As we have previously discussed, on August 26, the Securities and Exchange Commission (SEC) voted to adopt amendments to modernize the description of business (Item 101), legal proceedings (Item 103), and risk factor (Item 105) disclosures that registrants are required to make according to Regulation S-K. For a summary of the rules and practical takeaways, see our prior blog post here. The new rules will be effective on November 9, 2020. The amendments, particularly the revisions to Item 101 (description of business), reflect the SEC’s continued movement to a principles-based, registrant-specific approach to disclosure.

As stated in the SEC’s economic analysis in its adopting release, prescriptive requirements employ bright-line, quantitative or other thresholds to identify when disclosure is required or require registrants to disclose the same types of information. Principles-based requirements, on the other hand, provide registrants with the flexibility to determine (1) whether certain information is material, and (2) how to disclose such information.

As registrants transition to a more principles-based disclosure regime under new Item 101, it will be interesting to see how disclosures change, if at all. However, a recent SEC comment letter exchange may reveal one example of how companies that were previously required to include sensitive disclosures as a result of the prescriptive requirements (e.g., the names of material customers), might now be able to modify their disclosures in order to remove these sensitive areas, to the extent they deem such information immaterial to investors.

Background

Currently, Item 101(c)(vii) requires a registrant to disclose, to the extent material to the registrant’s business as a whole, “[t]he name of any customer and its relationship, if any, with the registrant or its subsidiaries…if sales to the customer by one or more segments are made in an aggregate amount equal to 10 percent or more of the registrant’s consolidated revenues and the loss of such customer would have a material adverse effect on the registrant and its subsidiaries taken as a whole.” As a result of this requirement, the SEC Staff will often issue a comment asking for the identification of material customers if the surrounding facts otherwise suggest that the customer crosses this 10% threshold and the customer is not otherwise identified.

In connection with the recently-adopted amendments to Item 101, the SEC decided to drop this prescriptive language requiring the names of 10%+ customers; instead, the amended item generally defaults into a principles-based disclosure requirement to describe the registrant’s business, and notes that disclosure “may include, but should not be limited to…revenue-generating activities, products and/or services, and any dependence on revenue-generating activities, key products, services, product families or customers, including governmental customers.” (emphasis added)

Further, the SEC stated in its adopting release, “We continue to believe that disclosure regarding revenue-generating activities, products and/or services, and any dependence on key products, services, product families, or customers, including governmental customers, generally would be material to an investment decision.”

Therefore, while a discussion of customers is likely considered material by the SEC, the disclosure is now more principles-based and a more prescriptive requirement to disclose the name of a customer has been removed. (But note the name of the customer may still be required in this principles-based regime, but such a requirement is more opaque and governed by general principles of materiality and whether the name of the customer is “material to an understanding of the registrant’s business as a whole”).

Recent SEC Comment Letter Exchange

With this background, let’s now turn to the recent SEC comment letter on this topic. The SEC Staff was reviewing a Form 10 registration statement for a smaller reporting company when it spotted disclosure in the filing that certain customers accounted for 36.8%, 10.4% and 10.2% of the registrant’s net revenues in 2019.

As this was a smaller reporting company (SRC), the business section disclosure rules are governed by Item 101(h), which is generally more principles-based as compared to the disclosure rules for all other registrants found under Items 101(a)-(c). Item 101(h)(4) states, “Briefly describe the business and include, to the extent material to an understanding of the smaller reporting company:….(vi) Dependence on one or a few major customers[.]” As such, the disclosure rules required a discussion of the dependence on one or a few major customers, but it didn’t specifically require the identification of the customers. The SEC Staff’s comment and the registrant’s response are repeated below, and no follow-up comment was issued by the Staff.

The takeaway is that this letter exchange demonstrates how a registrant is more empowered under a principles-based regime to choose the disclosures it believes are material to investors. In some cases, particularly when the topic may be sensitive or proprietary to the registrant, this may result in the removal or omission of certain disclosures that would have previously been prescribed by the rules.

Amendment No. 1 to Registration Statement on Form 10

Business, page 5

    1. We note your response to prior comment 2 but your new risk factor indicates that your business would be harmed if you lose one or more of your major customers or a major customer significantly reduces its volume of business. Given that you “expect to continue to be dependent on [y]our major customers,” please identify the customers who comprised 36.8%, 10.4% and 10.2% of your net revenues in 2019. Also disclose whether any of these top three customers accounted for a material portion of your revenue in prior years.

The Company respectfully asserts that disclosure of the names of its customers is not required by Item 101(h)(4)(vi) of Regulation S-K, nor does the Company believe the identity of its largest customers is material to an understanding of its business taken as a whole or necessary for investors to make an informed investment decision. Unlike Item 101(c)(1)(vii) of Regulation S-K, Item 101(h)(4)(vi) does not require a smaller reporting company to identify the name of any customer that accounts for 10% or more of its revenue. The Company also believes that the identities of its customers are of significantly less importance than a qualitative and quantitative description of the extent to which revenue from such customers is relied upon.

Each of the Company’s top three customers in 2019 have been customers for many years. The Company’s largest customer, representing 36.8% of revenue in 2019, has been a customer for 30 years. The second and third largest customers in 2019 have been customers for approximately 10 years and 7 years, respectively. While the Company does consider the loss of revenue from any one of its largest customers significant, warranting appropriate risk factor disclosure of the potential consequences of such loss, the Company does not believe investors will be more informed of these risks by knowing the customers’ identities.

Additionally, the Company respectfully submits that both the Company and its customers consider the identities of such customers to be highly confidential and commercially sensitive. For these reasons, the Company believes its current disclosures are sufficient and the Company has omitted disclosure of the identity of these customers in the Amendment No. 2.

The Company has included additional disclosure in the Amendment No. 2 about whether any of the Company’s top three customers in 2019 accounted for a material portion of its revenue in 2018.

If you have any questions regarding any of the topics covered in this blog post, please feel free to email the author directly or, if applicable, contact your primary Bass, Berry & Sims relationship attorney.