When it comes to “general” versus “specific” risk factors, the Orrick team of JT Ho, Carolyn Frantz, Bobby Bee and Hayden Goudy share a reminder that “specific” is better.
In addition to the growing number of ESG-related risk factors, we’ve seen an increase in the number of ESG-related risks specific to the reporting company’s business, rather than “general” or “other” risks. The increase in specific ESG-related risk factors is consistent with guidance from 2019 in which the Securities and Exchange Commission (“SEC”) “eschewed ‘boiler plate’ risk factors that are not tailored to the unique circumstances of each registrant.” See below for an example ESG-related risk factor specific to the reporting company’s business compared with an example ‘general’ ESG-related risk.
Example Specific Risk Factor
Costs of Compliance with Environmental Laws are Significant, and the Cost of Compliance with New Environmental Laws, Including Limitations on GHG Emissions Related to Climate Change, Could Adversely Affect Cash Flows and Financial Condition
Our operations are subject to extensive federal, state and local environmental statutes, rules and regulations. Compliance with these legal requirements requires us to incur costs for, among other things, installation and operation of pollution control equipment, emissions monitoring and fees, remediation and permitting at our facilities. These expenditures have been significant in the past and may increase in the future. We may be forced to shut down other facilities or change their operating status, either temporarily or permanently, if we are unable to comply with these or other existing or new environmental requirements, or if the expenditures required to comply with such requirements are unreasonable.
Compare that to a “general” ESG risk factor:
Example General Risk Factor
Catastrophic events may disrupt our business which could have a material adverse effect on our business, financial condition, and results of operations.
Our business, financial condition, results of operations, access to capital markets and borrowing costs may be adversely affected by a major natural disaster or catastrophic event, including civil unrest, geopolitical instability, war, terrorist attack, the effects of climate change, or pandemics or other public health emergencies such as the recent COVID-19 outbreak, and measures taken in response thereto. In the event of a major disaster or event impacting any of our locations, we may be unable to continue our operations and may endure system interruptions, reputational harm, delays in our application development, lengthy interruptions in our services, breaches of data security and loss of critical data, all of which could have a material adverse effect on our business, financial condition, and results of operations.
To estimate the increase in the specificity of ESG-related risk factors, we reviewed the headings used to categorize each risk factor in the annual report and assumed that risk factors in the “General” or “Other” category were non-specific, while risk factors that were in other categories (such as “Legal and Regulatory Risks” or “Market and Industry Risks”) were specific to the reporting company’s business. This assumption is not true in every case, but we believe it is a good proxy. Following this methodology, for fiscal year 2019, 43% of the S&P 500 had a specific ESG-related risk factor, which increased to 80% for fiscal year 2021. This chart shows the percentage of the S&P 500 with a specific ESG-Related Risk Factor in the annual report (by fiscal year):
Rounding out the intel on ESG-related risk factors, the Orrick team of JT Ho, Carolyn Frantz, Bobby Bee and Hayden Goudy break down the variety of climate-related risk factors that are appearing in S&P 500 disclosures:
Climate-related risks accounted for most ESG-related risk factors in the S&P 500, with a significant increase in the number of companies reporting climate related risks since 2019. 82% of companies in the S&P 500 reported climate-related risks in fiscal year 2021, compared to just 45% for fiscal year 2019. For the 20% of companies in the S&P 500 which have already filed an annual report for fiscal year 2022, 85% had climate-related risk factors.
Most climate-related risk factors were specific to the reporting company’s business. The most common type of climate-related risks reported for fiscal year 2021 were physical risks related to business operations, with 45% of companies identifying operational risks including potential disruptions in the supply chain due to climate related events and the direct exposure of company assets and operations to more severe hurricanes and wildfires. 15% of the S&P 500 disclosed climate-related legal and regulatory risks for fiscal year 2021. We expect this percentage to increase for fiscal year 2022 given the SEC’s proposed climate-related disclosure rules (the “Proposed Rules”) which are expected to be finalized this year, and the European Union’s Corporate Sustainability Reporting Directive (the “CSRD”), which went into effect this year. Companies should engage with counsel to understand how the Proposed Rules and CSRD may affect their reporting practices and risk-related disclosures.
Climate-related risk factors are also becoming more prevalent across industries. For fiscal year 2019, only three industries had more than 50% of their companies report a climate-related risk; energy and transportation (82%), real estate and construction (63%), and manufacturing (56%). By fiscal year 2021, a large majority in every industry across the S&P 500 reported a climate-related risk. Here’s the percentage of the S&P 500 (by industry) with a specific Climate-Related Risk Factor in the annual report (by fiscal year):
Not every company will have ESG- or climate-related risk factors. But regardless of your industry, if you do not have a process in place to identify material company-specific ESG-related risks, especially climate-related risks, there is a potential that your risk management processes and disclosures will fall behind market practices.
