Yesterday, ISS announced its policy updates for next year. Here’s the policy document. The big news this year is that ISS is ratcheting up the pressure on companies to improve board diversity, and taking a more accommodating approach to exclusive forum bylaws. Here are a couple of excerpts from ISS’s executive summary of the policy changes:
– For 2021, ISS benchmark research reports for companies in the Russell 3000 or S&P 1500 indexes will highlight boards that lack racial and ethnic diversity (or lack disclosure of such) to help investors identify companies with which they may wish to engage and foster dialogue between investors and companies on this topic.
– For 2022, for companies in the Russell 3000 or S&P 1500 indexes where the board has no apparent racially or ethnically diverse members, ISS will recommend voting against or withhold from the chair of the nominating committee (or other directors on a case-by-case basis).
– Under the new policy, ISS will generally recommend a vote for federal forum selection provisions in the charter or bylaws that specify “the district courts of the United States” as the exclusive forum for federal securities law matters and recommend a vote against provisions that restrict the forum to a particular federal district court.
– Under the updated policy for exclusive forum provisions for state law matters, in the absence of concerns about abuse of the provision or about poor governance more generally, ISS will generally recommend in favor of charter or bylaw provisions designating courts in Delaware as the exclusive forum for state corporate law matters at companies incorporated in that state.
We’ll be posting memos in our “Proxy Advisors” Practice Area. With proxy season just around the corner, check out this Davis Polk blog for a list of key dates on ISS & Glass Lewis’s calendars for the upcoming months.
California Voters Adopt New Privacy Statute
Remember how much fun getting geared up to comply with the CCPA and its seemingly endless rulemaking process was? Well if you enjoyed that, you’ll be delighted to learn that on election day, California voters passed Proposition 24, the California Privacy Rights Act (CPRA). This intro to Thompson Hine’s memo on the new statute provides an overview of its provisions:
On November 3, California voters approved Proposition 24, also known as the California Privacy Rights and Enforcement Act of 2020 (CPRA), which amends and expands upon California’s other landmark privacy legislation, the California Consumer Privacy Act of 2018 (CCPA). In particular, the CPRA establishes new data privacy rights for California residents, imposes new obligations and liabilities on businesses and service providers, and creates a regulatory agency empowered to enforce California privacy law and prosecute noncompliance. The CPRA becomes operative on January 1, 2023, and, with some exceptions, will apply to California residents’ personal information collected by organizations after January 1, 2022.
The CPRA’s proponents put Proposition 24 on the ballot because of their objections to several legislative amendments to the CCPA & the California AG’s new regulatory framework that they believe “significantly weakened” its safeguards. The memo reviews the key provisions of the CPRA, and notes that approving the CPRA ballot initiative, California voters made several substantive amendments to the CCPA – and effectively prevented California’s state government from undermining them through future legislation.
Post-Election Suggestion: “Look at Mills! Look at Mills!”
There’s a zero percent chance that I’m going to use this blog to wade into the giant cauldron of rage into which our country has descended following last week’s election. I’m also not going to minimize the differences that separate us. We have a lot of work to do. But, like you, I have friends and family members whose political opinions differ significantly from mine, and I’d kind of like to continue to share the country with them and with all of you.
With that objective in mind, I want to close out the week with a suggestion as to how we might at least start to turn down the temperature. This is going to sound strange, but hear me out – I would like you to watch this video of NBC’s coverage of the final lap of the men’s 10,000 meters at the 1964 Tokyo Olympics. It’s only about a minute long.
I know the video quality is terrible, but I’m guessing that you still felt the same chills that I did watching the last 100 meters of that race. You know what? The people who voted for the other guy felt those chills too, and it’s fair to say that the letters “U.S.A” on the front of Bill Mills’ uniform probably had a lot to do with that. I believe that this kind of shared feeling is what Abraham Lincoln was getting at in his First Inaugural Address, and since there’s no blogger alive who can follow Honest Abe, I’ll let him have the last word:
We are not enemies, but friends. We must not be enemies. Though passion may have strained, it must not break our bonds of affection. The mystic chords of memory, stretching from every battle-field, and patriot grave, to every living heart and hearthstone, all over this broad land, will yet swell the chorus of the Union, when again touched, as surely they will be, by the better angels of our nature.
3. Does your board have the same or different dollar thresholds requiring board approval for the following categories: acquisitions, financing transactions, general contracts, and real estate?
– Same – 38%
– Different – 62%
Please take a moment to participate anonymously in these surveys:
This SquareWell Partners report addresses investor approaches to ESG issues during 2020 and predicts how they will shape the dialogue between companies & shareholders during the upcoming year. This excerpt address investors’ increasing focus on capital allocation decisions:
As the impacts of COVID-19 will continue and the ‘V’-shaped recovery looking less likely, capital allocation decisions will require a delicate balancing act for companies in 2021 to manage the diverging expectations of its stakeholders (especially within its shareholder base regarding the payment of dividends).
