E-Minders March 2018
In This Issue:
E-Minders is our monthly e-mail newsletter containing the latest developments and practical guidance for corporate & securities law practitioners.
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Despite a dose of drama when the SEC cancelled its open Commission meeting, the SEC released its 24-page interpretive release on cybersecurity disclosures by seriatim in late February.
Here's a statement by SEC Chair Clayton that indicates that Corp Fin will be reviewing disclosures to help decide whether further guidance - or rulemaking! - is necessary. And these statements by Commissioner Jackson & Commissioner Stein are a bit critical of the new guidance.
We're posting the inevitable flood of memos about the guidance in our "Cybersecurity" Practice Area. Many are analyzing the "duty to update" discussion in the guidance...
Join us on Wednesday, March 14th for the webcast - "The SEC's New Cybersecurity Guidance" - to hear WilmerHale's Meredith Cross, Ropes & Gray's Keith Higgins and Jenner & Block's Dave Lynn discuss the SEC's brand new cybersecurity guidance.
As noted in this Reuters article, the Council of Institutional Investors has sent this letter to Corp Fin objecting to its recent no-action decision allowing AES Corp to exclude a shareholder proposal on the threshold required for investors to call a special meeting.
CII claims that AES is gaming the no-action process to exclude a shareholder proposal that typically receives substantial investor support — and urges the SEC to revisit its approach to Rule 14a-8(i)(9)(the "directly conflicts" exclusion basis) - so that it is more consistent with the language & intent of the underlying rule. CII says that AES's reasoning is reminiscent of the argument that Whole Foods used in '15 to exclude a shareholder proposal about proxy access. That ultimately prompted a Corp Fin review that led to Staff Legal Bulletin No. 14H as the appropriate guidance for determining the scope of Rule 14a-8(i)(9). Also see this Cooley blog...
It will be interesting to see if Equilar's new 'pay ratio' survey proves accurate after the proxy season - the survey predicts that companies will disclose a ratio of 140:1 on average. Here's the intro from the blog by Cooley's Cydney Posner about the survey results (see this related WSJ article):
Equilar has just released the results of an anonymous survey of public companies, with 356 respondents, which asked these companies to indicate the CEO-employee pay ratios they anticipated reporting in their 2018 proxy statements. As you would expect, there was a lot of variation among companies based on industry, market cap, revenue, workforce size and geography. In addition, because the rule provided significant flexibility in how companies could identify the median employee and in how they calculate his or her total annual compensation, variations in company methodology likely had a significant impact on the results.
These variations in the data underscore the soundness of the SEC's view, expressed at the time it adopted the pay-ratio rule, that the rule was "designed to allow shareholders to better understand and assess a particular [company's] compensation practices and pay ratio disclosures rather than to facilitate a comparison of this information from one [company] to another"; "the primary benefit" of the pay-ratio disclosure, according to the SEC, was to provide shareholders with a "company-specific metric" that can be used to evaluate CEO compensation within the context of that company.
Here's something that Broc recently blogged:
I'm calling it a "crisis" because periodic problems continue to happen - and the SEC continues to provide very little (if any) transparency around what is going on with Edgar. The last time that I blogged about Edgar problems was October - when I heard that offerings were being delayed and there were fee problems. I heard about this from a number of members - but the SEC never said a word about it.
Now I've heard through the grapevine that the filing deadline for Schedule 13G amendments on Valentine's Day caused some rough sledding for Edgar. Form 5s were due then too. Companies with 8-Ks, etc. couldn't get their filings through on Edgar. Again, not a word from the SEC. Same story told in these old blogs: "Edgar is Down? (Crickets)" - or this one: "EDGAR is Down": A Familiar Refrain?"
I've blogged about a simple solution for years - that the SEC launch an Edgar blog in which they indicate when Edgar is experiencing issues. And they then post follow-up blogs when the issues are resolved. Without this transparency, we are left to assume the worst. And given the high-profile hacking problems that the SEC has faced over the past year, you would think they would want to improve how they are perceived when it comes to handling this type of crisis communication...
