The Securities and Exchange Commission has continued its effort to update and streamline the disclosure requirements for filings with the SEC. In November, the SEC adopted amendments to the rules for Management’s Discussion and Analysis and related financial disclosures.  MD&A, because of its principles-based nature, is among the most challenging of the disclosure requirements. Within MD&A, addressing “known trends or uncertainties,” because the requirements are not only principles-based but also future oriented, can be especially challenging. In the recent amendments, the SEC, although not directly modifying its previous interpretations regarding disclosure of known trends or uncertainties that have troubled practitioners over the years, provides useful guidance that should align the specific requirements with the approaches followed in practice.
MD&A, as required by Item 303 of Regulation S-K, has long been a part of required disclosure. It is designed to provide additional meaning to the required financial information and to put that information in context “through the eyes of management.” Part of providing that context is to disclose known trends, demands, commitments, events or uncertainties that have had or would reasonably have a material effect on the company‘s financial condition, cash flow or results of operations in a way that makes the past financial information not necessarily indicative of future condition or results.
In 1989, the SEC established a two-step test for determining whether a known trend or uncertainty required disclosure. First, management must determine if the known trend or uncertainty is likely to occur – if it determines it is not likely to occur, no disclosure is required. If it cannot make that determination, it must go to the next step, which is to evaluate objectively the materiality of the known trend or uncertainty on the assumption that it will occur. Disclosure is then required unless management determines that the effect is not reasonably likely to be material. This two-step negative presumption test has caused concern for practitioners. Despite comments expressing that concern, the Commission chose to reaffirm the 1989 two-step test, asserting that the language of Item 303 as amended codified that position. At the same time, however, the Commission provided guidance in the adopting release on how to apply the two-step test in making disclosure determinations that should align Item 303’s requirements with how it is generally applied in practice.
First, the Commission has included in Item 303(a) general concepts applicable to MD&A that previously appeared as guidance in instructions and interpretations. Although provisions of Regulation S-K items usually are applied as legal requirements, because of their generality the provisions of Item 303(a) are unlikely to be applied that way. The Commission also makes clear in the adopting release that MD&A should include a thoughtful discussion and analysis of factors specific to the particular company’s business that from management’s perspective are necessary to an understanding of the company’s financial condition, changes in financial condition and results of operations. The Commission emphasizes that materiality is the overarching principle of MD&A disclosure.
With specific reference to known trends and uncertainties, the amendments to Item 303 establish a consistent “reasonably likely” standard as opposed to a “will” or “reasonably expected” standard. The required analysis is to be based on “management’s assessment,” which must be “objectively reasonable.” The Commission then explains that in applying the two-step test in assessing whether disclosure of a known trend or uncertainty is required, the analysis is to be based on “materiality,” as commonly understood as being what would be considered important by a reasonable investor in making a voting or investment decision. In applying the two-step test under the “reasonably likely” standard, a company must first objectively consider whether it is likely to occur. If the known trend or uncertainty is not remote or if management cannot make that determination, management must then on an objective basis consider whether, if the known trend or uncertainty were to occur, it would have a material effect. If so, disclosure would be required if omission of the information would significantly alter the mix of information a reasonable investor would consider important, with the objective being to provide investors with an understanding of the material consequences of the known forward-looking trends or uncertainties. The Commission expressly rejected use in this context of the Basic probability/magnitude standard for assessing materiality.
Although the two-step negative presumption test is reaffirmed, the Commission’s guidance puts it in a context that should give companies somewhat more leeway in assessing the materiality to investors of non-remote known trends or uncertainties and greater comfort in reaching good faith thoughtful disclosure decisions.
The following is a summary of some of the other changes made by the SEC:
Effective Date and Transition.
The amendments become effective 30 days after publication in the Federal Register but the changes only apply to filings beginning the first fiscal year ending on or after 210 days following publication in the Federal Register (for calendar year companies that will be the fiscal year ending December 31, 2021). Companies may choose to use the new rules any time after they become effective so long as they comply with an item (such as Item 303) in its entirety.
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If you have any questions about these amendments or related topics, your regular Locke Lord contact or any of the authors can discuss these matters with you.
 Basic, Inc. v. Levinson, 485 U. S. 224 (1988).
The post SEC Revision of MD&A – Focus on Future Uncertainties Disclosure appeared first on Capital Markets.
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