Last week, SEC Chair Jay Clayton issued another cautionary statement on cryptocurrencies & ICOs. The statement covers a lot of ground – and it zeroes in on the professionals involved in these deals & their actions following the SEC’s 21(a) Report:
Following the issuance of the 21(a) Report, certain market professionals have attempted to highlight utility characteristics of their proposed initial coin offerings in an effort to claim that their proposed tokens or coins are not securities. Many of these assertions appear to elevate form over substance. Merely calling a token a “utility” token or structuring it to provide some utility does not prevent the token from being a security.
Tokens and offerings that incorporate features and marketing efforts that emphasize the potential for profits based on the entrepreneurial or managerial efforts of others continue to contain the hallmarks of a security under U.S. law. On this and other points where the application of expertise and judgment is expected, I believe that gatekeepers and others, including securities lawyers, accountants and consultants, need to focus on their responsibilities. I urge you to be guided by the principal motivation for our registration, offering process and disclosure requirements: investor protection and, in particular, the protection of our Main Street investors.
That boldface type isn’t from me – it’s from Jay Clayton. This is what a warning shot looks like, folks – and if you’ve been talking yourself into concluding that your client’s coin offering is different than all the rest, think again.
ICOs: SEC Halts ICO Offering
Just to make sure nobody missed the message, on the same day that Chair Clayton’s statement was issued, the SEC announced that it had entered a C&D order halting an ICO on the basis that it involved an unregistered public offering.
The SEC’s order is worth reading – if for no other reason than to drive home the point that a token can be a security even if it has some “utility”:
Even if MUN tokens had a practical use at the time of the offering, it would not preclude the token from being a security. Determining whether a transaction involves a security does not turn on labeling – such as characterizing an ICO as involving a “utility token” – but instead requires an assessment of “the economic realities underlying a transaction.” Forman, 421 U.S. at 849. All of the relevant facts and circumstances are considered in making that determination.
Interestingly, the issuer of the token contended in its offering materials that it had conducted a “Howey analysis” and that the tokens did not “pose a significant risk of implicating federal securities laws.” The SEC thought otherwise.
ICOs: Meanwhile, Over at the Plaintiffs’ Bar…
I recently blogged that the plaintiffs’ bar has jumped in on the ICO fun – and this recent blog from Kevin LaCroix at the “D&O Diary” highlights another new securities class action suit involving a coin offering. A company called Centra apparently raised $30 million in a token offering that was completed in October 2017. As this excerpt notes, that’s when things got interesting:
On October 27, 2017, shortly after the company completed its ICO, Centra was the subject of an unflattering profile in the New York Times entitled “How Floyd Mayweather Helped Two Young Guys From Miami Get Rich”). Among other things, the article disclosed that on Oct. 5, the company’s co-founders, Sam Sharma and Raymond Trapani, had been indicted by a Manhattan grand jury in connection with their testimony in a July trial involving drunk-driving charges against Sharma.
The article also detailed that Sharma and Trapani had no prior professional experience associated with the debit cards they hoped to build. Their prior business experience consisted of running a luxury rental car company. The Times was also unable to confirm with the major credit card companies the supposed business arrangement Centra had described on its website.
The company subsequently announced that the two founders were stepping aside – and a class action lawsuit was filed on December 13th…
The Trump administration on Wednesday abandoned its defense of the Securities and Exchange Commission’s in-house judicial system, siding with opponents who say the hiring process for the SEC’s judges is unconstitutional. In a brief filed with the U.S. Supreme Court, lawyers for the Justice Department wrote they now consider the SEC’s administrative law judges to be officers like other presidential appointees, instead of employees who are picked through a human-resources process. That means the way the SEC hires the judges may violate a constitutional clause that safeguards separation-of-powers principles.
The Justice Department’s brief didn’t explicitly describe the judges’ appointments as unconstitutional, but said the selection process for the in-house judge at issue in the case “did not conform” to a constitutional requirement. Mark Perry, a partner at Gibson, Dunn & Crutcher LLP who represented the challengers, said the Supreme Court’s involvement is still needed to resolve a disagreement between lower courts over the judges’ status. The Supreme Court would have to appoint an outside party to argue the case since the Justice Department has turned its back on defending it, the brief says. “We are one step closer to victory,” Mr. Perry said Wednesday.
The SEC didn’t sign the Justice Department’s brief. The regulator likely felt it couldn’t join the position because SEC commissioners have previously issued opinions in contested cases stating that judges are employees, not officers, said Andrew Vollmer, a professor at the University of Virginia School of Law and a former deputy general counsel of the SEC. An SEC spokesman declined to comment.
