On Thursday, once again without holding an open meeting, the SEC voted, with a dissent from Commissioner Allison Lee, to propose to simplify and modernize MD&A and the other financial disclosure requirements of Reg S-K. As summed up in the press release, the proposed amendments are intended to “eliminate duplicative disclosures and modernize and enhance Management’s Discussion and Analysis disclosures for the benefit of investors, while simplifying compliance efforts for companies.” The proposal is part of the SEC’s Disclosure Effectiveness Initiative and follows on the 2013 S-K Study, the Report on Review of Disclosure Requirements in Regulation S-K, required by Section 108 of the JOBS Act, and the 341-page 2016 concept release, which sought comment on modernizing certain business and financial disclosure requirements in Reg S-K (see this PubCo post). The proposal also took into account the staff’s experience with Reg S-K as part of Corp Fin’s disclosure review program. Once again, the proposal employs a more principles-based approach, describing the objectives of MD&A with the goal of eliciting more thoughtful, less rote analysis. Some of the proposed changes are fairly dramatic—such as eliminating selected financial data (Item 301), supplementary financial data (Item 302), and that pesky table of contractual obligations, or adding a requirement to disclose critical accounting estimates—while some just address moving parts and conforming changes. Whether the proposal, if adopted, actually leads to more nuanced, analytical disclosure remains to be seen. The proposal will be open for comment for 60 days.
Copied at the end of this post is the SEC’s table of changes.
At the same time, the SEC released guidance on disclosure regarding key performance indicators (to be discussed in a subsequent post).
Commissioners views. In his statement, SEC Chair Jay Clayton characterized the SEC’s work to modernize the disclosure requirements as efforts that “have improved issuer disclosures of material information, allowing investors to make better capital allocation decisions while reducing compliance burdens and costs.” Commissioner Lee dissented, in part, because of the SEC’s continued emphasis in the MD&A proposal on a “principles-based approach rather than balancing the use of principles with line-item disclosure.” She continues “to be concerned that the increased flexibility and discretion that this approach affords company executives may result in significant costs to investors—both if materiality is misapplied and through the loss of important comparability in disclosure.”
In his statement, Clayton also noted the staff’s ongoing disclosure initiatives, such as the LIBOR transition and cybersecurity, among others. He also indicated that he has “asked the staff to monitor and, to the extent necessary or appropriate, provide guidance and other assistance to issuers and other market participants regarding disclosures related to the current and potential effects of the coronavirus.” Although he recognized that the impact may be uncertain and difficult to predict, “how issuers plan for that uncertainty and how they choose to respond to events as they unfold can nevertheless be material to an investment decision.”
Most interesting, however, is the fierce debate that appears to be going on at the SEC regarding climate-related disclosure regulation, which Clayton discusses at length in his statement, as do Commissioners Lee and Hester Peirce in their statements (to be discussed in a subsequent post). It’s not hard to guess who was taking what position. Clayton, for one, continues to believe that the SEC’s regulatory commitment on sustainability and climate should remain “disclosure-based and rooted in materiality, including providing investors with insight regarding the issuer’s assessment of, and plans for addressing, material risks to its business and operations.” Lee, on the other hand, based her dissent largely on the SEC’s failure to address climate change (the “elephant in the room”) more prescriptively. Peirce, who supported the proposal, complained that the SEC faces “repeated calls to expand our disclosure framework to require ESG and sustainability disclosures regardless of materiality.” These calls she attributed “in part to an elite crowd pledging loudly to spend virtuously other people’s money….”
Elimination of Selected Financial Data and Supplementary Financial Information (Items 301 and 302)
The SEC is proposing to eliminate the requirement to include the five-year table of selected financial data. In response to questions about the cost and utility of the Selecteds, the SEC notes that most commentators suggested yanking the requirement (with some remarking on the cost of obtaining accountant’s comfort on the earliest years where another accountant audited those years). In addition, material trend information is already required in MD&A. Now with the ready availability of data on EDGAR, the Selecteds may no longer be necessary and the cost not justified.
