In a recent postwe began reviewing the changes made by the SEC’s March 20, 2019 Disclosure Modernization and Simplification final rule to disclosures in Part III of Form 10-K and the proxy statement.  This post concludes the discussion of changes to these areas, focusing on S-K Item 405 disclosures about delinquent Section 16 filers and a minor change to S-K Item 407 governance disclosures.  Changes in both areas are fairly straightforward and, like most of the changes in the final rule, are effective for filings made after May 2, 2019.

Section 16 Delinquent Filer Disclosures

As a brief review, Section 16 of the 1934 Act requires directors, executive officers and owners of over 10% of a registrant’s stock to provide filings on Forms 3, 4 and 5 about stock ownership and transactions.  This is important information as investors have a high level of interest in insider stock transactions.

Because there are so many Section 16 filers it would be tactically difficult for the SEC to assure that all Section 16 reports were timely filed.  To deal with this situation, S-K Item 405 requires companies to disclose information about delinquent Section 16 filers in their proxy statement or Form 10-K if they do not file a proxy.

In the Disclosure Modernization and Simplification final rule the SEC dealt with three aspects of this disclosure:

1.  Eliminated a very confusing S-K 405 check-box from the cover page of Form 10-K. You can read about the cover page change in this post.

2. Simplified the Section 16 reporting process by allowing registrants to rely on a review of Section 16 reports submitted on EDGAR instead of gathering copies of reports from Section 16 filers. The rule also removed a requirement in Rule 16a-3(e) that mandated Section 16 reporting persons to provide a duplicate copy of their reports to the company.  In an EDGAR world, this furnishing of paper copies was clearly redundant.  However, in some circumstances a company may need to look beyond reports on the EDGAR system.

The relevant section of old S-K Item 405 read:

(a) Based solely upon a review of Forms 3 and 4 (17 CFR 249.103 and 249.104) and amendments thereto furnished to the registrant under 17 CFR 240.16a-3(e) during its most recent fiscal year and Forms 5 and amendments thereto (17 CFR 249.105) furnished to the registrant with respect to its most recent fiscal year, and any written representation referred to in paragraph (b)(1) of this section.

The new S-K Item 405 now includes this instruction:

(b) Scope of the Inquiry. In determining whether disclosure is required pursuant to paragraph (a) of this section, the registrant may rely only on the following:

(1) A review of Forms 3 and 4 (17 CFR 249.103 and 249.104) and amendments thereto filed electronically with the Commission during the registrant’s most recent fiscal year;

(2) A review of Forms 5 (17 CFR 249.105) and amendments thereto filed electronically with the Commission with respect to the registrant’s most recent fiscal year; and

(3) Any written representation from the reporting person that no Form 5 is required. The registrant must maintain the representation in its records for two years, making a copy available to the Commission or its staff upon request.

3.  Changed the required title of the disclosure from “Section 16(a) Beneficial Ownership Reporting Compliance” to “Delinquent Section 16(a) Reports”. Also, to help minimize unnecessary disclosure, the new S-K Item 405 encourages that the disclosure not be included in a company’s proxy or Item 12 of Form 10-K when there are no delinquent filers to disclose.

This change was made with the following new instruction:

Instruction 1 to paragraph (a) of Item 405. If no disclosure is required, registrants are encouraged to exclude the caption “Delinquent Section 16(a) Reports.”

As a bonus to this discussion, and as a response to a question that arises frequently in our workshops, here is the definition of “executive officer”:

240.3b-7   Definition of “executive officer”.

The term executive officer, when used with reference to a registrant, means its president, any vice president of the registrant in charge of a principal business unit, division or function (such as sales, administration or finance), any other officer who performs a policy making function or any other person who performs similar policy making functions for the registrant. Executive officers of subsidiaries may be deemed executive officers of the registrant if they perform such policy making functions for the registrant

Governance Disclosures

The SEC made one “technical” correction to S-K Item 407 and also added a clarification for emerging growth companies (“EGCs”).

Regulation S-K Item 407(d)(3)(i) used to include this requirement:

The audit committee must state whether:

…

(B)  The audit committee has discussed with the independent auditors the matters required to be discussed by the statement on Auditing Standards No. 61, as amended (AICPA, Professional Standards, Vol. 1. AU section 380), as adopted by the Public Company Accounting Oversight Board in Rule 3200T;

The reference to AU Section 380 is out of date as this was a reference to the old PCAOB standard system and not the new PCAOB organization of their auditing standards.  This S-K requirement has been updated to read:

(B) The audit committee has discussed with the independent auditors the matters required to be discussed by the applicable requirements of the Public Company Accounting Oversight Board (“PCAOB”) and the Commission;

