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Bond Market Regulation
By Nixon Peabody LLP

Risk Factor Disclosure in Municipal Offerings: Why Do We Do It and What Is the Best Way to Do Them?

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Risk factor disclosures vary substantially in the municipal securities market. In some cases, offering documents dedicate a substantial part of the offering document to risk factors while in others there is no risk factor section at all. The detail, subject matter, and specificity of risk factors vary substantially as well. In working group conference calls, we sometimes sense that market participants do not clearly grasp the purpose and objectives of risk factor disclosure and how an offering document should present risk factors, if at all. In this article, we discuss where risk factor disclosures emerged from, whether we need them or not, and some practice tips about how to present them well.

Where does the practice of risk factors come from and why do we do it?

Risk factor disclosures derived from the registered offering regime of the United States Securities and Exchange Commission (the SEC), and then were adopted by the municipal securities market into its offering documents. Risk factor disclosure has been a hallmark of public company securities disclosure for many decades now. According to the SEC, the SEC has focused on risk factor disclosure since 1964. At first, the SEC required specific risk factor sections in offering documents and then extended this requirement to periodic reports like a public company’s Form 10-K, its annual disclosure filing.
We believe that the municipal securities market can learn about effective risk factor disclosure from the SEC’s efforts at improving risk factor disclosure by public companies. The SEC has been concerned for many years now that much of the risk factor disclosure by public companies is not effective. These concerns are largely two-fold: first, the SEC has been concerned with how public companies frequently write and organize their risk factor disclosure and second, the SEC has been concerned with the actual risks that many public companies have chosen to include in their risk factor sections. These concerns by the SEC have been outlined in two of its formal rulemaking changes. First, the SEC re-wrote Item 105 in 2020. Second, the SEC provided plain English guidance in 1998. In addition to these formal efforts, the SEC staff has also sought to change these practices in the comment process when public companies submit filings to the SEC. Understanding these formal efforts and the larger narrative of the SEC’s efforts of improving public company risk factor disclosure provides the municipal securities market with key guidance of why risk factor disclosure is important and how to write risk factor disclosure effectively. Thus, let us summarize these two formal efforts.
SEC’s Revised Item 105.
In 2020, the SEC approved the re-writing of its requirement that public companies include a risk factor section in their offering documents and other periodic reports—which is contained in Item 105 of Regulation S-K. When the SEC approved this re-writing, it stated that: “In proposing amendments to Item 105, we aimed to address the lengthy and generic nature of the risk factor disclosure presented by many registrants.” In other words, the SEC expected a risk factor section to be a relatively short section that briefly, but poignantly, explained to investors the unique, specific risks of the offering. Instead, the SEC found that public company risk factor disclosure was long and focused on generic risk factors that do not explain much to investors about the specific offering. After years of battling this trend of long, generic risk factor sections, the SEC tried to strike a balance with public companies that, in the SEC’s view, would change the incentives of public companies to provide what the SEC thinks is appropriate risk factor disclosure.
Here is how Item 105 reads after the 2020 re-writing:

