Month-In-Brief: Securities Law

CURRENT MONTH (March 2019)

Securities Regulation

SEC Adopts Rules under FAST Act to Modernize and Simplify Certain Reg S-K Disclosures

By Rani Doyle, EY

On March 20, 2019, the Securities Exchange Commission (SEC or Commission) adopted amendments to modernize and simplify certain disclosure requirements in Regulation S-K, and related rules and forms, in a manner that reduces the costs and burdens on registrants while continuing to provide all material information to investors. The amendments are also intended to improve the readability and navigability of disclosure documents and discourage repetition and disclosure of immaterial information.

Among other things, the amendments:

• Simplify disclosure or the disclosure process, including changes that would allow registrants to omit confidential information from most exhibits without filing a confidential treatment request, and changes to Management’s Discussion and Analysis that allow for flexibility in discussing historical periods;
• Revise rules or forms to update, streamline or otherwise improve the Commission’s disclosure framework by eliminating the risk factor examples listed in the disclosure requirement and revising the description of property requirement to emphasize the materiality threshold;
• Update rules to account for developments since their adoption or last amendment by eliminating certain requirements for undertakings in registration statements; and
• Incorporate technology to improve access to information by requiring data tagging for items on the cover page of certain filings and the use of hyperlinks for information that is incorporated by reference and available on EDGAR.

The amendments also include parallel amendments to several rules and forms applicable to investment companies and investment advisers, including amendments that require certain investment company filings to include a hyperlink to each exhibit listed in the exhibit index of the filings and be submitted in HyperText Markup Language (HTML) format.

The amendments will be effective 30 days after they are published in the Federal Register, except that the amendments relating to the redaction of confidential information in certain exhibits will become effective upon publication in the Federal Register. The requirements to tag data on the cover pages of certain filings are subject to a three-year phase-in, depending on the nature of the filer. All investment company registration statement and Form N-CSR filings made on or after April 1, 2020 must be made in HTML format and comply with the rule and form amendments pertaining to the use of hyperlinks.

SEC Proposes Offering and Communications Reforms for BDCs and Closed-End Funds

By Anna Pinedo, Mayer Brown

Also on March 20, the SEC proposed rule amendments that are intended to modernize the offering related provisions of the Securities Act and the communications safe harbors available to business development companies (BDCs) and closed-end funds (CEFs) in order to harmonize these with the provisions applicable to operating companies. The SEC also proposed accompanying amendments to Form N-2. The SEC was required to undertake rulemaking with respect to BDCs by the Small Business Credit Availability Act, and to undertake rulemaking with respect to CEFs by the Economic Growth, Regulatory Relief and Consumer Protection Act, often referred to as the Crapo Act. Pursuant to the provisions of the Small Business Credit Availability Act, certain amendments became self-effectuating on the Act’s one-year anniversary, which has now passed; however, BDCs may want to consider whether to rely on those provisions, or await SEC Staff guidance regarding the transition period since the amendments address the same matters.

Among the most important proposed changes for BDCs and CEFs would be: (1) the ability to qualify as well-known seasoned issuers; (2) to benefit as WKSIs from the ability to engage in certain communications and rely on expedited shelf registration provisions; (3) the ability for other BDCs and CEFs to use more streamlined shelf registration statement procedures; and (4) the ability to rely on a number of important communications safe harbors.

SEC Division of Corporation Finance Director William Hinman delivers speech “Applying a Principles-Based Approach to Disclosing Complex, Uncertain and Evolving Risks”, with a focus on Brexit and Sustainability

By Rani Doyle, EY 

With the outcome of Brexit negotiations still very uncertain, it was timely that on March 15, 2019, while in London at the 18^th Institute on Securities Regulation in Europe, SEC Division of Corporation Finance Director William Hinman delivered a speech on how the U.S. securities disclosure requirements, “which are largely principles-based, apply in areas where the disclosure topics may be complex, associated with uncertain risks and rapidly evolving.” Theresa May’s proposed Withdrawal Agreement was opposed for the third time last week and with British Parliament still struggling to find a consensus, there are still a variety of potential outcomes. Hinman explained that many SEC reporting companies have international operations and may be materially impacted by Brexit. He emphasized that the SEC’s disclosure regime is based on materiality and noted that a principles-based approach to disclosure calls for companies to provide disclosure on such topics using the “lens through which each company’s management looks at its exposure.”

With respect to Brexit disclosures specifically, Hinman stated that there “should not be material gaps between how the board is briefed [on Brexit] and how shareholders are informed [about Brexit].” Hinman expressed the same view with respect to sustainability disclosures.