On Friday, the SEC announced a $35 million settlement with Activision Blizzard for findings that it failed to maintain disclosure controls related to complaints of workplace misconduct – and separately, that it violated the whistleblower protection rule. The SEC’s 7-page order rests on two main allegations by the SEC. The press release summarizes:
According to the SEC’s order, between 2018 and 2021, Activision Blizzard was aware that its ability to attract, retain, and motivate employees was a particularly important risk in its business, but it lacked controls and procedures among its separate business units to collect and analyze employee complaints of workplace misconduct. As a result, the company’s management lacked sufficient information to understand the volume and substance of employee complaints about workplace misconduct and did not assess whether any material issues existed that would have required public disclosure.
Separately, the SEC’s order finds that, between 2016 and 2021, Activision Blizzard executed separation agreements in the ordinary course of its business that violated a Commission whistleblower protection rule by requiring former employees to provide notice to the company if they received a request for information from the Commission’s staff.
For the disclosure controls aspect of this settlement, the SEC focused on the company’s risk factors and cautionary language in Forms 10-K & 10-Q. The SEC didn’t allege that any particular statement was materially inaccurate or misleading – the problem in the SEC’s view was that shortcomings in how workplace-related information was collected and communicated to the company’s disclosure committee prevented the disclosure decision-makers from evaluating whether disclosure on this topic was needed. SEC Commissioner Hester Peirce dissented from both aspects of the order. Here’s her objection to the alleged “disclosure controls” violation:
In other words, the required disclosure controls and procedures must capture not only information that a company is required to disclose, but also an additional, vaguely defined category—information “relevant” to a company’s determination about whether a risk or other issue reaches the threshold where it is “required to be disclosed.”
She continues:
The requirement cannot be that a company’s disclosure controls and procedures must capture potentially relevant, but ultimately—for purposes of disclosure—unimportant information. As I read it, in this Order, the SEC once again has sat down at the gaming console to play its new favorite game “Corporate Manager.” Using disclosure controls and procedures as its tool, it seeks to nudge companies to manage themselves according to the metrics the SEC finds interesting at the moment. For Activision Blizzard, today, that metric is workplace misconduct statistics, but other issues will follow. In this level of the enforcement game, the SEC has added $35,000,000 to its point total despite the Order not identifying any investor harm.
The settlement comes at a time when the SEC has signaled that it may propose more prescriptive human capital disclosure rules in response to investors wanting more comparable info on that topic. Those rules are not yet in place, but the Enforcement Division already appears to be interested in the principles-based aspects of that topic.
Regardless of whether you find yourself nodding along with Commissioner Peirce, this settlement is another reminder that “workplace misconduct” continues to be a topic that requires board attention, appropriate oversight & information collection, and careful disclosures. The whistleblower component of the action also suggests you should take a fresh look at your separation terms. As this Cooley blog notes, this stuff is no longer just “employment lawyer” territory – you should have a cross-functional team.
Recall that last month, the SEC brought an enforcement action against McDonald’s to allege that the company mischaracterized the nature of the former CEO’s separation from service by not acknowledging that purported workplace misconduct was “cause.” (Commissioners Peirce & Uyeda dissented and said they believed the SEC was rewriting Item 402 disclosure requirements through an enforcement proceeding.) Two weeks later, the Delaware Court of Chancery allowed a fiduciary duty claim to proceed against McDonald’s HR head, finding at the motion to dismiss stage that if all the facts alleged by the plaintiff were true, the officer consciously ignored red flags and didn’t put in place reasonable information systems to report to the CEO & board. And while Activision settled an EEOC claim last year for a lower amount than this SEC matter, that company continues to face litigation in state court.
Many practitioners are taking the inclusion of the Dodd-Frank clawback checkboxes on the Form as confirmation that they are required on filings to be made this spring, and interpreting the SEC’s late-January CDI as guidance that you simply don’t need to mark the boxes. As I blogged on CompensationStandards.com, concerns linger – specifically, that including the checkboxes without marking them is a disclosure in and of itself and could be misleading. We heard informally last week that Corp Fin may issue additional guidance on this point, if it continues to cause consternation. But when it comes to “The Great Checkbox Debate of 2023,” one thing is pretty clear: you’re unlikely to face consequences from the SEC for any sort of perceived foot-fault this year.
Whenever the SEC issues a Form, it includes an “estimated average burden hours per response.” That’s because the Paperwork Reduction Act requires federal agencies – including the SEC – to estimate the compliance burden for any reporting or recordkeeping requirements. There’s always a section about this at the back of SEC proposals and adopting releases, although practitioners rarely comment on it. For the latest Form 10-K, the estimated burden is 2,255 hours!