Companies will be expected to justify their capital allocation decisions, whether it is to remunerate shareholders or not. Whilst investors like Schroders have communicated that they would be more flexible regarding capital raising requests, other investors (and proxy advisors) will scrutinize the management quality, urgency of the funds, and the long-term strategy before supporting any capital raise (as in the case at French mall operator, Unibail-Rodamco-Westfield).
The report cautions that while investors demonstrated restraint during the current year, 2021 will likely be a critical year during which investors will pass judgment on corporate actions or failures to act in response to the crisis.
Rule 10b5-1 Plans: No Affirmative Defense to Bad Publicity
Pfizer’s announcement earlier this week about the apparent efficacy of its Covid-19 vaccine is the best news the market – and the world – has heard this year. That announcement helped fuel a stock market surge, and according to media reports, Pfizer’s CEO & another executive sold a sizeable amount of the company’s shares during the rally.
The more thoughtful coverage of these sales pointed out that they were made under the terms of pre-existing Rule 10b5-1 plans, but the situation provides another example of the fact that whatever else a 10b5-1 plan does, it doesn’t provide an affirmative defense against bad publicity.
Last week, Liz blogged about a recent report from the NYSE & Diligent that said that 81% of directors indicated that their board either already has a plan for increasing boardroom diversity or will have one soon, but that 45% lacked a specific timeframe for meeting diversity goals. However, the report goes on to say that those companies that have established a timeframe plan to move fast, and are limiting the number of boards on which directors may serve to help them achieve their diversity goals. Here’s an excerpt from this CorporateSecretary.com article:
But when a timeframe is set, it is ambitious: 35% of companies have set a one to three-year period in which to meet their diversity goals. The most widely adopted approach companies are taking to promote board refreshment is limiting the number of boards a director can sit on (17%). This brings a new focus on the concept of overboarding – a growing issue for investors in recent years. Although the Diligent and NYSE study doesn’t provide numbers when talking about limiting the number of boards a director can sit on, both ISS and Glass Lewis have tightened their stance on this in recent years.
The report says that 14% of companies have also introduced age limits for their directors in order to promote board refreshment & greater diversity. Another 11% percent have added more seats to their boards in order to make room for more diverse directors to join.
Covid-19: U.S. Chamber Petitions SEC for Liability Protection
The Covid-19 pandemic has already prompted a wave of litigation, including nearly three dozen securities lawsuits. In an effort to protect businesses from what it characterizes as “unjustified Covid-19 lawsuits,” the U.S. Chamber of Commerce recently filed a rulemaking petition with the SEC seeking to enhance protections against pandemic-related securities claims. Here’s an excerpt from Kevin Lacroix’s D&O Diary blog:
On October 30, 2020, the U.S. Chamber Institute for Legal Reform and the Chamber’s Center for Capital Markets Competitiveness filed a petition with the Securities Exchange Commission, pursuant to Rule 192(a) of the Commission’s Rules of Practice. (Rule 192(a) provides that “Any person desiring the issuance, amendment or repeal of a rule of general application may file a petition therefor with the Secretary” of the SEC.) The petition urges that the SEC should exercise the authority given to the agency in the PSLRA an “act without delay to place reasonable limits on securities litigation arising out of the COVID-19 pandemic.”
The Chamber’s petition asks the SEC to consider several specific actions. These include:
– Using its authority under the PSLRA to “bar liability for statements about a company’s plans or prospects for getting back to business, resuming sales or profitability, or other statements about the impacts of COVID-19, whether forward-looking or not—as long as suitable warnings were attached.”
– Alternatively, limiting liability for all such statements to circumstances in which the plaintiff can prove that the speaker had actual knowledge of their falsity (which would have the effect of treating all such statements as “opinions” for purposes of the securities laws).
– Requiring financial statements – which aren’t protected by the PSLRA safe harbors – to include language reminding users that a number of the elements of those statements “are determined on the basis of projections of future business or market conditions or by applying “mark to market” standards and stating that due to the tremendous uncertainties flowing from the pandemic and its effect on the economy, there is a greater possibility of variation than in the past.” Liability for pandemic-related misstatements in financial statements that include these warnings would be barred or, or alternatively, treated as the equivalent of opinions requiring proof that the company subjectively knew they were false in order for them to be actionable.
Kevin’s blog reviews the petition in detail, as well as some of the impediments to any quick action by the SEC on it. He also provides additional context for the concerns about a potential explosion in Covid-19-related securities litigation in light of the rise of “event driven” securities class actions in recent years.
Tomorrow’s Webcast: “The Top Governance Consultants Speak”
Tune in tomorrow for the webcast – The Top Governance Consultants Speak – to hear Laura Wanlass of Aon, Rob Main of Sustainable Governance Partners, Allie Rutherford of PJT Camberview and Chris Young of Jefferies discuss what you should be focusing on in fall engagements and what proposals are emerging for the upcoming year.
