E-Minders July 2019
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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Although many of you know our work simply by the names of our "Essential Resources" - e.g. TheCorporateCounsel.net, CompensationStandards.com, Section16.net, DealLawyers.com and our related print newsletters - we're actually part of a company called "EP Executive Press" that was founded by Jesse Brill over 40 years ago (here's the last installment of Jesse's "reminiscences" when the company celebrated its 35th anniversary).
Now, we're entering another new chapter - with a parent-company rebranding to "CCRcorp." Our new name stands for "Corporate Counsel Resources" - but we'll forgive anyone who mixes us up with a certain '60s rock band, especially since we'll be "chooglin' on down to New Orleans" for our "Proxy Disclosure Conference" this September.
You may notice some logo changes - but rest assured, we'll be providing the same practical info...and when we can, we'll even make it entertaining.
In mid-June, the SEC announced that it's seeking input - via this 211-page concept release - on ways to "simplify, harmonize & improve the exempt offering framework." While this sounds like a pretty low bar given the complicated interplay of all the federal & state exemptions, we don't envy the staffers who might be tasked with crafting further changes that please everyone...and don't cause more confusion. Among the many topics discussed in the concept release, the Commission is considering whether:
- The SEC's exempt offering framework, as a whole, is consistent, accessible & effective - or whether the SEC should consider simplifications
- There should be any changes to streamline capital raising exemptions - especially Rule 506 of Reg D, Reg A, Rule 504 of Reg D, the intrastate offering exemption, and Regulation Crowdfunding
- There may be gaps in the SEC's framework that make it difficult for small companies to raise capital at critical stages of their business cycle
- The limitations on who can invest in exempt offerings, or the amount they can invest, provide an appropriate level of investor protection - versus making offerings unduly difficult for companies and/or restricting investors' access to investment opportunities (this includes a discussion of the "accredited investor" definition)
- The SEC can & should do more to allow companies to transition from one exempt offering to another - and ultimately to a registered public offering - without undue friction or delay
- The SEC should take steps to facilitate capital formation in exempt offerings through pooled investment funds - and whether retail investors should be allowed greater exposure to growth-stage companies through these funds
- The SEC should change exemptions for resales to improve secondary market liquidity
This Cooley blog notes that SEC Chair Jay Clayton & Corp Fin Director Bill Hinman have been laying the groundwork for this release in several speeches during the last year. And many of these ideas have been discussed (passionately) for years in securities law circles and at the SEC's annual Small Business Forum - so no doubt we'll see some pretty thorough comments over the next few months. The comment period ends in late September.
Over on Twitter, Professor Ann Lipton pointed out that the concept release has a great table of existing exemptions on pages 10-11 - and intel on how much money was raised last year under each type of offering. We'll be posting memos in our "Private Placements" Practice Area...
FOIA Exemption 4 protects "trade secrets and commercial or financial information obtained from a person [that is] privileged or confidential." However, most federal circuit courts have read in a "substantial competitive harm" test under which commercial information would be regarded as "confidential" only if its disclosure was likely to cause substantial harm to the competitive position of the person from whom it was obtained.
The substantial competitive harm requirement had its genesis in the D.C. Circuit's 1974 decision in National Parks & Conservation Association v. Morton, and the standard had been widely adopted by other courts. But earlier this week, by a 6-3 vote, the SCOTUS invalidated the requirement in Food Marketing Institute v. Argus Leader Media. Here's an excerpt from this Cleary Gottlieb memo that addresses the Court's reasoning:
Notwithstanding that the lower courts have followed National Parks in one form or another for 45 years, the Supreme Court roundly rejected it. Writing for six members of the Court, Justice Gorsuch criticized the D.C. Circuit's creation of the "substantial competitive harms test" based on its interpretation of legislative history as demonstrating a "casual disregard of the rules of statutory interpretation."
Food Marketing Institute held that a court must begin its analysis of statutory terms by referencing the ordinary meaning and structure of the law itself, and when this leads to a clear answer, the court must not go further. The Court found that because there is "clear statutory language" in FOIA, legislative history should never have been allowed to "muddy the meaning" of this language.
The decision should substantially reduce the burden associated protecting confidential information submitted to the government, but the memo says that it also raises questions about how agencies and courts will apply existing regulations that incorporate the "substantial competitive harm" test, and whether they will need to revise such regulations or attempt to justify disclosure decisions on other grounds.