SEC Ratifies ALJ Appointments: Are Prior Decisions at Risk?
In response to the Trump administration’s action, the SEC announced that it had ratified its prior appointments of its current ALJs in order to resolve “any concerns that administrative proceedings presided over by its ALJs violate the Appointments Clause.”
The SEC’s decision to ratify these prior appointments raises an important issue – are cases that were previously decided at risk of being invalidated? Check out this tidbit from a K&L Gates memo about the D.C. Circuit case challenging the ALJ system that’s currently before the Supreme Court:
Despite a question from the bench, the parties did not discuss potential remedies to the possible Appointments Clause violation in detail. Should the D.C. Circuit rule in favor of Petitioners, the SEC Commissioners could ameliorate the issue simply by reappointing the Commission’s five ALJs directly. Because the SEC may risk invalidating other adjudicated findings of liability by acknowledging that its ALJs are unconstitutionally appointed, the SEC may instead choose to stay all administrative proceedings in which a respondent has the option to seek review in the D.C. Circuit while it appeals the case to the Supreme Court.
Interestingly, as part of its order ratifying the ALJ appointments, the SEC lifted a stay on administrative proceedings subject to the jurisdiction of the 10th Circuit that it had put in place in response to a decision in that circuit holding that they were unconstitutionally appointed. So, it looks like the SEC is all-in on the ratification approach.
When you think about it, the administration’s action left the SEC with no other choice – but it looks like there’s really big can of worms that could be opened depending on how the Supreme Court ultimately resolves the issue.
Late last month, the DOJ announced a revised FCPA corporate enforcement policy. The policy – which builds upon the DOJ’s pilot program that we’ve previously blogged about – is intended to provide further enhancements for cooperation. This Simpson Thacher memo reviews the key elements of the new policy (we’ve posted oodles of memos in our “FCPA” Practice Area). Here’s the intro:
On November 29, 2017, Deputy Attorney General Rod J. Rosenstein announced a revised U.S. Department of Justice Foreign Corrupt Practices Act Corporate Enforcement Policy, designed to further incentivize companies to self-report potential FCPA violations. Building on the framework announced in a DOJ pilot program last year, the new policy offers companies that voluntarily self-disclose, fully cooperate, and timely and appropriately remediate substantial cooperation credit—including the presumption of a declination from DOJ criminal prosecution (absent certain aggravating circumstances).
Companies will still be required to pay all disgorgement, forfeiture, and/or restitution resulting from any misconduct at issue. The policy has been added to the U.S. Attorneys’ Manual, which guides prosecutors on when and how to exercise discretion in reaching charging decisions.
The policy has no impact on other U.S. or foreign enforcement authorities, including the SEC.
This blog from Bass Berry’s Jay Knight flags a “sleeper issue” arising out of the lower corporate rates in the tax bill recently passed by the Senate & House – and if you’ve got deferred tax assets on your balance sheet, it just might cause you a few sleepless nights. Here’s the skinny:
At a high level, deferred tax assets are reported as assets on the balance sheet and represent the decrease in taxes expected to be paid in the future because of net operating loss (NOL) and tax credit carryforwards and because of future reversals of temporary differences in the bases of assets and liabilities as measured by enacted tax laws and their bases as reported in the financial statements. NOL and tax credit carryforwards result in reductions to future tax liabilities, and many of these attributes can expire if not utilized within certain periods. If a company believes it is more likely than not that some portion or all of the deferred tax asset will not be realized, a valuation allowance must be recognized.
By “recognized,” of course, Jay means “run through your income statement.” He highlights some disclosure from a major financial institution about the income statement impact of the UK’s rollback of corporate rates in 2013 – and suggests flagging this issue to your audit committee and reviewing your disclosures.
Do You Need an 8-K for the “Deferred Tax Assets” Sleeper?
Another thing to keep in mind is the possibility of tripping an 8-K requirement. For instance, if your deferred tax asset is impaired, you may need to consider whether an Item 2.06 Form 8-K is required. See this one, for example…
Release of “After-Hours” Info: SEC Approves NYSE Rule
On Monday, the SEC approved an NYSE rule limiting listed companies’ ability to issue material news releases shortly after the close of the market. Here’s an excerpt from this Ning Chiu blog summarizing the new rule:
A listed company must not issue material news after the NYSE closes trading until the earlier of (a) publication of the company’s official closing price on the Exchange or (b) five minutes after the Exchange’s official closing time. The NYSE amended its initial rule filing to make clear that the one exception to this revised requirement would be to permit companies to still publicly disclose material information following a nonintentional disclosure, if needed to comply with Regulation FD.
