E-Minders March 2020
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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In mid-February, the SEC issued a public statement on the effects of the coronavirus on financial reporting. In late January, John blogged about Chairman's Clayton's statement addressing disclosure implications from the coronavirus outbreak.
The February statement said SEC Chairman Clayton, Corp Fin Director Hinman, SEC Chief Accountant Teotia and PCAOB Chairman Duhnke met with the leaders from the Big 4 audit firms to continue discussions around difficulties in conducting audits in China and other emerging markets. In these discussions, they also discussed the "potential exposure of companies to the effects of the coronavirus and the impact that exposure could have on financial disclosures and audit quality, including, for example, audit firm access to information and company personnel." Here's an excerpt from the SEC's statement:
The coronavirus effects on any particular company may be difficult to assess or predict, because actual effects may depend on factors beyond the control and knowledge of issuers. However, how issuers plan and respond to the events as they unfold can be material to an investment decision, and we urge issuers to work with their audit committees and auditors to ensure that their financial reporting, auditing and review processes are as robust as practicable in light of the circumstances in meeting the applicable requirements.
Specifically, we emphasized: (1) the need to consider potential disclosure of subsequent events in the notes to the financial statements in accordance with guidance included in Accounting Standards Codification 855, Subsequent Events and (2) our general policy to grant appropriate relief from filing deadlines in situations where, in light of circumstances beyond the control of the issuer, filings cannot be completed on time with appropriate review and attention. In addition, if issuers have questions regarding the reporting of matters related to the potential effects of the coronavirus, including potential subsequent event disclosure, we welcome engagement on these matters.
The SEC's statement says that companies are encouraged to contact the SEC regarding any need for relief or guidance.
It looks like the SEC didn't waste much time in finding its big company poster child for key performance indicators (KPI). In mid-February, the SEC issued a press release announcing an enforcement proceeding where it brought charges against Diageo plc for disclosure failures. The enforcement proceeding is right on the heels of the SEC's KPI interpretive release that John blogged about at the end of January. Here's the crux of what the SEC had to say:
According to the SEC's order, employees at Diageo North America (DNA), Diageo's largest and most profitable subsidiary, pressured distributors to buy products in excess of demand in order to meet internal sales targets in the face of declining market conditions. The resulting increase in shipments enabled Diageo to meet performance targets and to report higher growth in key performance indicators that were closely followed by investors and analysts. The order finds that Diageo failed to disclose the trends that resulted from shipping products in excess of demand, the positive impact the overshipping had on sales and profits, and the negative impact that the unnecessary increase in inventory would have on future growth. The order further finds that investors were instead left with the misleading impression that Diageo and DNA were able to achieve growth in certain key performance indicators through normal customer demand for Diageo's products.
Without admitting or denying the findings in the SEC's order, Diageo agreed to cease and desist from further violations and to pay a $5 million penalty.
You can find memos about the SEC's KPI interpretive release posted in our "MD&A" Practice Area.
Well, it didn't take long for the Division of Enforcement to focus everybody's attention on the SEC's recent guidance on the use of key performance indicators in MD&A, did it? This Fried Frank memo focuses on how that guidance may influence the use of ESG metrics in MD&A. While the guidance itself only references ESG metrics in a footnote, this excerpt says that what it had to say about them is consistent with recommendations of some well-known sustainability frameworks:
Although the Metrics Guidance is largely silent with respect to ESG metrics as a specific category, it does note that some companies "voluntarily disclose environmental metrics, including metrics regarding the observed effect of prior events on their operations." In a footnote, the Metrics Guidance provides examples of metrics to which the guidance is intended to apply, which include a number of ESG metrics, such as total energy consumed, percentage breakdown of workforce, voluntary and/or involuntary employee turnover rate and data security breaches.
While the Metrics Guidance addresses ESG metrics only via footnote, it is consistent with the recommendations in certain voluntary sustainability frameworks that require both qualitative and quantitative disclosure associated with ESG metrics. For example, SASB's Conceptual Framework notes that sustainability metrics should be accompanied by "a narrative description of any material factors necessary to ensure completeness, accuracy, and comparability of the data reported."
In addition, the TCFD recommendations note that reporting companies should provide metrics on climate-related risks for historical periods to allow for trend analysis and, where not apparent, should provide a description of the methodologies used to calculate the climate metrics. Similarly, both SASB and TCFD emphasize the importance of having effective disclosure controls and governance, as well as verifying ESG data (by third-party auditors, if possible).
As the memo also points out, many companies have been criticized by stakeholders for using ESG metrics that aren't "easily comparable, decision-useful, and verifiable." The new guidance on MD&A key performance indicators heightens the stakes for these ESG disclosures, and companies that don't respond appropriately may face a bigger downside than complaints about "greenwashing."
