This is the third in a series of blog posts delving into the practical aspects of implementing the Regulation S-K changes in the SEC’s August 26, 2020 Final Rule that modernizes and updates three disclosure areas in Regulation S-K:

Item 101 – Description of business

Item 103 – Legal proceedings

Item 105 – Risk factors

The Final Rule was published in the Federal Register on October 8, 2020 and is effective for filings made on or after November 9, 2020, regardless of the accounting period-end of the financial statements included in a filing.

This post focuses on the legal proceedings disclosures required by S-K Item 103.  You can review the firstand second posts in this series for information about the new disclosures for description of the business changes.  The changes discussed in this post are effective for 10-Q’s and 10-K’s filed on or after November 9, 2020.

The overall theme of all these changes is to modernize disclosure requirements and make them less prescriptive and more principles based with a focus on information that is material.  It has been over 30 years since there were any significant changes in these disclosure requirements, and it would be fair to say that the world and businesses have changed a lot over these 30 years.  It makes sense that these disclosures could stand some “modernization.”

The final rule made three relatively straightforward changes in legal proceedings disclosures:

First, the following language was added to the overall requirement to provide that information may be in other parts of a filing and hyperlinked or cross-referenced to the legal proceedings disclosure:

Information may be provided by hyperlink or cross-reference to legal proceedings disclosure elsewhere in the document, such as in Management’s Discussion & Analysis (MD&A), Risk Factors and notes to the financial statements.

Second, requirements that were formerly in the Instructions have been moved into the body of Item 103.  See bolded paragraphs (b) and (c) below.  Some wording was adjusted to fit this reorganization.

Third, in paragraph (c)(3) below, the threshold for disclosure of monetary sanctions where a governmental authority is a party to an environmental proceeding has been increased from $100,000 to $300,000.

Included below are the new text and old text of S-K Item 103 if you would like to review the details of these changes.  The changes described above are bolded in the new version.

As always, your thoughts and comments are welcome.

New Text of S-K Item 103

(Item 103) Legal proceedings.

(a) Describe briefly any material pending legal proceedings, other than ordinary routine litigation incidental to the business, to which the registrant or any of its subsidiaries is a party or of which any of their property is the subject. Include the name of the court or agency in which the proceedings are pending, the date instituted, the principal parties thereto, a description of the factual basis alleged to underlie the proceedings and the relief sought. Include similar information as to any such proceedings known to be contemplated by governmental authorities.

Information may be provided by hyperlink or cross-reference to legal proceedings disclosure elsewhere in the document, such as in Management’s Discussion & Analysis (MD&A), Risk Factors and notes to the financial statements.

(b) No information need be given under this section for proceedings:

(1) That involve negligence or other claims or actions if the business ordinarily results in such claims or actions, unless the claim or action departs from the normal kind of such claims or actions; or

(2) That involve primarily a claim for damages if the amount involved, exclusive of interest and costs, does not exceed 10 percent of the current assets of the registrant and its subsidiaries on a consolidated basis. However, if any proceeding presents in large degree the same legal or factual issues as other proceedings pending or known to be contemplated, the amount involved in such other proceedings shall be included in computing such percentage.

(c) Notwithstanding paragraph (b) of this section, disclosure under this section shall include, but shall not be limited to:

(1) Any material bankruptcy, receivership, or similar proceeding with respect to the registrant or any of its significant subsidiaries;

(2) Any material proceedings to which any director, officer or affiliate of the registrant, any owner of record or beneficially of more than five percent of any class of voting securities of the registrant, or any associate of any such director, officer, affiliate of the registrant, or security holder is a party adverse to the registrant or any of its subsidiaries or has a material interest adverse to the registrant or any of its subsidiaries;

(3) Administrative or judicial proceedings (including proceedings which present in large degree the same issues) arising under any Federal, State, or local provisions that have been enacted or adopted regulating the discharge of materials into the environment or primarily for the purpose of protecting the environment. Such proceedings shall not be deemed “ordinary routine litigation incidental to the business” and shall be described if:

(i) Such proceeding is material to the business or financial condition of the registrant;

(ii) Such proceeding involves primarily a claim for damages, or involves potential monetary sanctions, capital expenditures, deferred charges or charges to income and the amount involved, exclusive of interest and costs, exceeds 10 percent of the current assets of the registrant and its subsidiaries on a consolidated basis; or

