In response to a reader comment about our recent posts delving into the SEC’s August 2020 modernization of business, risk factor and legal proceedings disclosures, this post explores the implications of these changes for smaller reporting companies or SRCs.

A review of the SRC definition and a list of SRC disclosure accommodations is included at the end of this post.  SRCs can use this system in an “à la carte” fashion, picking and choosing which disclosure accommodations they will use.

The impact of the SEC’s August 2020 Final Rule on SRCs is essentially the same as non-SRCs, with the differences described below.

Description of  Business

Consistent with the changes for non-SRCs, the requirements for how many periods to present and hyperlinking were updated for SRCs.  Notably, the prescriptive and detailed business description requirements for SRCs in S-K Item 101(h) were not changed.  They are included at the end of this post.

Number of Periods to Present

The old version of S-K Item 101(h) contained this language:

A smaller reporting company, as defined by §229.10(f)(1), may satisfy its obligations under this Item by describing the development of its business during the last three years.

This is replaced by a more principles-based requirement:

In describing developments under paragraphs (h)(1) through (3), information should be provided for the period of time that is material to an understanding of the general development of the business.

One note in this regard – remember the instructions to Form 10-K Item 1 limit this requirement to the period from the beginning of the year of the report:

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.

Hyperlinking

The new S-K Item 101(h) also has this language about hyperlinking, which is consistent with the changes made for non-SRCs:

Notwithstanding the provisions of § 230.411(b) or § 240.12b-23(a) of this chapter as applicable, a smaller reporting company 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 smaller reporting company 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

Risk Factors

The August 2020 changes to risk factor disclosure did not include any special provisions for SRCs.  As a result, SRCs are subject to the new requirement to provide a risk factor summary if their risk factor disclosures are over 15 pages long.  This requirement is now in S-K Item 105(b):

(b) Concisely explain how each risk affects the registrant or the securities being offered. 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.

SRC’s do have a disclosure accommodation for risk factors that was not changed by the August 2020 Final Rule.  The Instructions to Form 10-K Item 1A provide that SRCs do not have to disclose risk factors:

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. 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.

Legal Proceedings

There are no SRC legal proceedings disclosure accommodations.  All the disclosure changes described in this post apply to both SRCs and non-SRCs.

As always, your thoughts and comments are welcome!

Here, for ease of reference are:

• Definition of an SRC
• SRC disclosure accommodations
• S-K Item 101(h) description of business

Definition of an SRC

As a brief reminder, the definition of a small reporting company is in Regulation S-K Item 10(f):

(1) Definition of 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), or a majority-owned subsidiary of a parent that is not a smaller reporting company and that:

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

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

(A) No public float; or

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

This definition was adopted in this June 2018 Final Rule which increased the public float level from $75 million to $250 million and also added the provision that companies with less than $100 million in revenue and public float less than $700 million could use the SRC system.  This allowed tech and biotech companies that are in a “pre-revenue” stage to use the SRC reduced disclosure regimen.  In the final rule the SEC estimated that approximately 966 additional registrants would meet the new SRC definition.

SRC Disclosure Accommodations

You can find a list of the Regulation S-K disclosure accommodations for SRCs in S-K Item 10(f) and the financial statement requirements for SRCs in S-X Article 8.  SRC financial statements need only comply with US GAAP.  The additional requirements in Regulation S-X, with the exception of the auditor requirements in Article 2, do not apply to SRCs.

SRC Description of Business

The detailed requirements in S-K Item 101(h) for an SRC to address in the description of its business were not changed by the August 2020 Final Rule.  They include:

(1) Form and year of organization;

(2) Any bankruptcy, receivership or similar proceeding; and

(3) Any material reclassification, merger, consolidation, or purchase or sale of a significant amount of assets not in the ordinary course of business.

(4) Business of the smaller reporting company. Briefly describe the business and include, to the extent material to an understanding of the smaller reporting company:

(i) Principal products or services and their markets;

(ii) Distribution methods of the products or services;

(iii) Status of any publicly announced new product or service;

(iv) Competitive business conditions and the smaller reporting company’s competitive position in the industry and methods of competition;

(v) Sources and availability of raw materials and the names of principal suppliers;

(vi) Dependence on one or a few major customers;

(vii) Patents, trademarks, licenses, franchises, concessions, royalty agreements or labor contracts, including duration;

(viii) Need for any government approval of principal products or services. If government approval is necessary and the smaller reporting company has not yet received that approval, discuss the status of the approval within the government approval process;

(ix) Effect of existing or probable governmental regulations on the business;

(x) [Reserved]

(xi) Costs and effects of compliance with environmental laws (federal, state and local); and

(xii) Number of total employees and number of full-time employees.