1. The hours figure is intended to capture both internal & external hours, and isn’t limited to legal compliance (i.e., it also includes the compliance efforts of finance, treasury, auditors, etc.).
2. Although the Paperwork Reduction Act is a very important procedural requirement for SEC rulemaking, it’s difficult for companies to parse out the effort that goes into preparing a specific form – because it is just one component of a year-round integrated governance and disclosure process.
Dave blogged last week that you’ll need to make sure your insider trading policy is ready for “prime time” in light of the increased transparency that will result from the SEC’s recently adopted rules on on Rule 10b5-1 and insider trading (here are memos that lay out the requirements).
There’s been some confusion around when exactly a copy of these policies will need to be filed as an exhibit. With all of the other triage happening on securities compliance right now, people have been asking, “how urgent is this?”
At the Northwestern Pritzker School of Law’s Securities Regulation Institute last week, Corp Fin Director Erik Gerding said the Staff may issue additional guidance about the effective dates for disclosures under the new rules. He clarified that for annual disclosures, the phrase “the first filing that covers the first full fiscal period” would mean the first annual report that covers the 2024 year – which calendar-year companies will file in spring 2025. So, as John summarized in a recent post in our “Q&A Forum” (#11,400):
– Companies with a calendar year end will be required to disclose the information required by Item 408(a) of Regulation S-K beginning with their second quarter 2023 Form 10-Q filing (i.e., the 10-Q for the period ending June 30, 2023).
– Companies with a calendar year end will be required to provide the disclosures called for by Item 408(b) and 402(x) of Regulation S-K and Item 16J of Form 20-F in the Form 10-K filing for their 2024 fiscal year (i.e., the 10-K covering the year ended December 31, 2024, which will be filed in 2025). Copies of their insider trading policies will also need to filed as exhibits to that filing.
If this helps you breathe a sigh of relief, great – but don’t get too comfortable. Some folks still want to see a CDI from Corp Fin before planning for a 2025 exhibit. And even if we do have a two-year runway, the insider trading policy is a sensitive document – so it will take time to socialize and approve amendments. That means you need to dust it all off sooner rather than later. Don’t wait till the eleventh hour!
In his blog last week, Dave suggested several issues to consider. We’ll be providing even more guidance in the forthcoming issue of The Corporate Counsel newsletter. Email sales@ccrcorp.com if you want immediate access to that resource and aren’t already subscribed.
A WSJ article from late last week reported that the SEC is considering less onerous climate-related financial reporting after significant pushback to its proposal from companies – as well as investors. Here’s an excerpt:
The final version of the SEC rules, expected this year, will likely still mandate some climate disclosures in financial statements, according to the people close to the agency. But the commission is weighing making the requirements less onerous than originally proposed, the people said, such as by raising the threshold at which companies must report climate costs.
The article continues:
After the backlash to the climate proposals, officials are considering changes such as a higher trigger for disclosure, using different percentages depending on the financial item in question or eliminating a bright-line test altogether, the people close to the agency said.
Some of the groups pushing for the new climate-disclosure rules said they are open to changes.
The SEC doesn’t appear to be signaling that it’s giving up on the climate disclosure rule altogether – although that might be the preference of two of the Commissioners, based on public speeches like this one. At this point, the Staff is continuing to wade through thousands of comments on its way towards a final rule. They’re aiming for that rule to be more workable for companies – and survive anticipated legal challenges.
Tune in tomorrow for the webcast – “Activist Profiles & Playbooks” – to hear Joele Frank’s Anne Chapman, Okapi Partners’ Alexandra Higgins, Spotlight Advisors’ Damien Park and H/Advisors Abernathy’s Dan Scorpio discuss lessons from 2022’s activist campaigns & expectations for what the dawn of the universal proxy era may have in store!
We are making this DealLawyers.com webcast available on TheCorporateCounsel.net as a bonus to members – it will air on both sites.
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As I wrote in the November-December 2022 issue of The Corporate Counsel, the Say-on-Frequency vote is the “Halley’s Comet” of the securities laws. Per the Dodd-Frank Act, the Say-on-Frequency vote only comes around once every six years, which means that we really don’t retain the “muscle memory” from including it in past proxy statements. As a result, this year we are busy revisiting decisions made in long ago proxy seasons for those issuers who were first required to conduct a Say-on-Frequency vote in 2011, after the Dodd-Frank Act was enacted. I thought it might be helpful to review some of the common questions that come up every time the Say-on-Frequency vote rolls around.
Do I have to include the Say-on-Frequency Vote if the issuer conducts annual Say-on-Pay votes and the issuer has never changed the frequency of Say-on-Pay Votes?
