|March 31, 2014|
Previously published on March 2014
The SEC Staff Chooses to Propose Reform of Regulation S-K for all Public Companies Over Simplification for Emerging Growth Company Offerings
In December 2013, the Staff of the Securities and Exchange Commission’s Division of Corporation Finance issued to Congress its “Report on Review of Disclosure Requirements in Regulation S-K” (the S-K Study) that originally was mandated by the JOBS Act. The S-K Study can be found at http://www.sec.gov/news/studies/2013/reg-sk-disclosure-requirements-review.pdf.
The S-K Study went beyond the JOBS Act mandate, which tasked the Staff with determining how Regulation S-K requirements “can be updated to modernize and simplify the registration process and reduce the costs and other burdens associated with these requirements for issuers who are emerging growth companies.” (emphasis added). The Staff instead focused its proposed reform efforts on virtually every aspect of disclosure affecting all public companies, rather than focusing attention solely on the registration process for emerging growth companies (EGCs). The Staff noted in its report that it “believes that a comprehensive inventory of the Commission’s disclosure regulations that identifies the origin and purpose of existing disclosure requirements and sets forth the history of updates to those requirements is an essential first step in formulating recommendations with respect to modernizing and simplifying disclosure.”
Further Market Input and Economic Analysis are Required
The Staff concluded that it requires more information from market participants and further economic analysis before specific S-K Study recommendations can be formulated. However, it did identify certain key principles and objectives to be considered for disclosure reform, including:
- “Improving and maintaining the informativeness of disclosure to existing security holders, potential investors and the marketplace . . .”
- “Maintenance of the Commission’s ability to conduct an effective enforcement program and deter fraud . . .” and
- “... maintaining investor confidence in the reliability of public company information, in order to, among other things, encourage capital formation.”
A potential framework for change could involve Staff consideration of the historical objectives of a given rule, which would be evaluated in conjunction with:
- Consideration of any specific disclosure gaps that have arisen since adoption;
- Whether policy objectives or other conditions at adoption are still applicable;
- Whether scaling back or eliminating disclosure requirements is appropriate; and
- Whether the information provided by a given rule is already available outside of SEC filings on a non-discriminatory basis from reliable sources.
Specific EGC considerations that will be evaluated by the Staff include:
- “The extent to which a given disclosure requirement entails high administrative and compliance costs . . .” and
- “The extent to which disclosure of a company’s proprietary information may have competitive or other economic costs . . .”
Potential Fundamental Changes
The Staff’s preliminary suggestions for revisiting existing requirements are likely to focus on the following potential fundamental disclosure changes:
- Emphasizing a principles-based approach as an overarching component of the disclosure framework, while preserving the benefits of a rules-based system, similar to the current rules and guidance for MD&A disclosure; and
- Evaluating information delivery and presentation both through EDGAR and otherwise. Such a potential approach could be premised on a somewhat novel disclosure framework consisting of a shift to:
- A “core” disclosure or a “company profile” filing that would contain information that could change infrequently;
- Periodic filings and current disclosure filings with information that changes from period to period; and
- Transactional filings that have information relating to specific offerings or shareholder solicitations.
The Staff is also (1) considering ways to present information to improve readability and navigability of disclosure documents through the use of technology, including, for example, dynamic cross-referencing (such as hyperlinks), and (2) reevaluating quantitative thresholds of materiality incorporated into disclosure rules, including the express thresholds contained in disclosure of legal proceedings (S-K Item 103), related party transactions (S-K Item 404) and interests of experts and counsel (S-K Item 509).
What Does the Commission Think of the Staff’s Study?
The S-K Study is technically the work-product of the Staff. In fact, the cover page of the study clearly discloses that the Commission expresses no view on the S-K Study. Despite this disclaimer, recent speeches by Commissioners suggest that the Staff and Commission are aligned on certain substantive materiality-based disclosure approaches set forth in the S-K Study. Speaking before the National Association of Corporate Directors Leadership Conference 2013 (the 2013 Leadership Speech), SEC Chair Mary Jo White explained:
I am raising the question here and internally at the SEC as to whether investors need and are optimally served by the detailed and lengthy disclosures about all of the topics that companies currently provide in the reports they are required to prepare and file with us. When disclosure gets to be “too much” or strays from its core purpose, it could lead to what some have called “information overload” ... The Supreme Court addressed this overload concern over 35 years ago in TSC Industries when it ... held that a fact is “material” if “there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote.”
Citing Commission decision-making shortly prior to the TSC decision, Chair White concurred with the Commission’s prior findings in Release No. 33-5627 that “disclosure should generally be tethered to the concept of materiality ...”