The other change in S-K Item 407 is related to EGCs. Because EGCs are not required to provide a  Compensation Discussion and Analysis (S-K Item 402), there was some ambiguity about whether or not S-K Item 407(e)(5) applied to EGCs.  This is the language in that paragraph:

(5) Under the caption “Compensation Committee Report:”

(i) The compensation committee (or other board committee performing equivalent functions or, in the absence of any such committee, the entire board of directors) must state whether:

(A) The compensation committee has reviewed and discussed the Compensation Discussion and Analysis required by Item 402(b) (§229.402(b)) with management; and

(B) Based on the review and discussions referred to in paragraph (e)(5)(i)(A) of this Item, the compensation committee recommended to the board of directors that the Compensation Discussion and Analysis be included in the registrant’s annual report on Form 10-K (§249.310 of this chapter), proxy statement on Schedule 14A (§240.14a-101 of this chapter) or information statement on Schedule 14C (§240.14c-101 of this chapter).

(ii) The name of each member of the registrant’s compensation committee (or other board committee performing equivalent functions or, in the absence of any such committee, the entire board of directors) must appear below the disclosure required by paragraph (e)(5)(i) of this Item

This ambiguity has been removed by adding this instruction to S-K Item 407(g):

(2) A registrant that qualifies as an “emerging growth company,” as defined in Rule 405 of the Securities Act (§230.405 of this chapter) or Rule 12b-2 of the Exchange Act (§240.12b-2 of this chapter), is not required to provide the disclosure required by paragraph (e)(5) of this Item.

As always, your thoughts and comments are welcome!

In the last several weeks we have been delving into the details of each change in the SEC’s March 20, 2019 Disclosure Modernization and Simplification final rule.  This is the first of two posts that review changes to areas that are included in Part III of Form 10-K and in proxy statement disclosures about executive officers and delinquent Section 16 filers.  Changes in both areas are fairly straightforward and, like most of the changes in the final rule, are effective for filings made after May 2, 2019.

Executive Officer Disclosures

A question that frequently arises in our workshops is “Why do companies sometimes include a list of executive officers at the end of Part I of their Form 10-K?” Answering this question starts with S-K Item 401, which requires disclosure of a wealth of information about both executive officers and directors.  These disclosures are required in Part III of Form 10-K and in the proxy statement disclosures in Schedule 14A:

Item 7. Directors and executive officers. If action is to be taken with respect to the election of directors, furnish the following information in tabular form to the extent practicable. If, however, the solicitation is made on behalf of persons other than the registrant, the information required need be furnished only as to nominees of the persons making the solicitation.

(a) The information required by instruction 4 to Item 103 of Regulation S-K (§229.103 of this chapter) with respect to directors and executive officers.

(b) The information required by Items 401, 404(a) and (b), 405 and 407 of Regulation S-K (§§229.401, 229.404(a) and (b), 229.405 and 229.407 of this chapter), other than the information required by:

The proxy, however, is essentially about the election of directors and by including the information about executive officers with the information about directors could create confusion for shareholders in the voting process.

To mechanically deal with this potential problem many years ago the SEC added this instruction to S-K 401:

Instructions to paragraph (b) of Item 401:

…

3. The information regarding executive officers called for by this Item need not be furnished in proxy or information statements prepared in accordance with Schedule 14A under the Exchange Act (§240.14a-101 of this chapter) by registrants relying on General Instruction G of Form 10-K under the Exchange Act (§249.310 of this chapter); Provided, that such information is furnished in a separate item captioned “Executive officers of the registrant” and included in Part I of the registrant’s annual report on Form 10-K.

The Disclosure Modernization and Simplification final rule addressed two issues surrounding this instruction:

1. The instruction was part of paragraph “(b) Identification of executive officers”, so it was not clear whether or not the instruction applied to all the S-K Item 401 disclosures about executive officers, and
2. The title for the disclosure, “Executive officers of the registrant” read in a formal kind of compliance language and is not particularly focused on communication.

To address these issues the SEC made two changes in their final rule.  The SEC:

1. Moved the instruction so that it now is clear it applies to all the S-K Item 401 disclosures, and
2. Reworded the title so that it now has a more “plain English” communication focus.

The now moved and reworded instruction reads:

Instruction to Item 401. The information regarding executive officers called for by this Item need not be furnished in proxy or information statements prepared in accordance with Schedule 14A or Schedule 14C under the Exchange Act (§240.14a-101 and §240.14c-101 of this chapter) if you are relying on General Instruction G of Form 10-K under the Exchange Act (§249.310 of this chapter), such information is furnished in a separate section captioned “Information about our Executive Officers,” and is included in Part I of your annual report on Form 10-K.

As always, your thoughts and comments are welcome!

Over the last several years the SEC’s focus on disclosure effectiveness and capital formation have driven significant change in public company reporting.  From the 2015 and 2016 requests for comment on a variety of S-K and S-X requirements to the latest proposal to amend the definition of accelerated filer this process has generated much to watch and implement.