(iii) A governmental authority is a party to such proceeding and such proceeding involves potential monetary sanctions, unless the registrant reasonably believes that such proceeding will result in no monetary sanctions, or in monetary sanctions, exclusive of interest and costs, of less than $300,000 or, at the election of the registrant, such other threshold that (A) the registrant determines is reasonably designed to result in disclosure of any such proceeding that is material to the business or financial condition is disclosed, (B) the registrant discloses (including any change thereto) in each annual and quarterly report, and (C) does not exceed the lesser of $1 million or one percent of the current assets of the registrant and its subsidiaries on a consolidated basis; provided, however, that such proceedings that are similar in nature may be grouped and described generically.

Old Text of S-K Item 103

Describe briefly any material pending legal proceedings, other than ordinary routine litigation incidental to the business, to which the registrant or any of its subsidiaries is a party or of which any of their property is the subject. Include the name of the court or agency in which the proceedings are pending, the date instituted, the principal parties thereto, a description of the factual basis alleged to underlie the proceeding and the relief sought. Include similar information as to any such proceedings known to be contemplated by governmental authorities.

Instructions to Item 103: 1. If the business ordinarily results in actions for negligence or other claims, no such action or claim need be described unless it departs from the normal kind of such actions.

2. No information need be given with respect to any proceeding that involves primarily a claim for damages if the amount involved, exclusive of interest and costs, does not exceed 10 percent of the current assets of the registrant and its subsidiaries on a consolidated basis. However, if any proceeding presents in large degree the same legal and factual issues as other proceedings pending or known to be contemplated, the amount involved in such other proceedings shall be included in computing such percentage.
3. Notwithstanding Instructions 1 and 2, any material bankruptcy, receivership, or similar proceeding with respect to the registrant or any of its significant subsidiaries shall be described.
4. Any material proceedings to which any director, officer or affiliate of the registrant, any owner of record or beneficially of more than five percent of any class of voting securities of the registrant, or any associate of any such director, officer, affiliate of the registrant, or security holder is a party adverse to the registrant or any of its subsidiaries or has a material interest adverse to the registrant or any of its subsidiaries also shall be described.
5. Notwithstanding the foregoing, an administrative or judicial proceeding (including, for purposes of A and B of this Instruction, proceedings which present in large degree the same issues) arising under any Federal, State or local provisions that have been enacted or adopted regulating the discharge of materials into the environment or primary for the purpose of protecting the environment shall not be deemed “ordinary routine litigation incidental to the business” and shall be described if:
   1. Such proceeding is material to the business or financial condition of the registrant;
   2. Such proceeding involves primarily a claim for damages, or involves potential monetary sanctions, capital expenditures, deferred charges or charges to income and the amount involved, exclusive of interest and costs, exceeds 10 percent of the current assets of the registrant and its subsidiaries on a consolidated basis; or
   3. A governmental authority is a party to such proceeding and such proceeding involves potential monetary sanctions, unless the registrant reasonably believes that such proceeding will result in no monetary sanctions, or in monetary sanctions, exclusive of interest and costs, of less than $100,000; provided, however, that such proceedings which are similar in nature may be grouped and described generically.

This is the second in a series of blog posts delving into the practical aspects of implementing the Regulation S-K changes in the SEC’s August 26, 2020 Final Rule that modernizes and updates three disclosure areas in Regulation S-K:

Item 101 – Description of business

Item 103 – Legal proceedings

Item 105 – Risk Factors

The Final Rule was published in the Federal Register on October 8, 2020 and is effective for filings made on or after November 9, 2020, regardless of the accounting period-end of the financial statements included in a filing.

This post focuses on the description of the business disclosures required by S-K Item 101.  You can find the first post in this series, dealing with the new disclosure for general developments of the business, here.  The changes discussed in this post are effective for 10-Q’s and 10-K’s filed on or after November 9, 2020.

The overall theme of all these changes is to make disclosure requirements less prescriptive and more principles based with a focus on information that is material.  It has been over 30 years since there were any significant changes in these disclosure requirements, and it would be fair to say that the world and businesses have changed a lot over these 30 years.  It makes sense that these disclosures could stand some “modernization.”

This is a pretty long post.  To help you navigate it is divided into three main sections.

Section One is a list of some of the possible steps you may need to take to implement this new disclosure requirement.  You can read this section to get the “big picture” of the changes.

