Liz blogged last week that the NYSE and Nasdaq proposed amendments to their listing standards to implement the Dodd-Frank clawback rules. The amendments would extend the effective date of the rules to October 2, 2023. The consequence is that companies will have until December 1, 2023 to adopt compliant clawback policies and that they’ll apply to incentive-based compensation received by executive officers on or after October 2, 2023.
The open question was whether and how the SEC would approve these amendments, since Friday was the last day that they could act on the original proposals. The Commission came through at the 11th hour with notices for the NYSE and Nasdaq (and other exchanges) that granted accelerated approval of each exchange’s proposal, as modified by the amendment.
Although a number of companies have already adopted a Dodd-Frank clawback policy in anticipation of these listing standards, there are also a significant number who were going to be attempting to cram it into summer board agendas. This is a welcome development that gives companies & boards more breathing room to carefully consider their policies. We’ve posted several helpful samples in our “Clawbacks” Practice Area on CompensationStandards.com!
While companies may not need to rush out and adopt a new clawback policy over the summer, there are a few discretionary considerations that companies may be grappling with as they look to adopt the required policy. I recently discussed some of these with Ali Nardali of K&L Gates in the first episode of our new Pay & Proxy Podcast series over on CompensationStandards.com. To better understand how companies are handling some of these considerations, we’re also running a short, anonymous survey on clawback policies. Please take a moment to participate!
For future episodes of this new podcast series, the idea is to focus on topics of interest to the members of CompensationStandards.com, including executive and director pay trends, compensation governance and disclosure considerations. Like our other podcasts, we hope to talk to folks—in the compensation space—willing to spend 15 minutes sharing a little bit about themselves, their work, or topics they find interesting. If you have something you’d like to talk about, please feel free to reach out to me via email at mervine@ccrcorp.com.
In a big decision last week that has immediate implications for companies facing derivative claims in the 9th Circuit and may eventually head to the US Supreme Court, the 9th Circuit Court of Appeals issued a decision in Lee v. Fisher that could have the practical impact of abolishing federal derivative suits. The court, re-hearing the case en banc after a 3-judge panel decision last year in favor of the company, once again upheld a forum selection bylaw at Gap that designated the Delaware Court of Chancery as “the sole and exclusive forum for . . . any derivative action or proceeding brought on behalf of the Corporation.”
The plaintiff in this case had brought a derivative suit in federal court in California, alleging that the company and its directors violated Section 14(a) of the Exchange Act and Rule 14a-9 by making false or misleading statements to shareholders about the company’s commitments to diversity. The decision affirmed the district court’s dismissal of the case on the basis of the exclusive forum bylaw. Since Delaware courts don’t have jurisdiction to hear federal claims, this case could essentially eliminate this type of shareholder suit, at least in the 9th Circuit.
In this blog and her related paper, Tulane law prof Ann Lipton walks through in detail why she believes this decision is problematic:
As a policy matter, my problem with the decision is that, contra the Ninth Circuit, in fact, direct claims do not function as a complete substitute for derivative claims. Suppose an acquiring company needs a shareholder vote to complete a merger, and the proxy statement is misleading. Suppose the merger is a bad deal for the company. Under Delaware law, that’s an injury to the company, not the shareholder – and, in fact, in the very Delaware cases cited by the Ninth Circuit for the proposition that these should be brought as direct claims, Delaware also held that it could not identify any injury that would justify an award of damages directly to the stockholders, because the only harms were derivative.
…All of which to say: There is no remedy under Delaware law for negligent proxy statements whether the claim is brought directly or derivatively (with an asterisk), and if federal law is following Delaware, there’s no remedy for shareholders suing directly under federal law for transactions that harm the company, at least not unless shareholders manage to act quickly enough to halt the transaction entirely. That’s the hole that derivative Section 14(a) claims can fill.