“(Item 105) Risk factors.
(a) Where appropriate, provide under the caption “Risk Factors” a discussion of the material factors that make an investment in the registrant or offering speculative or risky. This discussion must be organized logically with relevant headings and each risk factor should be set forth under a subcaption that adequately describes the risk. The presentation of risks that could apply generically to any registrant or any offering is discouraged, but to the extent generic risk factors are presented, disclose them at the end of the risk factor section under the caption “General Risk Factors.”
(b) Concisely explain how each risk affects the registrant or the securities being offered. If the discussion is longer than 15 pages, include in the forepart of the prospectus or annual report, as applicable, a series of concise, bulleted or numbered statements that is no more than two pages summarizing the principal factors that make an investment in the registrant or offering speculative or risky. If the risk factor discussion is included in a registration statement, it must immediately follow the summary section required by § 229.503 (Item 503 of Regulation S–K). If you do not include a summary section, the risk factor section must immediately follow the cover page of the prospectus or the pricing information section that immediately follows the cover page. Pricing information means price and price-related information that you may omit from the prospectus in an effective registration statement based on Rule 430A (§ 230.430A of this chapter). The registrant must furnish this information in plain English. See § 230.421(d) of Regulation C of this chapter.”
A few things about the SEC’s approach here are helpful guidance. First, unlike past efforts to prohibit or restrain generic risk factors, the SEC allows generic risk factors but then requires them to be in the end of the risk factor section. Second, the SEC places a page limit on risk factors and if the risk factor section exceeds that length, then the public company needs to include a summary (or, frankly, what the SEC was hoping the risk factor section itself would look like). The SEC’s thought process is that this would change the incentives and ultimately result in the kind of risk factor disclosure the SEC had sought for a long time. In a sense, though, the SEC’s commentary surrounding this rule approval gives the sense of almost exacerbation as the SEC finally shifted away from outright prohibiting long or generic risk factor sections but re-wrote Item 105 in an effort to shepherd risk factor disclosure to what it considers effective risk factor disclosure.
SEC’s Plain English Disclosure Rule.
In addition to the effort by the SEC in 2020 to address risk factor disclosure, the SEC also made an earlier effort to improve risk factor disclosure in 1998 when adopting its Plain English Disclosure rules and related guidance. In 1998, the SEC adopted its Plain English Disclosure rule, which, in general, required public companies to write their securities disclosure in what the SEC referred to as “plain English.” Rule 421(d) outlines some of these requirements. It states in part that:
“Issuers must use plain English writing principles in the organization, language, and design of the front and back cover pages, the summary, and the risk factors section. Also, when drafting the language in these parts of the prospectus, issuers must substantially comply with these plain English principles: short sentences; definite, concrete everyday language; active voice; tabular presentation of complex information; no legal jargon; and no multiple negatives.”
In addition, in the Plain English Disclosure rule, the SEC offered the following examples of risk factors for public companies to consider:
The risk factors may include, among other things, the following: (1) Your lack of an operating history; (2) Your lack of profitable operations in recent periods; (3) Your financial position; (4) Your business or proposed business; or (5) The lack of a market for your common equity securities or securities convertible into or exercisable for common equity securities.”
We think these examples are helpful because they provide us examples of what the SEC is focusing on when it comes to risk in an offering. These examples show that the SEC is focused on material vulnerabilities that are unique to the issuer or investment and the balance of the offering document may disclose those facts but an investor may not appreciate those vulnerabilities. They also offer the kind of plain language the SEC contemplated in the Plain English Disclosure rule.
In addition, in 1999, the SEC staff issued a Staff Legal Bulletin to explain some of these requirements and, in particular, that the application of the plain English requirements to risk factor disclosure “seems to be the least understood of the plain English requirements.” In this Staff Legal Bulletin, the SEC spent most of the bulletin in helping public companies understand the SEC’s expectations of risk factor disclosure. Most of that guidance presents 41 sample comments that the SEC had provided to public companies in their SEC filings. These comments are voluminous and we do not have the space to discuss them here. But the comments fall into these broad categories:
  • The SEC instructed public companies to clearly tie the risk factors to industry risk factors, company risk factors, or investment risk factors (in other words, is this a risk shared by the industry, a risk unique to the company, or a risk that is unique to an investment in the company).
  • The SEC instructed public companies to write the caption in a sentence so that the nature of the risk is clear.
  • The SEC instructed public companies to not use technical jargon, use defined terms that are intuitive to the reader, and use plain terms and write the disclosure in a manner that appropriately flows like plain English.
What should we learn from the SEC guidance to public companies?
Our view is that the SEC’s long narrative of improving risk factor disclosure can help us in the municipal securities market because it sheds light on why risk factor sections are important and how to write them effectively. Here are our takeaways from this SEC guidance for public companies:
  • The purpose of risk factor disclosure is to identify to investors those risks that are specific and unique to the issuer or the investment. That is, a risk factor section is not an exercise to identify every theoretical risk to an offering. The SEC has now made multiple efforts at preventing public companies from including generic risk factors that do not provide investors with meaningful information about the specific investment.
  • Effective risk factor sections are easily read and understood by investors. When a risk factor section is buried under technical writing or writing that does not flow like natural language, it loses a lot of its effectiveness to communicate to investors those risks.
  • Effective risk factor sections are not long. One common theme from the SEC guidance is where a risk factor section is so long that an investor cannot derive the key risks to the offering, then a briefer section that identifies higher-level risks is better than a longer section in which investors will get lost in reading the section.

Do we need risk factors in our municipal offerings and, if so, in all of our municipal offerings?