Section Two is a side by side comparison of the description of the business disclosure guidance before and after the new rule, along with thoughts and a few examples to help begin updating disclosures for the new rule.  At the end of this section are examples of human capital disclosures.

Section Three is a helpful reminder list of the issues to consider as you draft and revise this disclosure for you next Form 10-K.

Section One – A Preview of Possible Steps.

The new principles-based rule will require thoughtful consideration and several materiality evaluations.  Here is a preview of some of the judgments implementation may involve.  The issues behind each step in this list are described in the next section which presents a side-by-side comparison of the old and new rules.

1. Review your previous business description disclosures and assess whether, based on the more detailed requirements in the old rule, you included any information that is not really material.

2. Discuss within your disclosure committee or other participants in your disclosure process whether there is information not included in previous disclosures which might be relevant based on the principles in the new rule.

3. Use the concept of “tell your story” as you draft this disclosure.

4. With respect to products, services, major customers, etc., review previous disclosures based on old quantitative thresholds and assess materiality.Also consider whether there may be issues surrounding “Revenue-generating activities, products and/or services, and any dependence on revenue-generating activities, key products, services, product families or customers, including governmental customers” that should be disclosed based on the new principles-based language in S-K Item 101.

5. Consider disclosure committee or disclosure process discussion of “Status of development efforts for new or enhanced products, trends in market demand and competitive conditions.”Note that the trends in market demand and competitive conditions involve principles-based judgments beyond those in the old disclosure requirements.

6. Consider disclosure committee or disclosure process discussion of “resources material to a company’s business” beyond the two items listed in the new rule, raw materials and intellectual property.

7. Assess the materiality of old working capital and backlog disclosures and consider removing them if the information is not material.In particular the new revenue recognition disclosures about unfulfilled performance obligations may make backlog disclosures not material.

8. Consider the impact of governmental regulation beyond environmental matters and where material include appropriate disclosure.

9. Review human capital policies, processes and procedures and determine which are “human capital measures or objectives that the registrant focuses on in managing the business” and assess materiality for disclosure.

Section Two – Side-by-Side Comparison of Old and New Requirements.

As a beginning to this section, this is the overall guidance for the description of the business disclosure:

As you can see, the overall approach to the description of the business is the same, using the words “Describe the business done and intended to be done by the registrant and its subsidiaries, focusing upon the registrant’s dominant segment or each reportable segment about which financial information is presented in the financial statements.”

Immediately following, however, is the more principles-based approach to the new rule.  It states that “only information material to an understanding of the business is required.”  And, the words “Disclosure may include, but should not be limited to” also makes this disclosure less checklist and more principles based.  The first step in implementing this new disclosure requirement may well be to review your previous disclosures and consider whether you included information that is not really material based on the more detailed requirements in the old rule.  The second step might be a disclosure committee discussion about whether, based on the knowledge and experience of your disclosure committee members or other people in your disclosure process, there is information that likely should be included in this disclosure.

A relevant perspective for this disclosure is to “tell the story” of your business, so this could be a helpful framing issue for discussions.

Next, here are the first of the changes in the details of S-K Item 101.

The new disclosure guidance is very broad and principles based, essentially requiring disclosure of all material information about products, services, customers and related matters.  This may require some complex materiality judgments.  For example, the old S-K Item 101 provided quantitative thresholds for disclosure of revenue for a class of similar products and services.  In addition, the old quantitative guidelines, including those for major customers in old paragraph (vii) below are all removed in this transition to a principles-based disclosure.

The next change deals with development of new or enhanced products and related issues:

Clearly, the new more principles-based disclosure requirements, including trends in market demand or competitive conditions require consideration, particularly in the uncertain COVID-19 environment.

These next disclosures are not changed significantly, but the new disclosure includes a broad, principles-based judgment:

Note that while the paragraph numbers are rearranged, the old disclosure requirements are essentially carried over into the new S-K language.  What is different is the new language requiring disclosure of resources material to a company’s business beyond the two items listed.  This again would be a relevant issue for disclosure committee members or others involved in your disclosure process to discuss.  Issues such as transportation availability could require disclosure.

These sections are essentially carried over from the old rule to the new rule:

Note that while the paragraph numbers are rearranged,  the old disclosure requirement is essentially carried over into the new S-K language

This paragraph was also carried over from the old to the new disclosure requirements.