The ongoing proceeding against the alleged perpetrators of the 2016 hack of the Edgar system is one of the Division of Enforcement’s most high-profile cases. Last week, the SEC announced that it had reached a settlement with three of the defendants in that case, Sungjin Cho, Ivan Olefir, and Capyield Systems, Ltd., an entity affiliated with Olefir. According to the SEC’s complaint, the defendants allegedly traded on the basis of the hacked information during the period from July to October 2016. The SEC’s litigation release lays out the sanctions imposed:
Cho, Olefir and Capyield consented to the entry of final judgments that would permanently enjoin them from violating the antifraud provisions of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder and Section 17(a) of the Securities Act of 1933. Additionally, Cho and Olefir agreed to conduct-based injunctions limiting their ability to trade U.S.-listed securities and derivatives. Cho agreed to pay a civil penalty of $175,000, and Olefir and Capyield agreed to pay a joint and several penalty of $250,000.
Earlier this year, the SEC reached a similar settlement with two other defendants. But the two alleged masterminds of the scheme – Ukrainian nationals Artem Radchenko & Oleksandr Ieremenko – are currently being sought by the Secret Service & the State Dept. The U.S. government has offered a reward of $2 million for information leading to their arrest or conviction.
SEC Enforcement: 2020 Annual Report
Last week, the SEC’s Division of Enforcement issued its annual report for the 2020 fiscal year. This Sullivan & Cromwell memo summarizes the report’s highlights:
As the Report details, the Division obtained a record-breaking $4.68 billion in monetary remedies in FY 2020, including $3.59 billion in disgorgement and $1.10 billion in penalties. Total monetary relief in FY 2020 exceeded that in FY 2019 by $330 million, or 8%.
The Division filed 715 enforcement actions in FY 2020, which reflected a 17% decline from the previous year. Of the total actions brought, 405 were so-called “standalone” enforcement actions, 180 were follow on administrative proceedings, and 130 were actions to de-register companies that were delinquent in their SEC filings. Of the total number of enforcement actions, 492 were brought after instituting mandatory telework in mid-March. The decline in the number of actions is attributable largely to the disruptions resulting from COVID-19, as well as the fact that the prior year included numerous actions filed as part of the SEC’s Share Class Selection Disclosure self-reporting initiative.
Three enforcement areas drove the majority of the SEC’s standalone cases: (i) securities offerings (32%); (ii) investment advisory and investment company issues (21%); and (iii) issuer reporting/accounting and auditing (15%). The SEC also brought actions relating to broker-dealers (10%), insider trading (8%), market manipulation (5%), Public Finance (3%), and FCPA (2%). The SEC continued to pursue charges against individuals; 72% of the SEC’s standalone cases involved charges against one or more individuals.
The Division of Enforcement received 23,650 tips, complaints, and referrals in FY 2020, with most of them being received during the pandemic. That represents a substantial increase over the comparable FY 2019 figures, and the report says that they’ve helped to create a “strong pipeline for future enforcement actions.”
Virtual Annual Meetings: Gearing Up for 2021
At this point, most of us have reconciled ourselves to the fact that things aren’t getting back to normal anytime soon. Since that’s the case, companies will need to prepare for possibility that their 2021 annual meeting will once again need to be a virtual or hybrid meeting. This recent Bryan Cave blog offers up some tips on preparing for next year’s virtual meetings. This excerpt lays out some things to think about when it comes to such a meeting’s format and rules of conduct:
Companies need to decide whether a meeting will be virtual-only, physical-only or a hybrid. For any virtual component, they need to decide whether the access will be audio-only or audio plus video. While a majority of virtual meetings during the 2020 proxy season appeared to be in audio-only format, we expect that in 2021 companies will increasingly use video for their meetings, as video conferencing has evolved during the pandemic.
Clear rules of conduct are imperative. As more companies transitioned to virtual meetings in 2020, one area of focus was on how and when shareholders could submit questions. Investors and others questioned whether companies might be “cherry-picking” the questions they answered and requested that all shareholders have access to the questions submitted. Companies in 2021 will need to put in place and clearly address the Q&A process. For example, issuers need to decide whether questions may be asked live during the meeting via a chat function and/or over the phone, and/or prior to the meeting by submitting online or through email.
If you’re not already thinking about the possibility of a virtual component to your meeting next year, you probably ought to be. The blog says that many companies are already exploring retention of virtual meeting providers and video and real-time Q&A alternatives, and have also begun drafting disclosure about meeting logistics to include in their proxy materials.
This Bloomberg Law article lays out some thoughts on what the Biden administration might mean for the SEC & its rulemaking and enforcement priorities. This excerpt points out that the recent amendments to the proxy rules targeting proxy advisors & shareholder proposals top the list of rules that could be undone by a reconstituted SEC:
In July 2020, the SEC made significant changes to the proxy advisor rules. Critics, such as Commissioner Allison Herren Lee, argued that the new rules were unwarranted, as they addressed no identifiable problem. The scope of the opposition to this measure makes it a candidate for early reversal in 2021. A to-do list of similar measures could also include recent changes to the shareholder proposal rules that make it more difficult for a small investor to submit or resubmit a proposal for inclusion in company proxy materials.