The SEC is one of the agencies that will need to sort out how the SCOTUS's decision to eliminate the "substantial competitive harm" standard impacts existing rules. In that regard, here are some insights that Bass Berry's Jay Knight shared with us on how the Court's decision complicates the SEC's recently simplified CTR process:
As everyone may recall, in March the SEC adopted amendments to disclosure requirements for reporting companies, as mandated by the 2015 Fixing America's Surface Transportation Act (the "FAST Act"). Among the amendments was a simpler CTR process, which now allows registrants to omit immaterial confidential information from acquisition agreements filed pursuant to Item 601(b)(2) of Regulation S-K and material contracts filed pursuant to Item 601(b)(10) of Regulation S-K without having to file a concurrent confidential treatment request. In short, registrants are permitted to redact provisions in such exhibit filings "if those provisions are both not material and would likely cause competitive harm to the registrant if publicly disclosed." (emphasis added)
In the SEC's adopting release, the SEC notes that it slightly revised the language of the amendment in the final rule to refer to information that "would likely cause competitive harm" to "more closely track the standard under FOIA." (see page 25 of the adopting release) With the Supreme Court holding that FOIA exemption 4 does not have a competitive harm condition, it calls into question whether the "competitive harm" standard in Item 601 continues to be appropriate. (Other potential rules impacted are Exchange Act Rule 24b-2 and Securities Act Rule 406, which require that applicants for confidential treatment justify their nondisclosure on the basis of the applicable exemption(s) from disclosure under Rule 80, as well as Staff Legal Bulletin No. 1 and 1A, and Rule 83.)
Since that competitive harm standard is embedded in the SEC's rules, at this point the prudent path for companies appears to be to continue to adhere the requirements of those rules until the SEC provides further guidance.
The Staff has informally advised us that they are evaluating the potential implications of the Food Marketing Institute decision on Rule 24b-2, Rule 406 & other rules that involve confidential treatment requests under FOIA. However, the Staff does not believe that Item 601(b) is implicated by the decision, since the new procedures relate to situations in which information need not to be filed with the SEC, rather than situations in which companies are seeking to use FOIA exemption 4 to protect information that has been filed.
The SEC's private offering concept release includes a mandated Staff report on the impact of Regulation Crowdfunding on capital formation & investor protection. Here's the quotable stat:
From May 2016 (when the rule became effective) through the end of last year, there were only 519 completed offerings - mostly conducted by companies in California & New York - which raised a total of $108 million. During the same time period, 12,700 companies raised a total of $4.5 billion under Reg D.
The SEC does think the Regulation has been attracting new companies to the exempt offering market (rather than encouraging currently participating companies to switch exemptions). But that's not too surprising given all the downsides of the current rule compared to a more traditional fundraising approach. The concept release includes 13 multi-part questions about ways to make crowdfunding more of a crowd-pleaser.
Here's something that Alan Dye recently posted on his "Section 16.net" Blog:
The SEC has announced enhancements to the EDGAR system, one of which affects the submission of Form ID. New filers will now complete an updated online version of Form ID, which is accessible via a hyperlink from sec.gov. Filers will print out the completed version, for manual signature and notarization, and then upload the signed version for submission with the Form ID. The old "courtesy pdf copy" of Form ID previously available for use as an authenticating document has been removed from the SEC's website.
In mid-June, the SEC issued this 77-page adopting release to amend the auditor independence requirements in Rule 2-01 of Regulation S-X. The amendments impact the analysis of auditor independence when the auditor has a lending relationship with a client or its shareholders. Here's what the revised rule will do:
- Focus the analysis on beneficial ownership rather than on both record and beneficial ownership
- Replace the existing 10 percent bright-line shareholder ownership test with a "significant influence" test
- Add a "known through reasonable inquiry" standard with respect to identifying beneficial owners of the audit client's equity securities
- Exclude from the definition of "audit client," for a fund under audit, any other funds, that otherwise would be considered affiliates of the audit client under the rules for certain lending relationships
According to the SEC, the amendments will more effectively identify debtor-creditor relationships that could impair an auditor's objectivity and impartiality - as opposed to more attenuated relationships that don't pose threats & aren't important to investors.
