SEC’s New Reg S-K Is Good News for Investors and Directors Alike

On August 26, 2020, the US Securities and Exchange Commission (SEC) took three decisive deregulatory actions—all intended to ease burdensome mandates for current and aspiring US public companies. In a single day, the agency approved a new New York Stock Exchange rule to permit direct listings, approved a new SEC rule broadening the definition of “accredited investor,” and released a rule on Modernization of Regulation S-K Items 101, 103, and 105. Of these three, Regulation S-K may be the most significant to directors.

The Regulation S-K Revisions

The amendments to Regulation S-K (Reg S-K) were a major task many years in the making. Reg S-K is a broad umbrella regulation governing written disclosures to shareholders, such as the management discussion and analysis section of annual reports, which many investors use to gauge the worthiness of a company’s securities. Reg S-K parallels Regulation S-X, which focuses on financial disclosures.  

Reg S-K itself was intended as a reform but over time proved to need reform itself. It grew out of a landmark 1977 report by former SEC Commissioner A. A. Sommer, Jr., who was tasked with integrating disclosures under the two main securities acts—the Securities Act of 1933 and the Securities Exchange Act of 1934. (Interestingly, Sommer was involved in the founding of NACD, served on our board of directors, and chaired our first Blue Ribbon Commission on the audit committee.) But the broad umbrella of S-K, as expanded through the years by rule making under laws such as the Sarbanes-Oxley Act and the Dodd-Frank Wall Street Reform and Consumer Protection Act, has proved unwieldy. An academic study on annual report length that appeared in the Journal of Accounting and Economics as well as in a Columbia University blog, showed that annual report length more than doubled between 1996 and 2013 due largely to evolving disclosure requirements; a 2015 Wall Street Journal article lamented the “109,894-word annual report.”

Both the Jumpstart Our Business Startups Act of 2012 and the Fixing America’s Surface Transportation Act of 2015 directed the SEC to streamline the current disclosure regimes, including S-K. In response to these directives, the SEC put out a 2016 concept release on S-K, paving the way for this final August 26 rule. The new rule, which contains a convenient summary in chart form (pages 8-10), aims to modernize the description of business, legal proceedings, and risk factors that are now required in company annual reports. The gist of many of the changes was to lessen the overall number of words in disclosures. The following is a brief roundup of these changes:

• Business (Item 101). Under the new rule, the business description must cover material risks only; it need not extend back any set number of years (the old rule said five years for all except small companies; three for others). It broadens the requirement for regulatory disclosure to include all material regulatory matters, not just environmental ones, and adds human capital to the list of one-dozen topics to include. Overall, it emphasizes a principles-based approach based in what is material, not disclosure for disclosure’s sake.

• Legal proceedings (Item 103). The new rule allows hyperlinks in lieu of extensive disclosures and changes the threshold of materiality from $100,000 to $300,000, unless the company selects another threshold, as long as the threshold does not exceed $1 million or one percent of the company’s assets, whichever is lower.

• Risk factors (Item 105). Finally, and most importantly, the new rule zeroes in on the problem of lengthy and generic disclosures on risk factors. The rule says that to be disclosed, the factors must be material. It also requires a summary of no more than two pages if the discussion is longer than 15 pages, and categorization of risk by type, with the most generic risk descriptions (about the risk of investing in any security) at the end under the heading “General Risk Factors.”

The vote for the new rule was three to two. Voting for the new rule was Commissioner Hester M. Pierce, whose statement called these “common sense reforms” that make the rules “more principles-based and rooted in materiality, which provides registrants with sufficient flexibility to tailor disclosures to their unique circumstances.” Also praising the rule was Commissioner Elad Roisman, whose statement says that the new rules will help investors “focus their attention on material information that better captures the circumstances of each particular company.” Dissenting in a public statement issued the day of the vote, Commissioner Alison Herren Lee called the omission of prescriptive requirements on diversity and climate risk an “unsustainable silence.” Commissioner Caroline A. Crenshaw issued a similar statement. Chair Jay Clayton cast a third vote in favor of the new rule.

Good News

In general, despite what some view as missed opportunities to mandate more disclosures on the burning issues of our day, this new rule can be considered good news for both shareholders and directors in at least a few respects. Investors will not need to wade through as much material to find key points. The same applies to directors who use the annual report to deepen their understanding of the companies they serve.

And there is an added benefit: By making disclosure mandates principles-based, the new rule makes it more difficult for shareholders to sue over their violation. These types of lawsuits persist despite the Delaware Chancery Court’s landmark 2016 decision in In re Trulia Inc. Stockholder Litigation to reject a settlement on the grounds that it was based on disclosure alone. As noted in this recent D&O Diary blog, the cases simply moved to new venues such as federal courts.

Such cases against directors will have a harder time succeeding now that companies are no longer required to list everything but the proverbial kitchen sink when describing their businesses, their liability exposures, and their risks.