On August 26, 2020, the Securities and Exchange Commission ("SEC") adopted amendments1 to crucial SEC disclosure requirements under Regulation S-K, including Item 101 (Description of Business), Item 103 (Legal Proceedings) and Item 105 (Risk Factors) as part of its ongoing initiative to update and modernize its disclosure requirements.2 These amendments continue a shift towards a more principles-based disclosure framework rooted in materiality.3
Notably, the amendments include a requirement to include disclosure on human capital resources to the extent material to the business taken as a whole, with Chairman Clayton emphasizing that human capital can be a key driver for company performance.4 The amendments also sparked a heated debate at the SEC's open meeting of its Commissioners who voted 3-2 to approve the amendments, with two Commissioners dissenting and criticizing the changes for not sufficiently modernizing the SEC's disclosure rules and not going far enough to enhance disclosure on climate change, diversity and human capital management.5
This memo provides practical information on the amendments in the following three sections:
- Part I: Overview of Key Action Items for U.S. Public Companies
- Part II: Summary of Amendments
- Part III: Strategic Considerations and Take-Aways
I. Overview of Key Action Items
Key action items for the preparation of upcoming Form 10-Ks and registration statements in light of the amendments include the following four items:
1) Business Strategy under Item 101 ("Description of Business"):
Add disclosure of any material changes to a "previously disclosed business strategy", to the extent material to an understanding of the general development of the business.6
2) Human Capital Resources under Item 101 ("Description of Business"):
Add a description of the "registrant's human capital resources, including the number of persons employed by the registrant, and any human capital measures or objectives that the registrant focuses on in managing the business", to the extent material to an understanding of the registrant's business taken as a whole.7
3) Compliance with Government Regulations under Item 101 ("Description of Business"):
Add a description of the "material effects that compliance with government regulations may have upon the capital expenditures, earnings and competitive position of the registrant and its subsidiaries", to the extent material to an understanding of the registrant's business taken as a whole.8
4) Risk Factors under Item 105 ("Risk Factors"):
Generic Risk Factors. Determine if your risk factor section includes risk factors that apply generically to any registrant or offering, and then either (i) tailor these risk factors to emphasize the specific relationship of the risk to your company or the offering, or (ii) disclose the generic risk factors at the end of the risk factor section under the caption "General Risk Factors". 9
Relevant Headings. Organize risk factors into groups of related risk factors under "relevant headings", in addition to the subcaption currently required for each risk factor.10
Summary of Risks. If your risk factor section exceeds 15 pages, add 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" and place this summary in the forepart of the prospectus or annual report, as applicable.11
5) Hybrid Monetary Threshold for Governmental Environmental Proceedings under Item 103 ("Legal Proceedings"):
Assess potential monetary sanctions from environmental proceedings with a governmental authority in light of the change in the threshold for disclosure of such proceedings from $100,000 to a threshold of either (1) $300,000 OR (2) such other threshold that:
i. the registrant determines is reasonably designed to result in disclosure of a proceeding that is material to its business or financial condition;
ii. 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;12 and
iii. a registrant must disclose in each annual and quarterly report (including any change thereto).
