbor under the Private Securities Litigation Reform Act of 1995 does not apply to financial statements. Relocating disclosures outside the financial statements would have the opposite effect. Notably, numerous commenters expressed concern about moving disclosures that contain forward-looking information into the financial statements, noting that this relocation would introduce liability concerns (because of the unavailability of the PSLRA) for registrants and could create potential verification and auditability issues for auditors. The second theme, “bright line disclosure threshold considerations,” relates to disclosure requirements that are similar, except that one includes a bright line disclosure threshold, while the other set of requirements does not. For these topics, the elimination of the bright line threshold has the potential to change the disclosure provided to investors.

Redundant or Duplicative Requirements

The SEC identified a number of requirements that mandate substantially the same disclosures as GAAP, IFRS or other SEC disclosure requirements and is largely eliminating the redundant SEC disclosure requirements.  Most of these redundancies relate to Reg S-X, but some involve Reg S-K Item 601 exhibits. For example, the final rules eliminate Item 601(b)(11) and Instruction 6 to “Instructions as to Exhibits” of Form 20-F, which require a statement showing the calculation of per-share earnings (unless the computation can be determined from information already in the report) in annual filings. According to the SEC, that requirement is duplicative of information required under GAAP, Reg S-X and IFRS. Similarly, the final rules eliminate as duplicative of GAAP the reference to “earnings per share” in the first sentence of Rule 10-01(b)(2) of Reg S-X, which requires presentation of earnings per share on the face of an interim income statement. Another provision eliminated as duplicative of GAAP is the requirement to disclose the reason for a change in accounting principle in an interim period in Rule 8-03(b)(5) and Rule 10-01(b)(6) of Reg S-X.  The release includes extensive tables (beginning on page 29) showing the specific provisions proposed to be eliminated and the GAAP or IFRS provisions that they duplicate. (Note, however, that the tables reflect the proposals and must be read in conjunction with the discussion of the final amendments.)

Overlapping Requirements

The SEC has also identified SEC disclosure requirements that overlap with GAAP, IFRS or other SEC disclosure requirements, that is, they relate to those requirements, but are not exactly the same.  In some cases, the SEC disclosure requirement would be deleted and, in other cases, integrated.  In some cases, the result is a referral to FASB. In this context, there are two approaches: eliminate the overlapping disclosure where the information is the same or the incremental information required is immaterial, or, where the incremental information is material, integrate it with other overlapping requirements.

Among the overlapping disclosures the SEC determined to eliminate are:

• Elimination of Items 101(c)(1)(xi) and 101(h)(4)(x) of Reg S-K, which require disclosures, if material, of the amount spent on research and development activities for all years presented. While some of the terms used for the same disclosure under GAAP are different, the SEC contended that GAAP required “reasonably similar” disclosures. The relocation could result in prominence considerations as well reluctance to provide forward-looking information because of the absence of the PSLRA safe harbor; however, the SEC responded that disclosure of trend information related to R&D, where material, is required by Item 303 of Reg S-K and could otherwise be provided voluntarily outside of the financial statements.
• Elimination of Item 201(a)(2)(i) of Reg S-K, which requires disclosure on Form S-1 or Form 10 of the amount of common equity subject to outstanding options, warrants or convertible securities, when the class of common equity has no established US public trading market. U.S. GAAP includes a broader requirement to disclose the terms of significant contracts to issue additional shares and other reasonably similar information.
• Deletion of Item 503(d) and Item 601(b)(12), with conforming revisions, relating to disclosure, in connection with debt securities, of the historical and pro forma ratio of earnings to fixed charges and the related exhibit showing that computation. The SEC observes that now a “variety of analytical tools are available to investors that may accomplish a similar objective as the ratio of earnings to fixed charges.” In addition, debt investors often negotiate covenants requiring issuers to provide more relevant financial information.
• Deletion of the requirements in Item 201(c)(1) of Reg S-K to disclose the frequency and amount of cash dividends declared for the two most recent fiscal years and any subsequent interim period. Amended  Rule 3-04 of Reg S-X will require the amount of dividends in interim periods.
• Elimination of the requirements for pro forma financial information in interim filings for business combinations in Rule 8-03(b)(4) and Rule 10-01(b)(4) as GAAP and Item 9.01 of Form 8-K require reasonably similar  disclosures.
• Elimination of the requirement in Item 101(b) of Reg S-K to disclose in the business description segment financial information, restatement of prior periods when reportable segments change, and discussion of interim segment performance that may not be indicative of current or future operations. GAAP and Item 303(b) of Reg S-K require similar disclosures, and Item 101(b) explicitly permits issuers to cross-reference to the notes to the financial statements and the description of business to avoid duplication.
• The same duplication exists with regard to the GAAP and Reg S-K disclosure requirement of financial information by geographic area. In that case,  Item 101(d)(2) explicitly permits issuers to cross-reference between the notes to the financial statements and the description of business to avoid duplicative disclosures about geographic areas. Here again, the SEC deleted Item 101(d)(1) and Item 101(d)(2).
• Elimination of the Reg S-K Item 101(d)(3) requirements of disclosure of any risks associated with an issuer’s foreign operations and any segment’s dependence on foreign operations, in light of the similar, although slightly less expansive, requirements of Item 503(c) of Reg S-K to disclose significant risk factors. Similarly, Item 303(a) of Reg S-K requires disclosure of trends and uncertainties by segment (if appropriate to an understanding of the issuer as a whole), which would include disclosure of a segment’s dependence on foreign operations. The SEC is amending Item 303(a) to add an explicit reference to “geographic areas.” Together with risk factors disclosure, the SEC believes that these requirements “will provide the disclosure necessary to understand the risks associated with geographic factors and to assess a company’s ability to create long-term value for shareholders.”
• Elimination of Instruction 5 to Item 303(b) regarding seasonality because it requires disclosures that convey reasonably similar information to that required under GAAP and the remainder of Item 303.  The SEC had also proposed to eliminate Item 101(c)(1)(v), which requires annual seasonality disclosure, on the basis that interim seasonality disclosures required by GAAP seemed to the SEC to be more useful. However, the SEC determined instead to retain the seasonality disclosure requirements in annual reports in Item 101(c)(1)(v), because GAAP may not elicit information about seasonality in the fourth quarter.
• Elimination of the requirement in Reg S-X to disclose, in interim financial statements, material events subsequent to the end of the most recent fiscal year in light of similar disclosures that result from compliance with a combination of GAAP and Item 303(b) of Reg S-K.

