With Sarbanes-Oxley in the rear-view mirror for 4 years now, one would think that this would have been a quiet year for corporate governance developments. To the contrary, it was arguably the most dramatic year of change in recent history. Here is a snapshot of some of the more significant developments:
– The majority-vote movement matured at an incredible pace. Within the span of a single year, over half of the Fortune 500 adopted some form of policy or standard to move away from pure plurality voting for director elections. This trend is likely to continue as it’s the governance change that investors seek the most.
– An area not touched by Sarbanes-Oxley – executive compensation – continued to be inspected under a microscope by both investors and regulators. The SEC adopted sweeping changes to its compensation disclosure rules and investors became more willing to challenge companies that continue outlandish compensation policies. And House Democrats intend to consider executive compensation legislation early in 2007. [Today’s WSJ and Washington Post contain articles in which Rep. Barney Frank expresses displeasure over the SEC’s recent change in its exec comp rules – and we have announced a January 11th webcast just on these new changes. More on all this next week.]
– More and more hedge funds and private equity funds found “value” in using governance as an entree into forcing management to alter strategic course or to put a company into “play.” The recent hiring of Ken Bertsch, a former TIAA-CREF governance analyst who had been working for Moody’s, by Morgan Stanley is an indicator that using governance as a “big stick” is likely to continue.
– The recent sale of the two primary proxy advisory services – ISS and Glass Lewis – at handsome premiums is a pretty good indicator that governance as a skill set can be quite profitable.
– The re-opening of the SEC’s “shareholder access” proposal – spurred by a recent 2nd Circuit decision – was unthinkable a year ago. But it’s now reality.
– The proposed elimination of broker votes in 2008 – via a rulemaking from the NYSE – means that the 2008 proxy season promises to be the wildest yet. But 2007 surely will be wild enough.
One thing we know for sure – we can’t predict what the New Year will bring! Happy Holidays!
Some Thoughts from Professor John Coffee
In an interview with the Corporate Crime Reporter, Professor John Coffee waxes on problems with the McNulty Memo and the Paulson Committee Report.
A Conservative Year for Holiday Cheer
Fried Frank took it easy in this year’s annual festive message. Each year, the firm issues an alert at the end of the year which focuses on a true – and zany – government prosecutorial act. No food fraud to report on this year…
More and more members are e-mailing me their stories (or posting their queries in the Q&A Forum) regarding their challenges in getting a PIPEs registration statement processed by Corp Fin. Today’s WSJ includes this article about how the Staff is “increasingly reluctant to sign off on transactions involving “private investments in public equity.”
Deputy Director Marty Dunn is quoted as follows: “We have not told anyone that they cannot do these deals, we’ve just told them that they have to register them appropriately.” Mr. Dunn says SEC staffers hope to provide clarification early next year on when registrations for shares issued in connection with PIPE transactions may be done in a secondary offering, and when a primary offering would be needed.
As the article notes, it doesn’t help that the Enforcement Division is having success finding insider trading involved in some of these deals. The D&O Diary Blog covers the latest Enforcement developments regarding PIPEs – and the “SEC Actions Blog” has an interesting discussion of the latest Enforcement case against Friedman Billings Ramsey that involves a unique theory.
Problems with Empty Voting
From ISS’ “Corporate Governance Blog”: Reuters ran an article recently entitled “MergerTalk: Hedge Funds Find New Ways to Sway Votes,” which looks at the practice of empty voting. The practice of “empty voting” entails borrowing shares prior to a record date, which then gives the borrower the voting rights. Once the record date has passed, the borrower returns the shares and effectively controls a large number of votes without a continuing economic interest. Some critics say this creative share borrowing is being done to manipulate voting outcomes and seriously undermines corporate governance transparency for large shareholdings.
The story specifically cited hedge fund’s ability to purchase over-the-counter (OTC) equity swaps, obtaining large blocks of shares for voting without any true ownership. Holders are also not required to disclose their current assets in OTC swaps, nor are the banks that structure the swaps. Henry Hu, a University of Texas Law Professor, recently came out with a study on the practice of share lending and empty voting and is advocating fixing the disclosure system to make this practice more transparent.