In addition,the FASB has also reviewed disclosures and made improvements to many areas in the Codification.

One area where there has been overlap between the SEC’s and the FASB’s activities is the SEC’s August 2018 Disclosure Update and Simplification final rule.  This rule included a number of changes to Regulation S-K and S-X and also identified places where the SEC required information that in part overlapped and also sometimes went beyond current GAAP requirements.  The SEC referred these areas to the FASB for consideration in the standard-setting process.

On May 6, 2019, the FASB issued an exposure draft related to this “referral” from the SEC.  The proposed amendments in the exposure draft would modify disclosure or presentation requirements in a variety of topics in the Codification, ranging from removing the impracticability exception, to the requirement to disclose revenues for each product and service or each group of similar products and services, to adding disclosure of where derivative instruments and their related gains and losses are reported in the statement of cash flows.  The exposure draft has a very helpful table of all the proposed changes.

As always. your comments and questions are welcome!

In June 2018, when the SEC changed the definition of “smaller reporting company” (SRC) by increasing the public float threshold from $75 million to $250 million and adding a revenue test, the Commission also directed the staff to review the issues in changing the definitions of accelerated and large accelerated filer. (The current definition is at the end of this post if you would like to review it.)

These instructions to the staff came to fruition on May 9, 2019.  As we mentioned in this post the SEC met on that date to consider changing the definitions of accelerated and large accelerated filers.  At the meeting the Commission voted to issue this proposed rule.  You can read a summary of the proposal in this fact sheet.

The proposed rule does have an interesting level of complexity.  It would not completely conform the definitions involved. According to the proposed rule:

“The proposed new conditions would only be available to issuers that are eligible to be an SRC under the SRC revenue test. Issuers that are eligible to be an SRC that have a public float between $75 million and $250 million would be accelerated filers if their annual revenues are $100 million or more, and thus they would remain subject to all of the requirements applicable to accelerated filers.”

The actual regulatory language that would be added to Rule 12b-2 in the definitions of accelerated and large accelerated filer is:

(iv) The issuer is not eligible to use the requirements for smaller reporting companies under the revenue test in paragraph (2) or (3)(iii)(B), as applicable, of the “smaller reporting company” definition in this section.

Thus, the dollar thresholds in the definitions would not be changed.  For example, the new definition of accelerated filer would read as follows:

(1) Accelerated filer. The term accelerated filer means an issuer after it first meets the following conditions as of the end of its fiscal year:

(i) The issuer had an aggregate worldwide market value of the voting and non-voting common equity held by its non-affiliates of $75 million or more, but less than $700 million, as of the last business day of the issuer’s most recently completed second fiscal quarter;

(ii) The issuer has been subject to the requirements of section 13(a) or 15(d) of the Act (15 U.S.C. 78m or 78o(d)) for a period of at least twelve calendar months; and

(iii) The issuer has filed at least one annual report pursuant to section 13(a) or 15(d) of the Act.

(iv) The issuer is not eligible to use the requirements for smaller reporting companies under the revenue test in paragraph (2) or (3)(iii)(B), as applicable, of the “smaller reporting company” definition in this section.

The relevant paragraph in the SRC definition refers to the $100 million-dollar revenue test. (That definition is at the end of this post.)

This table provides a summary of how the proposed rule would work:

The big issue in this change of course is that more companies would become non-accelerated filers and would not be required to have an annual audit of their internal control over financial reporting.   The affected companies would also be subject to the longer deadlines for non-accelerated filers.

 In the economic analysis section of the proposed rule the SEC provides a wealth of data and analysis, along with the estimate that an additional 539 companies would become non-accelerated filers.

 The proposed rule also would increase the thresholds for exiting accelerated filer status (from $50 to $60 million) and large accelerated filer status (from $500 to $600 million).

As always, your thoughts and comments are welcome!

Lastly, here, as mentioned above, is the SRC definition:

Smaller reporting company. As used in this part, the term smaller reporting company means an issuer that is not an investment company, an asset-backed issuer (as defined in §229.1101 of this chapter), or a majority-owned subsidiary of a parent that is not a smaller reporting company and that:

(1) Had a public float of less than $250 million; or

(2) Had annual revenues of less than $100 million and either:

(i) No public float; or

(ii) A public float of less than $700 million.

In the last week there have been two very interesting developments in the SEC’s disclosure effectiveness process. 

On May 3, 2019, the SEC formally proposed a rule to “improve the information that investors receive regarding the acquisition and disposition of businesses.”  The SEC indicated that “[t]he proposed amendments are also intended to facilitate more timely access to capital and to reduce complexity and compliance costs of these financial disclosures.” 