One overlapping provision that was proposed to be eliminated is instead being retained and referred to FASB for potential incorporation into GAAP: the SEC decided not to eliminate Reg S-K Item 201(d) and references to it, which provides for tabular disclosure regarding existing equity compensation plans approved and not approved by shareholders. This information is currently required in Part III of Form 10-K, Item 11 of Form S-1, Item 9 of Form 10, and Item 10 of Schedule 14A. However, ASC 718-10-50-1 to 4 (formerly,  SFAS No. 123R, Share-Based Payment), mandates disclosures that overlap with Item 201(d). Although Item 201(d) also requires additional disclosures regarding certain options, warrants, or rights assumed in connection with a merger and any formula for calculating the number of securities available for issuance under the plan, the SEC had indicated in the proposal that it believed that the GAAP requirement would result in reasonably similar disclosures. The SEC also believed that drawing the distinction between approved and non-approved plans was no longer useful to investors because the major exchanges now require, with limited exceptions, shareholder-approved plans.  It was noted that relocating the disclosure to the financial statement notes raised PSLRA and prominence issues, particularly as the disclosure would no longer appear alongside information on equity compensation plans subject to shareholder action.  At the end of the day, however, the SEC decided not to eliminate the overlapping requirement, recognizing the concerns expressed by commenters that “GAAP does not explicitly require certain information, such as the formula for calculating the number of securities available for issuance under the plan. This information may be material to investors….”

As noted above, in some cases involving overlapping requirements, the SEC decided to integrate the overlapping requirements:

• There are a number of requirements to discuss restrictions on the payment of dividends.  For example, Rule 4-08(e) of Reg S-X requires disclosure related to restrictions on the issuer’s payment of dividends. Reg S-K Item 201(c)(1) requires disclosure of restrictions that currently or are likely to materially limit the issuer’s ability to pay dividends on its common equity. The SEC is streamlining these disclosure requirements into a single requirement in Reg S-X for the disclosure of material restrictions on dividends and eliminating the requirements in Item 201(c)(1). Similar changes are being made with regard to foreign private issuers.
• Likewise, two items in Reg S-K require disclosure of information indicating that the financial data may not be indicative of current or future operations. However, the requirement in Item 101(d)(4) refers explicitly to geographic performance, while Item 303 is more general. The SEC is deleting 101(d)(4) and adding in Item 303 an explicit reference to “geographic areas” as an example of a subdivision of a business that is required to be discussed when management believes such discussion would be appropriate to an understanding of the business, i.e., not in every case.