Trading on the Exchange ends at the Exchange’s official closing time of 4pm Eastern, or 1pm Eastern on certain days. The designated market maker, after close, facilitates the close of trading in an auction. Because there is trading of company securities on other exchanges and non-exchange venues even after the Exchange closes, there can be a significant price difference if a company issues news immediately after 4pm Eastern but before the closing auction on the Exchange is completed, leading to investor confusion.
In approving the rule change, the SEC noted that the price difference could increase market disruption and reduce investor confidence in trading on the Exchange, given that orders cannot be cancelled or modified to take into account the material news though the Exchange closing price may not yet have been established by the closing auction process. At the same time, however, the Commission recognizes that Section 202.05 of the Listed Company Manual requires a company to release quickly any news or information that might be expected to materially affect the market for its securities.
SCOTUS: Can State Courts Still Hear ’33 Act Claims?
Last week, the Supreme Court heard oral arguments in Cyan, Inc. v. Beaver County, which raises the issue of whether SLUSA strips state courts of jurisdiction over Securities Act claims. This recent blog from Lyle Roberts at “The 10b-5 Daily” reviews the arguments. Here’s an excerpt summarizing the legal background:
Congress passed the Private Securities Litigation Reform Act (PSLRA) to protect corporate defendants from meritless securities class actions. The PSLRA, however, only applied to federal cases. To evade the PSLRA’s impact, plaintiffs began filing securities class actions in state court, usually based on state law causes of action.
Congress passed SLUSA to close this loophole. Due to unclear drafting, however, there has been confusion in the lower courts over whether SLUSA also makes federal court the sole venue for class actions alleging Securities Act claims (which historically enjoyed concurrent jurisdiction in state or federal court).
The parties have put forward three competing interpretations of SLUSA. The petitioners say that SLUSA divests state courts of jurisdiction, the respondents say that it doesn’t – and the Solicitor General says that you can file in state court, but that cases can be removed to federal court.
We’ve previously blogged about the growing popularity among plaintiffs of state courts as a forum for Securities Act litigation – and about some of the steps that public companies have taken in response.
Whatever their underlying merits, coin offerings have quickly attracted their fair share of fraudsters – and the bad guys’ propensity for ICO scams hasn’t been lost on the SEC. In an October speech, Enforcement Co-Director Stephanie Avakian said that concerns about abuses in this area were one of the factors that led the SEC to create a new “Cyber Unit” in the Division of Enforcement:
As folks likely know, the Commission recently issued a Report of Investigation cautioning that offers and sales of digital assets by “virtual” organizations – often referred to as “Initial Coin Offerings” or “Token Sales” – are subject to the requirements of the federal securities laws, which can include the registration of securities offerings.
Blockchain technology presents many interesting issues and can of course present legitimate opportunities for raising capital. But, like many legitimate ways of raising capital, the popular appeal of virtual currency and blockchain technology can be an attractive vehicle for fraudulent conduct. We think that creating a permanent structure for the consideration of these issues within the Cyber Unit will ensure continued focus on protecting both investors and market integrity in this space.
Earlier this week, the Cyber Unit made its first big splash with the announcement that it had obtained an emergency asset freeze to stop what it called “a fast moving fast-moving Initial Coin Offering (ICO) fraud that raised up to $15 million from thousands of investors since August by falsely promising a 13-fold profit in less than a month.”
The alleged scam involves a recidivist securities law violator and his company, and the SEC’s complaint alleges that the defendants marketed and sold securities called “PlexCoin” – claiming that investments in PlexCoin would yield a 1,354% profit in less than 29 days.
The announcement notes that this represents the first action filed by SEC’s new Cyber Unit – and the extent of the ICO fraud problem strongly suggests that it won’t be the last. We’re posting memos in our “ICOs” Practice Area.
ICOs: Offerings Continue to Boom – But Class Actions Start to Bloom
The potential fraud issues associated with coin offerings haven’t just attracted the attention of the SEC. While these offerings continue to attract a high-level of investor interest, this “D&O Diary” blog points out that they’re also becoming an attractive target for securities class actions. Here’s the intro:
According to the latest update on the CoinSchedule website, there have been a total of 228 initial coin offerings so far this year through mid-October, raising a total of over $3.6 billion. At least five of this year’s ICOs have raised over $100 million. This burgeoning activity notwithstanding, ICOs are at the center of controversy.
