Quarterly Reports

Drafting Better Risk Factor Disclosure

by Vanessa Schoenthaler on December 4, 2011

Risk factors are an important part of a company’s disclosure documents. They caution potential and existing investors about specific, material risks that should be considered when making an investment decision.

Well-drafted, unambiguous risk factors can also serve as a safeguard against liability for inaccurate forward-looking statements under the twin safe-harbors of Sections 27A of the Securities Act and 21E of the Exchange Act, as well as the judicially derived “bespeaks caution” doctrine.

But quite often risk factors are bemoaned, by investors and regulators alike, as little more than mundane, boilerplate prose.

Accordingly, and in light of the perennial debate over how much of what kind of disclosure we really need, let’s take a look at what makes for an effective risk factor.

Basic Requirements as to Form and Substance

Item 503 of Regulation S-K addresses the basic form and substance of risk factor disclosure. It requires that you discuss, in plain English, the most significant factors that make an investment in your company or a particular securities offering speculative or risky. The factors should:

  • be concise and organized logically, with each limited to one or two short paragraphs set forth under a subheading that clearly describes the risk being addressed;
  • be limited to one risk per subheading;
  • plainly and directly describe the extent of each risk and how it specifically might affect an investment in your company or securities offering;
  • avoid generic (i.e., boilerplate) risks that could apply to any company or securities offering; and
  • avoid mitigating or offsetting language intended to explain away or lessen risks.

Item 503 also offers up a few examples of typical factors that may make an investment in a company or securities offering speculative or risky, including: lack of an operating history, lack of profitable operations in recent periods, a company’s financial position, business or proposed business, or lack of a market for a company’s equity securities.

The Plain English Rules

Beyond the basics of form and substance, Rule 421 of Regulation C requires that your risk factor disclosure be written in plain English, which entails, among other things, the use of:

  • short sentences;
  • definite, concrete, everyday language;
  • personal pronouns that speak directly to your audience;
  • an active voice with strong verbs;
  • tabular presentations and bullet lists for complex material, whenever possible; and
  • pictures, logos, charts, graphs or other design elements, provided their design is not misleading and any information required to be disclosed is clear.

In contrast, when drafting plain English disclosure you should avoid the use of:

  • legal jargon, highly technical business terminology and overly complex presentations that make the substance of your disclosures difficult to understand;
  • multiple negatives;
  • superfluous verbiage;
  • vague boilerplate explanations that are imprecise and subject to multiple interpretations;
  • complex information copied directly from legal documents without a clear or concise explanation of the provisions; and
  • repetitive disclosure that does not enhance the quality of the information presented.

Three Broad Categories of Risk

In a 1999 update to Staff Legal Bulletin No. 7A,addressing plain English disclosure, the Commission identified three broad categories that risk factors should address:

Industry Specific Risks

Industry specific risks are risks that you face by virtue of the industry in which you operate. For example, companies in the transportation industry may face significant risks related to pending climate change legislation because they depend on products that emit greenhouse gases.

Company Specific Risks

Company specific risks are risks that are particular to your company. For example, companies like Amazon.com and eBay may face significant risks related to incidents of cyber attacks, which could result in significant data breaches and have a material adverse effect on their operations and revenues. Whereas companies like Target and Walmart may not face similarly significant risks because of their large brick and mortar retail presence.

Investment Specific Risks

Investment specific risks are risks that are specifically tied to an investment in a security. For example, following an initial public offering, whether for Skullcandy or LinkedIn, there’s always the risk that an active trading market may not develop for a company’s securities, or, if one does develop, that it may not be sustained.

For a relatively more interesting sampling of investment specific risk factors, check out the “Risks Related to the Securities Markets and Ownership of Our Class A Common Stock” in Groupon’s recent IPO prospectus.

Drafting Better Risk Factors

Now that you have the basics of form, substance and plain English down, how do you improve your own risk factor disclosure?

One of the simplest things you can do, perhaps as part of your quarterly risk factor review (or annual review if you’re a smaller reporting company), is to assess your existing disclosures against each of the foregoing principles. Is each factor tied to a specific industry, company or investment risk? Have you adequately explained how the risk might impact your company or securities? Are you using an active voice and everyday, jargon-free language? Would a table or bullet list add clarity to your disclosure?