II. Summary of Amendments
Below is a detailed summary of the amendments and discussion of the rationale for the changes, in order of the Regulation S-K item:
- Section 1: Item 101(a)(General Development of Business)
- Section 2: Item 101(c) (Narrative Description of Business, Including Human Capital Resources Disclosure)
- Section 3: Item 103 (Legal Proceedings)
- Section 4: Item 105 (Risk Factors)
Section 1: Item 101(a) (General Development of Business)
The amendments to Item 101(a) include the following changes:
- Eliminate Prescribed Timeframe. Item 101(a) will now require disclosure of information that is material to an understanding of the general development of the company's business and eliminates the prescribed five-year timeframe specified in the rule.13 The changes are designed to provide companies with the flexibility to tailor their disclosures to their individual circumstances and provide material information for an understanding of the development of a company's business, irrespective of a specific timeframe.14
- Require Only Updated Disclosure in Subsequent Filings. In filings made after a company's initial registration statement, Item 101(a) will now permit a company to provide only an update of the general development of the business disclosing all of the material developments, if any, since the most recent full discussion of the general development of the business, and to incorporate by reference and hyperlink to a single previously filed document that contains such a discussion that, together with the update, sets forth the full discussion. The SEC believes this method will help focus investor attention on material developments in a registrant's business;15 however, the release makes clear that this method for updating general business development disclosure is completely optional, and that companies should take note of other applicable rules regarding incorporating documents by reference.16
- Include Material Changes to a Previously Disclosed Business Strategy. The amendments to Item 101(a) emphasize a principles-based approach and require disclosure of business developments, including the topics specified in Item 101(a), only to the extent material to an understanding of a registrant's business.17 The new Item 101(a) eliminates references to "the year in which the registrant was organized and its form of organization" and "any material changes in the mode of conducting the registrant's business," but adds as the first item in Item 101(a), disclosure of "material changes to a registrant's previously disclosed business strategy."
In adopting this amendment regarding business strategy, the SEC noted that once a registrant has disclosed its business strategy, it is appropriate for it to discuss the changes to that strategy, to the extent material to an understanding of the development of the registrant’s business. The adopting release emphasized the principles-based approach of the final amendments and the ability of companies to determine the appropriate level of detail for these disclosures. That said, it will be important for companies including detailed disclosure related to their business strategy in their initial registration statements to take this rule change into account when drafting their business strategy disclosure.
Section 2: Item 101(c) (Narrative Description of Business, Including Human Capital Resources Disclosure)
Item 101(c) requires a narrative description of the business done and intended to be done by the company and its subsidiaries. Below is a summary of the "Two Expanded Topics under Item 101(c)(2)" (in Part I below) and a "Before and After Comparison Chart for Item 101(c)" (in Part II below).
I. The Two Expanded Topics under Item 101(c)(2)
As noted in our key action items above, there are two topics that expanded in scope under the amendments, as further described below.
1) Requirement to Discuss Compliance with Material Government Regulations (Not Just Environmental Regulation). This amendment expands the regulatory compliance requirement by including material government regulations, not just environmental laws, as a topic. Specifically, the final rule requires, to the extent material to an understanding of the business taken as a whole, disclosure of the material effects that compliance with government regulations, including environmental regulations, may have upon the capital expenditures, earnings, and competitive position of the registrant and its subsidiaries. The final rule also continues to require registrants to include the estimated capital expenditures for environmental control facilities for the current fiscal year and any other subsequent period that is material.
The SEC's approach with this amendment codifies what has become common practice regarding government regulation disclosure by requiring disclosure about a company's compliance with government regulations that materially affect its business. Moreover, the SEC declined to add prescriptive requirements to this amendment, such as requiring disclosure of international tax strategies, because the principles based approach aims to enable each registrant to tailor its disclosure to discuss only those governmental regulations that are of particular importance to it.
2) Requirement to Include Human Capital Disclosure. The final amendments require, to the extent such disclosure is material to an understanding of the company's business taken as a whole, a description of human capital resources, including any human capital measures or objectives that the company focuses on in managing the business. As Chairman Clayton noted in his remarks at the open meeting, the amendments "require that, in crafting their human capital disclosure, companies must incorporate the key human capital metrics, if any, that they focus on in managing the business."
The amendments provide non-exclusive examples of such human capital measures and objectives (i.e., "measures or objectives that address the attraction, development, and retention of personnel"), which may be material, depending on the nature of the company's business and workforce. In this context, the SEC specifically noted that these examples are only provided as potentially relevant subjects, rather than mandates, and that each company's disclosure must be tailored to its unique business, workforce, and facts and circumstances. Moreover, the SEC reiterated that the principles-based approach affords companies the flexibility to tailor their disclosures, including by providing disclosure in accordance with a standard or framework that facilities human capital resource disclosure.
