In recent years, the SEC has made a number of incremental changes to make disclosures more effective – not only more meaningful and user-friendly for investors, but also helpful to those of us who prepare disclosures for our companies and clients.
The drive to make disclosures more effective seems to have kicked into a higher gear with the August 8 issuance of a proposal that may result in the most significant changes in the disclosure rules in more than 30 years. The proposal would modify some key provisions of Regulation S-K, and in doing so would move considerably closer to a principles-based approach to disclosure. Some details follow.
S-K Item 101(a) – Development of Business
As proposed to be modified, Item 101(a) would be “largely principles-based” and would eliminate the current requirement to “describe the general development of the business…during the past five years.” Instead, a company would need to provide information for the period it deems material. That’s a big change, but even bigger is that, after a company’s initial filing, the requirement would be “only an update…with a focus on material developments in the reporting period with a hyperlink to the…most recent filing…that, together with the update, would contain the full discussion of the development of the…business.” This change may place a greater burden upon companies and their counsel to determine what is/is not material, but the proposal seems to be banking (reasonably, IMHO) on the notion that the resulting disclosure will be more meaningful.
Moreover, instead of the current laundry list of topics to be addressed, Item 101(a) would include a non-exclusive list of only four topics, and even these would not need to be covered unless material. They are:
- transactions and events that affect or may affect the company’s operations, including material changes to a previously disclosed business strategy;
- bankruptcy, receivership or a similar proceeding;
- the nature and effects of any material reclassification, merger or consolidation of the company or any significant subsidiary; and
- the acquisition or disposition of any material amount of assets (other than in the ordinary course).
The reference to strategy strikes me as significant. SEC rules generally don’t refer to strategy – in fact, the word does not appear at all in Item 101 – and many companies never discuss their strategies in their SEC filings. If the rules are adopted in more or less their current form, that may change, and in adding strategy to the list, the SEC may be suggesting that companies transition to longer-term, more forward-looking disclosures.
S-K Item 101(c) – Narrative Description of Business
Item 101(c) currently lists 12 topics that must be described for a company’s “dominant segment or each reportable segment about which financial information is presented in the financial statements.” The proposal would retain some of these topics, in some cases in modified form; others would be dropped (such as backlog), but would still have to be addressed if material; and some new topics would be added. The latter category includes a broader focus on “revenue-generating activities” and “trends in market demands,” suggesting – again – a possible transition to longer-termism and forward-looking information.
The proposed rules would continue to call for disclosure of certain items on a company-wide basis. The first is regulatory compliance, expanded from the current, more limited requirement relating to environmental matters, though substantial environmental-related disclosure would still be required.
The second company-wide disclosure topic is already generating extensive buzz – namely, a proposed requirement to describe “human capital resources, including…any human capital measures or objectives that management focuses on in managing the business (such as…measures or objectives that address the attraction, development and retention of personnel)”. As noted in the proposing release,
“Item 101(c)(1)(xiii) dates back to a time when companies relied significantly on plant, property, and equipment to drive value. At that time, a prescriptive requirement to disclose the number of employees may have been an effective means to elicit information material to an investment decision. Today, intangible assets represent an essential resource for many companies.”
SEC Chairman Clayton had previously dropped some hints about possible human capital disclosure requirements, so this proposal should not come as a big shock. However, it may be interesting to see whether companies that have said “our greatest asset is our people” provide meaningful disclosure on the topic.
S-K Item 103 – Legal Proceedings
The proposed changes to Item 103 are not dramatic – at least not substantively. However, one proposed tweak could lead to a huge change — namely, the elimination of duplicate disclosures of legal proceedings. Specifically, the rules would permit hyperlinks or cross-references to disclosures of legal proceedings appearing elsewhere in the filing. Thus, companies accustomed to including dozens of pages of disclosure about litigation – and having to check those disclosures against virtually identical disclosures in the financial statement notes – might be able to replace those pages with a hyperlink or two.
S-K Item 105 – Risk Factors
As is the case with Legal Proceedings disclosures, there are no significant substantive changes proposed for Item 105. However, presumably in an effort to reduce seemingly endless risk factors disclosures, the new rules would require a summary of the risk factors if the risk factors section exceeds 15 pages. Another inducement to reduce these disclosures is a change in the disclosure standard from “most significant” to “material.”
As noted above, the SEC has demonstrated a commitment to improving disclosure effectiveness. Many of the changes it’s made have been baby steps; in fact, some have criticized the SEC’s incremental approach to the challenge. However, there’s an argument — a strong one, I believe — that slow and steady does win the race. And, based on a quick read of the new proposal, the race is being won (though it’s probably never over). The proposals discussed above provide some innovative approaches to disclosure, including what appears to be a greater emphasis on longer-term, forward-looking disclosure and, of course, principles-based disclosure.
In general, it seems to me that principles-based disclosure is a good thing. However, it carries some risks, some of which derive from the fact that we’ve had a rules-based disclosure system in place since the 1930s. How many of us have heard a client say “show me where it says we have to disclose that”? Under a rules-based system, that can often be done. Under a principles-based system, not so much. Persuading our companies and clients to comply with the spirit of the law may be challenging when there is no explicit letter of the law.
Similarly, if the rules are adopted substantially as proposed, we may look back fondly on the good old days, when we were able to look at the rules and generally be satisfied that our disclosures addressed the items in those rules. Instead, we’ll be dealing in the brave new world of trying to figure out what really is – and isn’t – material on a relatively granular basis. For this and other reasons, my bet is that many companies will embrace the new rules slowly and possibly reluctantly, lest something material be missed when there’s no explicit rule to comply with. And we can probably expect, at least initially, that the plaintiffs’ bar will be busy trying to find new causes of action.
However, I think the SEC – particularly, the hard-working, diligent staff of Corp Fin, deserves a gold star for thinking out of the box and bringing effective disclosure a bit closer to reality.