Yes. Exchange Act Rule 14a-21(b) requires that companies provide a separate shareholder advisory vote in proxy statements for annual meetings to determine whether the vote on the compensation of executives required by Section 14A(a)(1) of the Exchange Act “will occur every 1, 2, or 3 years,” and this advisory vote must occur “no later than the annual or other meeting of shareholders held in the sixth calendar year after the immediately preceding vote.” The Say-on-Frequency vote must occur even if the company does not intend to change the frequency with which it seeks to conduct its Say-on-Pay votes.
Is there a specific form of resolution that issuers must use for the Say-on-Frequency vote?
No. Rule 14a-21(b) does not require that issuers use a specific form of resolution for the Say-on-Frequency vote. Unlike the Say-on-Pay vote requirement in Rule 14a-21(a), the rule does not specify a nonexclusive example of a Say-on-Frequency resolution. Exchange Act Rules Compliance and Disclosure Interpretations Question 169.04 indicates the Staff’s view that the Say-on-Frequency vote need not be set forth as a resolution. Separately, the Staff has informally cautioned that the Say-on-Frequency vote must be clearly stated, in that it must be clear that shareholders can vote on the options of every one, two or three years (or abstain from voting), rather than solely following management’s recommendation as to the frequency, if one is provided.
Companies have relied on this Staff guidance to provide Say-on-Frequency votes in a “proposal” format, such as by simply referencing the four choices that are available on the proxy card, rather than using a “resolution” approach. The Staff indicates in Exchange Act Rules Compliance and Disclosure Interpretations Question 169.06 that it is permissible for the Say-on-Frequency vote to include the words “every year, every other year, or every three years, or abstain” in lieu of “every 1, 2, or 3 years, or abstain.”
Does the inclusion of a Say-on-Frequency vote proposal require the filing of a preliminary proxy statement?
No. The inclusion of a Say-on-Frequency vote proposal does not necessitate the filing of a preliminary proxy statement under Exchange Act Rule 14a-6.
Does the board of directors have to make a recommendation to shareholders on the Say-on-Frequency vote?
No. Rule 14a-21(b) does not require that the board of directors make a recommendation as to the frequency of Say-on-Pay votes, but the SEC has noted that uninstructed proxy cards may be voted in accordance with management’s recommendation only if the company follows the requirements of Rule 14a-4, which include specifying how proxies will be voted (i.e., in accordance with management’s recommendations) in the absence of an instruction from the shareholder. Historically, most companies have provided shareholders with a recommendation as to the frequency of Say-on-Pay votes, and that recommendation has usually been to conduct a Say-on-Pay vote annually.
How do I determine which frequency “wins” the vote?
The Say-on-Frequency proposal is unusual because the issuer is not asking the shareholders to “approve” a specific proposal or resolution. Instead, shareholders are being to select one of three frequency options or abstain from voting. In footnote 121 of the adopting release from 2011, the Commission stated: “Because the shareholder vote on the frequency of voting on executive compensation is advisory, we do not believe that it is necessary to prescribe a standard for determining which frequency has been ‘adopted’ by the shareholders.”
Item 5.07 of Form 8-K requires that an issuer must disclose its decision as to how frequently the company will conduct Say-on-Pay votes following each Say-on-Frequency vote (the Say-on-Frequency vote is advisory, so the company must ultimately decide the frequency of future Say-on-Pay votes). To comply with this requirement, a company must disclose the determination in the original Form 8-K or file an amendment to its original Form 8-K filing (or filings) that disclosed the preliminary and final results of the Say-on-Frequency vote.
The Form 8-K amendment is due no later than 150 calendar days after the date of the end of the annual meeting in which the Say-on-Frequency vote occurred, but in no event later than 60 calendar days prior to the deadline for the submission of shareholder proposals as disclosed in the proxy materials for the meeting at which the Say-on-Frequency vote occurred. Specifically with respect to Say-on-Frequency votes, an issuer must disclose the number of votes cast for each of the choices (every one, two or three years), as well as the number of abstentions in Item 5.07 of Form 8-K.
Failure to provide the required disclosure under Item 5.07 could impact an issuer’s ability to use Form S-3 and maintain WKSI status, therefore it is important to remember to include the necessary disclosure about the determination as to the frequency of future Say-on-Pay votes, even if there is no change from past practice. Back in 2011 when the first Say-on-Frequency vote was conducted, many issuers failed to timely disclose the board’s decision on the frequency of future Say-on-Pay votes, which resulted in a significant number of late Form 8-K filings. The Staff granted Form S-3 eligibility waivers fairly liberally at that time, but then became much less accommodating on this issue over time.
Most companies now opt for including the determination language in the original Form 8-K, rather than filing the amendment at a later date. To accomplish this, it is often necessary to ask the board of directors to approve the frequency of Say-on-Pay votes after the votes from shareholders are tallied.