This article quotes SEC Chair Jay Clayton as saying that he's "not anxious" to pursue a rule that would allow companies to adopt bylaws compelling their shareholders to arbitrate securities claims. As we've previously blogged, it's been suggested that such a move is under consideration by the SEC - but as we've also blogged, the idea has attracted heat from investor groups.
So, these comments suggest that this idea is likely dead, right? Not so fast. With a hot potato issue like this, we all probably read too much into prior reports suggesting that the SEC was ready to act, and we're probably reading too much into his remarks now.
After all, those comments were in response to the customary "beating about the head and shoulders" that Senator Elizabeth Warren administers to every financial regulator who testifies in front of the Senate banking committee. Sen. Warren demanded a "yes or no" answer on whether the Chair would support "eliminating class actions" - and his response beyond the "not anxious to see a change" sound-bite fell far short of that. Here's an excerpt:
"If this issue were to come up before the agency, it would take a long time for it to be decided, because it would be the subject of a great deal of debate. In terms of where we can do better, this is not an area that is on my list of where we could do better."
This FedNet video captures Jay Clayton's full testimony before the committee. The exchange with Sen. Warren begins at the 55:25 mark. The Senator didn't get the yes or no answer she was looking for - instead, she got one that seemed to say "I'm not prepared to die on this hill, but I'm not going to let myself be pinned down either."
Late last year, Attorney General Sessions issued a memo announcing his intention to curb the practice of "rulemaking by guidance." This King & Spalding memo says that the DOJ has acted to implement the AG's directive. Here's an excerpt summarizing the new policy:
On January 25, 2018, Associate Attorney General Rachel Brand issued a memorandum significantly restricting Department of Justice civil litigating units' use of executive agency guidance documents in affirmative civil enforcement actions. The Brand Memo outlines new policies for cases in which an executive agency previously issued relevant non-binding guidance, including:
- Reinforcing the long-standing principle that guidance documents are just that—recommendations for regulated industries;
- Emphasizing that guidance does not bind regulated parties or create new legal obligations beyond the scope of existing statutes and regulations;
- Precluding the Department from "effectively convert[ing] agency guidance into binding rules"; and
- Preventing Department lawyers from using noncompliance with guidance to establish violations of law.
The Brand Memo's potential impact is very broad, and it will influence any DOJ investigation that relies heavily on regulatory agencies' non-binding interpretive guidance, but the King & Spalding memo suggests that it may have a particularly significant impact in the life sciences sector - where DOJ attorneys have long leveraged guidance from the DHS's Office of the Inspector General and the FDA to support the government's claims.
We blogged a few weeks ago about BlackRock's desire for a quota of two women on every board. I'm glad that BlackRock is advocating for two women on every board - but I'm sad that an investor has to advocate for such a thing as quotas at all. There should be more than two women on every board - but it should happen naturally, just as it has happened in so many professions over the past 40 years or so. We'll get there.
Anyway, Allen Matkins' Keith Bishop told us about this bill recently introduced in California that would require at least three women on a board when the authorized number of directors is six or more. This bill would apply to public companies with their principal places of business in California, to the exclusion of the law of the state of incorporation...
Wasn't it was only yesterday that proxy access was one of the most hotly contested corporate governance issues? Now this Sidley memo says the game's pretty much over - and proxy access has become mainstream:
As of the end of January 2018, 65% of S&P 500 companies have adopted proxy access. Through the collective efforts of large institutional investors, including public and private pension funds and other shareholders, shareholders are increasingly gaining the power to nominate a number of director candidates without undertaking the expense of a proxy solicitation. By obtaining proxy access (the ability to include shareholder nominees in the company's own proxy materials), shareholders have yet another tool to influence board decisions.