In February, the SEC issued an order granting accelerated approval of Nasdaq's amended proposal to change the definition of a "family member" for purposes of determining director independence under Nasdaq's Listing Rules. Under the new definition:
"Family Member" for purposes of determining whether a director is independent under Nasdaq Rule 5605(a)(2) means a person's spouse, parents, children, siblings, mothers and fathers-in-law, sons and daughters-in-law, brothers and sisters-in-law, and anyone (other than domestic employees) who shares such person's home. As stated by Nasdaq, the purpose of the proposed rule change is to exclude domestic employees who share the director's home, and stepchildren who do not share the director's home, from the types of relationships that always preclude a finding that a director is independent.
This Cooley blog from Cydney Posner discusses more of the details as the new definition leaves the board to determine whether stepchildren not residing at home with the director still have a relationship with the director that could interfere with the director's exercise of independent judgment.
With everybody's 401(k) plan smarting from the stock market's belated realization that the coronavirus epidemic was actually a thing, this Nelson Mullins memo seems particularly timely. It takes a deep dive into the potential disclosure issues that the ongoing outbreak may raise for public companies. As this excerpt demonstrates, the memo is a great resource for issue spotting:
The impact of CV may have repercussions on a number of disclosure areas, including liquidity and capital resources, sources and uses of funds, gross and net revenues in the short, medium and long term, and other economic and noneconomic, personal and ESG considerations. Enhanced or additional risk factor disclosure related to CV pursuant to Regulation S-K Item 105 may be needed if it is or becomes one of the most significant factors that make an investment in the company or any offering speculative or risky.
Since SEC disclosure is increasingly principles-based, even if there is not a rule specifically dealing with a situation that a company may find itself in related to CV, the principles of full and fair disclosure apply. Companies should be mindful that their planning for uncertainties that may arise as a result of CV and their response to events as they unfold may be material to an investment decision, and should plan accordingly.
Consider other situations where disclosure of material nonpublic information may be necessary, such as if senior management or boards become impaired and are unable to serve or whether a "material adverse change" in "prospects" has occurred or is reasonably likely to occur. Business interruption insurance policies may be triggered. "Act of God" provisions may be applicable. Contract disputes may occur over CV related matters. Professionals should review and update insider trading policies, blackout periods and trading activity monitoring in light of new information related to CV.
As if that wasn't enough, the memo also addresses a variety of other legal issues that may arise as a result of the outbreak, including potential labor and employment law, privacy, and even cybersecurity considerations.
It really is difficult to get your arms around the sweeping legal & business implications of the coronavirus epidemic. This Cleary Gottlieb memo picks up on one of the topics alluded to in the Nelson Mullins memo - the potential inability of companies to perform their contractual obligations due to the impact of the epidemic on supply chains. This excerpt addresses the potential availability of the "force majeure" clause to provide relief from contractual liability:
Force majeure clauses seek to define circumstances beyond the parties' control which can render performance of a contract substantially more onerous or impossible, and which may suspend, defer or release the duty to perform without liability. They can take a variety of forms but most list a number of specific events (as well as more general 'catchall' wording to make clear the preceding list is not exhaustive) which may constitute a "Force Majeure Event" and excuse or delay performance, or permit the cancellation of the contract.
Matters such as war, riots, invasion, famine, civil commotion, extreme weather, floods, strikes, fire, and government action (i.e. serious intervening events that are outside the control of ordinary commercial counterparties) are typically included within the scope of Force Majeure Events.
The memo reviews how courts in the U.K., the U.S. & France have interpreted these clauses, and also discusses how common law doctrines of frustration and impossibility of performance may come into play in situations involving U.K. or U.S. contracts. It also touches on the right of parties to contracts entered into after October 1, 2016 under French civil law right to renegotiate those contracts based on a change in circumstances.
Last month, John blogged about the first 10-K filing to include a coronavirus risk factor. As concerns about the virus's economic impact have continued to grow, a total of 26 companies have included a risk factor or, in some cases, MD&A disclosure about the virus in their 10-K filings. This Audit Analytics blog reviews those disclosures. Here's an excerpt:
While the economic effects of the Wuhan coronavirus are still unknown, it makes sense that the majority of references to the disease have been included in the Risk Factors section of a company's 10-K. Most of the language seen thus far discusses the uncertainty of the disease's effects on global macroeconomic conditions, production capabilities, and decreases in international travel; this is similar language used surrounding other risk factors such as political unrest, natural disasters, and terrorism.