On November 17, 2020, the SEC adopted a Final Rule  –  “Electronic Signatures in Regulation S-T Rule 302.”  As you can read in the accompanying Press Release, the SEC is modernizing its signature requirements to accept electronic signatures for many filings.

This change was, at least partially, in response to this rulemaking petition by a group of law firms representing hundreds of public companies.  The amendments “recognize the widespread use of electronic signatures and technological developments in the authentication and security of electronic signatures, as well as the continuing need to support remote workforces.”

The Final Rule makes changes to Regulation S-T and various forms for the Securities Act, Exchange Act and Investment Company Act.  Under the new rules, a signatory to an electronic filing who follows certain procedures will be able to use an electronic signature to sign a signature page or other “authentication document.”  The related procedures must meet specific requirements being added to the EDGAR Filer Manual.

The Final Rule will be effective when published in the Federal Register.

In a related change, the SEC is also amending its Rules of Practice to allow for filing and serving documents electronically.

As always, your thoughts and comments are welcome!

Financial accounting and SEC reporting involve more judgments, estimates and uncertainties every quarter and year-end.  Challenges such as making the principles-based judgments for disclosing disaggregated revenues under ASC 606, estimating the appropriate discount rates to use for lease accounting in ASC 842, and determining the necessity of an MD&A know-trend disclosure about an uncertainty, are inescapable.

One of the scariest “oh my” moments we have as SEC reporting professionals is when actual results differ materially from our estimates and judgments.

Unfortunately, in the realm of SEC reporting we are sometimes – perhaps all the time – aware that when we deal with these challenges we are subject to SEC scrutiny.  The SEC Enforcement Division’s leadership has emphasized that they are “incredibly focused” on company disclosures.  Sometimes we are concerned that we are “darned if we do and darned if we don’t” when making challenging decisions about judgments, estimates and uncertainties.

At an October 2020 securities enforcement conference, Enforcement Division Associate Director Melissa Hodgman discussed how the Division approaches situations where companies miss an estimate or judgment.  In her remarks, Associate Director Hodgman told the audience that the Division will not assume wrongdoing if a company misses an estimate or judgment in an uncertain situation.  She stated that the staff will “trust good faith estimates” and does not view this as a “gotcha” game when a company misses an estimate or judgment.  Instead, the Division will focus on process and documentation.  They will try to ascertain that we have made reasoned and good faith judgments using a consistently applied process.  The staff has also repeatedly emphasized the importance of robust and clear documentation about why we did what we did.

NOTE:  You may find of interest, PLI’s Insecurities Podcast episode 23, “A GAAP in Your Financial Reporting,” where hosts Chris Ekimoff and Kurt Wolfe further summarize and discuss her remarks.

These remarks are consistent with those of Chief Accountant Sagar Teotia who has said on a number of occasions that well-thought-out applications of principles will not be second guessed.  This is an excerpt from a speech by Mr. Teotia on June 23, 2020:

Significant Estimates and Judgments; Reasonable Judgments

 As we noted in our April 2020 statement, in connection with their financial reporting responsibilities, many companies have been required to make significant judgments and estimates to address a variety of accounting and financial reporting matters.  As those who engage with us well know, OCA has consistently not objected to well-reasoned judgments that entities have made, and we will continue to apply this perspective.   Companies should ensure that significant judgments and estimates are disclosed in a manner that is understandable and useful to investors, and that the resulting financial reporting reflects and is consistent with the company’s specific facts and circumstances.

What both the Enforcement Division and the Chief Accountant are telling us is that when we miss on a challenging estimate or judgment we may be questioned by the staff.  To put ourselves in the best position possible to answer the staff’s questions we must be able to show that we consistently followed a well-thought-out process with complete and robust documentation.

As always, your thoughts and comments are welcome.

This is the fourth 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 risk factor disclosures required by S-K Item 105.  You can read discussions of the description of business and legal proceedings disclosure changes in the first, second and third posts in this series.  The changes discussed in this post for risk factor disclosures 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.

The Final Rule makes a number of changes in risk factor disclosures:

1. In the first sentence of S-K Item 105 the word significant is changed to material.

Old version

Where appropriate, provide under the caption “Risk Factors” a discussion of the most significant factors that make an investment in the registrant or offering speculative or risky.

New version

Where appropriate, provide under the caption “Risk Factors” a discussion of the material factors that make an investment in the registrant or offering speculative or risky.

This change is consistent with the overall goal of disclosure modernization to make requirements more principles based and to focus on material information.

2. The disclosure reorganizes and slightly changes the details about presentation of risk factors.

Old version

This discussion must be concise and organized logically. ….. 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.