The proposed rules would change Regulation S-X Rules 3-05 and 3-14, Article 11, and other related rules and forms.  Among the many changes in the proposed rule are: 

• Updates to the investment test and the income test in the significant subsidiary test 
• Expanding the use of pro forma financial information in measuring significance 

• Conforming the significance threshold and tests for a disposed business 
• Requiring the financial statements of the acquired business to cover up to the two most recent fiscal years rather than up to the three most recent fiscal years 
• Permitting disclosure of financial statements that omit certain expenses for certain acquisitions of a component of an entity. 

There are a raft of details in the proposed rule and you can find an extensive Fact Sheet with a link to the proposed rule here. 

 On May 9, 2019, in an open meeting, the SEC will consider proposing changes to the definitions of accelerated and large accelerated filers.  According to the meeting agenda: 

 The Commission will consider whether to propose new rule amendments to the accelerated filer and large accelerated filer definitions to promote capital formation for smaller reporting issuers by more appropriately tailoring the types of issuers that are included in the categories of accelerated and large accelerated filers and revising the transition thresholds for these filers. 

 As always, your thoughts and comments are welcome! 

When reading the results of operations section in MD&A it is not unusual to experience a feeling of  déjà vu. When comparing the current year to last year companies will explain why financial statement line items changed with the goal of helping readers understand quality of earnings and the likelihood that past performance predicts future performance. (For a quick review of these objectives you could re-read the SEC’s 2003 MD&A release, FR 72.)

Unfortunately, when companies write the next part of this discussion and compare last year to the third year back, they frequently follow a sort of literal interpretation of the S-K Item 303 guidance and end up repeating this discussion but with the prior year numbers.

It is difficult to argue that this repetition does much to add to an investor’s understanding of earnings quality and predictability, and in fact this information is already available in prior year filings.

This was the issue that the SEC addressed in their March 20, 2019 Disclosure Modernization and Simplification rule in the one MD&A area they changed – S-K Item 303(a) instruction 1.  (As you likely have heard, most of the changes in this rule, including MD&A changes, are effective for filings after May 2, 2019.)

Here is the new language in this instruction, with changes bolded:

Instructions to paragraph 303(a): 1. The registrant’s discussion and analysis shall be of the financial statements and other statistical data that the registrant believes will enhance a reader’s understanding of its financial condition, changes in financial condition, and results of operations. Generally, the discussion shall cover the periods covered by the financial statementsincluded in the filing and the registrant may use any presentation that in the registrant’s judgment enhances a reader’s understanding. A smaller reporting company’s discussion shall cover the two-year period required in Article 8 of Regulation S-X and may use any presentation that in the registrant’s judgment enhances a reader’s understanding. For registrants providing financial statements covering three years in a filing, discussion about the earliest of the three years may be omitted if such discussion was already included in the registrant’s prior filings on EDGAR that required disclosure in compliance with Item 303 of Regulation S-K, provided that registrants electing not to include a discussion of the earliest year must include a statement that identifies the location in the prior filing where the omitted discussion may be found. An emerging growth company, as defined in Rule 405 of the Securities Act (§ 230.405 of this chapter) or Rule 12b-2 of the Exchange Act (§ 240.12b-2 of this chapter), may provide the discussion required in paragraph (a) of this Item for its two most recent fiscal years if, pursuant to Section 7(a) of the Securities Act of 1933 (15 U.S.C 77g(a)), it provides audited financial statements for two years in a Securities Act registration statement for the initial public offering of the emerging growth company’s common equity securities.

This instruction used to read:

Instructions to paragraph 303(a): 1. The registrant’s discussion and analysis shall be of the financial statements and other statistical data that the registrant believes will enhance a reader’s understanding of its financial condition, changes in financial condition and results of operations. Generally, the discussion shall cover the three-year periodcovered by the financial statementsand shall use year-to-year comparisons orany other formats that in the registrant’s judgment enhance a reader’s understanding. However, where trend information is relevant, reference to the five-year selected financial data appearing pursuant to Item 301 of Regulation S-K (§229.301) may be necessary. A smaller reporting company’s discussion shall cover the two-year period required in Article 8 of Regulation S-X and shall use year-to-year comparisonsor any other formats that in the registrant’s judgment enhance a reader’s understanding. An emerging growth company, as defined in Rule 405 of the Securities Act (§230.405 of this chapter) or Rule 12b-2 of the Exchange Act (§240.12b-2 of this chapter), may provide the discussion required in paragraph (a) of this Item for its two most recent fiscal years if, pursuant to Section 7(a) of the Securities Act of 1933 (15 U.S.C 77g(a)), it provides audited financial statements for two years in a Securities Act registration statement for the initial public offering of the emerging growth company’s common equity securities.

As you can see in the highlighted sections above, the key changes from the old instruction to the new instruction are:

1. Removing the language referring to “year-to-year” comparisons and replacing it with “registrants may use any presentation that in the registrant’s judgment enhances a reader’s understanding”.