Some of the 2017 developments noted in the memo suggest that not only is the concept of shareholder proxy access well-established, but investors and management are generally in accord on what it should look like:
- The continuing pace of proxy access bylaw adoptions and ongoing convergence toward standard key parameters (83% of companies that adopted proxy access in 2017 did so on the following terms: 3% for 3 years for up to 20% of the board (at least 2 directors) with a nominating group size limit of 20);
- Slightly increased average support (54% versus 51%) for shareholder proposals to adopt proxy access in 2017, but fewer proposals being voted on as more companies adopted proxy access in exchange for withdrawal of the proposals;
- The failure to pass of all shareholder proposals seeking specified revisions to existing proxy access provisions (so-called "fix-it" proposals) in 2017, despite favorable recommendations from ISS, which voting results suggest that many shareholders are satisfied with proxy access on market standard terms.
The memo also points out that Fidelity's shift from opposing to supporting proxy access shareholder proposals may seal the fate of many companies that receive such a proposal in the future.
It seems fair to say that given current trends, proxy access may soon become ubiquitous. Of course, one big question remains - is anybody ever going to actually use it?
This Morrison & Foerster blog highlights a recent Nasdaq proposal that would tinker with the rules governing when listed companies would have to go to their shareholders for approval of new stock issuances. Here's an excerpt summarizing the proposed changes:
The proposal would, among other things:
- Amend the measure of "market value" in connection with assessing whether a transaction is being completed at a discount from the closing bid price to the lower of: the closing price as reflected by Nasdaq, or the average closing price of the common stock for the five trading days preceding the definitive agreement date;
For some Nasdaq companies, this is kind of a big deal. Currently, listed companies need shareholders to sign off on any financing transaction (other than a public offering) that would result in the issuance of 20% or more of their outstanding shares at a price less than the greater of book or market.
Changing the rules to eliminate the reference to book value and shake out some of the effects of market volatility will enhance companies' ability to raise private money quickly - and doesn't seem to do violence to shareholders' interests either.
Here's the intro from this blog by Steve Quinlivan:
The SEC has approved a rule change to the NYSE listing standards to facilitate the listing of an issuer without conduction an IPO. According to the NYSE, the rule change is necessary to compete for listings that might otherwise by listed on NASDAQ.
As revised, the NYSE will, on a case by case basis, exercise discretion to list companies whose stock is not previously registered under the Exchange Act, when the company is listed upon effectiveness of a registration statement registering only the resale of shares sold by the company in earlier private placements.
In recent years, some prominent governance commentators have advocated that the SEC follow the lead of EU & UK regulators and eliminate mandated quarterly reporting. A recent study published in the March issue of "The Accounting Review" says that there's empirical data supporting the idea that the SEC should "lose the 10-Qs." Here's an excerpt from a recent American Accounting Association press release on the article:
With regulatory reform a high priority for the Trump administration, a new study focuses on one possible target - and it's a fat one - the half-century-old SEC rule mandating the filing of quarterly financial reports by public companies.
The EU and UK no longer require quarterly financials, and the question of whether the SEC should follow suit has evoked heated debate. While there has been plenty of theorizing about the subject, what has been absent until now is large-scale evidence of the advantages less frequent reporting offers to companies and their shareholders. The research challenge: How to compare the effect of reporting frequency when all U.S. companies have to file quarterly.
Now a study in "The Accounting Review," published by the American Accounting Association, finds a way around this problem by analyzing evidence from periods when reporting-frequency mandates changed in the U.S., permitting before-and-after comparisons to be made.
While acknowledging that, yes, there may very well be advantages in increased reporting frequency - such as lower cost of capital and more information for investors - the study concludes, crucially, that shorter reporting intervals engender "managerial myopia" which finds expression in a "statistically and economically significant decline in investments" along with "a subsequent decline in operating efficiency and sales growth."
Therefore, "our evidence...supports the recent decision by the EU and the UK to abandon requiring quarterly reporting for listed companies with an apparent intent to preventing short-termism and promoting long-term investments," write the study's authors, Rahul Vashishtha and Mohan Venkatachalam of Duke University's Fuqua School of Business and Arthur G. Kraft of the Cass Business School of City University London.