Industry and academic focus is growing on instances where manipulating the vote is the objective, but similar problems can exist through normal sharelending, even if the motivation is benign. What are your thoughts on the practice of share lending and its impact on voting as well as the practice of “empty voting”…widespread problem or an anomaly to be watched?
A Boom Year for Mergers and a Furious Pace for Law Firms
On Friday, the NY Times ran this article about how busy law firms were doing deals this year. It notes the impact this has had on associate bonuses and quotes one partner on how he recently had to do his first all-nighter. Geez, I did all-nighters pretty regularly when I was at my law firms (and even do them occasionally in this job). My favorite quote was from Peter Lyons: “If you’re an M.& A. lawyer and you’re not busy now, it’s time to find something else to do for a living.”
In a surprise move, the SEC adopted interim final rules late Friday, which more closely conform the amounts reported for stock-based awards in the Summary Compensation Table and other tables to the expense for such awards reflected in financial statements as dictated by FAS 123(R). These new rules go into effect for this coming year, as they are effective upon publication in the Federal Register. Note that the SEC is also soliciting comment on these rule changes, so it’s possible that the SEC may take further action addressing them (including their effective date). Here is the SEC’s press release – and here is the adopting release.
This holiday gift from the SEC has a hint of Festivus to it. Perhaps a feat of strength from the Commission? Or a subtle way for the agency to air a grievance?
What The New Rules Mean for You: Modifications to Align with FAS 123(R)
The purpose of the SEC’s new rules is to more closely align the SEC’s disclosure requirements with the accounting dictates of FAS 123(R). The bottom line of these new rules for us means that the value of equity awards granted in a particular year will now be spread out over a number of years instead of all in the year of grant – and this will change who are the highest paid executive officers when determining NEOs.
So the good news is that the new rules should reduce anomalies arising from one-time grants and are more consistent with other parts of the SEC’s compensation disclosure rules (such as reporting cash compensation as it is accrued or as performance goals are met). But the bad news is that a lot of companies have already done a lot of work preparing to make disclosures under what suddenly are “old” rules – and under the new rules, companies will have to reassess who are their “Named Executive Officers.”
The rule changes will impact the value of equity awards that are reportable in the Stock Awards and Option Awards columns of the Summary Compensation Table, as they will now be amortized over the same period – and in the same manner – as they are accounted for under FAS 123(R) (with some exceptions; for example, the SEC requires a “no forfeiture” assumption in the case of service-based awards for SCT purposes – so if a company’s FAS 123(R) expense assumes any service-based forfeitures for the NEOs, the SCT amount and the corresponding amount in the financials will differ). Under the new rules, there likely also will be changes in the amounts disclosed in the Grants of Plan-Based Awards Table as well as the Director Compensation Table.
– a luncheon speech from Commissioner Annette Nazareth, given before the ABA’s Committee on Federal Regulation of Securities a few weeks ago
PCAOB Inspections: PwC’s Turn in the Barrel
The AAO Weblog does a good job describing PricewaterhouseCooper’s new PCAOB inspection report that was issued last week. Here is an excerpt from Jack Ciesielski’s blog:
“It found that the firm’s quality control was lacking in some audits: revenue and receivables at one audit client were inadequately tested, for one example. When the auditors repaired their audit, they increased the confirmations of accounts receivable by a factor of ten. On other engagements, the firm had failed to test impairment charges, various aspects of inventory and fair values of investments. PwC acknowledged the deficient audits and remedied them.
One could look at the report – and the one issued on Deloitte & Touche last week as well – and get the idea that the Big Four are out of control. And certainly, it’s bound to be spun that way in the press.
No apologies here for their mistakes – they don’t even sound like they’re failures involving extremely vexing issues. But it’s not an unfair question to ask all involved: what do you expect a regulator like the PCAOB to do? How can you expect them to inspect the Big Four each year and NOT find something? After all, their existence has to be justified as well – and if there are tens of thousands of audit engagements occurring each year, they’re not all going to be pristine. One would believe there’s plenty of meat for the PCAOB to chew if it wants to find it.