You should also compare your risk factor disclosure with the disclosure of other companies in your industry, or companies in other industries that are similar in size, geographic reach or some comparable characteristic. If your risk factor disclosure is part of a registration statement, you should compare it to the disclosure of other companies that have undergone or are undergoing similar offerings. Are other companies disclosing risks that might equally apply to you? Are theses risks significant enough that you should consider disclosing them as well?

Finally, you should consider whether any of your existing risk factors should be eliminated because they are either no longer relevant or the risks described are no longer significant.

Additional Resources

If you’re looking for even more guidance on plain English and drafting risk factor disclosure you can find it in the plain English rule’s adopting release, the Commission’s ever useful Plain English Handbook and Updated Staff Legal Bulletin No. 7A.

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The Consequences of a Late Filing

by Vanessa Schoenthaler on March 4, 2011

Exchange Act Report Filing DeadlinesNobody likes a late filer, especially not if the filing is a quarterly report and the reason its late is because of an accounting issue.

A recent academic study, out of the University of Southern California and New York University, examines the Capital Market Consequences of Filing Late 10-Qs and 10-Ks and finds, as you might have guessed, that capital markets react negatively when a company files a late quarterly or annual report. In addition, and perhaps less intuitively, the study finds that capital markets react more negatively in response to the filing of late quarterly reports than to the filing of late annual reports, and even more so when accounting issues are cited as the reason for the delay. The authors postulate that this is because quarterly reports require less disclosure and are unaudited, and so markets perceive accounting issues associated with the filing of late quarterly reports as more significant than accounting issues associated with the filing of late annual reports.

The study uses change in share price to measure market reaction and observes late filers for a period of eight months following their notice of late filing. In the short term, companies experience an immediate negative reaction when they announce a late filing and a significantly more negative reaction if they miss the Securities Exchange Act Rule 12b-25 filing grace period. Interestingly, companies continue to experience share price declines for several months following a late filing, except when accounting issues are the reason for the delay, because, the authors suggest, investors are better able to interpret and immediately react to accounting-related information.

Beyond the capital market consequences of a late filing, there are a host of other issues to consider:

Filing Deadlines

By way of review, a public company is required to file its quarterly and annual reports with the Securities and Exchange Commission within a certain number of days following a fiscal period’s end:

Quarterly (Form 10-Q) and Annual (Form 10-K) Report Filing DeadlinesNote: these deadlines only apply to domestic companies, foreign private issuers are subject to a different set of filing requirements. For example, they currently have to file annual reports (on a Form 20-F) within 6 months following a fiscal year’s end. However, beginning with fiscal years ending on or after December 11, 2011, this deadline will be pushed up to within 4 months following a fiscal year’s end. Foreign private issuers also have an obligation to file current reports (on a Form 6-K) “promptly” after certain information is made public in accordance with the laws of their own jurisdictions.

Securities Law Consequences of a Late Filing

Exchange Act Rule 12b-25 provides that if a company cannot timely file all, or any portion, of a quarterly or annual report then within one business day after the report’s due date the company must file a Notification of Late Filing (on a Form 12b-25) stating the reason why.*

Rule 12b-25 also provides that if the report could not have been filed by its due date without unreasonable effort or expense, then it may still be deemed to have been timely filed if the company:

  • timely files its Notification of Late filing; and
  • files the late report within the applicable grace period (no later than 5 calendar days in the case of a quarterly report, and no later than 15 calendar days in the case of an annual report, regardless of the company’s filer status).

This is an important detail because if a company has not timely filed all of its Exchange Act filings (with the exception of certain filings required to be made on a Form 8-K) it will lose the ability to file a short form registration statement on Form S-3 (or Form F-3 in the case of a foreign private issuer) for at least a period of 12 months. This will in turn limit the company’s ability to conduct certain types of registered securities offerings.

In addition, until the late report is filed the company will also lose its ability to file a Form S-8 registration statement and its Rule 144 eligibility. Form S-8 is a short form registration statement used for offering securities under an employee benefit plan, and Rule 144 covers unregistered public resales of restricted and control securities. These are temporary consequences, however, because neither Form S-8 nor Rule 144 require that a company’s reports be timely filed, only that they are filed.