The article also predicts a more receptive environment for ESG-related disclosure requirements, and a more aggressive enforcement posture. Whether a Democratic led SEC can find a way to reach consensus on issues like these and end its string of 3-2 votes on rulemaking proposals remains to be seen, but I sure wouldn’t bet the farm on it.
Disclosure: Prescriptive v. Principles-Based Approaches
Since the S-K modernization amendments just became effective, I thought this recent Bass Berry blog provided a timely illustration of the differences in disclosure practices that might result when a principles-based rule replaces a prescriptive one.
The blog reviewed a Staff comment letter & response involving a company that disclosed its dependence on a handful of 10%+ customers. In its comment letter the Staff requested the company to disclose the identities as required – until recently – by the prescriptive language of Item 101(c) of S-K. However, as a smaller reporting company, the company was permitted to adopt the principles-based approach sanctioned by Item 101(h). Here’s an excerpt from the company’s response to the Staff:
The Company respectfully asserts that disclosure of the names of its customers is not required by Item 101(h)(4)(vi) of Regulation S-K, nor does the Company believe the identity of its largest customers is material to an understanding of its business taken as a whole or necessary for investors to make an informed investment decision. Unlike Item 101(c)(1)(vii) of Regulation S-K, Item 101(h)(4)(vi) does not require a smaller reporting company to identify the name of any customer that accounts for 10% or more of its revenue. The Company also believes that the identities of its customers are of significantly less importance than a qualitative and quantitative description of the extent to which revenue from such customers is relied upon.
Each of the Company’s top three customers in 2019 have been customers for many years. The Company’s largest customer, representing 36.8% of revenue in 2019, has been a customer for 30 years. The second and third largest customers in 2019 have been customers for approximately 10 years and 7 years, respectively. While the Company does consider the loss of revenue from any one of its largest customers significant, warranting appropriate risk factor disclosure of the potential consequences of such loss, the Company does not believe investors will be more informed of these risks by knowing the customers’ identities.
The Company also indicated that both it & its customers regarded their identities to be highly confidential and commercially sensitive, but also agreed to provide additional disclosure about the percentage of its revenue derived from sales to those customers during the prior year. The Staff did not comment further on the company’s disclosure.
Stock Buybacks: Guidance for Your Repurchase Program
The SEC’s recent enforcement action against Andeavor LLC arising out of internal control lapses relating to the company’s stock repurchase plan has caused many companies to take a hard look at the mechanics of their own plans. If you’re working with one of those companies, take a look at this recent Mayer Brown memo, which reviews the application of the Rule 10b-18 safe harbor and a variety of other potential issues that may arise under the federal securities laws, state corporate law, and – for some issuers – applicable provisions of the CARES Act.
What else can you say when the SEC announces that somebody just rang the whistleblower bell to the tune of $114 million? Here’s an excerpt from the SEC’s press release:
The Securities and Exchange Commission today announced an award of over $114 million to a whistleblower whose information and assistance led to the successful enforcement of SEC and related actions.
The $114 million award consists of an approximately $52 million award in connection with the SEC case and an approximately $62 million award arising out of the related actions by another agency. The combined $114 million reward marks the highest award in the program’s history, and eclipses the next highest award of $50 million made to an individual in June 2020.
It sounds like the award came at the end of a tough road for the whistleblower. The SEC’s press release says that the individual repeatedly reported that person’s concerns internally, and then, “despite personal and professional hardships,” the whistleblower alerted the SEC and the other agency of the wrongdoing and provided ongoing assistance that was critical to the success of the proceeding.
Now for the fun part – guessing which company is involved in the underlying case. For what it’s worth, here’s the SEC’s order, but it won’t be much help. The order contains more redactions than the average CIA response to a FOIA request.
Given the size of the award & the reference to another agency’s involvement, I’m sure some might guess that it’s related to the Goldman Sachs 1MDB settlement that was also announced yesterday, but I’m pretty sure that this doesn’t relate to that proceeding. For one thing, the SEC hasn’t yet issued a Notice of Covered Action for that case, which is required for any potential whistleblower case in which more than $1 million in sanctions have been imposed.
I have far too much journalistic integrity to speculate on such matters – but not enough to prevent me from pointing you to a Twitter thread where lots of people are doing just that.
Human Capital: Addressing the New Disclosure Requirement
One of the problems with adopting a principles based disclosure requirement is that you often end up with some poor soul staring at a blank sheet of paper trying to come up with something to say. If you’re worried about finding yourself in that position, this Freshfields blog provides some advice about how to address the SEC’s new human capital disclosure requirement. This excerpt lays out some potential disclosure topics:
– Diversity and inclusion: Programs or initiatives related to recruitment and retention of diverse candidates and other corporate partners, programs or initiatives to mentor and ensure equal opportunities at the company for diverse employees, unconscious bias trainings, and community involvement. For instance, if a company has adopted the Rooney Rule for directors or other positions, it could be helpful to provide that disclosure.