Unlike the securities law regime regulating public companies, municipal securities offerings are governed solely by the federal antifraud laws and not by specific, proscriptive rules like Item 105 or Rule 421(d). Accordingly, it is not accurate to state that issuers in the municipal securities market are required to include a risk factor section or to even follow the SEC’s risk factor guidance if they do in fact include a risk factor section. So, when and why are risk factor sections important in the municipal securities market?
The bottom line is that risk factors can matter even when we are not required to following Item 105 or the like. Risk factors can be helpful and even essential in ensuring that an offering document complies with the federal antifraud laws, which our offerings do need to comply with. While risk factors can help statements be materially accurate, if they briefly and directly address a risk, the most valuable aspect of a risk factor section in a municipal securities offering is its ability to assist the offering document to not be misleading as a whole. We will give some examples below, but risk factor sections can be valuable space in an offering document where those key facts that represent risks in an offering can be thought through and directly disclosed to investors, which helps to provide what may otherwise be lacking from the balance of the offering document. But, to do that, we need to be thoughtful about what risks an offering presents and how the offering document may not communicate that clearly. When we do that well and there are material risks, and we call those out conspicuously, it can strongly protect the offering document from challenges that the facts underlying the risks were not communicated to investors. But to avail us of the value of such a section, it is important that the risk factors need to call out the key facts that relate to the risks to the offering, which means that we should avoid long risk factor sections that include obvious, generic risks.
What are circumstances where risk factor sections are important?
We believe that there are two circumstances where risk factor sections are particularly important:
  • Where there is a known, significant vulnerability to the investment—especially if that is not readily apparent from the ordinary factual descriptions.
Mere descriptions of the financial and operating condition of an issuer or a credit do not necessarily communicate or communicate well the ways in which an investment into that financial and operating condition can involve risk. For example, an airport can have a solid history of enplanements and net revenues but descriptions of that history may not communicate clearly ways in which the airport has become dependent on a given airline for its results of operations. Another example is where there has been a solid history of result of operations but a development has occurred that calls into question whether the past history of finances and operations will carry into the future. Where there are circumstances that reviewing the descriptions set forth in the offering document can fail to communicate or bury a vulnerability that presents real risk to investors, then a risk factor section can conspicuously identify those risks.
  • Where dot-connecting needs to happen for investors to appreciate the risks to the offering.
With more complex offerings, investors may need dots to be effectively connected in order for investors to appreciate the risks of the offerings. An example of this is pension disclosure where the pension section in the offering document may include detail about the financial condition of the pension system but that may not connect how that presents risk for the issuer’s general fund structural balance. In this case the risk factor section can be a valuable space to connect the financial condition of the pension system to how that could impact the creditworthiness of the municipal securities.
But is it possible that there are offerings where a risk factor section is not needed or appropriate?
In municipal securities offerings, where the SEC cannot mandate us to include a risk factor section, we do not believe that risk factor sections should be automatically included. If after consideration of the material risks of an offering all that the working group identifies are generic risk factors that do not disclose anything unique to the offering, we believe it may be better to have no risk factor section. That is because including a risk factor section with just generic risk factors can accidentally communicate to an investor that the offering actually does not have any unique or specific risks. In the municipal securities market, there are very highly rated credits that have very strong cash flow and liquidity and where risk factors truly only could be overly generic. We believe that a risk factor section should be the result of intentionally thinking through an investment in the municipal securities and identifying those key specific risks investors need to consider.

What are some practice tips for good risk factor disclosures?

Based on this guidance from the SEC and our experience, here are the tips we offer for crafting risk factor disclosure:
  • Be wary of copying and pasting.
In most circumstances, risk factor sections should, by nature, not be the same from one issuer to another. Examples of other risk factor sections can be helpful but, in the end, a risk factor section should be the byproduct of a thoughtful process that identifies the material risks of an offering. Where risk factor sections are copied and pasted from another issuer, they can sometimes make matters worse because they can give the appearance that the key risks are identified and if one hasn’t been identified due to a lack of process it can almost make the document more misleading than it would have been without the section.
A problem also arises with frequent issuers. An offering document for a frequent issuer can be thoughtfully constructed with an effective risk factor section but if this form of offering document is used over and over, the risk factor section can become stale. With frequent issuers, it is important to periodically review the risk factor section and not just assume that the risk factor section has been appropriately written.
  • Focus on what is specific and unique to the investment.
While the mere fact that other issuers may experience the same risk does not mean that it is not an appropriate risk factor. But, at the same time, it is important for risk factors not to tell investors what they probably already know. The more that risk factors can derive from ensuring that the balance of the offering document does not mislead investors into some of the key risks, the more that the risk factor section will be effective. But this requires thoughtful, specific risk factors that explain what may be misleading to investors in a clear manner.
  • Be plain and intuitive to an investor.
As the SEC has noted, the key to an effective risk factor section is its ability to clearly communicate what may not be obvious from the balance of the offering document. Here, the SEC has offered good tips about how risk factors are drafted. The Staff Legal Bulletin we reference above develops these writing tips quite a bit. These include captions that are clear sentences, no use of technical terminology, use of plain language, and active sentences. The clearer and more intuitive the writing, the more effective the risk factor and more valuable it is for the disclosure purposes for which we prepare a risk factor section.
  • Be brief.
If everything is a risk factor, then nothing is a risk factor. Effective risk factor sections do not attempt to identify every risk to the offering but rather the key, material risks that investors need to understand in order to make an informed investment decision. Accordingly, brief risk factor sections that identify those key risks are more effective at communicating their points.

Concluding thoughts

While the municipal securities market is not subject to Item 105 or the SEC’s efforts at requiring effective risk factor disclosure, the SEC has provided extensive guidance that can help our offering documents be more effective at writing risk factor sections. The SEC guidance encourages us to be thoughtful, specific, and clear in writing when preparing risk factors, and that guidance is as helpful for us as for public companies.