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The SEC has proposed to extend risk factor disclosure to annual and quarterly reports. Effective risk factor disclosure alerts existing and potential investors to risks specific to the company or its industry, and protects the company from risks of liability based on statements or omissions in its public filings.
Risk factors, which have long been an important part of S-1 registration statements and annual reports for foreign private issuers on Form 20-E may now become a regular part of US public companies' annual reports on Form 10-K and periodic reports on Form 10-Q. In the November 17, 2004, Securities and Exchange Commission (SEC) rule proposal dealing with securities offering reform, (1) the SEC proposed to extend risk factor disclosure to quarterly and annual reports. Similar to risk factor disclosure in registration statements filed with the SEC, risk factor disclosure in annual reports on Form 10-K would "describe the most significant factors that may adversely affect the issuer's business, operations, industry or financial position, or its future financial performance," would be governed by Item 503 of Regulation S-K and would have to be written in plain English per Rule 421 under the Securities Act of 1933. Additionally, risk factor disclosure would have to be updated in quarterly reports on Form 10-Q to reflect any material changes from previously disclosed risk factor disclosure in Exchange Act reports. (2)
As the SEC is proposing to make risk factor disclosure a regular part of a public company's annual and quarterly disclosure on Forms 10-K and 10-Q (Exchange Act Reports), it is important for public companies and their counsel to understand risk factors and their purpose, to review the rules that deal with risk factor disclosure and to understand best practices in order to be able to draft effective risk factor disclosure.
What Are Risk Factors?
Risk factors are one of the main features of registration statements on Forms S-1, F-1 and 20-F, and are also prevalent in offering documents such as prospectuses or offering memorandum under Rule 144A and/ or Regulation S (collectively, Offering Documents). (3) Traditionally, risk factors alert existing and potential investors to risks specific to the company or its industry that make an offering speculative or high risk. In Exchange Act Reports, risk factors will presumably alert potential and current investors as to the risks of either purchasing or continuing to own the company's stock. Risk factors present a summary of the risks facing the company, and therefore identify to existing and potential investors, factors that should be considered when making an investment decision. (4)
The "Risk Factors" section should present a concise synopsis of risks that are explained in more detail in other places in the annual or quarterly report. (5) Companies and their counsel who are drafting and revising risk factors must anticipate potential problems facing the company and describe them to existing and potential investors. (6) As the SEC has noted that "only through the steady flow of timely, comprehensive and accurate information can people make sound investment decisions," (7) it is important that risk factors in both Offering Documents and Exchange Act Reports comprehensively cover important risks facing the company and present such information as of the date of publication.
SEC Rules Regarding Risk Factors
Regulation S-K Items 501 and 503 deal with risk factors. Item 501(b)(5) states that the outside front cover page of the prospectus must contain a cross-reference to the risk factors section, including the page number where it appears in the prospectus. In addition, this cross-reference to the Risk Factor section must be highlighted by prominent type or in another manner. Most companies comply with this rule by using bold, underline, italics, larger font size or some combination thereof to highlight the cross reference.
Item 503(c) describes what must be included in the section entitled "Risk Factors." It states that risk factors should be concise and organized logically, while also noting that "risks that could apply to any issuer or any offering" should be avoided. Each risk should be set forth under a heading that adequately describes the risk. In Offering Documents, the risk factor discussion must appear directly after the summary section. (8) Item 503(c) provides a few examples of typical risk factors, including those dealing with a company's lack of operating history, lack of profitability, financial position, business or lack of a market for the company's securities. Other typical risk factors include those dealing with possible litigation, competition, (9) future capital needs, dependence on key personnel, government regulation, and other factors unique to the company or its industry.
In addition, in 1999 the SEC published the Division of Corporation Finance: Updated Staff Legal Bulletin No. 7 (Updated SLA7)--"Plain English Disclosure," which has a section entitled "Risk Factor Guidance." In this section, the SEC Staff provides two examples of risk factors that have been staff e-written so that the risks are specifically linked to either the company or its industry, the risks themselves are more fully elucidated and the presentation uses various plain English principles to make the risk factors easier to read, including shorter sentences and bullet point lists. In addition, Updated SLA7 provides some sample comments to risk factors. (10)
Rule 421(d) of Regulation C requires that the risk factors section be written using plain English principles. (11) The six basic plain English principles that must be followed are:
1. Short sentences;
2. Definite, concrete, everyday words;
3. Active voice;
4. Tables or bullet point lists, whenever possible;
5. No legal jargon and highly …