As for any currently effective registration statement, a company’s ability continue to rely on that registration statement prior to filing a late report will depend on whether the prospectus and anti-fraud provision of the Securities Act are satisfied, the late filing notwithstanding.

Securities Exchange Consequences of a Late Filing

Where a company’s securities are listed or quoted will also effect what happens when a filing is late.

In the case of a NYSE-listed company, the NYSE Listed Company Manual (Section 802.01E) sets forth a series of procedures that are triggered if a company files a late annual report.

In the case of an AMEX or Nasdaq-listed company, both the AMEX Company Guide (in Section 1101) and Nasdaq Stock Market Rules (in Rule 5250(c)(1)) require that a company file with the exchange copies of reports filed with the Commission on or before their filing deadline. Late filings will result in a company’s receipt of a notice of failure to meet the exchange’s continued listing requirements, which must be disclosed on a Form 8-K, and will require a company to submit a plan for regaining compliance with those requirements. In each case, if a company fails to regain compliance with the exchange’s continued listing requirements, its securities may be suspended from trading or delisted.

In the case of a company with securities quoted in an over the counter market, like the OTC Bulletin Board, there are no listing requirements. However broker-dealers participating in the OTC Bulletin Board markets are members, and governed by the rules, of the Financial Industry Regulatory Authority (FINRA).  FINRA Rule 6530(e) prohibits members from quoting the securities of a company that has failed to timely file a required report three times in any 2-year period, or that has had its securities removed from the OTC Bulletin Board quotation service twice in a 2-year period for failing to file a required report within 30 days of the filing deadline. Once a company’s securities are prohibited from being quoted on the OTC Bulletin Board the company must timely file all required reports for a period of one year before it can regain eligibility.

Other Consequences of a Late Filing

Late filings occur for all kinds of reasons and under certain circumstances may simply be unavoidable. In addition to these general capital market, securities law and securities exchange consequences, late filers also need to be aware of and consider company-specific consequences, such as whether a late filing will trigger an event of default or violate any other contractual covenants.

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* In gathering and investigating data for their Capital Market’s study, the authors communicated with Wayne Carnall, Chief Accountant of  the Commission’s Division of Corporation Finance, regarding discrepancies in the number of reported late filings that appeared in different data sources.  The authors noted that Mr. Carnall “suggested that it is very rare for late filers not to file [a Form 12b-25], and that he would be very interested in knowing of any … ” non-filers they were able to identify.

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The Commission May Not Be So Quick to Grant Your Next Confidential Treatment Request

by Vanessa Schoenthaler on November 3, 2010

The Office of Inspector General has been conducting an audit of the Securities and Exchange Commission’s processes and procedures for handling confidential treatment requests under Securities Act Rule 406 and Exchange Act Rule 24b-2.  In September OIG released its final report containing eight recommendations designed to improve these processes and procedures; the Commission has agreed, or partially agreed, with seven of them and will provide OIG with a written action plan to address the agreed upon recommendations by November 12, 2010.

A Brief Overview of Confidential Treatment Requests

There are generally two types of confidential treatment requests, those made pursuant to:

  • Securities Act Rule 406 or Exchange Act Rule 24b-2 with respect to information required to be filed with the Commission, such as a material agreement filed as an exhibit to a registration statement or periodic report; and
  • Rule 83 of the Commission’s Rules of Practice with respect to information not required to be filed with the Commission, such as supplemental information provided in the context of the comment and review process.

Requests Made Pursuant to Securities Act Rule 406 or Exchange Act Rule 24b-2

When making a request for confidential treatment pursuant to Securities Act Rule 406 or Exchange Act Rule 24b-2 the request must:

  • be sufficiently narrow, so that only information eligible for exemption under the Freedom of Information Act is covered;
  • contain legal and factual analyses substantiating the exemption;
  • contain an affirmative representation as to the confidentiality of the information; and
  • set forth the duration for which the exemption is being sought;

The Commission will not generally grant a request for confidential treatment with respect to information that is specifically required to be disclosed under applicable securities laws or information that is material to investors.