– Workforce compensation and pay equity: Company-wide compensation program design and implementation more generally, including incentive structures, internal minimum rates of pay, as well as efforts to promote gender and diversity pay equity. This may include involvement of outside compensation advisors or use of benchmarking data. This coming year, we expect to see disclosures around changes made to compensation programs in response to COVID-19 and the considerations that were involved.
In the case of companies that had to reduce compensation or furlough employees, we expect to see disclosure of actions taken to ease departures or reduced wages that demonstrate a commitment to the workforce. For example, many companies provided severance packages, extended health insurance to part-time employees or furloughed employees, offered paid sick leave, or established wellness initiatives and mental health services.
– Talent acquisition and retention: Competitive trends affecting recruitment and retention of employees (including, if material, voluntary and involuntary turnover rates), trends in overall workforce composition and talent needs, and succession planning for senior leadership roles.
Other potential topics include employee engagement and wellness, development and training, company culture, and oversight and governance. If you’re looking for more insights into the new human capital disclosure requirement, we’re posting memos in our “Human Capital Management” & “Regulation S-K” Practice Areas.
Corporate Governance: Preparing for “Black Elephants”
This year has been a barrel of laughs. Pandemic, lockdowns, recession, divisive politics – and now to top it all off, I’m going to have to subscribe to Apple TV if I want to watch Charlie Brown! Thanks for nothin’ 2020.
I guess my point is that we live in interesting times, where unexpected and downright extraordinary events happen with alarming regularity. That’s why I thought that this recent HBR article made for interesting reading. The article discusses how corporate boards can build the resilience necessary for companies to address the “black elephants” that they’re likely to encounter in the future. According to the authors, these creatures are a cross between a “black swan” and the “elephant in the room,” and describe a “looming disaster that’s clearly visible, yet no one wants to address.”
The article addresses how boards can build the resilience necessary to deal with these stygian pachyderms through effective corporate governance, leadership development and compensation program design. Here’s an excerpt on governance:
Boards have a variety of means for promoting resilience and monitoring potential black elephant events. They can encourage stress tests in comprehensive risk reviews. They can press management on the worst-case scenarios for each black elephant, including when the threat becomes existential for the company. They can then suggest “war games” to develop principles for effective responses — with lessons brought back to the board for assessment and discussion.
The authors also highlight some of the operational steps that the board can take on the governance front, including pushing management to fortify the company’s physical & digital defenses, taking actions to improve resilience in supply chains, and promoting technological solutions to minimize potential disruptions.
Earlier this year, Liz blogged about an SEC enforcement action targeting the “Simple Agreement for Future Tokens,” a once popular method of structuring crypto-financings that was intended to avoid securities law compliance issues. Well, it obviously didn’t, and if one SEC enforcement proceeding wasn’t enough to drive that message home, this Brian Cave memo discusses a second one:
On September 30, 2020, Judge Alvin Hellerstein, of the Southern District of New York granted summary judgment to the Securities and Exchange Commission in its enforcement action against Kik Interactive Inc., in which the SEC contended that Kik’s 2017 $100 million Initial Coin Offering was an unregistered securities offering. The Kik decision marks the second time this year that a federal judge in the SDNY has determined that an ICO involving the “Simple Agreement for Future Tokens” (“SAFT”) framework constituted an unlawful unregistered securities offering, establishing a daunting precedent for both potential and past SAFT issuers.
Yesterday, Kik officially threw in the towel and settled with the SEC. One of the interesting things about this case is that the defendant was postively itching to fight the SEC. In fact, as I blogged last year, Kik even went out and raised a war chest from the crypto crowd to fund the litigation. I was skeptical that courting an enforcement proceeding was a particularly good strategy, and now that Kik has gotten its clock cleaned, perhaps the folks behind it don’t think so either.
Although the SAFT was a popular structure, people raised concerns about it from the start. Now that it’s been swatted down twice in the space of a few months, it’s probably time to concede that the SAFT structure doesn’t cut the mustard.
Insider Trading: Enforcement Numbers Way Down Last Year
According to an NPR report, the number of insider trading enforcement actions brought by the SEC declined dramatically in 2019:
The government agency responsible for policing Wall Street brought the fewest number of insider trading cases in decades, according to the most recent available data. That decline came just before the COVID-19 pandemic hit. The Securities and Exchange Commission now warns that the pandemic has created wild swings in the market and more opportunities for insider trading.
NPR reviewed data from the 1980s through last year and found that under the Trump administration, the SEC brought just 32 insider trading enforcement actions in 2019, the lowest number since 1996.The SEC charged 46 defendants as part of those cases. That was the lowest number of defendants in insider trading cases since Ronald Reagan was president, and about half of the annual average over the last three decades. The decline has alarmed experts and advocates, who worry that flagrant illegal trading may go unchecked.