The Court of Appeals took a different view – one that tracks with the arguments from U Oregon Law Prof Mohsen Manesh and Stanford Law’s Joe Grundfest set forth in this amici brief and reiterated post-decision in this blog on UCLA Law Prof Steve Bainbridge’s site. (Yes, we have a “who’s who” of corporate governance scholars who all make compelling arguments about what the proper outcome should be here.) Here’s the view that Mohsen Manesh shared:
As Grundfest and I have explained, in recent years, as Delaware courts have cracked down on meritless shareholder litigation, the plaintiff’s bar has sought refuge in federal courts by bringing derivative Borak claims. These federal derivative suits allege corporate harm arising from the board’s mismanagement of matters ranging from executive compensation, to oversight of regulatory compliance, to corporate policies concerning diversity, equity and inclusion.
Stated differently, these derivative suits concern internal corporate affairs—matters that are traditionally governed by state corporate law and, therefore, more sensibly litigated in the Delaware Chancery. But rather than bringing a state law claim for breach of fiduciary duty in Delaware courts, these federal derivative suits make the more tortured argument that the alleged corporate harm was a result of the shareholders being misled by the company’s proxy statement. In doing so, derivative Borak lawsuits transparently aim to establish federal court jurisdiction and, thereby, avoid the likely fate that such suits would face before a skeptical Delaware judge.
The suit in Lee exemplified this trend. In Lee, the plaintiff-shareholder brought a derivative Borak claim in federal court against the directors and officers of The Gap, alleging failures in the management’s efforts to promote racial diversity within the company’s leadership ranks. As a derivative suit, the Lee plaintiff alleged that The Gap’s proxy statements had included materially false or misleading statements about the company’s efforts to pursue diversity, which in turn harmed The Gap by enabling the re-election of the company’s incumbent directors and approval of the officers’ compensation packages.
This side of the argument emphasizes that the decision doesn’t affect direct claims under Section 14(a) and advocates that those are still a distinct and valuable way that shareholders can pursue recovery.
There is one thing that everyone agrees on, though: the Ninth Circuit’s holding squarely conflicts with the 2022 Seventh Circuit ruling in Seafarers v. Bradway. John blogged about that case last year when it was issued. This is a significant circuit split that SCOTUS eventually may be interested in resolving, if & when it gets asked to do so. Ann Lipton lays out a parade of horribles that could follow if SCOTUS takes up this topic and affirms the 9th Circuit’s view, culminating in:
…leaving aside what the effect might be on private contracts, the whole mess is dumped back into Delaware’s lap. Delaware will have to decide how far companies can go in charters and bylaws to waive private securities fraud claims. Delaware will have to decide when enforcing such waivers is a violation of directors’ fiduciary duties, and when directors are conflicted in enforcing such waivers, and whether enforcement of a waiver is a conflict transaction that needs to be reviewed under entire fairness.
It will add a whole separate layer of state litigation on top of the federal, where Delaware will decide the contours of the federal right. And it will be doing so in the shadow of jurisdictions like Nevada, which may very well adopt permissive rules.
We might even start with whether Delaware does, in fact, agree that directors may, consistent with their fiduciary duties, completely bar derivative Section 14(a) claims, especially if a situation comes up where, whether due to 102(b)(7) or Delaware’s vision of the direct/derivative distinction, Delaware would not provide any remedy but federal law would provide a derivative one. And of course, arbitration provisions may make a comeback – even apart from the FAA, Delaware then gets to decide whether and to what extent invoking arbitration for securities claims is consistent with Delaware-imposed fiduciary duties. This is the race to the bottom on the Autobahn.
The requirement under Reg S-K Item 303 to describe “known trends & uncertainties” is one of the trickier items to navigate in periodic reporting. As our “MD&A Handbook” discusses, that’s especially true if you are trying to evaluate the risk of not discussing a matter that, in management’s view, may not be “reasonably likely” to have a material impact at the time the report is filed.