The study says that prior to the reporting mandates, firms that reported results at longer intervals had greater annual sales, annual sales growth and return on assets than firms that reported more frequently. By contrast, in the period three to five years post-mandate, sales and sales growth were about the same for the two groups, while the difference in return on assets narrowed significantly.
Of course, one of the truisms of corporate governance research seems to be that for every study that says "white," there's another that says "black." This MarketWatch article from last year suggests that the issue of reporting frequency is no exception.
Here's commentary from Lynn Turner:
There's a serious issue brewing at the PCAOB - and SEC - regarding auditor independence. This summary report issued by the PCAOB a few months ago about inspections conducted over 2016 year-end audits states on pages 14-15 that independence issues were found. That apparently caused the PCAOB to delay issuing inspection reports. Inspection reports for the Big 4 were issued in the August-November time-frame during the prior year. For 2017, only one report - about Deloitte - has been issued so far. This also highlights the periodic lack of transparency & timeliness of the PCAOB inspection process.
Fight Over Independence Disclosures
It's my understanding that PCAOB inspectors found independence violations by the audit firms that were not reported to either investors or audit committees. This would mean these violations were not reported in writing as required by PCAOB Rule 3526, as noted in the PCAOB's summary report. As an investor & audit committee member, I find this misleading disclosure to be troubling. Footnote 30 of the report (pg. 14) states: "PCAOB Rule 3520, Auditor Independence, requires auditors to satisfy all independence criteria applicable to an engagement, including the criteria in PCAOB rules and the criteria in the rules and regulations of the SEC."
The Big 4 firms have prepared a white paper - collectively - that they submitted as a group to the PCAOB and its inspection group. The firms are apparently arguing they should not have to make the necessary disclosures - and despite the violations, can still publicly tell investors they are independent. I understand that white paper hasn't been made public.
The firms argue that if they engage in a violation, they should be able to somehow "fix" the problem. But that is clearly not how the auditor independence rules work. The SEC has stated that the independence rules are prophylactic - so as to ensure investors can have trust & confidence in the audit. Yet, apparently in the instances found by inspectors, the auditors failed to notify the proper people (audit committee, PCAOB, SEC, investors) about the problems. Similar issues were found by regulators in the Netherlands a number of years ago, who found that one could not rely on the auditors to put in place "safeguards" for their independence, as the auditors put in place self-serving "remedies" in some cases.
The Use of Indemnification Clauses
The PCAOB's summary report also notes that auditors continue to put indemnification clauses in their audit engagement contracts - despite the fact the AICPA has a clearly stated rule, as does the SEC, that indemnification clauses are not permitted for public company audits. In the recent Colonial Bank case, the judge ruled that PWC had improperly included an indemnification clause in one of its engagement letters and was therefore not independent.
The SEC also brought an enforcement case against an auditor in Florida for including an indemnification clause in the audit engagement letter (the auditor's second enforcement action within a few years). It appears some auditors believe they can "slip one by" if no one notices these. In fact, to the PCAOB's credit, they have been citing auditors for violations of the professional standards and GAAS for indemnification clauses for a number of years. This raises the question of why doesn't the PCAOB take enforcement actions instead of just writing up the deficiencies in inspection reports. Clearly, the latter action is not having the necessary impact.
The SEC's independence rules (Regulation 210.2-03) have a provision to exempt an audit firm if an inadvertent violation occurs, The exemption applies provided the person or persons on the audit: (1) were not aware of the circumstances giving rise to the violation, (2) the firm had adequate internal controls for independence in place, (3) violation was promptly corrected, (4) the firm had a training program in place, and (5) had an enforcement mechanism in place. But the SEC's rules don't permit an exemption if at the time of the violation, the auditor knew - or should have known - they were violating the rules. Here's a lawsuit involving such an example.