The fact that there’s a PCAOB inspection lurking in the bowels of each Big Four firm each year probably raises the quality of each employee’s work over what it would be in the absence of an inspection machine. But just because the PCAOB doesn’t bring one member of the Big Four to its knees each year doesn’t mean it’s not doing its job, either. Hopefully, if one of the Big Four goes off the rails into a swamp of total audit sleaze, the PCAOB mechanism is there to get them back onto the rails. Because it hasn’t happened yet, investors should be glad.”
Options Backdating Study: “Lucky” Directors Reap Benefits Too
Check out Harvard Law School’s new “Corporate Governance Blog” – and not to just read about the latest option backing study that has been in the media this week, co-authored by Professors Lucian Bebchuk, Yaniv Grinsten and Urs Peyer. The new study – entitled “Lucky Directors” – focuses on 800 seemingly backdated options at 460 companies involving 1400 independent directors. The key findings of the study are that, out of all director grants during 1996-2005, 9% fell on days with a stock price equal to a monthly low – and 3.8% of these grants were “super-lucky,” taking place at the lowest stock price of a quarter.
Maybe this is why IBM announced it will eliminate option grants to directors yesterday? I tend to doubt it as aligning shareholders’ interests with directors’ interests still makes sense…
Personal note: The holiday miracle at work: “Rocky Balboa” gets two thumbs up! I’m not kidding, the critics are liking this movie – a pretty good indicator about how bad movies were this year overall. Happy Festivus to you and yours!
As the FEI’s “Section 404 Blog” notes in its summary of the PCAOB’s action yesterday: One board member referred to the proposed rule as “AS5,” although standards are not assigned numbers until final. So perhaps it’s farewell old AS #2, we knew you more than we ever cared to…
– What forensic basics should in-house lawyers have a handle on to help prevent fraud?
– What are some examples of how lawyers can spot accounting fraud trouble?
– What types of documentary evidence should lawyers be looking for?
– If a lawyer spots trouble, how can they determine whether their CFO or someone else in the Controller’s office may be involved?
Another Proxy Advisor Sold: Glass Lewis
On the heels of ISS being sold last month, rival proxy advisor Glass Lewis is being acquired by Xinhua Finance, a Chinese financial media company. At the end of summer, Xinhua purchased an initial 19.9% of Glass Lewis and now plans to purchase the remaining 80.1% in early 2007. Given the influence of ISS and Glass Lewis on voting issues, these deals are noteworthy…
Yesterday’s WSJ carried an interesting article regarding interim CEOs and CEO succession planning (or more accurately, lack thereof). As I have pointed out a few times, the last remaining key area of corporate governance untouched by the reform wave of the past 5 years is CEO succession planning. It’s such a critical task for boards to perform, yet it is rarely done – and it was very hard for me to locate a company that actually had something in writing! I have added this sample CEO succession plan (in a Word file) to our “CEO Succession” Practice Area and our “Sample Documents” Portal.
404 Extension: Traps for the Unwary
Regarding last week’s release that further postpones the 404 compliance date for non-accelerated filers, thanks to Mike Kaplan of Davis Polk and John Newell of Goodwin Procter for the following traps for the unwary:
– If you become accelerated or large accelerated during the extension period, the postponement relief no longer applies (the same caution the SEC gave us last time)
– The extension for non-accelerated filers is for companies who are not accelerated filers at the end of the applicable year (so if you have a $55 million float in May, you need to decide whether you think your float may go up to $75 million by June 30th, in which case you now have just 6 months to finish 404 compliance – or you need to decide to spend money now, just in case your stock goes up)
– If you go public early in a year (pre-2/15 for US companies; pre-3/31 for FPIs) off of 9-month numbers, your first annual report (on which you get a pass) is the one you file within a few months after you go public; you are then subject to 404 in your next annual report, which is due the following year and covers a period before you went public (this may force people to delay 1st quarter IPOs or to spend money on SOX work before they are even public)
Tis the Season to Renew
As all our memberships are on a calendar year basis, don’t forget to renew them before the end of next week. You can renew all of our publications in our “Renewal Center” located at the top right of TheCorporateCounsel.net home page.