Among other things, China and South Korea have banned ICOs. The SEC has already shown its willingness to pursue enforcement actions against ICO sponsors, as discussed further here. And now a high-profile statement by one of the country’s leading securities regulation experts suggests even greater scrutiny may lie ahead. In the meantime, as discussed below, ICO and cryptocurrency-related litigation appears to be proliferating.
The blog goes on to provide details on several recent class action lawsuits involving coin offerings.
Whistleblowers: Supreme Court Hears Argument on Internal Whistleblower Issue
Last week, the Supreme Court heard oral arguments in Somers v. Digital Realty Trust – which gives the Court an opportunity to resolve a split between the circuits concerning whether Dodd-Frank’s whistleblower protections extend to individuals who report wrongdoing internally, but don’t reach out to the SEC. This recent blog from Cydney Posner reviews the case and the issue before the court. Here’s an excerpt:
In this case, the 9th Circuit had refused to dismiss Somers’ whistleblower claim brought under Dodd-Frank’s anti-retaliation provision, even though he had failed to report the violation to the SEC. As you may recall, Dodd-Frank added Section 21F to the Exchange Act, establishing new incentives and protections for whistleblowers, including monetary awards for reporting information, confidentiality provisions and employment retaliation protections.
The statute defines “whistleblower” as a person who reports potential violations of the securities laws to the SEC; however, in promulgating rules under the statute, the SEC distinguished the whistleblower anti-retaliation provisions from the award provisions, applying a broader definition in the context of anti-retaliation that would not require reporting to the SEC.
The 2nd Circuit agrees with the 9th Circuit’s approach – but the 5th Circuit has held that in order to qualify for protection, a whistleblower must report the wrongdoing to the SEC.
Yesterday, the PCAOB Staff issued implementation guidance addressing the changes in audit reports that are mandated under its new standard – AS 3101. As Liz blogged at the time of the standard’s adoption, AS 3101 requires a major revision in how auditors think about what – and how – they communicate to boards & investors.
The PCAOB Staff’s new guidance addresses both format & content and includes an annotated version of the new auditor’s report. Here’s an excerpt addressing the most controversial aspect of the new standard – the requirement that the report include a discussion of “Critical Audit Matters” (known as “CAMs”):
When the relevant requirements take effect, auditors of certain issuers will be required to include in the auditor’s report a communication regarding CAMs. CAMs are defined under AS 3101 as matters arising from the audit of the financial statements that have been communicated or were required to be communicated to the audit committee and that (1) relate to accounts or disclosures that are material to the financial statements and (2) involved especially challenging subjective, or complex auditor judgment.
The communication of CAMs is not required for audits of emerging growth companies; brokers and dealers; investment companies other than business development companies; and employee stock purchase, savings, and similar plans.
CAMs may be included voluntarily before the effective date or for entities for which the requirements do not apply. In advance of implementation, auditors may want to discuss the new CAM requirements with management and audit committees.
With the exception of the provisions relating to CAMs, the new standard goes into effect for audits of fiscal years ending on or after December 15, 2017. For large accelerated filers, the provisions relating to CAMs go into effect for audits of fiscal years ending on or after June 30, 2019. They go into effect for all other filers for audits of fiscal years ending on or after December 15, 2020.
Yesterday, PCAOB Chair Jim Doty delivered this speech entitled “The PCAOB’s Initiatives to Bolster Investor Trust in the Audit”…
Still More on “GAAP Means Nothing to Me”. . .
As another follow-up to my recent blog about institutional investors’ increasing disdain for GAAP, Broc pointed me in the direction of a series of articles in “Accounting Today” that say that it’s time for a paradigm shift in the way the accountants & standard setters approach GAAP. Why? According to the authors – two accounting profs – it’s because GAAP simply isn’t very useful:
We’re convinced that the consequence of practitioners’ inability to change is a status quo that is an unserviceable hodge-podge remnant of out-of-date practices. Specifically, we find today’s GAAP financial statements are as far removed from reports that meet the capital markets’ needs as hand-cranked telephones differ from smartphones. It follows, then, that financial accounting is stunningly ready for disruption.
Toward that end, we’re offering up paradigm-challenging truths to suggest that today’s financial accounting is bound to collapse. So, why would it?
It’s because the inability of practitioners to question their paradigm also keeps them from actually serving accounting’s ostensible information-providing purpose. Although they say they aim to present useful information, many inconsistencies between those words and their actions prove otherwise. Ultimately, their choices always favor what’s useful to themselves, not users.
Subsequent articles in the series drill down into some of the specific problems they have with the current financial reporting paradigm.
