Drafting Better Risk Factor Disclosure

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.