SEC Alters Long-Standing Monetary Sanctions Threshold for Disclosing Environmental Proceedings: Hybrid Approach Adopted
On August 26, 2020, the U.S. Securities and Exchange Commission (“SEC”) issued a final rule amending Regulation S-K that, among other things, changes a long-standing test obligating registrants to disclose certain environmental enforcement proceedings initiated by federal or state agencies in their public filings. Citing a need to “modernize” required disclosures, the SEC has replaced its venerable bright-line test – established and unchanged since 1982 – found in Item 103 of Regulation S-K with a hybrid approach to disclosing environmental enforcement proceedings.
Specifically, the rule increases the monetary sanctions disclosure threshold under Item 103 from $100,000 or more to $300,000 or more. Moreover, acknowledging that “one size does not fit all,” the rule allows registrants to use a higher monetary sanctions disclosure threshold, even if monetary sanctions exceed $300,000, so long as a registrant determines that its alternative disclosure threshold is reasonably designed to result in disclosure of material environmental proceedings; provided, however, that the alternative disclosure threshold level cannot exceed the lesser of $1 million or 1% of the current assets of the registrant and its subsidiaries on a consolidated basis.
The final rule will become effective 30 days after publication in the Federal Register.
Background on Regulation S-K and Item 103.
The SEC serves to protect financial investors, maintain fair, orderly, and efficient markets, and facilitate capital formation with respect to business conducted in the United States. Among other requirements, the SEC obligates public companies to disclose meaningful financial and non-financial information to the public that provides a common pool of knowledge for all investors to use to judge for themselves whether to buy, sell, or hold a particular security.
Citing a need to “modernize” its non-financial disclosure requirements in Regulation S-K that had not been changed in 38 years – specifically, the description of business (Item 101 of Regulation S-K), legal proceedings (Item 103) and risk factor disclosures (Item 105) – the SEC published a proposed rulemaking in the Federal Register on August 23, 2019. A final rule on Items 101, 103 and 105 was issued by the SEC approximately one year later, on August 26, 2020, but has not yet been published in the Federal Register.
Item 103 addresses legal proceedings and generally requires disclosure of any pending material legal proceedings – other than ordinary routine litigation incidental to the business – to which the registrant or any of its subsidiaries is a party or of which any of their property is the subject. If required to disclose, a registrant must provide disclosure of the name of the court or agency in which the proceeding is pending, the date instituted, and the principal parties thereto, as well as a description of the factual basis alleged to underlie the proceeding and the relief sought. Similar information is required to be included for such proceedings known to be contemplated by governmental authorities. Additionally, so as to avoid excessively detailed disclosures prepared by registrants without a commensurate benefit to investors, the SEC allows registrants to group similar governmental proceedings and to describe them generally.
The SEC first adopted a requirement to disclose all pending litigation that may materially affect the value of the security to be offered in 1933. In 1973, this legal proceedings disclosure requirement was expanded to require additional disclosure about environmental matters. In 1982, the SEC added Instruction 5.C. to Item 103 to provide clear guidance to registrants on the need to disclose environmental enforcement proceedings. Specifically, Instruction 5.C. directs registrants to disclose any proceeding under environmental laws to which a governmental authority is a party unless the registrant reasonably believes it will not result in monetary sanctions of $100,000 or more, exclusive of interest and costs. This “bright-line” disclosure threshold of $100,000 provides a clear demarcation for registrants to rely upon in preparing disclosures of environmental proceedings in applicable public filings.
Proposed Adjustments to the Monetary Sanctions Disclosure Threshold under Item 103.
As a preliminary matter, the SEC confirmed that inclusion of a bright-line monetary sanctions disclosure threshold in Item 103 for environmental enforcement proceedings remains necessary. In making this determination, the SEC concluded that imposition of a governmental fine may be important for investors in assessing a registrant’s overall environmental compliance. A disclosure threshold based on the amount of a governmental fine also provides a useful benchmark for registrants when determining whether a particular environmental proceeding should be disclosed. Additionally, the SEC determined that a monetary sanctions disclosure threshold promotes comparability among registrants in the disclosure of environmental proceedings.
Nonetheless, the SEC also believed that an increase in the disclosure threshold was due and was unequivocal in its proposed rulemaking regarding its basis for revising this threshold – inflation. Using the May 1981 date of the agency release in which the $100,000 threshold was first proposed and using a Consumer Price Index inflation model, the SEC estimated that the monetary sanctions threshold would be $285,180.40 as of May 2019. Consequently, for ease of reference, the SEC proposed rounding this amount up to $300,000. The SEC sought comment in its proposed rulemaking on the increase of the monetary sanctions disclosure threshold to $300,000, or perhaps an even higher threshold.
Moreover, the SEC was uncertain that simply increasing the monetary sanctions disclosure threshold constituted a sufficient measure of materiality for all registrants, given the wide disparity in the relative size and business currently conducted by registrants. In particular, the agency considered the findings of a 1996 SEC Task Force that had noted that the “one size fits all” approach may result in the disclosure of information about environmental proceedings of a particular registrant that are not material to an investment decision. Accordingly, the SEC requested comment in the proposed rulemaking on whether an alternative threshold for environmental proceedings should be adopted and, if so, what threshold should be used and what data or sources should provide the basis for the alternative threshold.
Adoption of Final Rule Establishing a Hybrid Monetary Sanctions Disclosure Threshold.
Comments to the proposed rule on the recommended increase in the monetary sanction disclosure threshold in Item 103 were mixed: as reported in the final rule, several commenters supported an increase of the sanctions level to $300,000 to adjust for inflation whereas many commentators were opposed to the change. Likewise, commenters were also varied in their responses as to whether a bright-line quantitative value should be retained or replaced by an alternative approach. Comments included retaining the existing test, as it provided a useful benchmark and promoted comparability amongst registrants; consideration of whether the fixed dollar test should be scrapped in favor of a materiality standard; and adoption of a hybrid approach that required disclosure of any fine above a quantitative threshold of at least $300,000 that the registrant determined was material. Other commenters recommended inclusion of a non-exhaustive list of qualitative factors that a registrant should consider when assessing the materiality of an environmental proceeding.
Upon consideration of these public comments, the SEC decided to establish a hybrid test that not only retains a quantitative disclosure threshold but also provides registrants flexibility to apply a more tailored disclosure threshold that accounts for a registrant’s size in determining materiality. However, in an attempt to alleviate concerns that a higher threshold may result in larger registrants not providing any disclosure under Item 103, the alternative test is capped, with registrants having to provide disclosure if the dollar value of monetary sanctions exceeds the lesser of $1 million or 1% of the current assets of the registrant and its subsidiaries on a consolidated basis.
Consequently, the final rule requires disclosure for any environmental enforcement proceeding in which the government is a party that involves potential monetary sanctions of $300,000 or more or, at the election of the registrant, such other amount that the registrant determines is reasonably designed to result in disclosure of any such proceeding that is material to its business or financial condition. However, regardless of the disclosure approach used by a registrant, disclosure is required for any proceeding when the potential monetary sanctions exceed the lesser of $1 million or 1% of the current assets of the registrant and its subsidiaries on a consolidated basis. Additionally, if a registrant decides to use a disclosure threshold other than the quantitative $300,000 disclosure level, the registrant must disclose the threshold used in each annual and quarterly report.
The next step is publication in the Federal Register, 30 days after which the Item 103 rule changes will become effective.
This information is provided by Vinson & Elkins LLP for educational and informational purposes only and is not intended, nor should it be construed, as legal advice.