Corp Fin Updates “Financial Reporting Manual” for New Accounting Standards
On Friday, as noted in this Cooley blog, Corp Fin updated its “Financial Reporting Manual” to revise guidance on the pro forma impact of new accounting standards, address adoption of new accounting standards upon termination of EGC status, and clarify the effective date of the new revenue recognition & lease accounting standards for certain entities.
‘Tis the season for the “Big 4” accounting firms to weigh-in on Corp Fin comment priorities. Earlier this month, we blogged about EY’s take on the topic – and now Deloitte’s weighed in with its own study on Corp Fin comments for the 2016-2017 review period. The study found that the top 10 areas for comments were:
– Non-GAAP measures
– MD&A
– Fair value
– Segment reporting
– Revenue recognition
– Intangible assets & goodwill
– Income taxes
– State sponsors of terrorism
– Signatures, exhibits & agreements
– Acquisitions, mergers & business combinations
The list includes plenty of the usual suspects, but one of these things is clearly not like the others – here’s what the study says about comments addressing state sponsors of terrorism:
This category is new to the top 10 this year. The SEC staff has increased its focus on registrants that do business with countries designated by the U.S. State Department as state sponsors of terrorism, including Iran, Sudan, and Syria. SEC staff comments focus on disclosure about (1) the nature and extent of these contacts and (2) quantitative and qualitative factors about such activities.
The study includes examples of comments that the Staff has issued to companies disclosing business in these countries.
More on “Farewell to Corp Fin Giant, Bill Morley”
Recently, I blogged that Bill Morley passed away. We now have information about his memorial: “Glory Days Restaurant” in Edgewater, Maryland – this Friday, December 1st from 6-10 pm. It’s informal in a private room. Please RSVP to Marty Dunn if you (& others you know) plan on going as they need a head count.
Here are a few more remembrances:
– Marty Dunn, who worked with Bill for several decades, notes: “From the day I arrived at the SEC in 1988, I knew what the goal was. It was to be Bill. He had the ’33 and ’34 (and ’39) Act in his being. He understood them all. Their purpose was in his soul. He taught us all so much while being so humble. He said to me ‘our job is important, we’re not.’ That always stuck with me. Mr. Carter and Mr. Morley were incredible mentors & teachers. There is an entire generation of Corp Fin lawyers who appreciate their contribution to our careers. Bless you, Bill.”
– Paul Dudek, who left Corp Fin after 22 years last year, notes: “Thanks for sharing the sad news about Bill, and the stories and the picture. He was outstanding in so many ways, as a person, as a securities lawyer, as a manager, and much more. I think at some level he was a model for me staying in Corp Fin for so long, a shining example of how to carry out the mission of investor protection through full and fair disclosure, and all the corollaries to that simple statement, through thick and thin.”
– Stan Keller notes: “Here’s one outside perspective on Bill. For so many of us practicing on the outside, Bill was for so long the face of the SEC and a good one at that. Bill treated you as a professional with respect and was always willing to listen to your position and share his vast knowledge of the law and the lore with you. You knew that you would get a fair hearing and a thoughtful, considered response. We learned a lot about securities law from Bill in this way and we learned about the agency. Bill helped instill the Corp Fin Staff ethic of the SEC as being a service agency, which continues to this day. We remember him with fondness, respect and appreciation.”
Farewell to Mort Koeppel
I’m also sad to report that Mort Koeppel also passed away recently. Mort retired in the early ’80s as an Associate Director in Corp Fin after 40 years at the SEC. He lived nearly another 40 years, passing away at 98. His son – Jeff Koeppel – who also served in Corp Fin a while back. Here’s a picture of Mort’s branch back in the day: (seated) Mort Koeppel; (standing, left to right) Bill Carter, Joe Hock, Becky Fleck, Alan Cohen, Jim McCabe, Paul Belvin, Letty Lynn, Mark Warner, Tom Klee & Laurence Lese:
We’ve previously blogged about FASB’s controversial proposal to conform its approach to financial statement materiality to the judicial definition of “materiality” that applies in other contexts. While that proposal is supported by business groups, most investor advocates have panned it.
After two years of back & forth, FASB has decided to throw in the towel on the new proposal – but instead of leaving things stand, it opted to return to an earlier materiality standard. This Thomson Reuters article explains what FASB has done:
A unanimous FASB agreed to return to the definition of materiality from Concepts Statement (CON) No. 2, Qualitative Characteristics of Accounting Information, which defines materiality in the context of “the magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement.” The FASB said the CON No. 2 definition is consistent with the definition used by the SEC, the PCAOB, and the AICPA.
