February 29, 2016

Management Representation Letters: Impact of AS #18

Here’s an excerpt from this great piece by Morgan Lewis’ Linda Griggs, Rani Doyle & Sean Donahue (also see this blog by Mike Gettelman):

Companies’ management should consider whether to add a materiality carve-out to the related party representations now being included in management representation letters as a result of the PCAOB’s Auditing Standard No. 18 (AS 18). AS 18 established “requirements regarding the auditor’s evaluation of a company’s identification of, accounting for, and disclosure of relationships and transactions between the company and its related parties” and is effective for audits of fiscal years ended after December 14, 2015.

The sample management representation letter for auditors to consider, which is set forth in Appendix A to AU Section 333, includes the following specific representations as a result of AS 18:

– Management has made available to auditors the names of all related parties and all relationships and transactions with related parties
– There are no side agreements or other arrangements (either written or oral) that have not been disclosed to the auditors

These representations are broad given the definition in the accounting literature of the term “related party,” which is applicable to AS 18 and the related management representation letter. The definition of “related party” included in the Master Glossary of the FASB’s Accounting Standards Codification includes affiliates of an entity, principal owners of an entity and members of their immediate families, management of an entity and members of their immediate families, and other parties that can influence an entity’s management or operating policies.

Please participate in this “Quick Survey on Auditing Standard #18: D&O Questionnaires.”

On Friday, CII announced that it hired Ken Bertsch to replace Ann Yerger as the Executive Director. Ken has served as head of the Society of Corporate Secretaries before his current job at CamberView…

Nasdaq’s Golden Leash Proposal: Commentary From In-House Counsel

As I’ve blogged, Nasdaq recently proposed a rule that would require listed companies to disclose third-party compensation arrangements of their directors/ nominees (while the proposed rule was rejected on technical grounds, Nasdaq plans to resubmit the proposal soon). I recently received this note from an in-house counsel:

Snapshot Summary

In short, this proposal would require Nasdaq-listed companies to publicly disclose (on their websites or in their proxy statements) compensation arrangements between activist stockholders and their director/director nominees. The proposal indicates that often times, such compensation arrangements are structured such that the director receives certain amounts from the activist if the company’s stock price increases by a certain amount over a specified time period. The concern of course is that undisclosed arrangements like these raise conflicts of interest and could interfere with those directors fulfilling their fiduciary obligations because they are incented to focus on short-term stock price results at the expense of long-term sustainable growth. The proposal recognizes that the company will only be able to disclose information that is provided to it (for example, in D&O questionnaires).


1. Overlap with Current SEC Rules

Arguably, third party compensation to directors for board service is already required to be disclosed under the SEC’s rules — and if clarification is needed on that, it could easily be provided by the SEC rather than being addressed in stock exchange rulemaking.

First of all, Reg SK, Item 402(a)(2) [entitled “All Compensation Covered”] requires “disclosure of all plan and non-plan compensation awarded to, earned by, or paid to …. directors.” Similarly, the specific provision requiring director compensation disclosure – Reg S-K, Item 402(k) – has no language limiting the disclosure to director compensation paid by the company. I don’t think it’s a stretch to say that the SEC provision covers compensation from whatever sources – i.e. the company and any other third parties. But presumably, an issue may be that the SEC’s rules are focused on compensation for the previous fiscal year – and these undisclosed activist arrangements (focused on stock price increase) could run past the fiscal year (and not result in any payment during that year).

But to that I say, let’s look at Form 8-K, Item 5.02(d)(2) that requires disclosure of “any arrangement or understanding between the new director and any other persons.” Wouldn’t that pick up the stock-price increase scenario? In case you say, “Not always – because that provision has a carveout for directors elected at an annual or special meeting,” I would point out that my understanding is that when companies settle with activists, they agree to put the directors on the board right away, and then they stand for re-election at the next annual meeting. So the Form 8-K would seem to pick up those arrangements.

I would also direct your attention to Reg S-K, Item 601(b)(10) [material contracts]. Even though most of us think this is limited to contracts to which the company itself is a party, the provision has more expansive language, picking up contracts in which the company “has a beneficial interest.” I don’t think it’s a stretch to argue that the company has a beneficial interest in a contract by a third party with a company director that rewards the director for an increase in the company stock price over a specified period of time, which would mean it would have to be disclosed under Item 601(b)(10)(ii)(A) or 601(b)(10)(iii).

Bottom line: I think it’s somewhat disingenuous for Nasdaq to have issued this proposal without any discussion about the existing SEC’s rules requiring disclosure of all compensation paid to directors. I think the better approach would just be for the SEC to clarify that its existing proxy statement rules regarding disclosure of director compensation cover third arrangements. Under that route, investors reading the proxy statements for NYSE- or Nasdaq-listed companies would be receiving comparable information when it comes to director compensation matters.

2. CII Letter – It’s not often I agree with CII, but they recently submitted a letter to the SEC asking that the proxy statement rules be clarified to require disclosure about compensation arrangements between nominees and those who nominated them. I agree with CII’s implicit suggestion that this subject matter falls within the purview of the SEC and should not be the subject of separate rulemaking by stock exchanges.

3. Sleeper Footnote #5 – Footnote #5 is a bit of a bombshell. It suggests that Nasdaq may propose to modify its director independence rules to provide that if a director receives compensation from third parties, s/he would not be considered independent. Whether it’s appropriate to adopt such a bright-line test would obviously be a very sensitive issue. My two cents worth is that it doesn’t make sense to establish this a bright-line test for director independence – but instead, the specific facts and circumstances of such arrangements should be considered by the Board when it’s making its independence determinations. The Nasdaq recently put out a survey to solicit input on this issue.

Nasdaq’s Survey: Third-Party Payments to Directors & Independence

As noted above, Nasdaq is running this survey that’s different – but clearly related to – to its Golden Leash proposal. The Golden Leash proposal relates to how companies will be required to provide disclosure about third-party director compensation arrangements. In contrast, Nasdaq’s survey is focused on the next part of this equation: the impact that these arrangements could have on director independence, with the Nasdaq asking for input on whether it should adopt rules to either prohibit directors that receive third-party payments from being considered independent directors under Nasdaq rules – or from serving on the Board at all. Nasdaq has not yet put out a proposal on this – and presumably will use the survey results to help form their opinion on this topic…

Broc Romanek