A cert petition filed last week is asking the Supreme Court to clarify the boundaries of private rights of action in these situations. This blog from “Jim Hamilton’s World of Securities Regulation” explains:
In the cert petition, Macquarie and the other petitioning defendants argue that a Section 10(b) claim cannot rest entirely on a failure to provide a disclosure required under Item 303; there needs to be some affirmative statement rendered misleading by the omission. While the SEC can inquire and bring an enforcement action for a violation of Item 303, the violation should not “open the floodgates to potentially crippling private class action liability.”
The petition argues that the Second Circuit has acknowledged its split from the Ninth Circuit’s 2014 holding in In re NVIDIA Corp. Securities Litigation, which in turn had cited a Third Circuit decision. Subsequently, the Eleventh Circuit wrote that a violation of Item 303 does not ipso facto indicate a violation of Section 10(b), and the Fifth Circuit said in dicta that it has never held that Item 303 creates a duty to disclose under the Exchange Act. Resolving the split is important because it involves the three dominant circuits for securities litigation and because different standards should not apply depending on where a plaintiff files suit, the petition asserts.
It would be nice to get more clarity here, but only if the answer is the one I want…
Earlier this week, at an open meeting, the PCAOB issued its long-awaited “NOCLAR” proposal – which for those not in the biz, stands for “non-compliance with laws or regulations.” The proposal is a big deal because it would enhance the responsibility of auditors to consider corporate non-compliance with laws & regulations, including financial statement fraud. The PCAOB’s press release summarizes the key points:
Broadly, the proposal seeks to strengthen and enhance auditor obligations related to a company’s noncompliance with laws and regulations in three key respects:
– Identify – The proposal would establish specific requirements for auditors to proactively identify – through inquiry and other procedures – laws and regulations that are applicable to the company and that could have a material effect on the financial statements, if not complied with. The proposal also makes explicit that financial statement fraud is a type of noncompliance with laws and regulations.
– Evaluate – The proposal would strengthen requirements related to the auditor’s evaluation of whether noncompliance with laws and regulations has occurred, and if so, the possible effects on the financial statements and other aspects of the audit. For example, the proposed standard would require the auditor to consider whether specialized skill or knowledge is needed to assist the auditor in evaluating information indicating noncompliance has or may have occurred.
– Communicate – The proposal would make it clear that the auditor is required to communicate to the appropriate level of management and the audit committee as soon as they are made aware that noncompliance with laws or regulations has or may have occurred. Additionally, the proposal would create a new requirement that the auditor must communicate to management and the audit committee the results of the auditor’s evaluation of such information. Specifically, this communication would address which matters are likely noncompliance and the effect on the financial statements for those matters that are likely noncompliance.
By requiring auditors to identify and communicate noncompliance sooner, the proposed amendments, if adopted, would encourage companies to take more timely remedial actions and thereby reduce investor harm caused by legal and regulatory penalties. Another potential benefit would be to lower the likelihood that financial statements are materially misstated due to noncompliance with laws and regulations.
Here is the PCAOB’s page that tracks the status of this project. The deadline for public comment on the proposal is August 7th, and I imagine that the legal community will be weighing in.
At their scheduled open meeting yesterday, the SEC Commissioners unanimously approved changes to Reg M to remove and replace references to “credit ratings” from the existing exceptions provided in Rule 101 and Rule 102, which had referred to certain securities being rated “investment grade” by at least one nationally recognized statistical rating organization and will now refer to alternative standards of creditworthiness. Specifically, according to the SEC’s Fact Sheet, the amendments:
– Remove existing rule exceptions that reference credit ratings for nonconvertible debt securities, nonconvertible preferred securities, and asset-backed securities included in Rule 101 and Rule 102 of Regulation M;
– Replace those rule exceptions with new standards that are based on alternative standards of creditworthiness; and
– Add an amendment to a recordkeeping rule applicable to broker-dealers in connection with their reliance on the new exceptions.
