CLIENT ALERT: SEC Staff Issues Report With Recommendations to Numerous Regulation S-K Disclosure Requirements
On December 20, 2013, the Staff of the SEC’s Division of Corporation Finance (the “Staff”) issued a report on its review of the disclosure requirements under Regulation S-K to determine how those requirements can be updated to modernize and simplify the registration process. The review was conducted in accordance with Section 108 of the Jumpstart Our Business Startups (JOBS) Act, passed by Congress in April 2012. The report makes no concrete recommendations on changes to the SEC’s disclosure requirements, but rather suggests areas where further review of changes would be merited, after further study, information gathering and input from companies, investors and other market participants. The report nonetheless reflects the current direction being taken by the Staff with regard to disclosure in public filings. Given expectations for increased activity in the equity capital markets in 2014, this Client Alert is meant to provide advance notice to prospective issuers and underwriters of likely disclosure changes and “hot topics” being considered by the SEC in the coming year.
Since the Staff’s report was mandated by the JOBS Act, its original intent was for it to be prepared from the perspective of easing the path to filing initial public offering registration statements by emerging growth companies (“EGCs”) and other smaller publicly-traded companies. The Staff observed, however, that the disclosure requirements in Regulation S-K also have an impact on the ongoing compliance costs and other burdens of publicly-reporting companies and, as a result, a comprehensive (as compared to targeted) review of all requirements of Regulation S-K would benefit companies at all stages in their development. The Staff concluded that any “simplifications, modernizations, revisions or eliminations” should be made for all public companies.
The report does not provide for any further public comment process. Like no-action letters and Staff legal bulletins, the Staff’s report does not necessarily represent the views of the entire SEC.
Background of Disclosure Rules
As a preliminary matter, the Staff’s report reviewed the origin and purpose of existing disclosure items in Regulation S-K and the history of significant substantive amendments to those requirements over the past 50 years, from simplified reporting for small issuers through guidance on the use of electronic media. Even with periodic piecemeal updates, the Staff indicated that no comprehensive review of the SEC’s disclosure requirements has been conducted in almost 20 years. During that time, the Staff noted that significant technological advances have significantly changed the ways that businesses operate and communicate with investors, and dramatic events such as the rise and collapse of the technology sector in 2000, the collapse of Enron, the enactment of the Sarbanes-Oxley Act, the financial crisis of 2008, the enactment of the Dodd-Frank Act and the enactment of the JOBS Act. Accordingly, the Staff concluded that the SEC’s disclosure requirements should be reevaluated to ensure that existing security holders, potential investors and the marketplace are provided with meaningful and non-duplicative information upon which to base investment and voting decisions.
The Staff’s report also includes, where appropriate, public comments submitted to the SEC’s JOBS Act website and recommendations from the SEC’s Government-Business Forum on Small Business Capital Formation with regard to suggested changes to particular disclosure items. These comments and recommendations will be considered in the SEC’s final disclosure amendments, many of which are noted below along with the Staff’s list of potential areas for rule changes.
Economic Principles to Be Applied
In looking at any disclosure changes, the Staff laid out seven prerequisite economic principles to rule changes:
- any change should improve and maintain the informativeness of disclosure to existing security holders, potential investors and the marketplace;
- after considering the historical objectives of the given rule (including the disclosure gap that had existed and associated policy objectives), determine whether the initial conditions of the rule are still applicable or, if not, still pose a potential risk of returning;
- determine whether the information provided by a given rule is available to existing security holders, potential investors and the marketplace on a non-discriminatory basis from reliable sources other than the issuer;
- ascertain the extent to which a given disclosure requirement entails high administrative and compliance costs for companies;
- ascertain the extent to which disclosure of a company’s proprietary information may have competitive or other economic costs;
- maintain the ability of the SEC to conduct an effective enforcement program with disclosures shown to be instrumental in the detection of fraud; and
- recognize the importance of maintaining investor confidence in the reliability of public company information.
Further Study Needed
The Staff’s report recommended further study and information gathering before any new rule writing in order to assemble a final list of proposed Regulation S-K disclosure changes. The Staff suggested that any such proposals should (i) emphasize a “principles-based” approach where companies would be expected to take the lead in identifying material information rather than simply responding to a static list of potentially relevant line-item disclosure requirements, (ii) include an evaluation of the appropriateness of scaled disclosure requirements, (iii) include an evaluation of methods for information delivery and presentation, both through the EDGAR system and other means and (iv) consider ways to present information that would improve the “readability and navigability” of disclosure documents and explore methods for discouraging repetition and disclosure of immaterial information.