2. Removing the reference to the five-year summary.

3. Allowing registrants who provide financial statements covering three years in a filing to omit discussion of the earliest of the three years if such discussion is already included in any other of the registrant’s prior filings on EDGAR. While the proposal had some limitations on this provision, companies can make this election with no limitations, but they must identify the location in the prior filing where the omitted discussion may be found.

As a point of interest, it is worth noting that the prior year MD&A does not have to be in a Form 10-K and in fact could be in any prior SEC filing.

Consistently with the other changes we have discussed so far and in alignment with CorpFin Director Hinman’s speech we reviewed in this post, these new requirements are not bright-line standards.  They are based on principles consistent with providing investors information they need to make investment and voting decisions and call on us to exercise judgment.

In the final rule release the SEC made these comments:

We believe the revisions to Item 303 that we are adopting give registrants the flexibility to tailor their presentation in MD&A in a manner that is most suitable for their varying circumstances, while at the same time continuing to require that they provide all of the information necessary to an understanding of their financial condition, changes in financial condition and results of operations. In that respect, we view the elimination of references to year-to-year comparisons and the new language in Instruction 1 of Item 303 allowing registrants to omit discussion of the earliest of the three years covered by the financial statements as complementary.

These amendments emphasize the flexibility available to registrantswith respect to the form of MD&A presentation. The major benefit of flexibility is that it allows registrants to frame the information in a way that emphasizes material information and allows registrants to omit information that is not material. One potential cost associated with this aspect of the amendment is that, to the extent the amendments lead to disclosure that varies more across firms and across a single firm’s filings, they also may make disclosure less comparable across registrants and over time.

The combined effects of these amendments will be to eliminate the burden on registrants to prepare and provide repetitive disclosure that is not material. The amendments are of particular significance because MD&A is typically one of the most labor-intensive sections of any form in which it is required. We anticipate that the amendments to simplify and clarify the MD&A requirements will reduce the paperwork burden associated with affected forms.

It will be interesting to see how companies use these new rules.

As always, your thoughts and comments are welcome!

This is a revised version of an earlier post, and demonstrates the risks in trying to get out with information as early as possible!  Drafting this post late yesterday and early this morning the SEC had not yet released updated versions of the cover pages for the forms and I created a version for this post.  And, shortly after I posted our suggested version the SEC updated the forms.  So, you can find the official revised cover pages for Forms 10-K, 10-Q and 8-K here.

As always, your thoughts and comments are welcome!

Risk factor disclosure frequently presents a conundrum in public reporting.  The SEC’s risk factor disclosure requirements focus on what makes an investment in a company’s securities “risky or speculative”.  Buy many companies present so many risk factors that questions arise about their relevance to investors.  This is one among a number of reasons the SEC included this disclosure in their March 20, 2019 Disclosure Modernization and Simplification rule.

As you likely have heard, most of the changes in this rule, including risk factor changes, are effective for filings after May 2, 2019.

To begin reviewing the changes in risk factor disclosures, Item 1A in Form 10-K previously read:

Item 1A. Risk Factors.

Set forth, under the caption “Risk Factors,” where appropriate, the risk factors described in Item 503(c) of Regulation S-K (§229.503(c) of this chapter) applicable to the registrant. Provide any discussion of risk factors in plain English in accordance with Rule 421(d) of the Securities Act of 1933 (§230.421(d) of this chapter). Smaller reporting companies are not required to provide the information required by this item.

Item 1A has been changed to now read:

Item 1A. Risk Factors.

Set forth, under the caption “Risk Factors,” where appropriate, the risk factors described in Item 105 of Regulation S-K (§ 229.105 of this chapter) applicable to the registrant.

The specific disclosure requirements surrounding risk factors have been moved to S-K Item 105 and out of Item 503. Since most of the disclosures in Part 500 of S-K deal with prospectus disclosures and risk factors are, since 2005, a regular ‘34 Act report disclosure requirement, this change makes sense.

In addition, as you will see below, the removal of the plain English language that was in the Item 1A instructions is not really a change as the requirement is now incorporated in new S-K Item 105.

The old text of Item 503(c), which has been removed, read:

 (c) Risk factors. Where appropriate, provide under the caption “Risk Factors” a discussion of the most significant factors that make the offering speculative or risky. This discussion must be concise and organized logically. Do not present risks that could apply to any issuer or any offering. Explain how the risk affects the issuer or the securities being offered. Set forth each risk factor under a subcaption that adequately describes the risk. The risk factor discussion must immediately follow the summary section. If you do not include a summary section, the risk factor section must immediately follow the cover page of the prospectus or the pricing information section that immediately follows the cover page. Pricing information means price and price-related information that you may omit from the prospectus in an effective registration statement based on §230.430A(a) of this chapter. The risk factors may include, among other things, the following:

(1) Your lack of an operating history;

(2) Your lack of profitable operations in recent periods;

(3) Your financial position;

(4) Your business or proposed business; or

(5) The lack of a market for your common equity securities or securities convertible into or exercisable for common equity securities.