As a result of these amendments, Chairman Clayton noted that he does "expect to see meaningful qualitative and quantitative disclosure, including, as appropriate, disclosure of metrics that companies actually use in managing their affairs". In addition, as is the case with non-GAAP financial measures, Chairman Clayton noted that he expects companies to "maintain metric definitions constant from period to period or to disclose prominently any changes to the metrics used or the definitions of those metrics."
In a change from the proposal, companies will still need to disclose, to the extent material to an understanding of a company's business, the number of persons employed by the company. The SEC noted that this disclosure topic should be retained because it can help investors assess the size and scale of a company's operations, as well as changes over time. Although this topic was not expanded to include additional metrics, such as the number of full-time, part-time and contingent workers, and employee turnover, the final release notes that, under the principles based approach being adopted, such disclosure is required if material to an understanding of a company's business.
Significance of Expansion of SEC Rules to Human Capital Management
The SEC's expansion of Item 101 to require human capital management disclosure is significant and follows increasing pressure on the SEC from investors to take action with respect to such disclosure. In particular, the adopting release cites to a rulemaking petition, which it received from a group of 25 institutional investors representing over $2.8 trillion in assets, calling on the SEC to require registrants to disclose information about their human capital management policies, practices and performance.18
Meanwhile, the SEC has increasingly emphasized the importance of human capital management. For example, the adopting release notes that human capital is a "material resource for many companies and often is a focus of management, in varying ways, and an important driver of performance", and Chairman Clayton stated in his remarks that he "cannot remember engaging with a high quality, lasting company that did not focus on attracting, developing and enhancing its people."
Moreover, recent disclosure guidance relating to the COVID-19 pandemic from the SEC's Division of Corporation Finance has focused in part on human capital resource issues.19
II. The Before and After Comparison Chart for Item 101(c)
New Item 101(c) provides a non-exclusive list of principles-based business topics derived from a subset of the 12 topics previously included in Item 101(c). Disclosure is required by companies only to the extent the information is material to an understanding of the general development of a company's business taken as a whole. As shown in the chart below, certain disclosure items previously included in Item 101(c) (such as the disclosure of working capital practices) and prescriptive requirements (such as requiring the name of any customer if sales equal ten percent or more of consolidated revenues) were eliminated, while two items were expanded.20 Despite the elimination of topics, the SEC emphasizes that, under its principles-based approach, companies will still have to provide disclosure about topics – even topics that were eliminated – if they are material to an understanding of the business.
Section 3: Item 103 (Legal Proceedings)
Item 103 requires disclosure of any material pending legal proceedings, other than ordinary routine litigation incidental to the business, to which the company or any of its subsidiaries is a party. Item 103 also requires disclosure of the name of the court or agency in which the proceedings are pending, the date instituted, and the principal parties thereto and a description of the factual basis alleged to underlie the proceeding and the relief sought. Similar information is to be included for such proceedings known to be contemplated by governmental authorities. The amendments add two points of flexibility to these existing Item 103 disclosure requirements:
1. Hyperlinks and Cross-References for Legal Proceedings Disclosure. In an effort to encourage companies to avoid duplicative disclosure, the amendments clarify that companies are permitted to provide disclosure responsive to Item 103 by including a hyperlink or cross-reference to legal proceedings disclosure elsewhere in the same document, such as MD&A, Risk Factors or a note to the financial statements. This rule amendment codifies a market practice widely followed by public reporting companies.
2. Implementing a Modified Threshold for Environmental Proceedings Disclosure. Previously, Item 103 specifically required registrants to disclose any proceeding under environmental laws to which a governmental authority is a party, unless the registrant reasonably believes it will not result in sanctions of $100,000 or more. This monetary threshold was adopted in 1982 and had not changed – until now. Under the newly adopted amendments, the SEC adopted a modified disclosure threshold that increases the existing quantitative threshold from $100,000 to $300,000, but also affords a company some flexibility to opt for a different threshold that is reasonably designed to result in disclosure of material environmental proceedings. Specifically, a company can use a monetary threshold that is different from $300,000 only if it opts for a different threshold that:
- A company determines is "reasonably designed to result in disclosure of any such proceeding that is material to the business or financial condition";
- 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; and
- The company discloses "in each annual and quarterly report", including any change thereto.