I suppose this report wouldn’t have been aired without including allegations that “flagrant illegal trading” was going unchecked but the report also includes commentary to the effect that the decline reflects the current regime’s enforcement focus, which has emphasized issues impacting “Main Street Investors.” That seems to me to be a more likely explanation for the drop in insider trading cases during a year where overall enforcement activity was near an all-time high.
Sustainability: A Random Walk All Over ESG Funds
Burton Malkiel’s book, “A Random Walk Down Wall Street”, has probably done more to promote index funds as an investment option than any other work. In a recent WSJ opinion piece, he comes down hard on the concept of ESG funds. Here’s an excerpt:
Some ESG providers have also claimed that social investing can enhance returns. During particular periods, some funds with specific ESG mandates have outperformed. In the first half of 2020 funds with no oil but high tech stocks did well as the price of oil plummeted and tech stocks soared. But no credible studies show that ESG investing offers consistently higher long-term returns. Such funds are less diversified than broad-based index funds and thus are riskier. They also have higher expense ratios, which tends to lower investment returns.
Further, ESG investing is inherently at odds with the goal of earning higher returns. Investor taste does influence asset prices. But as a thought experiment, suppose that oil stocks are so abhorred that they now sell at low prices relative to their earnings and prospects. That means they will offer higher future returns, and portfolios excluding them might underperform.
So what should investors interested in ESG investing do? Not surprisingly, Malkiel says that low-cost, broad-based index funds should be the core of any investment portfolio. Investors that want to invest in funds with particular mandates should do this as an add-on to their core portfolios.
It has been a couple of years since California enacted a statute requiring listed companies headquartered in the Golden State to have women on their boards. That statute was controversial and questions about its legality remain, but is it working? According to a recent study from the California Partners Project, the answer seems to be yes, although many companies still have work to do to reach the levels of female board representation required by the end of 2021. Here are some of the highlights:
– Of the 650 California-headquartered companies subject to the legislation, 29% did not have a single female director in 2018. Today, only about 2% lack female board representation.
– The number of California public company board seats held by women has grown from 766 in 2018 to 1,275 today – an increase of 67%
– 28% of California companies subject to the legislation currently meet the requirement for female board membership that will apply effective 12/31/21, while 72% need one or more additional female directors to come into compliance.
The law required all companies to have at least one female director by the end of 2019. By the end of 2021, companies with six or more directors must have at least three female directors, companies with five or more directors must have at least two, and companies with four or fewer directors must have at least one.
S-K Modernization: The Questions Just Keep Coming. . .
We continue to get a lot of questions on the SEC’s recent amendments to Item 101, 103 & 105 of Regulation S-K. As Liz blogged last month, some of these questions have focused on potential disconnects between the amended language of Item 101 of S-K & the language of Item 1 of Form 10-K. More recently though, we’ve been getting some interesting questions on our Q&A Forum on how the rules apply to Securities Act filings – and Form S-3 registration statements in particular. Here’s one question that we received:
Any thoughts on how the amendments will apply to outstanding shelf registration statements? If after November 9, 2020, a prospectus supplement incorporates by reference the risk factor discussion from a previously filed Form 10-K and that risk factor discussion does not comply with the amended rule (e.g., because it fails to include headings), must the prospectus supplement restate all risk factors in compliance with the amended rule?
Although Form S-3 does not specifically require disclosure of Items 101 and 103, Form S-3 incorporates prior disclosure of these items because of the required incorporation by reference if the Form 10-K. Must the Form 10-K disclosures be updated to conform to the rule changes?
Here was my response:
That’s an interesting question. For what it’s worth, here are my two cents: In the case of an already effective S-3, I don’t think that updating to address the new requirements would be required. That’s because the registration statement contained everything “required to be stated therein” under the rules applicable at the effective time, and that’s when Section 11 speaks. The fact that information incorporated by reference into that registration statement no longer complies with the amended requirements of Item 105 wouldn’t implicate Section 11.
I think the obligation to update the prospectus would instead be governed by the obligations imposed by the undertakings in Item 512 of S-K, Rule 10b-5, and Section 12(a)(2) of the Securities Act. My guess is that in most instances, issuers would likely conclude that the existing disclosure incorporated by reference into the filing doesn’t need to be updated to conform to the requirements of amended Item 105 in order to comply with any of these potential updating obligations.
There have been follow-up questions addressing situations involving Form S-3s filed before the new rules went into effect, but declared effective afterward, as well as whether existing 10-K language addressing Item 101 would need to be updated in the case of a Form S-3 filed after the S-K amendments. If you’d like to check those out, they’re all in Topic #10475.
I’ve taken a stab at answering these questions, but who cares what I think? The bottom line is that there are a lot of questions about the application of the S-K amendments, and with the effective date just around the corner, guidance from Corp Fin would be very helpful.