PCAOB Rule 3526 requires auditors to communicate with audit committees concerning relationships that might impact their independence. In early June, the PCAOB issued guidance concerning the communications that are required under this rule when the auditor identifies one or more violations of applicable independence rules - but doesn't think the violations disqualify it from continuing to serve as the auditor. The PCAOB also issued this summary of the guidance. This excerpt from the guidance document details the disclosures required by the rule:
The Firm would comply with Rule 3526 by:
a. summarizing for the audit committee each violation that existed during the year;
b. summarizing for the audit committee the Firm's analysis of why, for each violation and notwithstanding the existence thereof, the Firm concluded that its objectivity and impartiality with respect to all issues encompassed within its engagement had not been impaired, and why the Firm believes that a reasonable investor with knowledge of all relevant facts and circumstances would have concluded that the Firm was capable of exercising objective and impartial judgment on all issues encompassed within the Firm's engagement;
c. if more than one violation existed during the year, providing to the audit committee a separate analysis of why, notwithstanding all of the violations taken together, the Firm concludes that its objectivity and impartiality with respect to all issues encompassed within its engagement has not been impaired, and why the Firm believes that a reasonable investor with knowledge of all relevant facts and circumstances would conclude that the Firm was capable of exercising objective and impartial judgment on all issues encompassed within the Firm's engagement;
d. engaging in dialogue with the audit committee regarding the violation(s) and the Firm's related analyses (as described in (a)-(c) above);
e. documenting the substance of the Firm's discussion(s) with the audit committee (as described in (d) above); and
f. affirming in writing to the audit committee that, except for the violation(s) expressly identified, the Firm would be independent in compliance with Rule 3520.
In a nutshell, the auditor must consider the impact of the violation or violations on its objectivity and impartiality. It then communicates that analysis to the audit committee, which makes its own decision about whether to continue to retain the audit firm.
There are several other components to the guidance, and one of the more interesting is the PCAOB's view that in this situation, the auditor "should not state in its required annual affirmation that the auditor is independent, but instead indicate that the auditor would be independent except for the violation or violations that it has identified and discussed with the audit committee."
However, the auditor may issue its report without altering the required title: "Report of Independent Registered Public Accounting Firm." The PCAOB views this as stating a legal requirement, and not a specific assertion of compliance with the applicable PCAOB rule.
We've blogged a few times (here's the most recent) about the SEC's enforcement action against a handful of companies that couldn't get their acts together when it came to addressing material weaknesses in ICFR. Now, this Audit Analytics blog says that some companies with material weakness disclosures extending over multi-year periods are including "Risk Factor" disclosure specifically addressing the risk of SEC enforcement resulting from their inability to resolve those issues.
This excerpt suggests that we're likely to see more disclosure along these lines as the year progresses:
It appears public companies are taking notice of the SEC's January statement that merely disclosing ICFR material weakness is not enough. This year we may see more companies disclose ineffective controls, and this is meaningful because of the SEC's scrutiny.
In conclusion, analysts and investors need to be on guard for more companies disclosing material weakness with ICFR. Further, they need to consider that admission of weak internal controls doesn't necessarily mean 2018 was the first year the firm had problems. It's possible historical filings could show years of ineffective ICFR.
While the Staff hasn't said much about MD&A requirements in recent years, we think most lawyers appreciate that it's really one of the cornerstones of the entire disclosure system. This recent blog from Bass Berry's Kevin Douglas offers up 12 things that you need to know when you're preparing your company's MD&A. Here's an excerpt with some tips on Item 303 of S-K's trend disclosure requirements:
A core disclosure component of Item 303 of Regulation S-K (which sets forth the SEC disclosure requirements applicable to MD&A) is the requirement to provide an analysis of known material trends, uncertainties and other events impacting a registrant's results of operations, liquidity or capital resources. Practice varies widely among registrants regarding the extent to which the disclosure of forward-looking statements is included in the MD&A.
While there may be reticence among some registrants to include overly expansive forward-looking disclosure (for example, based on concerns about liability exposure if such forward-looking information is not ultimately accurate), countervailing considerations include the fact that such disclosure may result in more useful disclosure as well as the fact that the failure to disclose known trends can give rise to exposure from Rule 10b-5 allegations from private parties as well as SEC civil actions.
The blog also points out that when companies include trend disclosure in their MD&A, they need to keep in mind that this disclosure may need to continue to be included and updated in subsequent periodic reports. Other topics include presentation and readability of MD&A disclosure, the interaction between MD&A and risk factor disclosure, and the use of non-GAAP financial measures in the MD&A.
Breach of fiduciary duty allegations premised on a board's failure to fulfill its oversight obligations are notoriously difficult to establish. One reason that these Caremark claims are so tough to make is that a plaintiff needs to show "bad faith," meaning that the directors knew that they were not discharging their fiduciary obligations. But in mid-June, in Marchand v. Barnhill, (Del. Sup.; 6/19), the Delaware Supreme Court overruled the Chancery Court and held that - at least for purposes of a motion to dismiss - a shareholder plaintiff stated a viable Caremark claim.
The case arose from a 2015 listeria outbreak at Blue Bell Creameries. In addition to being implicated in the deaths of three people, the outbreak resulted in a recall of all of the company's products, a complete production shutdown, and a lay-off involving 1/3rd of its workforce. Ultimately, the financial fallout from this incident prompted the company to seek additional financing through a dilutive stock offering.