As Dave blogged last week, this is the culmination of years of consideration, dating all the way back to the Dodd-Frank Act, and that history is also mentioned in the SEC’s press release and the various Commissioner statements about the rule change. The amendments fulfill the mandate from Section 939A(b) of the Dodd-Frank Act.
You may be wondering what “alternative standards of creditworthiness” actually means. The Fact Sheet explains:
New Rule 101(c)(2)(i) and Rule 102(d)(2)(i) except nonconvertible debt securities and nonconvertible preferred securities of issuers having a probability of default of 0.055 percent or less, as estimated as of the sixth business day immediately preceding the determination of the offering price, over the horizon of 12 full calendar months from such day, as determined and documented in writing by the distribution participant acting as the lead manager, using a “structural credit risk model,” as newly defined in Rule 100 of Regulation M. In addition, new Rules 101(c)(2)(ii) and 102(d)(2)(ii) except asset-backed securities that are offered pursuant to an effective shelf registration statement filed on the Commission’s Form SF-3.
Clear as mud, right? My first thought was that this seems to just move reliance from credit ratings agencies to distribution participants. I admittedly have not parsed through the entire adopting release – certainly not as deeply as the Staff who put this together. And I am not familiar with credit assessment services, although I’m sure I’ll come to know and love them. Point being though, that on its face, I am not sure that legal counsel, investors or others have the skills (or desire?) to figure out structural credit risk models, even if they are “commercially or publicly available” – or to easily determine whether a model meets the requirements to be used under the rule.
While all the Commissioners supported the rule, they acknowledged it wasn’t perfect – and in her statement, Commissioner Peirce raised three questions that seem worth considering:
– One commenter suggested that the Commission’s proposed use of a structural credit risk model for determining eligibility for the exception under Rule 101(c)(2)(i) was unnecessarily complex and suggested using a simpler alternative, such as whether the securities are offered pursuant to an effective registration statement filed on one of several specific forms. Another alternative this commenter suggested was to limit the exception to securities issued by well-known seasoned issuers. Why doesn’t the final rule take one of these approaches?
– How confident is the staff that we’ve gotten the threshold right for this exception?
– The International Institute of Law and Finance submitted a comment letter that asked the Commission to consider allowing market participants more flexibility in estimating probability of default. Among the alternatives IILF suggested would be appropriate were statistical models and market measures of credit risk, such as debt security prices and yields, credit spreads, and credit default swap spreads. Why doesn’t the final rule provide this extra flexibility?
The final rules go effective 60 days following the date of publication of the adopting release in the Federal Register (which usually takes about a month, depending on the volume of what needs to get published). For those who are gluttons for punishment, here’s the 120-page adopting release. We’ll be posting memos in our “Regulation M” Practice Area.
Following up on the NYSE amendment that I blogged about yesterday, Nasdaq has now also posted an amendment to its Dodd-Frank clawback listing standard proposal. Just like the NYSE amendment, the amendment that Nasdaq has proposed would set an October 2nd effective date and a December 1st compliance date (60 days after the effective date). As amended, the proposed listing standard would say:
Effective Date. Each Company is required to (i) adopt a policy governing the recovery of erroneously awarded compensation as required by this rule no later than 60 days following October 2, 2023, (ii) comply with its recovery policy for all incentive-based compensation received (as such term is defined in Rule 5608(d)) by executive officers on or after October 2, 2023, and (iii) provide the disclosures required by this rule and in the applicable Commission filings on or after October 2, 2023. Notwithstanding the look-back requirement in Rule 5608(b)(1)(i)(D), a Company is only required to apply the recovery policy to incentive-based compensation received on or after October 2, 2023.
That’s the only change that Nasdaq has proposed, and it comes as welcome news! We’ll stay tuned for the SEC notice of these amendments.