Political Spending: Transparency & Accountability on the Rise
According to the latest CPA-Zicklin Index, corporate disclosure of and accountability for political spending is on the rise. Here are some of the stats:
– In 2020, 228 (over 60% of the 378 “core” companies that have been in the S&P 500 since 2015) had policies for general board oversight of political spending. Meanwhile, core companies with specific committee review of different types of political spending increased between 32% and 48% depending on the recipient type between 2016 and 2020.
– 240 companies, or nearly two-thirds of core companies, had policies in 2020 for fully disclosing or prohibiting donations to candidates, political parties and committees; 224 companies had them for donations to 527 groups; and 211 companies had them for independent expenditures.
– The biggest increase in any category – 50% to 135 companies from 90 in 2016 – came in disclosure or prohibition of donations to tax-exempt 501(c)(4) groups also known as “social welfare” organizations, often a focus of scrutiny over their “dark money” spending.
– The average score evaluating overall political disclosure and accountability for the core companies has risen steadily from 46% in 2016 to 57% in 2020, an increase of nearly 25%. In 2020, 144 core companies placed in the first Index tier (scoring from 80% to 100%) a dramatic increase of almost 80% compared to 79% of core companies in 2016.
The report says that the Trump years (2016-2020) have proven to be a boom time for corporate political disclosure and accountability, and that increases in adoption of board oversight and more detailed committee review of political spending are “especially striking.”
Last week, Liz blogged about ISS’s benchmark policy document. In addition to the ESG & diversity policy changes that she mentioned, page 34 of the document sets forth a proposed policy under which ISS would generally endorse Delaware exclusive forum bylaws for Delaware corporations. Here’s an excerpt from Wachtell Lipton’s memo on the proposed policy:
Institutional Shareholder Services (ISS) has released its proposed 2021 voting policy updates and, for the first time, proposes expressly recognizing the benefits of Delaware choice of forum provisions for Delaware corporations and generally recommending in favor of management-sponsored proposals seeking shareholder approval of such charter or bylaw provisions. Under the new ISS policy, ISS would:
(1) generally vote for charter or bylaw provisions that specify Delaware, or the Delaware Court of Chancery, as the exclusive forum for corporate law matters for Delaware corporations, “in the absence of serious concerns about corporate governance or board responsiveness to shareholders” (and continue to decline to vote against the directors of Delaware companies who adopt such bylaw provisions “unilaterally”);
(2) continue to take a case-by-case approach with respect to votes regarding exclusive forum provisions specifying states other than Delaware; and
(3) generally vote against provisions that specify a state other than the state of incorporation as the exclusive forum for corporate law matters or a specific local court within the state (and apply withhold vote recommendations to a board’s “unilateral” adoption of such a provision).
When it comes to federal forum bylaws, ISS’s proposed policy would would generally support charter or bylaw provisions that specify “the district courts of the United States” as the exclusive forum for federal securities law matters. However, the memo notes that ISS would recommend against against provisions that limit the forum to a particular federal district court. As with ISS’s other proposed policy changes, the time period to submit comments on this proposal ends on October 26th.
Financial Reporting: About Those Covid-19 One-Time Charges. . .
We’ve blogged quite a bit about the financial reporting issues created by the pandemic (here’s a recent one), but this WSJ article raises another one – how long can companies characterize Covid-19 related costs as “one time charges”? Here’s an excerpt:
More than six months into the pandemic, company executives say they expect to be dealing with the effects of Covid-19 for much longer than they initially anticipated. Still, some companies continue to treat virus-related costs as special, one-time items, which can give the impression that a business’s costs are lower than they actually are. This in turn can boost its non-GAAP financial results. Companies often highlight these metrics when also reporting earnings figures that comply with generally accepted accounting principles as required.
Some investors and accounting professionals suggest that after two quarters of reporting Covid-19-related costs, companies should consider treating these items as regular costs of doing business as they close the books for the third quarter and not adjust their non-GAAP earnings.
The article says that many prognosticators suggest that current conditions – and the heightened expenditures for PPE and other Covid-19 related costs – are going to continue at least until a vaccine becomes widely available. In that kind of environment, the appropriateness of continuing to back out these costs from non-GAAP numbers on the basis that they’re “one-time charges” is questionable.
Non-GAAP & KPIs: A Primer From the CAQ
The Center for Audit Quality recently published a report that supposedly deals with the role of auditors in non-GAAP financial measures and key performance indicators. Sure, there’s a section in there that addresses this topic, but most of the document is really a primer on the use of non-GAAP financial measures and KPIs. It’s pretty good too – particularly for someone who doesn’t deal with disclosure & other issues relating to these metrics on a regular basis.
On Friday, the SEC announced amendments to the auditor independence requirements set forth in Rule 2-01 of Regulation S-X. Here’s the 130-page adopting release. The amendments are intended to update the independence rules to address recurring fact patterns that triggered technical independence rule violations without necessarily impairing the auditor’s objectivity and impartiality.