The SEC & PCAOB rules are very clear. The auditor must follow the independence rules throughout the audit year. The firms are required to have training programs in place to require this. These rules are not new to anyone - and any professional knows they are serious and to be followed. In fact, GAAS states that a violation of independence is a violation of one of the ten primary "Generally Accepted Auditing Standards" - and that such a violation cannot be corrected through other auditing procedures.
Will the States Be Brought In?
It will interesting to learn if the PCAOB has involved the "National Association of State Boards of Accountancy" in these discussions as the State Boards each have independence rules which are built around compliance with the rules of the SEC, PCAOB and AICPA. If you can't trust an auditor to follow the laws & regulations, what can you trust them for? Particularly if they engage in covering up their violations.
Last month, the government shut down - but the SEC stayed open. Back then, we conducted a poll about whether folks cared if the SEC was closed.
Here's the results:
- 47% said they wouldn't notice
We continue to post new items daily on our blog - "The Mentor Blog" - for TheCorporateCounsel.net members. Members can sign up to get that blog pushed out to them via email whenever there is a new entry by simply inputting their email address on the left side of that blog. Here are some of the latest entries:
- SEC Continues to File Amicus Briefs in Support of Its "Whistleblower" Definition
Karen Garnett to Depart Corp Fin: Associate Director Karen Garnett has announced that she will depart Corp Fin after 23 years in the Division.
Kyle Moffatt Named Corp Fin's Chief Accountant: Corp Fin has announced that Kyle Moffatt would be the Division's Chief Accountant. Not surprising given that Kyle has been serving in that capacity since Mark Kronforst left last month. Mark has joined EY's National office in DC.
Former Congressman Scott Garrett to Join SEC Chair's Office: Here's the intro from this WSJ article by Dave Michaels and Andrew Ackerman:
Scott Garrett, a former Republican lawmaker known for criticizing what he considered government overreach by Wall Street regulators, has landed a senior role at the Securities and Exchange Commission. Mr. Garrett, 58 years old, plans to take a position advising SEC Chairman Jay Clayton, according to people familiar with the matter. The job would represent a second act for Mr. Garrett, whom U.S. senators rejected last year as a pick to lead the U.S. Export-Import Bank under the Trump administration.
The hiring is a rare instance of a former lawmaker joining a federal agency in a staff role. Mr. Garrett, first elected to Congress in 2002, lost a re-election campaign for his northern New Jersey House seat in 2016. As a lawmaker, he routinely questioned the SEC's regulations and priorities during the Obama administration.
SEC's Budget Seeks Cybersecurity Boost: The SEC has issued a press release announcing its proposed budget for fiscal 2019. Last fall, SEC Chair Jay Clayton told Congress that he'd seek more funding to boost cybersecurity and IT in the wake of disclosure that the Edgar system had been hacked - and he's a man of his word.
The proposed budget represents a 3.5% increase over the agency's 2018 request, and the bulk of the request for increased funding is directed at those areas. Here's an excerpt:
In furtherance of the objectives of the SEC's 2018-2020 Technology Strategic Plan, this request seeks an additional $45 million to restore funding for technology development, modernization, and enhancement projects. Together with the support of the SEC Reserve Fund, the FY 2019 request would allow the agency to continue implementing a number of multi-year technology initiatives.
Uplifting the agency's cybersecurity program is a top priority. The FY 2019 request would support increased investment in tools, technologies, and services to protect the security of the agency's network, systems, and sensitive data. Priorities for FY 2019 include maturation of controls through continuous diagnostics and monitoring, and further enhancements to firewall technologies. Another way the FY 2019 request helps reduce the agency's cybersecurity risk profile is by enabling the funding of multi-year investments to transition legacy IT systems to modern platforms with improved embedded security features.
Additional funding is also being sought for the restoration of 100 positions (50 FTEs) across various SEC divisions. The SEC's budget request assumes that it will continue to have access to its reserve fund - something that many Republican legislators & the Trump Administration have targeted for elimination.
Among other new additions, during the last month we have:
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