The FASB’s new approach tracks a recommendation that it received this summer from the SEC’s Office of Investor Advocate – and also reflects an apparent consensus reached among participants at a roundtable meeting held by FASB last March.
More on “GAAP Means Nothing to Me”
Last month, I blogged about an investor survey that suggested that many institutional investors didn’t have a lot of use for GAAP. Here are some insightful comments on the results of that survey from Maynard Cooper’s Bob Dow:
It was suggested that GAAP is not useful because cash flow is more important. But of course there are GAAP measures for cash flow on the cash flow statement. I have always found the cash flow from operations to be an important measure. If a mature company consistently has a negative cash flow from operations, that almost always spells big trouble.
We do expect start-ups to have a negative number until they become cash flow positive, but the measure can help to indicate how far we are from that milestone. The cash flow from operations is harder to manipulate than some other measures, except maybe straight EBITDA (unadjusted). But EBITDA is a less reliable measure of cash flow because it doesn’t take into account changes in working capital. You can go all the way to bankruptcy court with a positive EBITDA.
That’s a major problem with non-GAAP measures, they are susceptible to manipulation. As a Corp Fin Staffer once said, the most prominent non-GAAP measure is EBBS – everything but the bad stuff.
Of course most non-GAAP measures themselves are built on GAAP. To have a consistent and comparable measure for EBITDA, you have to have an agreed-upon set of ground rules for, e.g., revenue recognition. GAAP provides that set of rules. If everyone starts making up their own rules for revenue recognition, how could any of the measures be comparable?
My own experience suggests that Bob’s comments about EBITDA are right on the money – forgetting that the accounting concepts of depreciation & amortization represent the reality that assets wear out is a great way to end up in over your head.
Non-Voting Common Stock: Delaware Law Overview
As I recently blogged, multi-class capital structures continue to hang around – despite the opposition of many institutional investors. This Hunton & Williams memo provides an overview of Delaware corporate law issues associated with non-voting common stock, and is a handy reference tool for companies considering such a capital structure.
1. Shareholder Rights Plans. In order to “simplify” ISS’s approach to rights plans and “to strengthen the [ISS] principle that poison pills should be approved by shareholders in a timely fashion,” ISS will now recommend voting against all directors of companies with “long-term” (greater than one year) unilaterally adopted shareholder rights plans at every annual meeting, regardless of whether the board is annually elected. Short-term rights plans will continue to be assessed on a case-by-case basis, but ISS’s analysis will focus primarily on the company’s rationale for the unilateral adoption.
2. “Excessive” Non-Employee Director Compensation. ISS will recommend voting against or withholding votes from members of board committees responsible for setting non-employee director compensation when there is a “pattern” (over two or more consecutive years) of “excessive” non-employee director pay without a compelling rationale or other mitigating factors. Because “excessive” pay would need to be flagged for at least two years under the new policy, ISS will not make negative vote recommendations on this basis until 2019.
3. Disclosure of Shareholder Engagement. In considering whether to recommend against compensation committee members of companies whose Say-on-Pay proposals received less than 70% of votes cast, ISS considers the company’s disclosure regarding shareholder engagement efforts. ISS provided guidance regarding the level of detail included in such disclosures, including whether the company disclosed the timing and frequency of engagements with major institutional investors and whether independent directors participated; disclosure of the specific concerns voiced by dissenting shareholders that led to the Say-on-Pay opposition; and disclosure of specific and meaningful actions taken to address the shareholders’ concerns.
4. Gender Pay Gap Proposals & Board Diversity. ISS will vote case-by-case on requests for reports on a company’s pay data by gender, or a report on a company’s policies and goals to reduce any gender pay gap, taking into account the company’s current policies and disclosure related to its diversity and inclusion policies and practices, its compensation philosophy and its fair and equitable compensation practices. ISS will also take into account whether the company has been the subject of recent controversy or litigation related to gender pay gap issues and whether the company’s reporting regarding gender pay gap policies or initiatives is lagging its peers. ISS also noted that it would highlight boards with no gender diversity, but would not make adverse vote recommendations due to a lack of gender diversity. In addition, ISS revised its “Fundamental Principles” to state that boards should be sufficiently diverse to ensure consideration of a wide range of perspectives.
In Canada where there are new disclosure requirements on companies’ gender diversity policies, ISS is introducing a new policy on board gender diversity that will generally recommend withhold votes for the chair of the nominating committee if a company has not adopted a formal written gender diversity policy and no female directors serve on its board.
5. Pledging of Company Stock. ISS has codified its existing practice to recommend withhold votes against the members of the relevant board committee or the entire board where a significant level of pledged company stock by executives or directors raises concerns absent mitigating factors.