These next disclosures from old S-K Item 101 are not included directly in the new principles-based language, but in essence could be required disclosure if the information is material to an understanding of your business.

To implement these changes it might be advisable to review historical disclosures and ask if the information is material, and if not remove these disclosures.

The next change deals with disclosures that have been for the business as a whole:

This disclosure requirement has been broadened to include all governmental regulation.  Many companies have included such discussion and now includes more descriptive language including effect on “capital expenditures, earnings and competitive position.”  The capital expenditures disclosure guidance is in substance the same.

The last change deals with human capital:

This is perhaps the most changed, or at least expanded, disclosure in the description of the business. Beyond the number of employees, companies will have to grapple with what “human capital measures and objectives” are material to investors and should be disclosed.  Issues could range from talent acquisition challenges, training, turnover and other performance-related information.

To help you think about what issues could be relevant for this disclosure, here are two examples.  This first example is from Intel’s Corporate Responsibility Report 2019-2020.

Growth and Development

Each year, we deliver millions of hours of web-based and face-to-face training for different employee segments: New to Intel, Employee Development, Manager Development, and Leader Development. In 2019, we launched a new performance management system to support our cultural transformation and increase focus on continuous learning and development.

We also create on-the-job development opportunities through rotation or temporary assignment programs. Our web-based development tool enables employees to apply for part-time or temporary assignments across the company. In addition, our U.S. sabbatical program creates growth opportunities through job coverage assignments; many of the employees who completed sabbatical coverage assignments in 2019 gained valuable management experience by covering for their direct managers.

This example is from General Motor’s Sustainability Report 2109:

GM’s people will always be our greatest strength. In order to stay competitive and relevant as a company, we must attract and retain the brightest talent around the world.

Today, we compete for that talent against other automotive companies and, increasingly, against businesses in other sectors, such as technology. To win and keep talent, we must provide a workplace culture that encourages employee behaviors aligned with our values, fulfills their long-term individual aspirations and achieves full engagement.

We do this by adhering to a responsible employer philosophy, which includes commitments to create job opportunities, pay workers fairly, ensure safety and promote wellness. GM pays a living wage. GM also offers quality health care coverage to all our employees, 401(k) plans with matches and paid time off to cover vacations, sick leave, parental leave and military leave. We also protect workers from harmful and hazardous conditions by adhering to strict health and safety standards.

Our efforts to be a responsible employer have been recognized for the past two years by the JUST 100, a list developed JUST Capital that ranks companies on the issues that Americans care about. The criteria for inclusion on the JUST 100 come directly from a survey of more than 80,000 Americans, and the number-one priority for survey participants is that they want to see fair treatment of workers from the nation’s biggest businesses. Our inclusion on the list and increasing rank since 2017 is a useful barometer to demonstrate that when it comes to people, GM is doing the right things.

Section Three – Implementation Steps.

Here is a review of steps you might want to take as you implement this new disclosure requirement.

1. Review your previous business description disclosures and assess whether, based on the more detailed requirements in the old rule, you included any information that is not really material.

2. Discuss with your disclosure committee or other participants in your disclosure process whether there is information not included in previous disclosures which might be relevant based on the principles in the new rule.

3. Use the concept of “tell your story” as you draft this disclosure.

4. With respect to products, services, major customers, etc., review previous disclosures based on old quantitative thresholds and assess materiality.Also consider whether there may be issues surrounding “Revenue-generating activities, products and/or services, and any dependence on revenue-generating activities, key products, services, product families or customers, including governmental customers” that should be disclosed based on the new principles-based language in S-K Item 101.

5. Consider disclosure committee or disclosure process discussion of “Status of development efforts for new or enhanced products, trends in market demand and competitive conditions.”Note that the trends in market demand and competitive conditions involve principles-based judgments beyond those in the old disclosure requirements.

6. Consider disclosure committee or disclosure process discussion of “resources material to a company’s business” beyond the two items listed in the new rule, raw materials and intellectual property.

7. Assess the materiality of old working capital and backlog disclosures and consider removing them if the information is not material.In particular the new revenue recognition disclosures about unfulfilled performance obligations may make backlog disclosures not material.

8. Consider the impact of governmental regulation beyond environmental matters and, where material, include appropriate disclosure.

