Disclosure Modernization Continues – Part One
By George Wilson
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
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.
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.
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!