6. Pay-for-Performance Analysis. In connection with its pay-for-performance analysis, ISS will consider, in addition to other alignment tests, the rankings of CEO total pay and company financial performance within a peer group measured over a three-year period.
7. Other Changes. ISS has further revised its voting recommendations on climate change shareholder proposals in order to promote greater transparency on these matters.
FCPA Disgorgement: Kokesh Decision Underlines “Need for Speed”
In a recent speech, SEC Enforcement Co-Director Steve Peikin reviewed the agency’s FCPA enforcement priorities. One of the more interesting parts of Steve’s remarks addressed the impact of the Supreme Court’s Kokesh decision on FCPA enforcement. Here’s an excerpt:
In many instances, by the time a foreign corruption matter hits our radar, the relevant conduct may already be aged. And because of their complexity and the need to collect evidence from abroad, FCPA investigations are often the cases that take the longest to develop. In contrast to the Department of Justice, the statute of limitations is not tolled for us while our foreign evidence requests are outstanding.
These limitations issues have only grown in the wake of the U.S. Supreme Court’s recent decision in Kokesh v. SEC, in which the Court held that Commission claims for disgorgement are subject to the general five-year statute of limitations. Kokesh is a very significant decision that has already had an impact across many parts of our enforcement program. I expect it will have particular significance for our FCPA matters, where disgorgement is among the remedies typically sought.
While the ultimate impact of Kokesh on SEC enforcement as a whole – and FCPA enforcement specifically – remains to be seen, we have no choice but to respond by redoubling our efforts to bring cases as quickly as possible.
Kokesh: The Bad Guys Want Their Money Back
It turns out that the need to bring FCPA cases on a more timely basis isn’t the only potential fallout from the Kokesh decision. In addition to barring claims for disgorgement beyond the limitations period, this King & Spalding memo points out that Kokesh raises the broader issue of whether the SEC has authority to seek disgorgement at all:
As it considers the impact of Kokesh, we expect that the SEC staff will be less aggressive in its disgorgement demands and more open to arguments limiting how disgorgement is calculated. At the same time, defendants and respondents who litigate will undoubtedly follow up on the Supreme Court’s apparent invitation, in a footnote, to challenge whether disgorgement is available at all as an SEC remedy in enforcement actions.
Now, this Bloomberg article says that the Supreme Court’s invitation to litigate that issue has been accepted. You know all of those guys that the SEC sought disgorgement from? Well, they want a refund:
Anyway some lawyers read the Kokesh opinion in that particular way and brought this class-action lawsuit against the SEC a couple of weeks ago. Delightfully the class of victims/plaintiffs in the lawsuit is securities fraudsters: Specifically, it’s “all persons or entities from whom the SEC has collected, during the period from October 26, 2011 to the present, purported ‘disgorgement,'” with some fairly minor-seeming exceptions. The alleged damages are “approximately but not less than $14.9 billion over the last six years.”
According to the most recent edition of the “Spencer Stuart” board survey, the CEO was the only insider serving as a director on approximately 60% of S&P 500 boards. This Sidley memo says that a recent study indicates that may not be such a good thing:
Based on S&P 1500 company data from 2003 to 2014, the study concluded that companies with lone-insider boards (i.e., boards with no inside directors other than the CEO) awarded their CEOs “excess pay” (i.e., pay above what factors such as firm size, CEO age, CEO tenure, CEO equity ownership, industry, stock returns and performance would predict), with such CEOs receiving approximately 82% more pay than CEOs at peers with more than one insider on the board.
The study found that, as compared to their non-lone-insider peers, companies with lone-insider boards (1) have a $2.99 million larger pay gap between the CEO and other top management team (TMT) members, (2) are 1.27 times more likely to experience financial misconduct (defined as instances of financial restatements that are not due to clerical errors or minor accounting issues) and (3) experience poorer performance (e.g., a 10% lower return on assets).
The study says that analyst coverage and a high percentage of institutional share ownership mitigated the negative effects of a sole insider board on CEO pay vs. company performance – but not for pay gaps between the CEO & other executives or financial misconduct.
While We’re on the Topic of Inside Directors…
This “Columbia Blue Sky” blog discusses a new study by Virginia Tech’s Prof. Donald Bowen that says maybe those pre-SOX insider dominated boards weren’t so terrible after all. This excerpt summarizes the study’s results;
In a new working paper, I examine these questions by taking a new approach that exploits the implementation of the law. In short, the independent board mandates defined independence such that some directors could reclassify from non-independent to independent.