As a result, the plaintiff brought a derivative action against the board & two of the company's executives. The plaintiff alleged that the board failed in its oversight duties, but the Chancery Court rejected those allegations. The Supreme Court disagreed, holding that the plaintiff had alleged shortcomings in board level oversight sufficient to survive a motion to dismiss:
When a plaintiff can plead an inference that a board has undertaken no efforts to make sure it is informed of a compliance issue intrinsically critical to the company's business operation, then that supports an inference that the board has not made the good faith effort that Caremark requires.
Since Marchand involved a motion to dismiss, it's hard to tell whether the case suggests that Caremark may be a more viable path to imposing liability than it has been in the past - but it's worth noting that this decision is the second case in the last two years in which a Delaware court has characterized a Caremark claim against directors as being "viable."
Check out the latest report from BarkerGilmore - a boutique executive search firm - about in-house counsel compensation trends. Among the findings:
- The average annual salary increase rate for all positions across industries increased to 4.4%, up 0.6% from the previous year.
- 41% of all respondents believe their compensation is below or significantly below that of their peers in other organizations, with labor & employment lawyers and insurance reporting the greatest dissatisfaction.
- 38% of respondents indicate that they would consider a new position within the next year due to compensation issues, 3% less than the previous year.
- Public company lawyers make more than private company lawyers, and public company GCs make a lot more - 41% more to be precise.
- On average, female in-house counsel earn 85% of what male in-house counsel earn. The disparity is largest at the General Counsel level, with a 17% gap, 5% smaller than the previous year.
On a personal note, when we saw BarkerGilmore's press release on the study, we noticed that they were headquartered in Fairport, NY. This charming canal town is the hometown of the late Philip Seymour Hoffman, who once described it as being "like Kansas, if Kansas was in New York." Why do we know so much about this little upstate New York burg? Well, our very own John Jenkins also called it home.
Under the attorney conduct rules adopted by the SEC following Sarbanes-Oxley, there are limited circumstances under which attorneys may be obligated to "report out" - i.e., blow the whistle to the SEC - on client misconduct. These obligations are not consistent with many states' ethics rules, but the SEC brushed those concerns aside by saying that its rules preempted those standards. Now, according to this recent "Dimensions" article, the federal courts are starting to weigh in:
A California federal court held that in-house counsel could be a whistleblower under the federal statutes because the SEC rules preempt the state's very strict duty of confidentiality. The case is on appeal and, the authors surmise, the holding will be limited because counsel reported internally, not to the SEC, before being fired (and thus falling outside the Dodd-Frank definition of a whistleblower).
Timing is also key to a case now pending in the Eastern District of Pennsylvania. In-house counsel seeks Dodd-Frank protection from retaliation for reporting to the SEC while still an employee. The company has counterargued that, prior to the report, it gave notice that counsel would be fired. A decision in the District of New Jersey denied Dodd-Frank protection to an attorney fired for reporting to FINRA, rejecting the argument that this was tantamount to reporting to the SEC, which supervises FINRA, while still employed.
The article notes that the 9th Circuit subsequently remanded the California federal court's decision, affirming it in part and remanding it in part. This Sheppard Mullin blog has more details on the case.
While lawyers may get tied-up in ethical knots for decades over whistleblower issues, for those who are unencumbered by such concerns, the SEC recently provided another example of just how lucrative whistleblowing can be. Late last month, it announced a $4.5 million award to a whistleblower, but as this excerpt from the SEC's press release points out, this award had a unique fact pattern:
The whistleblower sent an anonymous tip to the company alleging significant wrongdoing and submitted the same information to the SEC within 120 days of reporting it to the company. This information prompted the company to review the whistleblower's allegations of misconduct and led the company to report the allegations to the SEC and the other agency. As a result of the self-report by the company, the SEC opened its own investigation into the alleged misconduct.
Ultimately, when the company completed its internal investigation, the results were reported to the SEC and the other agency. This is the first time a claimant is being awarded under this provision of the whistleblower rules, which was designed to incentivize internal reporting by whistleblowers who also report to the SEC within 120 days.
As we blogged at the time, in 2018 the SCOTUS held that purely internal whistleblowers weren't entitled to the protections of Dodd-Frank. Concerns were subsequently expressed that the decision would incentivize people to go to the SEC before the company was even aware of the potential problem.
That didn't happen here - but because the whistleblower dropped a dime on the company to the SEC within 120 days of making an internal report, the person was credited with the results of the company's investigation. As the SEC's release noted, the policy establishing that 120 reporting period was intended to promote internal reporting, and in this case, it seems to have worked.