The new requirement in S-K Item 105 now reads:

229.105 (Item 105) Risk factors.

Where appropriate, provide under the caption “Risk Factors” a discussion of the most significant factors that make an investment in the registrant or offeringspeculative or risky. This discussion must be concise and organized logically. Do not present risks that could apply generically to any registrant or any offering. Explain how the risk affects the registrant or the securities being offered. Set forth each risk factor under a subcaption that adequately describes the risk. If the risk factor discussion is included in a registration statement, it must immediately follow the summary section. If you do not include a summary section, the risk factor section must immediately follow the cover page of the prospectus or the pricing information section that immediately follows the cover page. Pricing information means price and price-related information that you may omit from the prospectus in an effective registration statement based on Rule 430A (§ 230.430A(a) of this chapter). The registrant must furnish this information in plain English. See § 230.421(d) of Regulation C of this chapter.

New S-K Item 105 has some subtle wording changes which are highlighted above.  The addition of the phrase “an investment in the registrant” makes the application of this disclosure clearer for ‘34 Act periodic reports.  And, the addition of the phrase “apply generically” helps clarify that the requirement should not be interpreted too broadly.

Also, the removal of the examples makes it clear that this is intended to be a registrant specific, principles-based requirement.  In the Final Rule Release the SEC included these comments:

The Commission also proposed amendments that would eliminate the specific risk factor examples that are currently enumerated in Item 503(c). Although Item 503(c) is principles based, and the Commission has eschewed “boiler plate” risk factors that are not tailored to the unique circumstances of each registrant, the …. examples of factors that may make an offering speculative or risky have remained unchanged since the Commission first published guidance on risk factor disclosure in 1964.

As discussed in the Proposing Release, the Commission’s principles-based approach to risk factor disclosure is not consonant with the item’s list of examples of material risks. These examples may not apply to all registrants and may not correspond to the material risks of any particular registrant. In addition, the inclusion of these examples could suggest that a registrant must address each one in its risk factor disclosures, regardless of the significance to its business. Finally, the Commission was concerned that the inclusion of any examples in Item 503(c), whether to illustrate the specific kinds of risks that should be disclosed or generic risks that should be avoided, could anchor or skew the registrant’s risk analysis in the direction of the examples.

 It will be interesting to watch and see how or if companies take advantage of this new requirement.

As always, your thoughts and comments are welcome!

After our recent posts about the disclosure issues surrounding emerging and changing issues including Brexit and Libor, we are returning to our series delving into the details of implementing the SEC’s March 20, 2019 Disclosure Modernization and Simplification rule, and specifically the changes in properties disclosures.

As you likely have heard, most of the changes in this rule, including property disclosures, are effective for filings after May 2, 2019.

To being reviewing the changes in property disclosures Item 2 in Form 10-K requires the disclosures in Regulation S-K Item 102.

The old text Item 102 is:

229.102   (Item 102) Description of property.

State briefly the location and general character of the principal plants, mines and other materially important physical properties of the registrant and its subsidiaries. In addition, identify the segment(s), as reported in the financial statements, that use the properties described. If any such property is not held in fee or is held subject to any major encumbrance, so state and describe briefly how held.

Instructions to Item 102: 1. What is required is such information as reasonably will inform investors as to the suitability, adequacy, productive capacity and extent of utilization of the facilities by the registrant. Detailed descriptions of the physical characteristics of individual properties or legal descriptions by metes and bounds are not required and shall not be given.

2.  In determining whether properties should be described, the registrant should take into account both quantitative and qualitative factors. See Instruction 1 to Item 101 of Regulation S-K (§229.101).

The new text effective May 2, 2019 is:

229.102 (Item 102) Description of property.

To the extent material, disclose the location and general character of the registrant’s principal physical properties. In addition, identify the segment(s), as reported in the financial statements, that use the properties described. If any such property is not held in fee or is held subject to an encumbrance that is material to the registrant, so state and describe briefly how held.

Instruction 1 to Item 102: This item requires information that will reasonably inform investors as to the suitability, adequacy, productive capacity, and extent of utilization of the principal physical properties of the registrant and its subsidiaries, to the extent the described properties are material. A registrant should engage in a comprehensive consideration of the materiality of its properties. If appropriate, descriptions may be provided on a collective basis;detailed descriptions of the physical characteristics of individual properties or legal descriptions by metes and bounds are not required and shall not be given.

Instruction 2 to Item 102: In determining materiality under this Item, the registrant should take into account both quantitative and qualitative factors. See Instruction 1 to Item 101 of Regulation S-K (§ 229.101).