On Friday, the SEC issued an adopting release to provide for the extension proposed in August to push back the internal controls compliance dates for non-accelerated filers – such date is pushed back from annual reports for fiscal years that end on or after July 15, 2007 to annual reports for fiscal years that end on or after December 15, 2007. This is the 4th “reprieve from the guv’nor” for non-accelerated filers.
The SEC also extended the date by which a non-accelerated filer must begin to comply with the auditor attestation requirement – now that is not required until they file annual reports for fiscal years ending on or after December 15, 2008. This provides time to consider what will be in new (and improved) Auditing Standard No. 2, as well as any implementation guidance that the PCAOB plans to issue for auditors of smaller companies. Any company that provides only a management report – and not an auditor attestation – must state in the annual report that it doesn’t include the auditor’s attestation and that the company’s auditor has not attested to management’s report. The management report filed without the auditor attestation will be considered “furnished” rather than “filed.”
Both of these actions were adopted by the Commission in seriatim and were basically adopted as proposed. The SEC’s press release includes a nifty compliance date chart…
SEC Provides 404 Relief for New ’34 Act Reporters
As part of the same adopting release, the SEC gave relief from the Section 404 requirements for newly public companies by providing them with a transition period so that they can skip 404 for the 1st annual report that they file after becoming a ’34 Act reporting company. Any company that has become public through an IPO (equity or debt), a registered exchange offer or otherwise has become subject to the ’34 Act reporting requirements for the first time (eg. a newly registered foreign private issuer) can avail itself of this transition period. Any company that uses this transition period will need to include a statement in its first annual report that it doesn’t include either a management’s report or an auditor attestation.
And the SEC also posted its revised mutual fund governance proposal that reopens the comment period for its June 2006 proposal to enable the public to comment on two papers prepared by the SEC’s Office of Economic Analysis that will be made public by including them in the comment file at some point. The comment period is 60 days from the date that the second paper is placed on file…
– What were the key findings from The Boston Club’s report on women directors?
– Why should companies include more women on boards?
– How can companies looking for qualified director candidates find the right female candidates?
On Tuesday, Department of Justice Deputy Attorney General Paul McNulty announced major changes to the DOJ’s policies outlined in the 2003 Thompson Memorandum. In essence, this so-called “McNulty Memorandum” supersedes the “Thompson Memorandum” and “McCallum Memorandum.” Here are prepared remarks of Deputy Attorney General McNulty and a DOJ press release.
The two key policy shifts outlined in the “McNulty Memorandum” are (i) federal prosecutors must now obtain written approval before seeking a waiver of the attorney-client privilege and work product protection and (ii) prosecutors generally may not consider a corporation’s payment of legal fees to employees in determining a company’s cooperation.
The McNulty Memorandum spends considerable time addressing waiver issues, taking a more thoughtful approach to requests for waivers of the attorney-client privilege compared to the DOJ’s recent approaches – but skeptics remain. For example, one member notes that he is somewhat skeptical of the distinction that they make between “non-factual attorney work product” (Category II) and factual information that “may or may be privileged” (Category I). If it’s work product, then it should all be worthy of the same level of consideration.
Does Senator Specter’s New Bill Still Have a Purpose?
Beating the McNulty Memo by nearly a week, Senator Arlen Specter (R-Pa and outgoing chair of the Senate Judiciary Committee) introduced a bill on December 7th – the “Attorney-Client Privilege Protection Act of 2006” – that would curtail many of the hotly contested issues raised by the Thompson Memorandum.