9. Review human capital policies, processes and procedures and determine which are “human capital measures or objectives that the registrant focuses on in managing the business” and assess materiality for disclosure.

As always, your thoughts and comments are welcome!

On August 26, 2020, despite the disruption caused by COVID-19, the SEC continued its disclosure modernization process.  This Final Rule modernizes and updates three disclosure areas in Regulation S-K:

Item 101 – Description of business

Item 103 – Legal proceedings

Item 105 – Risk factors

The Final Rule was published in the Federal Register on October 8, 2020 and is effective for filings made on or after November 9, 2020, regardless of the accounting period-end of the financial statements included in a filing.

Accordingly, these changes are effective for 10-K’s and 10-Qs  filed on or after November 9, 2020.

In this next series of blog posts we will explore the practicalities of implementing these changes.

This post and the next will focus on S-K Item 101 changes and the third and fourth posts will address the changes to S-K Items 103 and 105.

The overall theme of all these changes is to make disclosure requirements less prescriptive and more principles based with a focus on information that is material.  It has been over 30 years since there were any significant changes in these disclosure requirements, and it would be fair to say that the world and businesses have changed a lot over these 30 years.  It makes sense that these disclosures could stand some “modernization.”

The business disclosures in S-K Item 101 that apply to Form 10-K fall into four categories:

General development of the business

Narrative description of the business

 Available information

 Smaller reporting companies

This post will review changes in the general development of the business disclosures.  The second post in this series will discuss the changes in the narrative description of the business and the requirements for smaller reporting companies.  This Final Rule did not change the available information disclosure requirements, which include information about a company’s website and the availability of SEC filings.

As you will see in the discussion below, this new rule will require us to make two principles-based judgments for the general developments disclosure in our next Form 10-K:

How may periods to address

 What are the general developments that will be material to investors

The old general developments disclosure requirements in S-K Item 101 are:

(a) General development of business. Describe the general development of the business of the registrant, its subsidiaries and any predecessor(s) during the past five years, or such shorter period as the registrant may have been engaged in business. Information shall be disclosed for earlier periods if material to an understanding of the general development of the business.

(1) In describing developments, information shall be given as to matters such as the following: the year in which the registrant was organized and its form of organization; the nature and results of any bankruptcy, receivership or similar proceedings with respect to the registrant or any of its significant subsidiaries; the nature and results of any other material reclassification, merger or consolidation of the registrant or any of its significant subsidiaries; the acquisition or disposition of any material amount of assets otherwise than in the ordinary course of business; and any material changes in the mode of conducting the business.

(Note:  There are additional requirements for registration statements that were not changed and are not discussed in this post)

The new general developments disclosure requirements in S-K Item 101 are:

(Item 101) Description of business.

(a) General development of business. Describe the general development of the business of the registrant, its subsidiaries, and any predecessor(s).

(1) In describing developments, only information material to an understanding of the general development of the business is required. Disclosure may include, but should not be limited to, the following topics:

(i) Any material changes to a previously disclosed business strategy;

(ii) The nature and effects of any material bankruptcy, receivership, or any similar proceeding with respect to the registrant or any of its significant subsidiaries;

(iii) The nature and effects of any material reclassification, merger or consolidation of the registrant or any of its significant subsidiaries; and

(iv) The acquisition or disposition of any material amount of assets otherwise than in the ordinary course of business.

(2) Notwithstanding the provisions of § 230.411(b) or § 240.12b-23(a) of this chapter, as applicable, a registrant may only forgo providing a full discussion of the general development of its business for a filing other than an initial registration statement if it provides an update to the general development of its business, disclosing all of the material developments that have occurred since the most recent registration statement or report that includes a full discussion of the general development of its business. In addition, the registrant must incorporate by reference, and include one active hyperlink to one registration statement or report that includes, the full discussion of the general development of the registrant’s business.

Time Period for Disclosure

One of the first noticeable changes in the general developments disclosure is that the old requirement addressed a specific time period, five years, while the new requirement does not specify a required time period.  This five-year period did not actually apply to Form 10-K as the 10-K instructions contain, and continue to contain, this “override” for the time period:

Item 1. Business.

Furnish the information required by Item 101 of Regulation S-K (§ 229.101 of this chapter) except that the discussion of the development of the registrant’s business need only include developments since the beginning of the fiscal year for which this report is filed.