Suggested Areas for Rule Changes
The Staff identified a number of general areas of Regulation S-K that merit reevaluation, as described below.
Risk-related Requirements. The Staff is considering the consolidation of requirements relating to risk factors, legal proceedings and other quantitative and qualitative information about risk and risk management into a single requirement, as well as the appropriateness of the disclosure requirements for quantitative and qualitative market risk in Item 305 of Regulation S-K. Commenters on the SEC’s JOBS Act website suggested that EGCs, like smaller reporting companies, should be exempt from Item 305 disclosure on quantitative and qualitative disclosures about market risk. They noted that EGCs are unlikely to have significant cash balances or outstanding borrowings so that they would be subject to interest rate risk that is material to the company, they generally do not engage in hedging activities or commodity trading and do not trade in foreign currencies but rather tend to complete offshore sales in U.S. dollars.
As to legal proceedings, a commenter recommended that the current exemption for disclosure of legal proceedings involving claims of less than 10% of the registrant’s consolidated current assets under Item 103 should be reconsidered because, for some companies, the amount of current assets is not as relevant as total company value or liquidity.
Requirements Relating to Registrant’s Business and Operations. The Staff is questioning whether information required by Items 101 and 102 of Regulation S-K about principal properties, mines and plants (which includes a list of locations, capacity and ownership) continues to be relevant when so many tech-based businesses do not require physical locations to operate, can easily substitute physical locations without any material impact on their operations or where physical plant or properties are not a significant element of enterprise value. For these companies, disclosure requirements could be refocused on material facts about their properties and their significance to the overall business.
The Staff also identified a potential disclosure gap dealing with tech-based businesses. The Staff is considering the need for additional disclosure where a business relies heavily on intellectual property owned by a third party or relies on service agreements with third parties to perform its business functions. Likewise, in comments submitted to the SEC’s JOBS Act website, commenters questioned whether the requirement to disclose the amount of backlog orders believed to be firm should be eliminated since it is not particularly meaningful to non-industrial, tech-based businesses, or, alternatively, those requirements should be moved to Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) with industry-specific disclosure.
On MD&A, recommendations were submitted to the SEC’s JOBS Act website for updating two MD&A requirements. First, they recommended eliminating or reducing disclosure in MD&A relating to a company’s historical practice for establishing the fair value of the company’s common stock in connection with stock-based compensation. Second, it was recommended that repetition of previous year-to-year analysis of results of operations should be eliminated in annual reports on Form 10-K.
Finally, the Staff raised the potential for calibrating business disclosure for different types of investors, presumably based on whether the offering would be intended primarily for retail or institutional investors.
Corporate Governance Disclosure Requirements. The Staff is recommending that corporate governance disclosure requirements be reviewed to confirm whether material information is disclosed effectively to investors. The Staff called for evaluating alternative forms of presentation for corporate governance disclosure in Item 407 of Regulation S-K, such as including the information in a filing that is updated only when changes occur.
Executive Compensation Requirements. The Staff acknowledges that executive compensation disclosure in Item 402 of Regulation S-K has become “lengthy” and “technical,” and should be reevaluated in light of those concerns and the usefulness of certain executive compensation disclosure requirements to investors. The Staff stated also that it may be appropriate to recommend further scaling of executive compensation disclosure for smaller public companies.
In Certain Relationships and Related Party Transactions disclosure, a commenter on the SEC’s JOBS Act website recommended revising the bright-line quantitative disclosure threshold of $120,000 for related party transactions in Item 404 of Regulation S-K to provide for a scaling test based on the size of the issuer and the nature of the transaction.
Offering-related Requirements. The Staff suggested reevaluation of the requirements for the presentation of information in prospectuses, required legends and undertakings in light of the shift from paper-based offering documents to electronically-delivered offering materials. Similarly, requirements concerning underwriting arrangements and compensation should be updated to reflect changes in market practice.
The Staff also pointed to combining information about dilution, shares eligible for future sale and securities authorized for issuance under equity plans and under outstanding securities and agreements. Some commenters on the SEC’s JOBS Act website suggested, instead, to exempt EGCs from the Item 506 dilution disclosure requirements in IPO registration statements, asserting that such disclosure is relatively meaningless in the context of EGCs because they rarely have an amount of net tangible book value per share that even approaches the level of the IPO offering price.