This WSJ article says that whistleblower lawyers are skeptical that this will be anything more than a one-off event, and that since internal whistleblowers are at risk for retaliation without Dodd-Frank's protections, blowing the whistle to the SEC first is likely to remain the preferred path.
Remember the movie Network? There's that great scene in which Ned Beatty's character, CEO Arthur Jensen, regales Howard Beale with his fire & brimstone "corporate cosmology" speech. It's his vision of a world led by "one vast and ecumenical holding company, for whom all men will work to serve a common profit, in which all men will hold a share of stock, all necessities provided, all anxieties tranquilized, all boredom, amused. . ."
If that's your cup of tea, then we've got great news for you - a recent study says that fulfillment of Arthur Jensen's vision may be right around the corner. Here's an excerpt from a recent FT article:
BlackRock, Vanguard and State Street Global Advisors are on course to control four votes out of every 10 cast at large US companies, as regulators and policymakers probe the wider consequences of their increasing dominance of the investment market. The influence of the Big Three, which have mopped up trillions of dollars of index investments in recent years, is being viewed by politicians as a possible antitrust issue. BlackRock, Vanguard and SSGA, which collectively manage more than $14tn, account for a quarter of votes cast at S&P 500 companies. This is set to grow to 34% over the next 10 years, and 41% in 20, according to academics at Harvard Law School.
Now, apparently the authors of this study are concerned that having 3 asset managers control 40% of the S&P 500 will make them unduly deferential to management(!) All we can say is, we sure hope so - because it seems to us a far more likely scenario is some variation of "Kneel before Zod!"
At a recent meeting of the Twin Cities Chapter of the Society for Corporate Governance, Dorsey's Bob Cattanach shared details on California's Consumer Privacy Act - or as he called it, "the single most difficult cyber development in the US over the last decade."
With the legislation set to become effective next January, Bob & other litigators are predicting a surge in class actions for companies that do business in that state. That's because the provision that allows consumers to recover up to $750 in damages per incident makes it much easier to show that the breach caused injury (and as this Womble Bond Dickinson chart says, a pending amendment may even allow consumers to sue for violations other than data breaches). So plaintiffs' firms are lining up - and there's reason to think twice about automatically treating any cyber incident as a "breach," before you're certain that breach notification & disclosure requirements have been triggered.
Bob noted that practicing mock breach scenarios under your "incident response plan" is now all the more important. With so much more soon to be at stake, you will need to anticipate the challenges of assessing your many overlapping disclosure obligations, and the likely lack of sufficient & reliable information necessary to make decisions under increasingly shortened time periods, in advance.
Recently, ISS ESG (the "responsible investment" arm of ISS) announced its annual ratings of ESG performance for companies across the globe. At first glance, things look good:
This year's report finds the share of companies covered by ISS' Corporate Rating and assessed as "good" or "excellent" (both assessments lead to Prime status) now stands at 20.4 percent, up from just over 17 percent in the previous year. This year's report also shows that the group rated with medium or excellent performance (on a four-category scale of poor, medium, good or excellent) now includes more than 67.5 percent of covered companies in developed markets. This represents an all-time high over the 11-year history of the report. Similar patterns can be observed among companies in emerging markets, the report finds, albeit at a considerably lower level.
But the jury's still out on whether companies are following through on the sustainability strategies that they're touting. We've blogged that CSR statements might serve as the basis for plaintiffs' claims - and the ISS ESG analysis confirms that these types of disputes are on the rise. Here's an excerpt:
Meanwhile, Norm-Based Research, which identifies significant allegations against companies linked to the breach of established standards for responsible business conduct, saw a more than 40 percent rise in the number of reported controversies across all ESG topics. This exemplifies a growing misalignment of corporate practices with stakeholder expectations that are grounded in UN Global Compact and the OECD Guidelines for Multinational Enterprises.
At the close of 2018, failures to respect human rights and labour rights together accounted for the majority (56 percent) of significant controversies assessed under ISS ESG's Norm-Based Research. Industries that are most exposed to controversies in the environmental area are Materials, Energy, and Utilities. On social matters, Materials is also leading, similarly followed by Energy and Capital Goods. The governance area sees most controversies within Banks, Capital Goods, and Pharmaceuticals & Biotechnology.
Among other new additions, during the last month we have posted the following:
Allison Lee Confirmed as SEC Commissioner: In late June, the Senate confirmed former SEC Staffer Allison Lee to serve as SEC Commissioner - and the SEC published this congratulatory note.
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