So, for Form 10-K disclosures we need to address general developments for the most recent year.  Of course, if you wish to provide more historical perspective to provide a more robust discussion of the trajectory of your business you can always go beyond the minimum required disclosures.  The removal of the five-year time horizon will mean that this disclosure in registration statements, particularly IPO registration statements, will require more thought than before.  Deciding what is an appropriate look-back period for general developments, implementing this principles-based requirement, will be more challenging than the old “bright-line” of five years.  In the Final Rule release, the SEC made this point:

“The amendment to Item 101(a) will focus registrants on information material to an understanding of the development of their business, irrespective of a specific timeframe.”

This is clearly the principle we should keep in mind as we consider how many periods to include in this discussion as we go forward.

Information to Be Disclosed

The second change that we will all need to address is what information to disclose as general developments.  The shift to a more principles-based model is clear in the new S-K language:

 “Disclosure may include, but should not be limited to, the following topics”

The old list of disclosures which included information such as the  “year in which the registrant was organized and its form of organization” resulted in disclosure that were, for almost all companies, clearly not material.  So our challenge will be to think about what are the developments in our business that are material to investors.

The list of examples starts with changes in strategy, which was never clearly articulated in the old rule, and provides a springboard to thinking about other general developments that could be material.  Examples might include major leadership changes, significant main office relocations, moving from full-time employees to contract workers, and shifting from a retail store concept to an on-line sales strategy.  We need to understand our business and all that is happening to develop this disclosure.

Hyperlinking

The last section of the new rule refers to Rule 12b-23(a):

12b-23   Incorporation by reference.

(a) Registration statement or report. Except as provided by this section or in the appropriate form, information may be incorporated by reference in answer, or partial answer, to any item of a registration statement or report.

 The new rule says that while incorporation by reference is generally allowed, it is limited for the general developments disclosure.  The new provisions essentially say that a company, other than for an IPO registration statement, must either:

1. Include a full discussion of general developments, even if it could be incorporated by reference from another filing, or

2. Provide an update to the most recent general developments discussion in a registration statement or report that was filed previously.In this case the company must incorporate by reference and include a hyperlink to the previous filing.  And, the incorporated information must all be in a single filing.

For Form 10-K, given that it will address developments for the year of the report, this particular option will likely not apply in most cases.

Conclusion

This section of the new description of the business disclosure will call upon us to make two principles-based judgments for the general developments disclosure:

How may periods to address

What are the general developments that will be material to investors

Timely focus on these questions will help us be prepared for this new requirement this year end.

As always, your thoughts and comments are welcome!

As you have likely heard, on August 26, 2020, the SEC adopted a Final Rule updating and modernizing three disclosure areas in Regulation S-K:

Item 101 – Description of business

Item 103 – Legal proceedings

Item 105 – Risk Factors

The Final Rule was published in the Federal Register on October 8, 2020 and is effective for filings made on or after November 9, 2020, regardless of the accounting period-end of the financial statements included in a filing.

Accordingly, these changes are effective for calendar third quarter 10-Qs filed after November 9, 2020.

The changes that may affect companies filing Form 10-Q for the third quarter of 2020 are the new legal proceedings and risk factor disclosure requirements.

There are two changes to the legal proceedings disclosures:

 First, the following language was added to the overall requirement to provide that information may be in other parts of a filing and hyperlinked or cross-referenced to the legal proceedings disclosure:

Information may be provided by hyperlink or cross-reference to legal proceedings disclosure elsewhere in the document, such as in Management’s Discussion & Analysis (MD&A), Risk Factors and notes to the financial statements.

Second, in paragraph (c)(3), the threshold for disclosure of monetary sanctions where a governmental authority is a party to an environmental proceeding has been increased from $100,000 to $300,000.

The main change to the risk factor disclosures is this new requirement:

If the discussion is longer than 15 pages, include in the forepart of the prospectus or annual report, as applicable, a series of concise, bulleted or numbered statements that is no more than two pages summarizing the principal factors that make an investment in the registrant or offering speculative or risky.

 Starting on November 5, we will be posting a series of deep-dive discussions into all the changes in the Final Rule.

As always, your thoughts and comments are welcome!

In this blog post we reviewed a “know-trend” enforcement case against HP INC., which had pushed inventory into channels, a tactic which was “reasonably likely” to result in lower revenues in the future.