Similarly, the SEC is proposing to eliminate the requirement to provide supplementary financial data, which comprises quarterly operating data for two years. Most commenters responding to the SEC’s request for comment about this item recommended scratching this Item as also duplicative of other filings available on EDGAR. One of the benefits cited was the availability of discrete results for the fourth quarter; however, the SEC observed that, to the extent that “fourth quarter results are material or there is a material retrospective change, existing requirements would still elicit this disclosure” in MD&A.
(Item 302(b), which relates to oil and gas producing activities is also proposed to be eliminated.)
Proposed Changes to MD&A (Item 303)
- Create new paragraph 303(a) that incorporates Instructions 1, 2 and 3 to current Item 303(a) to emphasize the objective of MD&A for both full fiscal years and interim periods;
- Streamline and recaption current Item 303(a) as Item 303(b), and add requirements to discuss:
- material cash requirements
- reasonably likely changes in the relationship between costs and revenues
- reasons underlying material changes from period-to-period in one or more line items
- critical accounting estimates
- Eliminate requirement to discuss the impact of inflation and changing prices (Item 303(a)(3)(iv), Instructions 8 and 9 to Item 303(a))
- Replace the requirement to discuss off-balance sheet arrangements under a separate caption (Item 303(a)(4)) with an instruction to discuss them in MD&A
- Eliminate table of contractual obligations (Item 303(a)(5))
Item 303(b). Recaption Item 303(b) as Item 303(c); simplify and amend to allow comparison with immediately prior period or corresponding year-ago period
Items 303 (c) and (d). Eliminate current Items 303(c) and (d) as conforming changes.
- Item 303(c) provides safe harbors for forward-looking information provided under Item 303(a)(4) (off-balance sheet arrangements) and Item 303(a)(5) (contractual obligations), both of which are also proposed to be eliminated as separate sections
- Item 303(d) relates to smaller reporting companies’ compliance with requirements regarding inflation and the table of contractual obligation, both of which are also proposed to be eliminated
Discussion of Proposed Changes to MD&A
The changes to MD&A are intended to streamline and clarify the rule, as well as to elicit more thoughtful and nuanced analysis.
New Item 303(a). This new item collapses some of the prior instructions and prior guidance into a new paragraph to provide principles-based direction regarding the objectives of MD&A. The SEC’s intent is “to facilitate a thoughtful discussion and analysis, and encourage management to disclose factors specific to the registrant’s business, which management is in the best position to know, and underscore materiality as the overarching principle of MD&A.” The discussion should include:
- material information relevant to an assessment of the financial condition and results of operations of the registrant, including an evaluation of the amounts and certainty of cash flows from operations and from outside sources,
- material events and uncertainties known to management that would cause reported financial information not to be necessarily indicative of future operating results or of future financial condition, including
- matters that are reasonably expected to have a material impact on future operations and have not had a material impact on past operations
- matters that have had a material impact on reported operations and are not reasonably expected to have a material impact upon future operations
- a narrative explanation of financial statements that enables investors to see a registrant “through the eyes of management”
Revised Item 303(b). This revised item will apply to all of MD&A, and seeks to elicit a thoughtful, less mechanical discussion. (Good luck!)
- add “product lines” as an example of the type of subdivisions of a registrant’s business that could merit separate discussion
- require, in the context of the business as a whole, a “narrative discussion of the ‘underlying reasons’ for material changes from period-to-period in one or more line items in quantitative and qualitative terms, rather than only the ‘cause’ for material changes”
- clarify that registrants should discuss material changes within a line item even when the material changes are offsetting
Capital Resources. This revised item is intended to expand the disclosure beyond just capex to “provide investors with a clear picture of a registrant’s ability to meet its material cash requirements generally.
- focus on “material cash requirements,” which could include funds necessary to maintain current operations (including perhaps human capital or intellectual property), complete projects underway, and achieve stated objectives or plans, as well as commitments for capex or other expenditures
- describe the anticipated source of funds and the general purpose of the requirements
Results of Operations
- Known Trends or Uncertainties. The proposed amendment would require disclosure when a registrant knows of events that are reasonably likely to cause (as opposed to will cause) a material change in the relationship between costs and revenues, such as known or reasonably likely future increases in costs of labor or materials or price increases or inventory adjustments.