Among other things, the amendments address independence issues that arise when sister companies with a common PE fund owner have engaged an audit firm to provide non-audit services that could impair the independence of the audit firm with respect to another sibling company. The amendments also shorten the look-back period for auditor independence from three years to one year for first time filers, which will provide increased flexibility for IPO companies to address potential disqualifying relationships with their audit firms.
The SEC’s press release summarizes the changes implemented by the amendments & provides a couple of examples of how they will work. According to the release, the amendments will:
– Amend the definitions of “affiliate of the audit client,” in Rule 2-01(f)(4), and “investment company complex,” in Rule 2-01(f)(14), to address certain affiliate relationships, including entities under common control;
– Amend the definition of “audit and professional engagement period,” specifically Rule 2-01(f)(5)(iii), to shorten the look-back period, for domestic first time filers in assessing compliance with the independence requirements;
– Amend Rule 2-01(c)(1)(ii)(A)(1) and (E) to add certain student loans and de minimis consumer loans to the categorical exclusions from independence-impairing lending relationships;
– Amend Rule 2-01(c)(3) to replace the reference to “substantial stockholders” in the business relationships rule with the concept of beneficial owners with significant influence;
– Replace the outdated transition provision in Rule 2-01(e) with a new Rule 2-01(e) to introduce a transition framework to address inadvertent independence violations that only arise as a result of a merger or acquisition transactions; and
– Make certain other miscellaneous updates.
I’ll give you three guesses how the SEC’s vote on this went down – and the first two don’t count. Anyway, here’s Chair Clayton’s statement on the adoption of the amendments, and here’s the customary dissenting statement from Commissioners Lee and Crenshaw. The dissenters expressed concern with the increased discretion provided to audit firms when assessing their own independence and the lack of any mechanism to provide visibility into how auditors are exercising this discretion. We’ll be posting memos in our “Auditor Independence” Practice Area.
Enforcement: SEC Provides $20MM Reminder That You’d Better Know What You Know. . .
In addition to the SEC’s amendment of Rule 2-01 of S-X, there was also some interesting news on the enforcement front last Friday. The SEC announced a settled enforcement proceeding against Andeavor LLC arising out of alleged internal controls violations that resulted in the company engaging in a stock buyback while it was engaged in preliminary merger negotiations with a potential buyer.
According to the SEC’s order, the company’s CEO directed its CFO to initiate a $250 million stock buyback two days before the CEO was scheduled to meet with his counterpart at Marathon to resume confidential discussions about Marathon’s potential acquisition of Andeavor at a significant premium. The next day, Andeavor’s law department approved a Rule 10b5-1 plan to repurchase $250 million of stock. It made that authorization after concluding that these discussions did not constitute MNPI.
According to the order, that conclusion was “based on a deficient understanding of all relevant facts and circumstances regarding the two companies’ discussions.” As this excerpt from the order notes, the SEC contended that this deficient understanding was the result of a breakdown in internal accounting controls:
This lack of understanding was the result of Andeavor’s insufficient internal accounting controls. Andeavor used an abbreviated and informal process to evaluate the materiality of the acquisition discussions that did not allow for a proper analysis of the probability that Andeavor would be acquired. Andeavor’s informal process did not require conferring with persons reasonably likely to have potentially material information regarding significant corporate developments prior to approval of share repurchases.
In particular, nobody involved in the process discussed with the CEO the prospects that the two companies would reach a deal, which the SEC said resulted in a miscalculation of its probability (remember, we’re in Basic v. Levinson territory here). The company ultimately consented to a C&D against violations of the book & records provisions of the Exchange Act and a $20 million penalty.
The trouble with contingency cases is that there’s a huge potential for hindsight when you know how things ended up, and this case is no exception. The parties ultimately did agree on a deal at a valuation of $150 per share in April 2018 – compared to an average price of $97 paid for shares acquired in the buyback during February & March of the same year. That’s not exactly an ideal fact pattern for defending a position that the preliminary merger negotiations weren’t material.
A key takeaway from this proceeding seems to be that one of the key functions of internal controls – whether you’re talking about disclosure controls & procedures or ICFR – is to enable companies to “know what they know.” That’s even more important when dealing with contingency disclosure. Companies that want to defend claims that are brought with the benefit of hindsight need to demonstrate that their control procedures were robust & well-functioning at the time a critical judgment call was made.
Virtual Meetings: P&G Gets It Right
Soundboard Governance’s Doug Chia has attended a slew of virtual annual meetings this year, and he says that Procter & Gamble’s recent meeting was among the best he’s seen. Check out his recent blog for the details.
Doug will also be participating in our webcast next Thursday, October 29th – “Virtual Annual Meetings: What To Do Now” – along with CII’s Amy Borrus, Dorothy Flynn of Broadridge, Independent Inspector of Election Carl Hagberg and Bristol-Myers Squibb’s Kate Kelly. Don’t miss it!