The Staff recommended that the disclosure requirements relating to use of proceeds, offering expenses and the securities of a registrant could be revised with a focus on “principles-based” requirements. As to use of proceeds disclosure under Item 701(f) (and Securities Act Rule 463), comments received by the SEC recommended the elimination of the continuing requirement to provide information in periodic reports regarding the application of offering proceeds inasmuch as cash is fungible and the discussion of cash flow in MD&A already covers material uses of cash.
A commenter on the SEC’s JOBS Act website also recommended elimination of the historical stock price disclosure requirements mandated by Item 201 of Regulation S-K, given the availability of such data on most finance websites. Other commenters recommended eliminating the requirement in Item 507 to name each stockholder selling shares in an offering.
Exhibit Requirements. The Staff believes it would be beneficial to reevaluate the manner in which exhibits are made publicly available on the SEC’s website, as some exhibit filings can be difficult to locate if not cross-referenced precisely and whether the revisions should be made to the types of required documents that must be filed.
Other General Requirements Included in Item 10. The Staff suggested possible reevaluation of the disclosure requirements relating to (i) the SEC’s policy on the use of securities ratings in filings, (ii) conditions for the use of non-GAAP financial measures and (iii) scaled disclosure for smaller reporting companies.
Emerging Growth Companies. The Staff recommended consideration of the criteria to be used for purposes of EGC eligibility and whether other companies that do not meet all of the EGC criteria should nonetheless be eligible for similar scaling of their disclosure requirements. Along with that, the Staff suggested further consideration of the definitional thresholds for smaller reporting companies, accelerated filers and large accelerated filers.
Industry Guides. The Staff recommended a review of its Industry Guides to evaluate whether they still provide useful information and conform to industry practices and trends. Specifically, the Staff mentioned Industry Guide 3 for financial institutions, in view of the industry’s growth and complexity, as well as developments in international regulatory reforms, and Industry Guide 5 for real estate companies, in light of changes in business and financial practices. The Staff questioned whether the Guides should be folded into Regulation S‑K, whether they are sometimes duplicative with accounting standards and whether scaled disclosure of Guide rules should be available for smaller issuers.
Financial Reporting and Disclosure Requirements. The SEC’s press release introducing the Staff’s report stated that the SEC’s Office of the Chief Accountant will coordinate with the Financial Accounting Standards Board to identify ways to improve the effectiveness of disclosures in corporate financial statements and to minimize redundancy with other existing disclosure requirements. The Staff indicated that this may touch upon Regulation S-K requirements for annual and quarterly selected financial data disclosure in Item 301 and the ratio of earnings to fixed charges in Item 503(d) of Regulation S-K.
Disclosure Requirements Contained in Rules and Forms. The Staff recommended that its comprehensive review include the disclosure requirements contained in related rules and forms, such as Form 10-Q and 8-K, in connection with the presentation and delivery of information to investors, including a possible filing and delivery framework based on the nature and frequency of disclosures.
The Staff of the SEC has articulated a strong case that a comprehensive review of Regulation S-K is overdue. As securities attorneys, we have seen the disclosure under Regulation S-K become overblown with the addition of new items and subsections, through SEC interpretative releases and guidance prompting disclosure not clearly required by the strict language of Regulation S-K, and through Staff comments on registration statements under the Securities Act of 1933 and periodic reports under the Securities Exchange Act of 1934 with inconsistent interpretations of rules. This trend is reflected in a study by several Silicon Valley law firms in which they reported the average length of final prospectuses of 22 technology and life sciences companies that completed initial public offerings after December 8, 2011 and qualified as EGCs was 183 pages. Less than 20 years ago, under essentially the same statutory disclosure requirements, the firms found that IPO prospectuses were considered large if they contained more than 100 pages.
If your company is serious about trying to go public in 2014, a fresh look at your disclosure can lead to a more streamlined prospectus that will likely speed your way through the SEC review process. In many areas, disclosure should be based upon consideration of what is relevant and appropriate for your company and not necessarily upon those requirements the Staff has already set aside for reevaluation or a desire to simply replicate the boilerplate disclosure of previous issuers. Until the SEC formally adopts changes to Regulation S-K, the Staff’s December 20 report represents its most recent position on multiple disclosure requirements.
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