- Net Sales and Revenues. The proposed amendment would provide that, to the extent there are material changes in net sales or revenues (not just increases, but also decreases), a narrative discussion is required of the extent to which the changes are attributable to changes in prices, the amount of goods or services being sold, or to the introduction of new products or services.
- Inflation and Price Changes. What inflation? Express requirement eliminated, but still expected to be discussed if part of a known trend or uncertainty that could be material or otherwise contributed to a material change.
Off-Balance Sheet Arrangements. In light of the changes to GAAP that created a “substantial overlap” between GAAP and the Item 303 requirement to include a separate captioned section for off-balance sheet arrangements, the proposal would eliminate the “current more prescriptive off-balance sheet arrangement definition and related disclosure requirement” and replace it with a principles-based instruction to Item 303 and examples of off-balance sheet items.
- expected to lead to less boilerplate and “greater integration of material off-balance sheet arrangements disclosure within the context of broader MD&A disclosures,” particularly the registrant’s overall financial condition
- would require discussion of “commitments or obligations, including contingent obligations, arising from arrangements with unconsolidated entities or persons that have, or are reasonably likely to have, a material current or future effect on a registrant’s financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, cash requirements, or capital resources,” even “when the arrangement results in no obligations being reported in the registrant’s consolidated balance sheet”
- proposed Instruction is intended to “mitigate any potential loss of information by requiring a discussion of material matters of liquidity, capital resources, and financial condition as they relate to off-balance sheet arrangements”
- forward-looking information included in off-balance sheet arrangement disclosures provided in response to proposed Instruction 8, along with disclosures regarding contractual obligations, would continue to be covered by existing safe harbors
- amends Items 2.03 and 2.04 of Form 8-K to include the definition of “off-balance sheet arrangements” that is currently in Item 303(a)(4)
Contractual Obligations Table. Proposed to be eliminated in light of overlaps with GAAP and inclusion in the notes to the financial statements, as well as the capital resources proposals, which would require discussion of material cash requirements and would include material contractual obligations.
Critical Accounting Estimates. In prior guidance, the SEC has said that, in connection with MD&A, in addition to discussing critical accounting policies, registrants should address material implications of uncertainties associated with critical accounting estimates. In addition, disclosure regarding critical accounting estimates was proposed in 2002, but never adopted. The disclosure was supposed to supplement the policies discussion, but often just duplicated it. To eliminate this duplication and promote enhanced analysis of measurement uncertainties, the proposal would amend Item 303(a) to explicitly require disclosure of critical accounting estimates.
- defines a critical accounting estimate as an estimate made in accordance with GAAP “that involves a significant level of estimation uncertainty and has had or is reasonably likely to have a material impact on the registrant’s financial condition or results of operations.”
- requires disclosure, to the extent material, of “why the estimate is subject to uncertainty, how much each estimate has changed during the reporting period, the sensitivity of the reported amounts to the material methods, assumptions, and estimates underlying the estimate’s calculation.”
- intent is to further understanding of amounts reported in the financials “by providing greater insight on the uncertainties involved in creating and applying an accounting policy and how significant accounting policies of registrants faced with similar facts and circumstances may differ”
- includes instructions that disclosure should supplement, not duplicate, disclosure in financials
Interim Period Discussion (Revised Item 303(c)). The proposal is intended to provide more flexibility in discussions of interim periods to allow registrants to provide an analysis that they view as most illuminating. For example, businesses that are not seasonal may find a sequential quarter analysis to be more relevant than a comparison to the corresponding quarter of the prior year.
- permits registrants to compare their most recently completed quarter to either the corresponding quarter of the prior year (as is currently required) or to the immediately preceding quarter
- if the registrant opts to provide a sequential quarter analysis, the registrant must provide summary financial information for that preceding quarter or identify the relevant prior EDGAR filing
- if a registrant changes the comparison from the prior interim period comparison (e.g., provides sequential quarter analysis after previously providing analysis of the corresponding quarter of the prior year), the registrant must explain the reason for the change and present both comparisons in the filing
Application to Foreign Private Issuers. The proposal also includes certain parallel amendments applicable to financial disclosures provided by foreign private issuers. The corresponding amendments would apply to FPIs using Form 20-F or Form 40-F, as well as to current Instruction 11 to Item 303, which specifically applies to FPIs that choose to file on domestic forms.