The adopting release notes that this this hybrid approach avoids a mandatory one-size-fits-all disclosure threshold that may potentially result in the disclosure of information that is not material by allowing registrants to determine a company-specific disclosure threshold that is more relevant to their particular circumstances.
Section 4: Item 105 (Risk Factors)
In proposing amendments to the SEC's risk factor requirements under Item 105 of Regulation S-K,22 the SEC aimed to address the lengthy and generic nature of the risk factor disclosure presented by many companies. To address these concerns, the SEC adopted the following amendments:
1. Summary Risk Factors Disclosure. If the risk factor section exceeds 15 pages, the company must include summary risk factor disclosure of no more than two pages, which must include a series of short, concise, bulleted or numbered statements summarizing the principal risk factors that make an investment in the company or offering speculative or risky. The summary must be included in the forepart of the prospectus or annual report. This comports with market practice for companies filing a registration statement for an initial public offering, where a bulleted summary of material risk factors is included in the prospectus summary.
In adopting this change, the SEC explained that the final amendment is similar to other disclosure requirements that require a summary (e.g., in Item 3(b) to Form S-11 and the optional summary in Item 16 to Form 10-K). Based on experience with these rules, the SEC noted its belief that a summary will "not detract from a registrant's more extensive disclosure elsewhere in a filing or subject a registrant to greater litigation risk". Rather, the SEC believes that a summary will enhance the ability of investors to process relevant information and will focus companies on disclosing material risks. Moreover, the SEC noted that the amendment may create an incentive for registrants to reduce the length of their risk factor discussion to avoid triggering the summary requirement, to the extent that such an incentive outweighs perceived litigation risks.
2. New Requirement for Generic Risk Factors. The final amendments require companies to present risks that could apply generally to any registrant or any offering at the end of the risk factor section under the heading "General Risk Factors." In the adopting release, the SEC noted that this change is solely meant to improve the organization and effectiveness of risk factor disclosure; however, the release also specifically notes that the SEC "encourages registrant[s] to tailor their risk factor disclosures to emphasize the specific relationship of the risk to the registrant or the offering," and thereby avoid the need to include the risk under the general risk heading.
3. Group Risk Factors Under Relevant Headings. The final amendments require risk factors to be "organized logically with relevant headings", in addition to the subcaption currently required above each risk factor. The aim of this amendment is to improve the organization of risk factor disclosure in an effort to help readers comprehend lengthy risk factor disclosures. Although the amendments do not specify the types of headings that should be used, the SEC notes that many companies already organize their risk factor disclosure through "groupings of related risk factors and the use of headings", and that this type of organization improves the readability and usefulness of the risk factor disclosure.
4. Change of Disclosure Standard from "Most Significant" to "Material". The final amendments change the standard for the disclosure of risks from the "most significant" risks to "material" risks.23 With this change, the SEC aimed to focus companies on disclosing the risks to which reasonable investors would attach importance in making investment or voting decisions. Moreover, the SEC stated its belief that the change in the disclosure standard should result in risk factor disclosure that is more tailored to the particular facts and circumstances of each company, which would in turn reduce the disclosure of generic risks and potentially shorten the length of risk factor disclosure, to the benefit of both investors and companies.
III. Strategic Considerations and Take-Aways
There are a number of strategic and practical considerations to approach the amendments, as discussed below.
1. Begin Planning Your Human Capital Disclosure Early for Upcoming 10-Ks. In planning for human capital disclosure in upcoming 10-Ks, companies will need to:
- Assess the company's human capital resources, including any human capital measures and objectives considered by the board and management, and whether any of this information is material to an understanding of the company's business taken as a whole.
- Recently, there has been a pronounced trend towards including increased human capital resource disclosure in SEC filings as a result of the COVID-19 pandemic, particularly disclosure on employee health and safety. According to a White & Case survey of 50 of the top Fortune 100 companies by revenue, 38 out of 50 top companies by revenue in the Fortune 100 (or 76%) included disclosure on employee health and safety in first quarter 10-Q filings.