He also noted the following six, non-exclusive types of questions the SEC staff will have in mind in evaluating Brexit-related disclosures in 2018 annual reports:

1. Is the business exposed to new regulatory risk given the uncertainty of which set of laws and regulations will apply and whether transition agreements will be in place? We have seen useful, tailored disclosure by some financial institutions that addresses the regulatory risks associated with the potential loss of passporting arrangements that currently permit U.K. entities to provide services to businesses and customers throughout the EU. Similarly, some firms have provided disclosure explaining specific efforts undertaken to re-locate their U.K. operations, or to merge with or acquire EU subsidiaries, to mitigate the regulatory risks of Brexit. Banking and financial services are obviously not the only industries subject to regulatory risk in light of Brexit. Biopharmaceutical companies with substantial U.K. operations face risks concerning how their products and clinical trials will be regulated. Airlines face risks that potential restrictions on flying rights or changes in administration of antitrust laws may negatively impact their joint ventures. For companies in these industries and others affected by regulatory risk, we would expect tailored disclosure explaining these risks where appropriate.
2. Are there significant supply chain risks due to the potential disruption to the U.K.’s access to free trade agreements with other nations and any resulting changes in tariffs on exports and imports? Will potential changes to customs administrations and delays materially impact a company’s business, particularly if the business relies on just-in-time supply chains? We believe that companies are actively considering the potential impact of these matters on their business, and we look forward to seeing disclosures that provide insight as to how management is assessing and mitigating these risks.
3. Does the company face a material risk of losing customers, a decrease in sales or revenues or an increase in costs due to tariffs or other factors? Is demand for the company’s products especially sensitive to exchange rates or changes in tariffs? Discussion and analysis of these types of questions regarding known trends, demands, commitments, events and uncertainties are critical for investors to understand the extent to which a company’s reported financial information is indicative of future results. To the extent management sees the potential impact of Brexit in terms of anticipated costs, reductions in forecasted sales or changes in working capital, it may be appropriate in some cases to include estimates or ranges of quantitative changes, as well as qualitative disclosures.
4. Does the company have exposure to currency devaluation, foreign currency exchange rate risk or other market risk? Given the potential for heightened foreign exchange volatility, we are aware of reports that companies are increasing their hedging activities. We will look at quantitative and qualitative disclosures about market risk to better understand each company’s approach to market risk management in this area.
5. What is the company’s exposure to contractual risk in the face of Brexit? Has the company undertaken a review of its existing contracts with counterparties in the U.K. or the EU to determine whether renegotiation or termination is necessary in light of contractual obligations? To the extent these discussions involve material contracts, we would expect disclosure to reflect these discussions.
6. Do Brexit-related issues affect financial statement recognition, measurement or disclosure items, such as inventory write-downs, long-lived asset impairments, collectability of receivables, assumptions underlying fair value measurements, foreign currency matters, hedge accounting or income taxes? We expect that boards and audit committees are considering these reporting implications and that these considerations will be discussed in company disclosures, as appropriate.

As to sustainability, Hinman noted that sustainability disclosures continue to be of interest to investors and other market participants and that investors continue to engage with companies on sustainability topics as other market participants and stakeholders are espousing increasingly vocal interest in seeing more fulsome and consistent disclosures on sustainability matters.

In determining what disclosures to make around sustainability matters, Hinman again expressed his view that management’s engagement with its board on such matters would be relevant. He also referred back to the SEC’s 2010 interpretive release on climate change disclosures, and stated that the “guidance remains a relevant and useful tool for companies when evaluating their disclosure obligations concerning climate change matters.” Hinman said that one relevant disclosure topic not addressed in the 2010 release was the board’s risk management role in climate-related matters.  He said that, under Regulation S-K Item 407(h), the SEC expects that companies would provide disclosure “about how a company perceives the role of its board and the relationship between the board and senior management in managing the material risks facing the company. To the extent a matter presents a material risk to a company’s business, the company’s disclosure should discuss the nature of the board’s role in overseeing the management of that risk.” Hinman expressed that this view would apply to climate-related matters, as it would other complex, evolving risks.

PCAOB Issues Staff Guidance re: Implementation of Critical Audit Matters: The Basics

By Rani Doyle, EY

On March 18, 2019, the PCAOB issued basic guidance to help audit firms implement the new requirements relating to critical audit matters (CAMs), including links to related PCAOB audit standards. Note that the PCAOB’s guidance and standards apply to auditors, but auditor disclosures required under PCAOB rules will apply in their public company audit client’s SEC filing.

Public company management and audit committees should already be engaging with the independent auditor on in how the auditor will address the CAM requirements.

The guidance is clear and should be very helpful for those still looking for a basic understanding of  CAMS as it:

• defines critical audit matters, including the meaning of terms and concepts within the CAM definition
• explains that the auditor’s report must now include a new section entitled “Critical Audit Matters” and outlines the communications that must be made in that section of the audit report
• explains the documentation requirements auditors must meet with respect to CAMs
• states the requirement for an engagement quality reviewer (from the audit firm) to evaluate the audit team’s determination, communication and documentation of CAMs
• states the need for audit committees to discuss and engage with the auditor about CAMs, in particular the communication of CAMs in the audit report and whether any sensitive information might be raised in such communication