Guidelines to Improve Disclosure of Risk Benefit Both Financial Advisers and Their Clients

Posted on July 5th, 2012 at 9:57 AM

Risk disclosure is everywhere.  Yet, it seldom is complete or easy to understand.  For years, securities regulators have sought to improve the “quality” of risk disclosure, most notably through “Plain English” disclosure initiatives for mutual funds prospectuses.  But for other investments, such as private placement offering memoranda, risk disclosure often appears to be nothing more than, or little more than, the 1,000th “cut and paste” job.  It is the polar opposite from a customized risk disclosure document, and certainly does little if anything to inform investors of the true risks involved with a particular investment.  Such ineffective risk disclosure is a disservice to investors and their financial advisers. 


            In searching for some guidance on the topic, however, I came across an oldie but goodie.  It is a 2001 publication by the North American Securities Administrators Association, entitled, “NASAA Risk Disclosure Guidelines.”  NASAA is the association of state and provincial securities administrators organized in 1919 to protect the interests of investors.  The guidelines are helpful and as relevant today as they were 11 years ago.  Let’s examine the key points.


            As background, NASAA issued the guidelines following reviews of numerous disclosure documents and the issuance of deficiency comments to those hoping to register their securities.  As NASSA puts it, the “guidelines attempt to collect and illustrate in a convenient manner, guidelines that in the past have been accessible only by researching securities regulators’ laws and regulations, releases, bulletin letters, published no-action positions and industry treatises.”


            The guidelines begin by outlining the two purposes of the risk section of the disclosure document.  They are, first, that risk factors “alert the potential investor to all of the material risks involved in the offering that bear on the likelihood of business success and financial return to the investor.”  Second, that “risk factors protect the issuer from subsequent claims by investors that they were misled by the information in the disclosure document, either by omission or by affirmative misstatements.”  NASAA recognizes that “many variables affect the determination of when disclosure is adequate in the context of a particular offering.”  Such variables include, but are not limited to, the nature of the offering and the sophistication of the investor.


            Next, the guidelines discuss the format for and use of risk factors.  There are four main points.  First, NASAA recommends that the risk factors immediately should follow the cover page or the summary page of the disclosure document.  The reason is that “potential investors often focus on the forepart of the document.”


            Second, NASAA guidelines suggest that the risk factor section should be a list identifying the material risks associated with the offering.  That is, the risk factor section should not be a comprehensive discussion of the risks and the counterbalancing considerations.  NASAA writes, “Like the summary section, the risk factor section is a summary listing of the material disclosures that are discussed and analyzed in more detail in the appropriate, related sections of the body of the disclosure document.” Interestingly, NASAA prefers that no ameliorative statements appear in that summary listing of the risk factors.

            Third, the guidelines recommend that one prioritize.  NASAA states that the “risk factors that identify risks the potential investor is likely to find most significant should appear at or close to the beginning of the list.”  By comparison, “Burying factors such as the auditors’ ‘going concern’, significant recent losses, or 100% dilution in the middle of a lengthy list of risk factors would be inconsistent with these guidelines.”


            Fourth, NASAA suggests that risk factor captions should not be lengthy and should appear in off-set type in order to stand out to the eye of the reader.  That is because “[i]italicized, bold-face, or underlined type assists the reader to quickly comprehend the scope and nature of the particular risk factors, and permits the reader to focus further on the risk factors of

most interest to that reader.”


            Finally, the guidelines make recommendations as to the risk factor content.  First, NASAA suggests that each caption should avoid general, boiler-plate language and, instead, succinctly indentify the risky element of the factor.  As an example, NASAA states that, “‘Competition’ merely identifies the subject of the risk factor”, whereas, “[t]he alternative, ‘Established Retailers Have Recently Entered The Company’s Market’, is specifically tailored to the offering, the nature of the competitive risk, and suggests the negative aspect of the risk.”


            Second, the guidelines recommend using specific cross-references to point the reader to the complete discussions of the issue.  The best approach is to summarize the risk factor in two or three sentences, with a cross reference to the discussion appearing elsewhere in the disclosure document, NASAA states. 


            Third, NASAA recommends eliminating general, boiler-plate risk factors.  The guidelines suggest that one “include only risks that are material to the particular offering or the particular issuer, and, in narrowly drawn cases, particular to the industry segment.”  As an example, NASAA offers, “A generic risk factor that the issuer faces significant competition from established, well-financed companies with greater resources…’is an example of an inappropriate risk factor.”


            Fourth, NASAA issues guidance with regard to forward looking statements.  The guidelines suggest that such disclosures are boiler-plate, are redundant with the general “cautionary language” statement found at the beginning of the risk factor section, and detract from the “reader-friendly” introduction to the risk factors.  NASAA suggests moving them to follow the risk factors or to some other section of the risk disclosure document.


            As one can see, those recommendations would be helpful for investors and advisers alike as they would convert the risk disclosure document from being a mere litigation defense tool in the tool box to being an effective client communication document.  That would be welcome news to all!


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