An additional important aspect of this case focuses on “disclosure controls and procedures.”  Unlike ICFR, companies must report on the effectiveness of their disclosure controls and procedures each quarter. Disclosure controls are defined in Exchange Act Rule 13a-15(e):

(e) For purposes of this section, the term disclosure controls and procedures means controls and other procedures of an issuer that are designed to ensure that information required to be disclosed by the issuer in the reports that it files or submits under the Act (15 U.S.C. 78a et seq.) is recorded, processed, summarized and reported, within the time periods specified in the Commission’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by an issuer in the reports that it files or submits under the Act is accumulated and communicated to the issuer’s management, including its principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.

In the AAER for the HP INC. case the SEC stated:

HP lacked sufficient disclosure controls and procedures to ensure that the use of pull-ins and A-Business to meet quarterly sales targets, and their negative impact on margin and potential impact on future quarters, was provided to the HP executives responsible for the company’s disclosures in a timely manner as required by Rule 13a-15(a). Among other things, HP lacked company-wide controls over the use of discounts by regional management. Moreover, HP’s lack of visibility into channel inventory levels below Tier 1 left it without meaningful insight into its overall channel health. In addition, HP’s disclosure process lacked sufficient interaction with operational personnel who reasonably would have been expected to recognize that the known trends attributable to the pull-ins and A-Business were absent from HP’s disclosures.

Instead, HP’s principal financial officers and principal executive officers who were responsible for the company’s disclosures learned of the conduct in connection with HP’s planned shift from a push to a pull model quarters after the actual conduct had taken place. HP’s failure to have controls and procedures in place to ensure the timely provision of information to the officers responsible for its disclosures violated Exchange Act Rule 13a-15(a).

An important theme in this case is that a company’s disclosure process needs to involve persons responsible for business decisions and strategy as well as those persons who are responsible for and knowledgeable about disclosure requirements.  This dovetails nicely with the new Regulation S-K Item 101 disclosure requirement to include:

“Any material changes to a previously disclosed business strategy.”

As always, your thoughts and comments are welcome!

As we discussed in this December 2019 post, the SEC has publicly raised concerns and issued comments about disclosures surrounding supplier finance programs.  On October 21, 2020, the FASB decided to add a project to its Technical Agenda titled “Disclosure of Supplier Finance Programs involving Trade Payables.”  You can read the Board Meeting Handout discussion of the project here.

The SEC’s comments and the FASB’s updated Technical Agenda seem to be sending a clear message:  if you are using this kind of finance tool be sure to address disclosures in a robust manner.  As a starting point, here is a list of disclosure considerations from an SEC comment letter:

We have reviewed your response to our prior comment. Please address the following:

Tell us the dollar amount of accounts payable that were settled via your supply chain finance program for each year from 2012 to 2018.

Tell us the balance of your accounts payable that represents amounts due to participating financial institutions under your supply chain finance programs as of each year from 2012 to 2018.

Provide us an analysis to support your conclusion that amounts settled under your supply chain finance program are accounts payable rather than bank financing.

Your analysis should also address the classification of your payments made to the participating financial institutions as well as related disclosure of non-cash financing activities required by ASC 230-10-50-3.

You state in your response that the payment terms to the participating financial institution are the same as if you paid the supplier directly. Please tell us the terms of your supply chain finance arrangements with the participating financial institutions as well as the payment terms with your vendors.

You also state in your response that the program improved your accounts payable days. Please explain how the supply chain finance program increased your accounts payable days outstanding.

Tell us the extent to which the continued improvement to your accounts payable days, and related liquidity, are expected to continue as well as the factors, such as changes in interest rates, that may limit the availability of your supply chain finance programs.

To the extent material, expand your management’s discussion and analysis to address the impact the supply chain finance program has had on your liquidity and whether or not that impact is expected to continue.

Please ensure you have filed as exhibits, all agreements relating to your supply chain finance program.

As always, your thoughts and comments are welcome!

“It’s like déjà vu all over again.”

                        Lawrence Peter “Yogi” Berra (May 12, 1925 – September 22, 2015)

Have you been wondering about current focus areas in the SEC’s Enforcement Division?  In our last post we explored one such area, channel stuffing and the related failure to disclose MD&A known trends.  On September 30, 2020, the SEC brought the latest in a series of cases dealing with failure to appropriately disclose executive perks.  This is clearly another focus area for enforcement.