Will “Streamlining” Produce Less Disclosure, or Will “Less” Be More?
At face value, potential proposed changes incorporating a broader principles-based approach could result in greater disclosure challenges and burdens for issuers. For a further explanation of what “principles-based requirements” means, the Staff cited the Commission’s 2003 MD&A Interpretive Release No. 33-8350 and emphasized that these types of
... requirements are intended to satisfy three principal objectives: (1) to provide a narrative explanation of a company ... that enables investors to see the company through the eyes of management, (2) to enhance the overall ... disclosure and provide the context within which ... information should be analyzed, and (3) to provide information about the quality of, and potential variability of, a company’s earnings and cash flow, so that investors can ascertain the likelihood that past performance is indicative of future performance.
A potential expansion of principles-based disclosure requirements could affect existing descriptions of material properties or asset classes. Rather than continuing to focus on real estate ownership and lease holdings, the Staff inquired whether a larger focus on intellectual property owned by third parties or service agreements with third parties are a more appropriate focus of disclosure, especially given the decline in brick and mortar assets for many public companies today as compared to when Regulation S-K was first adopted, in the early eighties. The Staff also indicated that principles-based approaches could be extended to securities offering disclosures (e.g., for use of proceeds, securities offered and offering expense disclosures) as well as securities information (e.g., disclosures concerning share dilution, overall shares available for future sale and shares reserved for issuance under option plans, warrants and equity linked securities).
The Staff also identified (1) a potential systematic review of Regulation S-K with Regulation S-X, which governs the form and content of financial statements presented in an SEC filing, and (2) a potential re-evaluation of risk-related disclosures, including the possibility of rewriting and consolidating disclosures concerning risk factors, legal proceedings, qualitative and quantitative market risk and potentially other risk-related disclosures.
If an expanded principles-based approach is advanced through new rulemaking initiatives, ideally the Staff should concurrently reduce certain existing prescriptive, line-item disclosure requirements, including current requirements that Chair White indicated could be inconsistent with the reasonable investor materiality standards expressed in the TSC ruling. This type of balancing approach could, in fact, elicit more meaningful, company-specific disclosures for the benefit of investors. Ultimate disclosure reform success for the benefit of investors will depend on the total mix of changes. However, barring a meaningful streamlining of existing line-item requirements, it is possible that an enhanced principles-based approach may produce neither overall disclosure simplification for issuers nor a reduction in issuer costs and burdens.
If an overall more burdensome principles-based disclosure proposal surfaces following the S-K Study, without meaningful prescriptive rule streamlining, issuers and practitioners should petition Congress and provide comments in opposition to any such rulemaking proposal, since this burden would be excessive when layered on top of recent Dodd-Frank and Sarbanes Oxley disclosure obligations.
Variables That Could Affect the Relative Success of SEC S-K Reform
If the end result of the S-K Study is that disclosure reform primarily produces obligations that focus on matters that a reasonable shareholder would consider important in deciding how to invest, there is the potential for a net positive result. However, the wild card in this outcome is the body that directed the S-K Study in the first case - Congress. If Congress either embraces the Staff findings, or at least gives the Staff deference to propose rules based on the approach it laid out in the S-K Study, potential good could ensue. However, this is not a given. Quoting from the Commission’s Release No. 33-5627 in her 2013 Leadership Speech, Chair White noted, “As a practical matter, it is impossible to provide every item of information that might be of interest to some investor in making investment and voting decisions.” White also suggested, “In some cases, lengthy and complex disclosure may indeed be a direct result of the Commission’s rules. Or, it may stem from legislative mandates.”
In fact, any ultimate success in advancing the S-K Study may depend on the Staff’s relative ability to have certain outdated requirements and “legislative mandates” streamlined out of the existing disclosure rules, particularly those that have little to do with what a reasonable investor would find useful in making an investment decision under the TSC disclosure framework. If public companies were to become obligated to provide more qualitative information and principles-based disclosures, it stands to reason that non-core prescriptive obligations (e.g., resource extraction and conflicts minerals requirements) and non-material obligations (e.g., CEO pay ratio disclosures) should be removed to promote the delivery of high-quality information to investors. This would further serve the purpose promoted by Chair White, to avoid an avalanche of useless investor information, or investor “overload.”
On January 24, 2014, Commissioner Daniel M. Gallagher likewise emphasized that disclosure reform should be focused primarily on material investor-driven information. He also made the following observation regarding recent Congressionally-mandated disclosure obligations:
We must also recognize politically-motivated disclosure mandates as the ill-advised anomalies they are and, as an independent, bipartisan agency, express our opposition to the use of the securities disclosure regime to advance policy objectives unrelated to providing investors with information material to investment decisions.