However, some companies have discussed the impact of the coronavirus in the Management's Discussion & Analysis (MD&A) section of the 10-K, indicating that some companies expect to experience significant effects. For example, Carnival Corp [CCL] disclosed in their MD&A that the travel restrictions as a result of the outbreak could have a material impact on financial performance:
Fiscal Year 2020 Coronavirus Risk
Other companies that have mentioned coronavirus in the MD&A section include Mondelez International, Inc. [MDLZ], Mettler-Toledo International, Inc. [MTD], and Las Vegas Sands Corp. [LVS].
If you're looking for disclosure precedent (who isn't?), the blog names all 26 companies that have included 10-K disclosure about the coronavirus to date. And to demonstrate that there's nothing new under the sun, the blog also includes a chart with the number of companies that included 10-K disclosure about other recent international public health emergencies.
Responding to SEC comment letters can be tricky, so it's always nice to read tips from Corp Fin on how to make the response process more efficient. This Deloitte memo summarizes Staff comments at a recent AICPA conference, which were aimed at helping companies respond to comment letters. Here's an excerpt:
– Provide the Staff with contact e-mail addresses for the responding company and its outside counsel
– Before providing courtesy paper copies, ask the reviewer if copies are needed or will be used.
– Clearly and directly address the issues raised in the comments.
– Share views on materiality with the Staff early in the process to increase overall efficiency
– Don't assume that the SEC has accepted an item solely because it has been reported similarly in another company's filing
– When calling the Staff with an interpretive or procedural question, don't assume that the Staff has all the facts. Responding companies should do the appropriate research, provide sufficient background information, and present an analysis that points to relevant authoritative literature
– Communicate the intended use of novel transactions up front
– Call the Staff to discuss or get clarification on a Staff comment
A recent paper from Stanford's Rock Center notes that while most insider trading policies are designed to prevent violations of law, companies need to ask whether their existing insider trading policies need to cover more ground in order to be consistent with good governance practices. Here's an excerpt:
Despite procedures designed to ensure compliance with applicable rules, news media and the public tend to be suspicious of large-scale executive stock sales.7 This is particularly the case when a sale occurs prior to significant negative news that drives down the stock price.
Public suspicion is exacerbated by inconsistent and nontransparent corporate practices - such as, lack of communication around why the sale was made, whether the general counsel approved the trade in advance, and whether the trade was the result of a 10b5-1 plan - and differing opinions about what constitutes "material" nonpublic information. Thus, an executive stock sale might pass the legal test but fail the "smell test" employed by the general public. A well-designed ITP lessens the likelihood of such a scenario.
The paper reviews 4 real-life vignettes involving insider transactions that, if not illegal, sure didn't look very good. It raises a number of governance issues, like why companies don't always make their insider trading policies public, mandate the use of 10b5-1 plans by senior execs or require pre-approval of all trades by the general counsel?
A shareholder proponent has filed a lawsuit against a Montana energy company in an attempt to ensure the proponent's proposal is included on the company's proxy ballot. The proposal asks the company to end using coal-fired generation of electricity from a power plant it operates no later than the end of 2025 and to replace the electricity with non-carbon emitting renewable energy.
The lawsuit follows the company's no-action request to the SEC on grounds that the proposal relates to the company's ordinary business operations and that the proposal contains materially false or misleading information about the company's carbon emission rate. As shown in the SEC's chart detailing SEC responses to shareholder proposal no-action requests, the SEC has "no view" and indicates that litigation is pending.
Last year, Liz blogged about how the NYC Comptroller filed a lawsuit as it sought to ensure a proposal related to greenhouse gas emissions would be included on a company's proxy ballot. In that case, SEC correspondence shows the company withdrew its no-action request and included the proposal on its ballot. Voting results for the company's shareholder meeting show the proposal failed to receive majority support.
Time will tell how the proponent fares in federal court for the district of Montana and/or whether the company relents and includes the proposal on its ballot. The company's no-action request says that the company intends to file its proxy materials on or about March 6, 2020 – stay tuned.
With D&O insurance premiums on the rise & more Section 11 suits being filed in plaintiff-friendly state courts, IPO companies and their directors & officers face an increasingly hostile environment. This Wilson Sonsini memo points out that for some companies, a direct listing may provide a practical solution for avoiding Section 11 liability by making it impossible to satisfy the statutory requirement to trace the shares purchased to those sold in the offering. This excerpt explains why:
In a direct listing, no shares are sold by the company and therefore no capital is raised. Rather, a company files a registration statement solely to provide certain of its existing shareholders, such as early stage investors and employees, the ability to resell their shares directly to the public.
The existing shareholders include both those whose shares are registered pursuant to the company's registration statement and those whose shares are exempt from the registration requirements of the securities laws. The shareholders have complete discretion about whether to sell their shares and all are equally able to sell shares upon the company's direct listing – i.e., starting from the moment of the opening bell.