These cases usually involve not using the appropriate tests to identify perks and the related failure to disclose these perks to shareholders in the proxy solicitation process and related Form 10-K disclosures.  This is a quote from the SEC’s September 30, 2020 press release:

“Hilton failed to disclose approximately $1.7 million worth of travel-related perquisites and personal benefits it provided to executive officers from 2015 through 2018. The perquisites included the CEO’s personal use of Hilton’s corporate aircraft and executive officers’ hotel stays. The order finds that Hilton failed to appropriately apply the SEC’s compensation disclosure rules to its system for identifying, tracking and calculating perquisites.”

 In July 2018, the SEC brought a very similar case against Dow Chemical.  In that case approximately $3 million in perks were not appropriately evaluated and disclosed.  Dow failed to use the appropriate test to evaluate items for disclosure as perks.  This test states:

An item is not a perquisite or personal benefit if it is integrally and directly related to the performance of the executive’s duties.

Otherwise an item is a perquisite or personal benefit if it confers a direct or indirect benefit that has a personal aspect without regard to whether it may be provided for some business reason or for the convenience of the company, unless it is generally available on a non- discriminatory basis to all employees.

Dow was required to hire a consultant to review the company’s policies and procedures and take appropriate corrective action to assure such disclosure were proper in the future and also paid a penalty of $1,750,000.

In a similar case announced on June 4, 2020, this one involving Argo Group International Holdings, the SEC stated in their press release:

“The SEC’s order finds that in its proxy statements for 2014 through 2018, Argo disclosed that it had provided a total of approximately $1.2 million in perquisites and personal benefits, chiefly retirement and financial planning benefits, to its then CEO.  According to the order, Argo failed to disclose over $5.3 million it had paid on the CEO’s behalf, including in filings for 2018 after a shareholder issued a press release alleging undisclosed perks to the CEO.  The order finds that the perks Argo paid for, but did not disclose, included personal use of corporate aircraft, helicopter trips and other personal travel, housing costs, transportation for family members, personal services, club memberships, and tickets and transportation to entertainment events.  The order finds that, as a result, Argo understated perks and personal benefits paid to the CEO over this period by more than $1 million per year, or 400%.  The CEO resigned from that position in November 2019.”

In December 2017, the SEC enforced against Provectus, stating in the related press release that:

“Provectus lacked sufficient controls surrounding the reporting and disclosure of travel and entertainment expenses submitted by its executives.  The order further finds that Provectus’ former CEO, Dr. H. Craig Dees, obtained millions of dollars from the company using limited, fabricated, or non-existent expense documentation, and that these unauthorized perks and benefits were not disclosed to investors.  Provectus’ former CFO, Peter R. Culpepper, also allegedly obtained $199,194 in unauthorized and undisclosed perks and benefits.”

In one last case to highlight, on September 8, 2015, the SEC enforced against MusclePharm Corporation for a number of issues including, as described in the related press release:

“that MusclePharm omitted or understated nearly a half-million dollars’ worth of perks bestowed upon its executives, including approximately $244,000 paid to CEO Brad Pyatt related to automobiles, apparel, meals, golf club memberships, and his personal tax and legal services.  Even after the company began an internal review of undisclosed executive perks and then-audit committee chair Donald Prosser became directly involved in the process, MusclePharm continued filing financial statements that failed to disclose private jet use, vehicles, and golf club memberships for its executives.“

Seems like there is a recurring theme in all of this and a related heads-up to be sure all perks are appropriately identified and disclosed!

As always, your thoughts and comments are welcome!

Thanks to the eagle eye of Reed Wilson, who, along with Rich Alven, teaches our new Zoom based “SEC Form 10-K Disclosure Best Practices” virtual workshop, for spotting the October 8, 2020 Federal Register  publication of the SEC’s August 26 Final Rule “Modernization of Regulation S-K Items 101, 103, and 105”. The effective date of the rule is 30 days after publication in the Federal Register.

This means that the new rule will be effective for filings made 30 days after October 8, 2020.

For 10-Q’s filed after this date the changes to S-K Item 105, requiring a summary of risk factors if you have over 15 pages of risk factors, and the new requirements for legal proceedings disclosures, will be effective.

For 10-K’s filed after this date the changes to all the modernized S-K Items will be effective.

We will have more details about these changes in posts next week.

As always, your thoughts and comments are welcome!