Based on the logic of the Supreme Court decision in TSC and public statements of certain current members of the Commission, S-K disclosure obligations should, in fact, be more closely “tethered to the concept of materiality.”
Will the S-K Study Keep JOBS Act Objectives in “Neutral” for Long?
While Vegas oddsmakers are likely to be too busy currently covering March Madness to quote “over and under” odds on a timetable for Regulation S-K reform, I would venture a bet, for the reasons discussed below, that a number 14 seed could win the NCAA basketball tournament before the comprehensive approach identified in the S-K Study is formally proposed and adopted.
It is notable that the Staff selected a comprehensive review for all issuers over a targeted review for EGC offerings, despite acknowledging that this approach would be far more time-consuming and tap resources across the entire Commission. This is surprising given recent history concerning Dodd-Frank rulemaking delays at the Commission that have been attributed to insufficient Staff resources. While current leadership at the Commission (Chair White and Corporation Finance Division Director Keith Higgins) may not be at direct fault for past delays, the fact remains that 60 SEC rules mandated by the Dodd-Frank Act still have yet to be completed as we approach the fourth anniversary of that Act’s adoption.
As Commissioner Gallagher noted in a February 2014 speech at the annual “SEC Speaks” conference, “... if we simply put our heads down and rotely implement each and every remaining Dodd-Frank mandate, it would take us over five years even at an unprecedentedly aggressive rulemaking pace.” Given this backlog, it really does not make sense to do a comprehensive review of Regulation S-K affecting all issuers. If that isn’t enough already, it’s fair to say that comprehensive Commission reform efforts in recent decades have either failed to get past preliminary conceptual stages or have sunk under the weight of considerable complexity or opposition (e.g., the “Aircraft Carrier Release”).
Thus, barring an unexpected Cinderella effort by Congress to embrace the S-K Study and support the streamlining of non-core and non-material disclosure obligations, it is hard to be optimistic about fundamentally positive disclosure reforms being implemented as contemplated by the S-K Study. Given the complexities and potential for uphill opposition, it is fair to say that long-shots like 14 seeds and the S-K Study are a lot of fun to root for, but they rarely (if ever) succeed.
What Reforms Could Stand a Better Chance of Passing SEC and Congressional Review?
The JOBS Act requested recommendations to simplify the registration process and reduce the cost and complexity of the offering process for EGCs. Given the level of interest already expressed by Congress on this front, it would make more sense for the Staff to take the S-K Study out of neutral and jumpstart reform by focusing on certain aspects of the offering process already identified by the Staff in the S-K Study and advancing an offering-focused rulemaking proposal relative to EGCs only. This would be far less time-consuming than trying to (1) harmonize Regulation S-K and Regulation S-X (which would require additional input and buy-in from other constituencies, such as the FASB and the accounting profession); and (2) propose and adopt new disclosure rules for an extremely wide variety of applications beyond the offering process (e.g., ongoing reporting, shareholder communications, mergers and acquisitions, shareholder solicitations and governance).
Any new offering requirements adopted by the Commission for EGCs could be tested through the R&D laboratory of the Staff’s principles-based review of, and comment process concerning, post-reform EGC registration statements. This testing ground could serve as a foundational basis to test new principles-based requirements against a dynamic group of EGC issuers and transactions. EGC IPO issuers would have the added benefit and flexibility of pursuing such offerings within the confines of confidential Staff reviews, as already permitted by the JOBS Act. Additional SEC consideration should be given to enabling all EGCs, and if appropriate smaller reporting companies, to elect to confidentially file all registration statements (i.e., follow-on offerings, secondary offerings and shelf offerings, not simply IPO filings) for a limited period of time (e.g., 12-18 months) after implementation of such new offering process rules.
This type of new approach could in fact be patterned after and build off of the past successes of the Staff in using its confidential and focused review processes to promote positive change (e.g., the Plain English Initiative). More importantly, this type of approach could advance two larger purposes. First, it could enable an additional jumpstart to accelerate EGC growth through a more streamlined and efficient offering process, rather than leaving EGCs to idle in neutral while waiting for comprehensive reform affecting all public companies across substantially all disclosure forums, as is currently proposed by the Staff. In addition, findings from EGC offering reform and subsequent Staff reviews of EGC registration statements could be used to further refine and define larger disclosure reform for all public companies. As a consequence, the first wave of EGC offering reform could serve as a foundation to enable the Staff, along with mature public companies, to chart a course for overall disclosure reform based upon Staff-tested principles-based disclosure practices that could be developed against the important backdrop of dynamic capital markets practices.