Senator Specter’s legislation would prohibit federal prosecutors from using a company’s waiver of attorney-client privilege, and other factors, to determine the level of cooperation while it is under investigation. In part, the proposed legislation states:
“In any Federal investigation or criminal or civil enforcement matter, an agent or attorney of the United States shall not—
(1) demand, request, or condition treatment of the disclosure by an organization, or person affiliated with that organization, of any communication protected by the attorney-client privilege or any attorney work product;
(2) condition a civil or criminal charging decision relating to a organization, or person affiliated with that organization, on, or use as a factor in determining whether an organization, or person affiliated with that organization, is cooperating with the Government —….”
While the McNulty Memo establishes that failure to comply with a DOJ request for waiver should not be held against a company in determining cooperation, the new Memo appears to still be viewed by some as “encouraging” the culture of waiver. Accordingly, the cooperation debate now is focused on whether the guidelines and procedures of the McNulty Memorandum go far enough to address the concerns of Sen. Specter and business organizations so that the Specter Act would be unnecessary…
SEC Speaks at the AICPA Conference
At the annual AICPA National Conference that wrapped up in DC Wednesday, a number of SEC Staffers from the Office of Chief Accountant gave speeches, including these:
I didn’t attend the shindig but I did run a few of my accountant friends to the airport afterwards. They said that this year’s AICPA Conference did not include any “big reveals” from any of the regulators. By the way, anyone notice the global warming on the East Coast? I have been driving with the top down for a week…
At the meeting, there were only a few surprises (but note that reading the releases – whenever they’re posted – often brings more surprises). Most people already had a head’s up regarding the change to a single trading volume test for purposes of FPI deregistration and there were no real surprises in connection with internal control guidance (other than that the SEC didn’t address the status of the August 2006 proposal to extend the 404 compliance deadlines for non-accelerated filers and create a SOX 404 transition period for IPO filers; apparently that will be approved seriatim by the Commissioners soon). By seriatim approval, the SEC re-opened the comment period on proposals to enhance the independence and effectiveness of investment company directors (and the proposing release will include economic analyses of mutual fund governance and independence issues by the SEC’s Office of Economic Analysis).
In this speech, Commissioner Campos identified some of the changes that the PCAOB is expected to make in the new standard to replace AS #2 next week:
– Scalable (meaning that smaller companies can scale the standard to meet their facts and circumstances)
– Streamlined (meaning intended to achieve maximum efficiency and cost effectiveness)
– Organized to make clear that management should perform their assessment from the top down (not bottom up)
– The new standard is supposed to be about 1/3 of the length of AS #2
– Supposed to be in plain English
Quite a few law firm memos have already emailed notes on the internal controls aspect of this meeting, including this one from Sidley Austin, and we will be posting them in the “Internal Controls” Practice Area.
The Adoption of E-Proxy – and a Proposal to Make It Mandatory
For me, the most surprises came in the e-Proxy initiative. It was no surprise that the earliest that companies and other persons can use e-Proxy is the compliance date of July 1, 2007 – but it was surprising that the SEC went on to propose that e-Proxy be mandatory. After speaking to a handful of companies about whether they would take advantage of e-Proxy, a few smart ones had calculated the thresholds for when its cheaper to continue to mail in paper (using bulk mail rates) rather than mail first class (to meet the “3 business day” requirement) to those that request paper (and incur the administrative headaches of maintaining a separate list for those shareholders who request paper). The thresholds were quite a bit lower than they had assumed before they went through this exercise. Companies should conduct their own calculations and see if it’s worth submitting a comment letter on this proposal.
Under the adopted e-Proxy framework, a company may deliver online to satisfy proxy material obligations if it:
– Posts its proxy materials on a website, and
– Provides a plain English notice at least 40 days before the shareholder meeting, which includes the URL of where the proxy materials are posted and a toll free number and email address to enable shareholders to request paper copies.
Brokers, banks and similar intermediaries can deliver proxy materials using e-Proxy, with the notice and paper delivery provided through them.