- A company's decision of whether to go beyond its human capital disclosure in response to the COVID-19 pandemic and include enhanced human capital resource disclosure in the 10-K should be made after considering a number of factors, including the following:
- Which measures and objectives related to human capital, if any, are the company's senior management and board focused on in managing the business? What are the key human capital metrics, if any, that management and the board focus on?
- How does the company define the metrics used to manage human capital resources, and are these definitions subject to oversight and review by senior management?
- Which information with respect to human capital is available, verifiable and can be prepared without undue cost?
- Have specific disclosure controls and procedures been developed to ensure that any human capital information is accurate and appropriately vetted prior to its disclosure? Which personnel will be able to certify with respect to the accuracy of such disclosures?
- What is the potential impact on employees of publicly disclosing this information and are there other sensitivities related to such disclosure?
- Will disclosing new human capital information result in demands and expectations from investors and other stakeholders for additional information going forward, such as whether the company has met any disclosed objectives and goals with respect to its human capital resources?
- How would human capital information present the company in terms of its brand, reputation, and competitive position?
- Should the company use an existing standard or framework to help prepare or inform its human capital resource disclosure for SEC filings, such as SASB?
2. Board Oversight over Human Capital Management Issues. Consider whether the board of directors or an appropriate committee of the board should oversee the development of the company's corporate culture and approach on human capital management, including the key considerations listed above. Moreover, as the board of directors will be signing the Form 10-K, any new disclosure should be highlighted to the board and discussed in advance with them.
3. Be Prepared to Engage with your Investors and Discuss Your Human Capital Disclosure. In light of the effects of the COVID-19 pandemic and these rule changes, companies should be prepared to engage with investors on their human capital disclosure during their annual outreach. Companies should therefore be prepared to tell their human capital "story" and explain the key human capital drivers and metrics used by management and the board, if any. Moreover, companies should review a particular investor's policy and approach with respect to human capital prior to any investor outreach.24
4. Risk Factors. With respect to risk factors, companies should begin assessing their risk factor disclosures early and determine if any risk factors are outdated, generic or simply no longer material. Companies must also consider the most appropriate way to group risk factors under headings, such that the headings provide a logical organization for the company's risks. Accordingly, it is appropriate for companies to conduct a full risk factor review ahead of their upcoming 10-Ks, including (i) a review of peer risk factors to broadly assess what is material to their industry at this time, and (ii) appropriately tailoring risk factors to a company's particular risks, facts and circumstances.
5. Environmental Proceedings Disclosure Threshold. Given the hybrid threshold for disclosing environmental proceedings with governmental authorities, companies facing environmental proceedings should begin to consider the nature and anticipated short- and long-term impacts of past and current environmental proceedings and determine the appropriate monetary threshold for their company under the amended rule. In the end, companies will need to weigh the appropriateness and desire for a threshold higher than $300,000 against the requirement to publicly disclose, in each annual and quarterly report, their materiality threshold for disclosing such proceedings.
6. The Great ESG Debate. The principles-based approach to these final amendments and their focus on materiality enable companies to focus their 10-Ks on "material information", while continuing to enhance and provide their full ESG stories on their websites (including in sustainability reports). That said, the SEC has opened the door on the 10-K to investor demands related to human capital resources, and the drumbeat of investor pressure to enhance ESG disclosure in SEC filings is likely to continue in the coming years. Moreover, the principles based approach rooted in materiality may provide an avenue for investors and shareholder proponents to continue to push for greater ESG information in the future, as they argue that more of this information is material for their investment decisions.
1 Available here. The SEC's press release is available here.
2 The amendments will become effective 30 days after publication in the Federal Register. All amendments apply to domestic issuers. The amendments to Item 105 (Risk Factors) also apply to foreign private issuers because Forms F-1, F-3 and F-4 specifically refer to that Item of Regulation S-K, while the amendments to Item 101 (Description of Business) and Item 103 (Legal Proceedings) do not.
3 The amendments are part of the SEC's Disclosure Effectiveness Initiative and draw on extensive comments received in response to the 2016 concept release that revisited business and financial disclosure requirements in Regulation S-K.