There are no initial allocations: any prospective purchaser can place orders with their broker of choice. Because both registered and unregistered shares are available for sale upon the company's direct listing and the sales are conducted through anonymizing brokerage transactions, it is not possible for any purchaser to trace the particular shares she bought back to the registration statement covering the direct listing. Accordingly, no purchasers have standing to assert an offering claim under the '33 Act.
Before we all get too carried away, the memo also points out that this is a fix that only works for those few cash-rich unicorns that don't need to raise capital in an IPO. But the memo says there's another potential fix that could work for the rest of the pack – with a little cooperation from their underwriters. How? Just tweak the shareholder lockups to allow some shares to be sold into the market in exempt transactions simultaneously with the IPO. That would also make tracing of shares to the IPO impossible. Well, at least until Blockchain ruins things for everybody. . .
When it comes to "cyber response plans," the planning stage is a lot more useful if it's actually been tested. A blog discussing the recently issued SEC OCIE Cybersecurity and Resiliency Observations says if you're not practicing what to do when you experience a cyber attack, you're not being realistic about your chances of effectively responding to it.
Although the SEC OCIE observations are primarily directed toward broker-dealers and investment advisors, the recommendations seem worthwhile for any company, one being testing and monitoring:
Establishing comprehensive testing and monitoring to validate the effectiveness of cybersecurity policies and procedures on a regular and frequent basis. Testing and monitoring can be informed based on cyber threat intelligence.
It also recommends testing the incident response plan and potential recovery times, using a variety of methods including tabletop exercises. If an incident occurs, implement the plan and assess the response after the incident to determine whether any changes are necessary.
This recent blog from McGuireWoods is helpful because it summarizes how to run an effective tabletop exercise to test your response plan. Here's a few recommendations:
– Objectives – set ground rules for the exercise, who speaks first, is there a budget for the response, level of detail to be provided, determine the focus of the exercise – detection, containment, etc.
– Evaluation – think about how to evaluate the exercise, identify a note-taker during the exercise, detail the evaluation process
– Full participation – ensure key participants coordinated their responses, ensure contractual partners are included, determine who has authority to resolve disagreements
– An experienced facilitator – bringing in an experienced facilitator can help ensure all areas have a voice and that the exercise stays on track so the result is measurable
Lynn blogged about the importance of testing a cyber response plan. Another great planning tool is reviewing and analyzing a real life example of how another company handled disclosure and response to a data breach.
Thanks to Jay Knight at Bass, Berry & Sims for sending along this blog that does just that – it walks through Chegg, Inc.'s disclosure and response to a 2018 data incident. The blog includes the back and forth between Chegg, Inc. and Corp Fin as they worked through the comment letter process. It's a quick, helpful read – topics covered in the exchange between Chegg, Inc. and Corp Fin include:
– Timing of public disclosure
– Disclosure controls and procedures
– Materiality of the incident
– Remedial actions
We recently mailed the January-February issue of "The Corporate Counsel" print newsletter (try a no-risk trial). The topics include:
– Annual Season Items
Among other new additions, we have posted:
The following memos & insights:
Nancy Sumption Named Senior Advisor to the Chairman for Cybersecurity Policy: The SEC announced in February that Nancy Sumption will serve as Chairman Clayton's Senior Advisor for Cybersecurity Policy. In the role, Sumption will coordinate efforts across the agency to address cybersecurity policy, engage with external stakeholders on matters related to cybersecurity, and help advance mechanisms for assessing and responding to cyber-related risks. Sumption, after holding positions in government service, held positions in cybersecurity, information governance, and privacy in the healthcare and finance sectors and at the MITRE Corporation.
Remembering Former SEC Chairman David Ruder: Many of us in corporate and securities law mourn the February 15th passing of Former SEC Chairman, David Ruder. The Commission issued a public statement on Former Chairman Ruder's passing and noted that "those who served with him often remark on his intelligence, candor and love for the Commission." Ruder was a leading scholar in corporate and securities law and in addition to serving as Chairman of the Commission from August 1987 to September 1989, Ruder served as Dean of Northwestern University's Pritzker School of Law from 1977 to 1985.
Antonia Chion, Associate Director of Division of Enforcement to Retire: At the end of February, the SEC announced that Antonia Chion, Associate Director of the Division of Enforcement is retiring after 32 years of service at the agency. In the press release announcing Chion's retirement, Chairman Clayton said "Toni's expertise, experience and commitment to her colleagues and our mission is a model for staff across the Commission. Equally important to her leadership, Toni has been a teacher and mentor to many at the Commission. Her unwavering commitment to the SEC and to getting to the right result for investors will leave an enduring legacy." Chion received several recognition awards during her years of service including the Stanley Sporkin Award, the Distinguished Service Award and the Scott W. Friestad Award.
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