With regard to some of the overlapping requirements, where SEC rules require disclosure of information incremental to GAAP, the SEC has determined to refer these items to FASB for potential incorporation into GAAP. In the meantime, the provisions are being retained.  (See the extensive table of these referred items, commencing on page  93.) These provisions include the following:

• Both GAAP and Reg S-K require disclosures about major customers, although Reg S-K is more expansive: Reg S-K requires disclosure if loss of one or a few customers would have a material adverse effect on a segment, while GAAP requires certain disclosures for each customer that accounts for 10% or more of total revenue. In addition, Reg S-K requires disclosure of the name of any customer that represents 10% percent or more of revenues and the loss of which would have a material adverse effect, while GAAP does not.  These differences give rise to bright line and financial statement issues, including loss of the PSLRA safe harbor.
• Item 601(b)(11) of Reg S-K, Rule 10-01(b)(2) of Reg S-X and GAAP require disclosure of the computation of earnings per share. However, GAAP does not specifically require disclosure of the computation in interim financial statements.
• Both GAAP and Reg S-K require disclosure regarding revenue from products and services; however, the S-K mandate has a 10% threshold, while GAAP requires disclosure for each product or service, or group of similar products and services, unless impracticable. Depending on the changes to these requirements, the modifications could result in PSLRA and other financial statement disclosure issues as well as bright line issues.

With regard to potential integration of disclosure regarding legal proceedings and loss contingencies, the SEC determined not to refer the disclosure requirement to FASB and instead, in light of comments received, to retain the current requirements and study the issue further.  GAAP requires disclosure of loss contingencies, while Reg S-K Item 103 requires disclosure of certain legal proceedings, which are one type of loss contingency. The overlap leads most companies to either repeat the disclosures or cross-reference to them. Item 103 includes a bright line disclosure threshold in some cases of 10% of the issuer’s consolidated current assets, while U.S. GAAP provides a more general materiality threshold. As the SEC described in the proposing release, incorporation of Item 103 requirements into GAAP would result in more instances of disclosure of the possible range of loss, more disclosure that is subject to audit or review, internal control and XBRL requirements, more disclosure of prescribed facts (such as the court or agency, the date instituted, the principal parties involved, the alleged factual basis of the proceeding and the relief sought) and a more general materiality threshold in connection with environmental legal proceedings (instead of the bright-line thresholds in Reg S-K). It would also give rise to PSLRA and other financial statement issues. The SEC observed in the adopting release that many commenters opposed the integration on a variety of bases, including the possible need to revisit the ABA policy statement regarding lawyers’ responses to auditors’ requests for information. Some commenters supported the integration, noting the repetition in many filings, or recommended that the SEC conduct more analysis and outreach.

Outdated Requirements

The SEC is also modifying certain obsolete requirements and deleting others, such as stale transition dates and requirements to identify the Public Reference Room and disclose its physical address and phone number.  The SEC will also  require all issuers to disclose their internet addresses if they have one (keeping in mind the SEC’s guidance about liability for website disclosures). See the table of other proposed changes beginning on page 107.

More significantly, the SEC is updating the market price disclosure requirements in Item 201(a)(1) of Reg S-K. Instead of information such as the high and low sales prices and sales price as of the latest practicable date, which are readily available for free on numerous websites on a daily basis and probably more up to date, Item 201(a)(1) is being amended as follows:

• Issuers with one or more classes of common equity will be required to identify the principal U.S. markets where each class is traded and the corresponding trading symbols used by the markets for each class of common equity. Foreign issuers will also be required to identify the principal foreign public trading markets, if any, and the trading symbols, for each class of their common equity.
• Issuers with common equity that is not traded on an exchange will be required to  indicate, as applicable, that any over-the-counter market quotations in these trading systems reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not necessarily represent actual transactions.
• Issuers with no class of common equity traded in an established public trading market will be required to state that fact and disclose the range of high and low bid information, if applicable, for each full quarter within the last two fiscal years and any subsequent interim period. Also, these issuers must disclose the source and explain the nature of the quotations.

As amended, Item 201(a)(1) eliminates the detailed disclosure requirement of sale or bid prices for most issuers with common equity traded in an established public trading market and replaces it with disclosure of the trading symbol. The changes also align Item 201(a)(1) with Item 501(b)(4) of Reg S-K.  Similar changes were adopted for foreign private issuers.

Superseded Requirements

The amendments update disclosure requirements to reflect recent legislation and more recently updated SEC or GAAP disclosure requirements, such as eliminating references to pooling-of-interests accounting treatment and “extraordinary items,” changing references to GAAS that should be references to the standards of the PCAOB or to “applicable professional standards,” and conforming the definition in Rule 12b-2 of ”significant subsidiary” to the definition if Reg S-X.   The relevant tables  of proposed changes are located throughout this section. (Note, however, that the tables reflect the proposals and must be read in conjunction with the discussion of the final amendments.)