I’ve been dragging my feet on writing about the SEC’s big crypto enforcement actions & related news because I had a feeling that there would be more to come. Now there’s been more activity than I bargained for, so I’m just going to recap what’s happened in the past week or so:
– Last week: The SEC announced that former Coinbase manager and his brother agreed to settle insider trading charges.
– Also last week: The Chairs of the House Committees on Financial Services & Agriculture published a 162-page discussion draft of legislation that would define CFTC and SEC jurisdiction over cryptoassets (commodities vs. investment contracts, respectively), create a new disclosure regime specific to the risks surrounding digital assets, define conditions for registration off-ramps and exemptions, establish a joint CFTC-SEC advisory committee, and more. Here’s the 8-page summary.
– Monday: The SEC announced 13 charges against Binance – the world’s largest crytpo exchange – along with its US arm and its founder. Here’s the 136-page complaint. You have probably seen the quote.
– Tuesday: The SEC announced charges against Coinbase – the largest crypto exchange in the US and the petitioner in a detailed request for rulemaking – for operating as an unregistered securities exchange, broker and clearing agency. Here’s the 101-page complaint. Unlike Binance, the SEC hasn’t alleged much in the way of fraud. Matt Levine’s column has a good comparison of the Binance and Coinbase approaches to compliance and the SEC’s complaints against each of them.
– Also Tuesday: The SEC announced that it had filed an emergency motion for a TRO to freeze certain Binance assets and prevent destruction of records, among other requests. Here is commentary from John Reed Stark, who was formerly with the SEC and has been calling for enforcement on crypto from various regulators for quite some time.
Here is Matt Levine again on the evolution of the SEC’s crypto enforcement since 2017. He describes the early days as:
The SEC’s 2017ish ICO crackdown was very much a ’33 Act crackdown: People were raising money by selling scammy stock-like tokens, and the SEC shut down their scams, one at a time.
And one result of this approach is that Coinmarketcap.com lists 10,408 crypto tokens, and only a handful of them have been sued by the SEC for doing illegal securities offerings. Maybe that’s fine! Maybe the SEC’s crackdown on ICOs deterred 30,000 other, scammier crypto projects from launching; maybe the 10,000 current crypto tokens are all pretty good and not scammy.
That’s different than today’s approach, which is coming under the ’34 Act:
What can the SEC do about it? Well, it can go sue thousands of crypto projects, but that is hard not only because there are thousands of them but because many will be decentralized and/or foreign enough that they are hard to sue.
Also some of them didn’t do anything wrong: Solana, let’s say, did do a securities offering of SOL tokens, but legally, selling them to venture capitalists in private placements subject to appropriate SAFTs and lockups. The fact that those tokens now trade publicly, with less disclosure and fewer investor safeguards than the SEC would like, is, from the SEC’s perspective, unfortunate. But it’s not exactly Solana’s fault, or rather it is Solana’s fault but in a perfectly legal way.
But what the SEC can do is sue crypto exchanges. What it can do is try to shut down Coinbase Inc., the biggest US crypto exchange, and shut Binance, the biggest global crypto exchange, out of the US market. And it can go after other companies — Bittrex, Kraken, Gemini — that offer crypto trading to US customers. Because if it is illegal to operate a crypto exchange in the US, then US customers won’t be able to trade crypto, which means that they will be protected from the bad aspects — the scams, the lack of disclosure, the lack of investor protections — of crypto.
The column goes on to explain that while the ’33 Act analysis is still important to the current enforcement arguments, there may be nuances that affect where all this lands. John Reed Stark and lots of others think the SEC’s cases are strong. This Reuters article reports that counsel for the defendants in this week’s cases includes lawyers from Wachtell Lipton, Sullivan Cromwell, Latham, Gibson Dunn and Wilmer Hale. So for those of us watching from the sidelines who enjoy the technicalities of securities law, there may be opportunities to geek out when we see the arguments.