Here are a few changes from what the SEC had originally proposed:
– A proxy card may not accompany the notice – but a proxy card may be delivered 10 days after delivery of the notice if accompanied by a second copy of the notice
– Shareholders can request paper delivery just one-time that would apply to all future meetings; they don’t have to request it on a per-meeting basis
– Once a shareholder requests paper, the must send the proxy materials within 3 business days after receiving the request (the proposal had been 2 business days)
– Third-parties who use e-Proxy must send a notice by the later of 40 days before the meeting or 10 days after the company filed its proxy materials – and must honor shareholder requests for paper delivery
Commissioner Campos stated that he viewed e-Proxy as a first step toward shareholder access. Commissioner Nazareth stated that while she was supportive of e-Proxy, she wanted further study of its impact before moving to shareholder access. No one else commented on the interplay between e-Proxy and shareholder access.
John W. Jones Legal Education Fund
In memory of my good friend and former Corp Fin Staffer, John Jones, Radio One and Minority Media and Telecommunications Council have created the “John W. Jones Legal Education Fund.” Donations, which are fully tax deductible, should be made to the “John W. Jones Legal Education Fund” and sent to:
Minority Media and Telecommunications Council
3636 16th Street, NW
Washington, DC 20010
A few weeks ago, the PCAOB released the first auditor inspection reports of this year; reports for Deloitte & Touche, BDO Seidman and Grant Thornton. These inspection reports were released a bit behind the schedule of reports released in past years (eg. last year, Deloitte’s report was released in late October) – leading some companies to criticize the PCAOB because they want to see how their auditors are performing before re-hiring them for next year.
The reports highlight some serious shortcomings in audits performed by these auditors. In some cases, the problems identified by the PCAOB were so significant that they resulted in the auditor’s clients making changes in their accounting or disclosure practices. Last year, the PCAOB found problems with the audits of 8 Deloitte clients; this year that number rose to 17.
Perhaps one reason it took so long for the PCAOB to issue these reports are the strong objections mentioned in this WSJ article by all three of the auditors. It also appears some of these differences of view arose due to the auditors not having clearly documented what they did do (or conversely, what they did not do). For example, Deloitte disagreed with the PCAOB’s conclusions in nearly two-thirds of the audits cited (their rebuttal is included as part of a response letter included with the PCAOB’s report).
SEC Proposes Changes to Regulation M and Regulation SHO
Last week, the SEC issued a proposing release regarding amendments to Rule 105 of Regulation M. The proposed amendments would prohibit a person that has effected a short sale during the Rule 105 restricted period from purchasing securities in the offering.
The SEC also issued a proposing release that would amend the short sale price test by removing restrictions on the execution prices of short sales as well as prohibiting any SRO from having a price test. In addition, the SEC proposed to amend Regulation SHO to remove the requirement that a broker-dealer mark a sell order of an equity security as “short exempt” if the seller is relying on an exception from a price test.
A Peak at Today’s SEC Commission Meeting?
A lot of last minute conjecture on how the SEC will handle internal controls during today’s open Commission meeting (here is the agenda). FEI’s “Section 404″ Blog does a nice job capturing some of the scuttlebutt, like this speech from PCAOB Chair Mark Olson and yesterday’s WSJ article. We shall soon see how reality shakes out…
IRS Guidance: Section 16 Persons Who Don’t Cure Discounted Stock Options by Year-End
Last week, the IRS issued Notice 2006-100 to provide interim guidance to employers regarding their reporting and withholding obligations for calendar years 2005 and 2006 with respect to deferrals of compensation and amounts includible in gross income under Section 409A. This WilmerHale alert summarizes the effect of the interim reporting and withholding guidance on persons subject to the disclosure requirements under Section 16, including:
– Section 16 persons are required to include the option spread on vested options as of December 31 in income for each such year, to the extent not previously included in income;
– The amount included in income is subject to the 20% Section 409A penalty tax and interest, in addition to regular income and employment taxes; and
– Employers and payers are required to report the option spread on vested options for each such year to the extent not previously reported; however, employers are only required to withhold income and employment taxes with respect to such amounts for 2006. No withholding of the Section 409A penalty tax or interest is required.