Other Conforming Amendments. The SEC is also proposing conforming amendments related to roll-up transactions (Reg S-K Item 914, asset-backed securities (Reg AB), summary prospectuses (Forms S-1 and F-1), business combination forms (Form S-4, Form F-4 and Schedule 14A), and standardized options (Form S-20).
Compliance Date. The proposed compliance date would be 180 days after effectiveness of any final rule, although companies could comply early upon effectiveness.
Copied below is the SEC’s table showing the proposed changes:
|Current Item or Issue||Summary Description of Proposal||Principal Objective(s)||Corresponding FPI Change(s)?|
Selected financial data
|Registrants would no longer be required to provide 5 years of selected financial data.||Modernize disclosure requirement in light of technological developments and simplify disclosure requirements.||Yes|
Supplementary financial information
|Registrants would no longer be required to provide 2 years of selected quarterly financial data.||Reduce repetition and focus disclosure on material information. Modernize disclosure requirement in light of technological developments||N/A|
|Clarify the objective of MD&A and streamline the fourteen instructions.||Simplify and enhance the purpose of MD&A.||Yes|
|Registrants would disclose material cash requirements, including commitments for capital expenditures, as of the latest fiscal period, the anticipated source of funds needed to satisfy such cash requirements, and the general purpose of such requirements.||Modernize and enhance disclosure requirements to account for capital expenditures that are not necessarily capital investments.||Yes|
Results of operations
|Registrants would disclose known events that are reasonably likely to cause a material change in the relationship between costs and revenues, such as known or reasonably likely future increases in costs of labor or materials or price increases or inventory adjustments.||Clarify item requirement by using a disclosure threshold of “reasonably likely,” which is consistent with the Commission’s interpretative guidance on forward-looking statements.||Yes|
Results of operations
Clarify that a discussion of the reasons under-lying material changes in net sales or revenues is required.
|Clarify MD&A disclosure requirements by codifying existing Commission guidance.||Yes|
Instructions 8 and 9 (Inflation and price changes)
|The item and instructions would be eliminated. Registrants would still be required to discuss these matters if they are part of a known trend or uncertainty that has had, or the registrant reasonably expects to have, a material favorable or unfavorable impact on net sales, or revenue, or income from continuing operations.||Encourage registrants to focus on material information that is tailored to a registrant’s businesses, facts, and circumstances.||Yes|
|Item 303(a)(4), Off- balance sheet arrangements|
The item would be replaced by a new instruction added to Item 303. Under the new instruc-tion, registrants would be required to discuss commit-ments or obliga-tions, including contingent obligations, arising from arrangements with unconsoli-dated entities or persons that have, or are reasonably likely to have, a material current or future effect on such registrant’s financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, cash requirements, or capital resources even when the arrangement results in no obligation being reported in the registrant’s consolidated balance sheets.
|Prompt registrants to consider and integrate disclosure of off-balance sheet arrangements within the context of their MD&A.||Yes|
|Item 303(a)(5), Contractual obligations||Registrants would no longer be required to provide a contractual obligations table.||Promote the principles-based nature of MD&A and simplify disclosures by reducing redundancy.||Yes|
|Instruction 4 (Material changes in line items)||Incorporate a portion of the instruction into proposed Item 303(b). Clarify that where there are material changes in a line item, including where material changes within a line item offset one another, disclosure of the underlying reasons for these material changes in quantitative and qualitative terms is required.||Enhance analysis in MD&A. Clarify MD&A disclosure requirements by codifying existing Commission guidance on the importance of analysis in MD&A.||Yes|
|Item 303(b), Interim periods||Registrants would be permitted to compare their most recently completed quarter to either the corresponding quarter of the prior year or to the immediately preceding quar-ter. Registrants subject to Rule 3- 03(b) of Regulation S-X would be afforded the same flexibility.||Allow for flexibility in comparison of interim periods to enhance the disclosure provided to investors.||N/A|
|Critical Accounting Estimates||Explicitly require disclosure of critical accounting estimates.||Facilitate compliance and improve resulting disclosure. Eliminate disclosure that duplicates the financial statement discussion of significant policies. Promote meaningful analysis of measurement un-certainties.||Yes|