If you’re at an NYSE-listed company and you’ve been panicking about fitting approval of a Dodd-Frank clawback policy into full compensation committee agendas this summer, we’ve got good news: the NYSE has filed an Amendment to its proposed listing standard, which sets an October 2nd effective date. If the Amendment is approved by the SEC as proposed, that means that NYSE companies will have until Friday, December 1st to adopt a compliant Dodd-Frank clawback policy and that the policy would cover incentive-based compensation received by executives on or after October 2, 2023.
Nasdaq hasn’t filed a corresponding amendment (yet) – we’ll see whether that happens before the end of this week when the original proposal is currently scheduled to go effective. The SEC also hasn’t posted the notice for the NYSE Amendment yet, which would clarify the process for this Amendment being approved.
This Wilson Sonsini blog highlights commentary from the Amendment to support this extended effective date – which is that the SEC’s adopting release for the Dodd-Frank clawback rules said:
…we note that issuers will have more than a year from the date the final rules are published in the Federal Register to prepare and adopt compliant recovery policies.
So, the Amendment recognizes that many folks had been expecting the compliance date to fall sometime after November 28, 2023, which would be the one-year anniversary of the rules being published in the Federal Register.
In addition, the NYSE Amendment changes the proposal to allow for a cure period when the Exchange believes that a company has failed to enforce the policy. It still requires NYSE companies to provide notice to the Exchange if they haven’t adopt a compliant clawback policy before the compliance date (and the proposal continues to provide a cure period for late adoption scenarios). NYSE’s changes to the delisting procedures align with comments on the proposal and the Nasdaq approach to delistings for lack of clawback policy enforcement. The Wilson Sonsini blog also provides color here:
Other than the change to the effective date, proposed Section 303A.14 of the NYSE Listed Company Manual is the same as proposed in the NYSE’s initial filing and as noted above, closely follow the requirements outlined in Rule 10D-1. Notably, this means that, similar to Nasdaq’s proposed listing standards, proposed Section 303A.14 does not include any guidance or factors that the NYSE will consider when making a determination as to whether the issuer has recovered “reasonably promptly” the amount of erroneously awarded incentive-based compensation.
However, the blog goes on to highlight that in Amendment No. 1, the NYSE stated the following:
“The issuer’s obligation to recover erroneously awarded incentive based compensation reasonably promptly will be assessed on a holistic basis with respect to each such accounting restatement prepared by the issuer. In evaluating whether an issuer is recovering erroneously awarded incentive-based compensation reasonably promptly, the [NYSE] will consider whether the issuer is pursuing an appropriate balance of cost and speed in determining the appropriate means to seek recovery, and whether the issuer is securing recovery through means that are appropriate based on the particular facts and circumstances of each executive officer that owes a recoverable amount.”
We’ve posted several very helpful sample policies on CompensationStandards.com, where we are covering all the ins & outs of clawbacks. In our “Proxy Season Post-Mortem: The Latest Compensation Disclosures” webcast coming up on June 27th on that site, Morrison Foerster’s Dave Lynn, Gibson Dunn’s Ron Mueller and Compensia’s Mark Borges will be sharing even more practical insights on how to finalize your policy. If you don’t already have access to CompensationStandards.com, email sales@ccrcorp.com to start a no-risk membership or sign up online.
Long-time SEC Staff member Sebastian Gomez Abero recently shared that he’s returning to Corp Fin – as Associate Director of the Disclosure Review Program. Sebastian joined the SEC in 2007 and among other roles, he previously led the Division’s Office of Small Business Policy before being named Deputy Director of the SEC’s Small Business Advocacy Office in 2020. Congrats on being back in Corp Fin, Sebastian!
As a reminder on a somewhat related “small business” topic, the SEC’s Small Business Capital Formation Advisory Committee Meeting is scheduled to meet next Wednesday, June 14th. Here’s Dave’s blog with more detail and here’s the agenda.