4 Chairman Clayton's remarks are available here.
5 See Commissioner Lee's remarks, available here, and Commissioner Crenshaw's remarks, available here.
6 See new Item 101(a)(1)(i) of Regulation S-K
7 See new Item 101(c)(2)(ii) of Regulation S-K.
8 See new Item 101(c)(2)(i) of Regulation S-K.
9 See new Item 105(a) of Regulation S-K.
10 See new Item 105(a) of Regulation S-K.
11 See new Item 105(b) of Regulation S-K.
12 See new Item 103(c)(3)(iii) of Regulation S-K.
13 "We note that the Form 10-K still includes a one-year time frame under Part I, Item 1, which states 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”. The rule change did not address this language in the Form 10-K.
14 For similar reasons, the SEC also revised Item 101(h) to eliminate the provision that required smaller reporting companies to describe the development of their business during the last three years.
15 The SEC also adopted corresponding amendments to Item 101(h) to permit smaller reporting companies, for filings other than initial registration statements, to provide an update to the general development of the business disclosure, instead of a full discussion, that complies with proposed Item 101(a)(2), including the proposed hyperlink requirement.
16 The adopting release states in Footnote 41 that: "Securities Act Rule 411(e) and Exchange Act 12b-23(e)…provide that information must not be incorporated by reference in any case where such incorporation would render the disclosure incomplete, unclear, or confusing, such as incorporating by reference from a second document if that second document incorporates information pertinent to such disclosure by reference to a third document. We remind registrants that, consequently, a filing that includes an update and incorporates by reference the more complete Item 101(a) discussion could not be incorporated by reference into a subsequent filing, such as a Form S-3 or Form S-4 (emphasis added)."
17 Three of the four matters that the SEC is proposing to list as disclosure topics are currently covered in Item 101(a)(1): material bankruptcy, receivership, or any similar proceeding; the nature and effects of any material reclassification, merger or consolidation of the company or any of its significant subsidiaries; and the acquisition or disposition of any material amount of assets otherwise than in the ordinary course of business.
18 The SEC also cited to comment letters it received in support of this petition from a number of investors. See the rulemaking petition to require registrants to disclose information about their human capital management policies, practices and performance, File No. 4-711 (July 6, 2017), available at here and related comments available at here. See also the press release related to this petition, available here. In addition, the adopting release also references the SEC Investor Advisory Committee, which recommended that the SEC take measures to improve the disclosure of a registrant's human capital management and, in line with the SEC's proposal, suggested that "any requirements should be crafted so as to reflect the varied circumstances of different businesses, and to eschew simple ‘one-size-fits-all' approaches that obscure more than they add." See the Recommendation of the Investor Advisory Committee Human Capital Management Disclosure (March 28, 2019), available here.
19 For more information, see our prior alerts, "SEC Emphasizes Importance of Robust Forward-Looking Disclosure for Q1 to Address COVID-19" and "Practical Tips to Prepare for Upcoming Quarterly Disclosures."
20 Specifically, as shown in the chart, three topics in new Item 101(c) are the result of a combination of two separate items from prior Item 101(c); two topics in new Item 101(c) are the same as the prior Item 101(c); two topics were eliminated; and two topics expanded.
21 Item 101(c)(1) specifies that the discussion should "focus upon the registrant's dominant segment or each reportable segment about which financial information is presented in the financial statements", while Item 101(c)(2) states that the information should be provided with respect to "the registrant's business taken as a whole, except that, if the information is material to a particular segment, you should additionally identify that segment." In either case, however, only information material to an understanding of the business taken as a whole is required.
22 Previously included in Item 503(c) prior to the FAST Act Modernization and Simplification amendments.
23 In adopting this change, the SEC explains the concept of materiality, noting that the Supreme Court defined the term in TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976) and that the definitions of "material" in Rule 12b-2 and Rule 405 are consistent with the Supreme Court's holding in TSC Industries.
24 For example, in State Street's 2019 letter to board members, the investment management firm urged board members to focus on corporate culture, which State Street links to human capital management.
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