The changes to this item focus on one of the more complex judgments we make in SEC reporting,materiality.  (This was one of the key judgments that CorpFin Director Hinman discussed in the speech explored in our last two posts.)

The old item started:

“State briefly the location and general character of the principal plants, mines and other materially important physical properties…”

 This has been changed to:

 “To the extent material, disclose the location and general character of the registrant’s principal physical properties.”

The change in wording from“materially important physical properties” to  “To the extent material, disclose…” tells us that we don’t need to include information that, in the words of CorpFin Director Hinman, does not provide investors:

“material information they need about companies and their securities offerings to make informed investment and voting decisions”

 While the information about segments and suitability, adequacy, productive capacity and extent of utilization reads very similarly from the old to the new requirement, the words “to the extent the described properties are material” makes clear we can make materiality calls and not be concerned with the other potential considerations in the old language.  We can hopefully no longer by rote disclose information about our properties that will not matter to investors.

Additionally, the new instruction “A registrant should engage in a comprehensive consideration of the materiality of its properties” more or less makes this a requirement.

In the final rule release, the SEC made this observation:

Despite existing language in Item 102 that limits the required information to properties that are “materially important” to the registrant and its subsidiaries, the disclosure elicited in response to this item may not have been consistently material.For many companies, the only physical properties held may be their headquarters, office space, or ancillary facilities, a description of which is likely to be unimportant to an investor’s evaluation of an investment in the company.

As an example, if a service company uses only simple office space and is in an area where an adequate supply of suitable space is available and the company has no excess space problems, it could be appropriate to make no disclosures about properties.  This would reduce the clutter of immaterial information in Form 10-K.

The last part of instruction 1 makes a suggestion to avoid immaterial details:

“If appropriate, descriptions may be provided on a collective basis”

Materiality Considerations

The last instruction, which is the same on both the old and new versions of S-K Item 102, makes it clear that the definition of materiality is not just the magnitude of an item.

Instruction 2 to Item 102: In determining materiality under this Item, the registrant should take into account both quantitative and qualitative factors. See Instruction 1 to Item 101 of Regulation S-K (§ 229.101).

Instruction 1 to Item 101 does not actually refer to SAB 99.  It does include an example that perhaps is similar to considerations in SAB 99

Instructions to Item 101: 1. In determining what information about the segments is material to an understanding of the registrant’s business taken as a whole and therefore required to be disclosed, pursuant to paragraph (c) of this Item, the registrant should take into account both quantitative and qualitative factorssuch as the significance of the matter to the registrant (e.g., whether a matter with a relatively minor impact on the registrant’s business is represented by management to be important to its future profitability), the pervasiveness of the matter (e.g., whether it affects or may affect numerous items in the segment information), and the impact of the matter (e.g., whether it distorts the trends reflected in the segment information). Situations may arise when information should be disclosed about a segment, although the information in quantitative terms may not appear significant to the registrant’s business taken as a whole.

While this change does present some new materiality judgments for properties, it does hopefully modernize and simplify these disclosures.  And, to provide a starting point, here are two examples from 3M Corporation and General Motors, which are wonderfully brief even though prepared under the old disclosure requirements:

3M Corporation – Item 2. Properties.

In the U.S., 3M’s general offices, corporate research laboratories, and certain division laboratories are located in St. Paul, Minnesota. The Company operates 80 manufacturing facilities in 29 states. Internationally, the Company operates 125 manufacturing and converting facilities in 37 countries.

3M owns the majority of its physical properties. 3M’s physical facilities are highly suitable for the purposes for which they were designed. Because 3M is a global enterprise characterized by substantial intersegment cooperation, properties are often used by multiple business segments.

General Motors – Item 2. Properties

At December 31, 2018 we had over 100 locations in the U.S. (excluding our automotive financing operations and dealerships) which are primarily for manufacturing, assembly, distribution, warehousing, engineering and testing. We, our subsidiaries or associated companies in which we own an equity interest own most of these properties and/or lease a portion of these properties. Leased properties are primarily composed of warehouses and administration, engineering and sales offices.

We have manufacturing, assembly, distribution, office or warehousing operations in 33 countries, including equity interests in associated companies which perform manufacturing, assembly or distribution operations. The major facilities outside the U.S., which are principally vehicle manufacturing and assembly operations, are located in Argentina, Brazil, Canada, China, Colombia, Ecuador, Mexico, South Korea and Thailand.

In November 2018 we announced our plans to realign our manufacturing capacity in response to market-related volume declines in passenger cars.

GM Financial owns or leases facilities for administration and regional credit centers. GM Financial has 39 facilities, of which 26 are located in the U.S. The major facilities outside the U.S. are located in Brazil, Canada, China and Mexico.