New version

This discussion must be organized logically with relevant headings and each risk factor should be set forth under a subcaption that adequately describes the risk. …… Concisely explain how each risk affects the registrant or the securities being offered

3. The new disclosure requirements acknowledge that companies frequently present “generic” risk factors, and requires that they be disclosed at the end of the risk factor section and include a specific heading.

Old version

Do not present risks that could apply generically to any registrant or any offering.

New version

The presentation of risks that could apply generically to any registrant or any offering is discouraged, but to the extent generic risk factors are presented, disclose them at the end of the risk factor section under the caption “General Risk Factors.”

4. The new rule includes provisions for a “summary” if your risk factors are over 15 pages.

(b) Concisely explain how each risk affects the registrant or the securities being offered. 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.

Here is an example of a risk factor summary from a KLA Corporation’s Form 10-Q for the quarter ended September 30, 2020:

ITEM 1A.    RISK FACTORS

A description of factors that could materially affect our business, financial condition or operating results is provided below.

Risk Factor Summary

The following summarizes the most material risks that make an investment in our securities risky or speculative. If any of the following risks occur or persist, our business, financial condition and results of operations could be materially harmed and the price of our common stock could significantly decline.

COVID-19 Pandemic Risks

• our supply chain may be disrupted, customer demand for our products may decline or customer purchases may be pushed out if the COVID-19 pandemic persists;
• we may not be able to meet customer demand and keep our workforce healthy if an outbreak should occur at one of our facilities and we are unable to contain it;
• we may be unable to provide service to our customers in a timely manner or at all if travel restrictions persist, common carrier routes are canceled or quarantines are imposed; and
• our facilities could be shut down for an extended period of time if an outbreak occurs in any of the jurisdictions where we manufacture our products.

General Commercial, Financial and Regulatory Risks

• laws, regulations or other orders may limit our ability to sell our products to certain customers or to provide service on products previously sold to those customers;
• we may be exposed to tariffs or similar trade impairments;
• international sales may expose us to longer payment cycles or collection difficulties;
• intellectual property disputes can be expensive and could result in an inability to sell our products in certain jurisdictions;
• we may be unable to attract or retain key personnel;
• reliance on third party service providers could result in disruptions if such third parties cannot perform services for us in a timely manner;
• cybersecurity incidents could result in the loss of valuable information or assets or subject us to costly litigation;
• we may face disruptions if we cannot access critical information in a timely manner due to system failures;
• we may fail to successfully integrate our acquisitions;
• natural disasters, acts of war or other catastrophic events could significantly disrupt our operations for lengthy periods of time;
• we may fail to successfully hedge our exposure to currency and interest rate fluctuations;
• we are subject to exposure from tax and regulatory compliance audits;
• economic, political or other conditions in the jurisdictions where we earn profits can impact the tax laws and taxes we pay in those jurisdictions, subsequently impacting our effective tax rate, cash flows and results of operations; and
• changes in accounting pronouncements and laws could have unforeseen effects.

Industry Risks

• we may not be able to keep pace with technological changes in the industries in which we operate;
• we have a highly concentrated customer base; and
• prevailing local and global economic conditions may negatively affect the purchasing decisions of our customers.

Business Model and Capital Structure

• we may not be able to maintain our technology advantage or protect our proprietary rights;
• we may not be able to compete with new products introduced by our competitors;
• we may not receive components necessary to build our products in a timely manner;
• we may fail to operate our business in a manner consistent with our business plan;
• we may not have sufficient financial resources to repay our indebtedness when it becomes due;
• we may fail to comply with the covenants in our revolving credit facility, which could impair our ability to borrow needed funds under the facility, or require us to repay it sooner than we planned;
• if our products fail to operate properly or contain defects or our customers are sued by third parties due to our products, we may be liable under indemnification provisions with our customers; and
• we may incur significant restructuring charges or other asset impairment charges or inventory write-offs.

For a more complete discussion of the material risks facing our business, see below.

As always, your thoughts and comments are welcome!

For your reference, here is the new language of S-K Item 105 risk factors with the changes bolded:

(a) Where appropriate, provide under the caption “Risk Factors” a discussion of the material factors that make an investment in the registrant or offering speculative or risky. This discussion must be organized logically with relevant headings and each risk factor should be set forth under a subcaption that adequately describes the risk. The presentation of risks that could apply generically to any registrant or any offering is discouraged, but to the extent generic risk factors are presented, disclose them at the end of the risk factor section under the caption “General Risk Factors.”

(b) Concisely explain how each risk affects the registrant or the securities being offered. 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. If the risk factor discussion is included in a registration statement, it must immediately follow the summary section required by § 229.503 (Item 503 of Regulation S-K). 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 of this chapter). The registrant must furnish this information in plain English. See § 230.421(d) of Regulation C of this chapter.

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!