Requests Made Pursuant to Rule 83 of the Commission’s Rules of Practice

As with a request for confidential treatment made pursuant to Securities Act Rule 406 or Exchange Act Rule 24b-2, a request made pursuant to Rule 83 of the Commission’s Rules of Practice must be sufficiently narrow so as only to include information eligible for exemption under the FOIA.  However, it is not necessary to substantiate a request for confidential treatment made pursuant to Rule 83 until such time as a FOIA request is made.  Additionally, it is possible to request that the Commission return any supplemental materials, thus rendering them unavailable for production in a FOIA request.  The Commission will generally do so provided returning the materials is consistent with the protection of investors and the provisions of the FOIA. Any request for confidential treatment that is granted under Rule 83 will expire after 10 years, unless renewed prior to its expiration.

How the OIG’s Recommendations Might Apply

Two of the OIG’s eight recommendations focus on the processes and procedures for the Commission’s initial screening and selective full review of requests for confidential treatment that are based on the required disclosures causing competitive harm and not being necessary for the protection of investors.  Specifically, that such requests are overly broad, use conclusory statements and contain boilerplate language.  The Commission has agreed, or partially agreed, to address these recommendations by revising its internal processes and procedures.  So as to avoid delay, or even further review, issuers should also consider whether they have fully addressed these concerns in their next confidential treatment request.

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Got A Calculator?

by Vanessa Schoenthaler on October 13, 2010

You’d better double-check those compensation figures before filing your next disclosure document or you may be needlessly inviting additional SEC scrutiny.

On Monday The Boston Globe ran a follow-up piece to an earlier story in which it identified 34 Massachusetts-based public companies which reported incorrect compensation figures for reasons such as “typos, mistakes in addition and other inadvertent blunders.”

Most of the companies, when initially interviewed, stated that they had no intention of correcting the errors, which they all viewed as immaterial.  However, in its follow-up piece, the Globe indicated that the Commission now plans to look into a number of the cases.  One law school professor interviewed for the piece even suggested that the Commission consider questioning the companies’ certifying accountants. … Surely they had calculators?

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Reading The SEC’s Tea Leaves: A Preview of Possible Staff Disclosure Comments

by Vanessa Schoenthaler on October 12, 2010

With an onslaught of Dodd-Frank activity looming, the third quarter earnings season officially underway and the year-end fast approaching, wouldn’t it be nice to have some indication of what the Securities and Exchange Commission will focus on when reviewing upcoming year-end filings?  Well there’s certainly no shortage of options, but the Commission’s Chief Accountant, Wayne Carnall, may have just given us a clue, at least with respect to financial disclosures.

As reported in CFO.com, Carnall, in a recent accounting-industry speech, named several areas that are of particular interest to the Commission and likely to be the focus of future staff comment letters.* Among them, Carnall pointed to disclosure regarding short-term liquidity.  No surprises there; just last month the Commission proposed a new set of rule amendments that would require companies to provide greater quantitative and qualitative disclosure of short-term borrowing during a reporting period.

Carnall also indicated that the Commission will increase its focus on the credentials and experience of those preparing and auditing the financial statements of companies with operations in developing countries.  For example the Commission has recently issued comments such as:

We note that your operations are in [a developing county] but your audit report was signed by an audit firm based in [the United States]. In this regard, please describe for us how the U.S. auditor performed the audit of [your foreign] operations.  In your response, please tell us whether another foreign audit firm assisted in the audit. If so, please tell us the name of the other firm, whether the other firm is registered with the PCAOB, and the extent to which audit work was performed by the other firm.

Other named areas of Commission focus included disclosure regarding the calculation of contingent liabilities, non-cash charges involving impairment to goodwill and deferred tax assets, and the consistency and accuracy of non-GAAP disclosure.

What about non-financial disclosures?  Carnall didn’t touch on any, but Director Meredith Cross, in recent testimony before the House Committee on Financial Services, indicated:

Executive compensation disclosure review remains a focal point of the Division’s review program and the staff continues to comment on ways that companies can enhance their disclosure.

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*Of course the Commission disclaims responsibility for the public statements of its employees, so Carnall’s predictions may not actually reflect future Commission policy.

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