One final note – the specific requirements in industries such as mining and oil and gas are not changed by this new rule.

As always, your thoughts and comments are welcome!

In this post we began a discussion about moving forward with our reporting after last year-end and identifying and planning for areas where we may need to adjust our on-going quarterly reporting for changes going on in the world around us and to also begin identifying areas where we may want to update, refine or improve our reporting.

We began this discussion with a review of a speech delivered at PLI’s 18^thAnnual Securities Regulation in Europe program on March 15, 2019, by CorpFin Division Director William Hinman.

In his speech Mr. Hinman discussed the principles-based foundations of the SEC’s disclosure system and how this requires us to use judgmentand think beyond just what the SEC’s rulesmay say or what we see other companies disclosing.

In his remarks Mr. Hinman said:

“The flexibility of our principles-based disclosure requirements should result in disclosure that keeps pace with emerging issues, like Brexit or sustainability matters, without the need to for the Commission to continuously add to or update the underlying disclosure rules as new issues arise.”

He also said:

  “our disclosure requirements are intended to provide investors with the material information they need about companies and their securities offerings to make informed investment and voting decisions”

With these reminders of our responsibility:

1. To monitor the world around us and identify issues that that may require changes in disclosure, and

2. To make judgments about materiality,

we can think about how they apply to Brexit and sustainability matters. While the SEC’s rules and regulations provide a starting point, we need to consider the whole context of a situation and include all information material to investors

 Both of these are areas we may want to place on our disclosure committee or disclosure process agendas.

Brexit Disclosures

Few issues in the economic world today create more uncertainty than Brexit.  Brexit will affect many companies and likely will have different effects company by company.  There is really no one-size-fits-all approach and likely no “industry” based disclosure that will meet the disclosure requirements for individual companies or individual industries.  In his remarks Mr. Hinman emphasized this with these words:

“Rather, investors are better served by understanding the lens through which each company’s management looks at its exposure. How does management assess and analyze Brexit-related risks and the potential impacts on the company and its operations? What is management doing to mitigate and manage these risks? What is the nature of the board’s role in overseeing the management of these risks? Depending on the facts and circumstances of each company, the answers to these questions should provide material information to investors seeking to understand the risks attendant to Brexit for that company. “

Sustainability Disclosures

Sustainability disclosures are an area where company management and investors are still exploring what they believe is material and what investors want to know about.  (And yes, there is a really interesting materiality discussion in that last sentence!). More and more companies are making significant sustainability disclosures.  For examples, you could review Etsy’s Form 10-Kand go back to our series of blog postson this topic. To help companies think about appropriate disclosures in this area Mr. Hinman said something very interesting about how he believed SEC rulemaking, if it had occurred, would have affected the “evolution” of these disclosures:

“The marketplace evolution of sustainability disclosures is ongoing – companies certainly provide more sustainability information than they did ten years ago – and allowing this evolution to continue should provide market participants with a continued opportunity to sort out the types of information they find useful. Had we leapt into action and issued prescriptive sustainability disclosure requirements when people first began calling for them, I believe we would have stymied that evolution and stifled efforts to develop useful disclosure frameworks. Substituting regulatory prescriptions for market-driven solutions, especially while those solutions are evolving, in my view, is something we need to manage with utmost care. In the meantime, we are watching carefully as market-led approaches develop in this area, and we actively compare the information companies voluntarily provide – typically outside of their SEC filings – with the disclosure we see filed with us.”

Clearly these comments put the onus on companies and investors in the disclosure marketplace to continue using judgment to determine the future direction of these disclosures.

A Concluding Thought – Board Oversight

Given the evolving and potentially material nature of these two disclosure areas it is not surprising that Mr. Hinman also discussed board oversight:

“To the extent a matter presents a material risk to a company’s business, the company’s disclosure should discuss the nature of the board’s role in overseeing the management of that risk. The Commission last noted this in the context of cybersecurity, when it stated that disclosure about a company’s risk management program and how the board engages with the company on cybersecurity risk management allows investors to better assess how the board is discharging its risk oversight function.”

This is also a great opportunity to begin updating and changing disclosures incrementally as we file each quarterly Form 10-Q with a view towards better disclosure in our next Form 10-K.  This kind of a gradual path of change from this year’s 10-K to each 10-Q to next year’s 10-K is generally far easier to manage organizationally than a big change all at once.  (This is particularly true with MD&A, and more about that later.)

As a last thought, these two areas are not the only ones that could require this kind of disclosure consideration.  Others could be the impact of Libor going away, the impact of tariffs, the risks surrounding evolving technology such as 5G cellular systems and a raft of things that we need to think about company by company and industry by industry.  And, as we approach our first quarter reporting, this is a great chance to review or reporting for areas where we need to use our judgment about evolving disclosures.

As always, your thoughts and comments are welcome!