The effect of this definition is that while some firms—“treatment” firms—were required to change the membership of the board to meet the requirement, other firms—“placebo” firms—complied not because their directors changed, but because the classification of their directors changed. Importantly, the social and economic relationship between the CEO and director are largely unchanged for reclassified directors. As such, the reclassifications made boards at placebo firms more independent legally, but not economically.
My main tests show that placebo firms significantly outperformed treatment firms following the introduction of the independent board rules. I also show that the specific conditions that determine whether a firm is defined as a treatment firm or placebo firm are effectively random. This gives the estimated performance advantage of placebo firms a causal interpretation and implies that treatment firms performed worse because their boards were changed. In other words, the mandated governance policies impeded the conduct of firms targeted by the regulations.
Overboarding: What’s Good for the Goose. . .
This WSJ article points out that overboarding is a big issue for institutional investors – and this excerpt says that some big players are using their voting clout to curb the practice:
BlackRock, the world’s largest asset manager, cast 168 votes against directors this year due to overboarding concerns. It fought the reelection of directors at companies such as Charter Communications Inc., Pfizer Inc. and PayPal Holdings, Inc., according to filings and a spokesman for the money manager.
BlackRock wasn’t alone – the article says that last year, State Street cast votes against 69 CEOs who served on more than 3 boards & against 22 non-CEO directors who each sat on more than 6 public boards.
But this blog from Professor Ann Lipton suggests that these institutions may not be the right folks to lead the charge on this issue:
Most mutual fund companies employ a single board – or a few clusters of boards – to oversee all of the funds in the complex. This can result in directors serving on over 100 boards in extreme cases. State Street’s Equity 500 Index Fund, for example, reports trustees who serve on 72 or 78 boards within the complex. BlackRock’s Target Allocation Funds have trustees who serve on either 28 and 98 different boards (depending on how you count).
I’ll admit this is something of a cheap shot: presumably each fund is much more similar to the other funds than are the various companies at which overboarding concerns are raised. Still, when you get to over 20 funds per director, that’s a lot, no? Or 50 funds? Especially since the funds have varying interests – they might stand on opposite sides of a merger, or invest at different levels within a single firm’s capital structure, or compete for limited opportunities like IPO allocations and pre-IPO shares.
Yesterday, the House Financial Services Committee approved 23 bills – including two pieces of legislation that would repeal Dodd-Frank’s conflict minerals & mine safety and health disclosure requirements.
– H.R. 4248 would amend the Securities Exchange Act to repeal Section 13(p) – which directed the SEC to adopt its conflict minerals disclosure rules and related certification and audit requirements. The bill would also make conforming changes to the text of Dodd-Frank.
– H.R. 4289 would amend the Securities Exchange Act to repeal Section 1503 of the Dodd-Frank Act, which requires detailed disclosures about mine safety and health in the quarterly and annual reports they file with the SEC.
So, should everybody put their pens down? This recent blog from Steve Quinlivan says that’s not necessarily a good idea:
I recommend that anyone working on conflicts minerals to continue to work. Bills passed by the Financial Services Committee have a relatively poor track record of being enacted into law, at least over the short term. Similar provisions were included in the Financial Choice Act 2.0 which has not been enacted.
Tax Reform & CEO Pay: Adding to the “Museum of Unintended Consequences?”
The GOP’s ever-evolving tax reform proposal has produced a torrent of memos from law firms, accounting firms, & other advisors (we’re posting them on CompensationStandards.com). Not surprisingly, many of the memos focus on the impact of proposed changes in the treatment of executive comp. Among other things, the current version of the proposal would repeal the provisions of Section 162(m) that allow companies to deduct performance-based pay in excess of $1 million.
Congress’ willingness to tinker with executive comp reminds me of the old adage that those who don’t learn from the past are condemned to repeat it. Remember, the much reviled Section 162(m) itself was enacted in 1993 in an effort to align executives’ interests with those of stockholders.
Instead, as former SEC Chair Chris Cox put it, Section 162(m) “deserves a place in the museum of unintended consequences.” That’s because, instead of aligning management & shareholder interests, the emphasis on performance-based pay led to something else entirely, as Prof. Steve Bainbridge explains in this blog:
Although CEO pay had been growing fast relative to other metrics during the 1980s, it was in the 1990s that CEO pay really started to explode as a percentage of corporate profits and total wages. In large measure, this occurred because of a huge shift towards options and other forms of incentive pay that were tax favored under the 1993 amendments.
How big is huge? According to this study, in 1992, the S&P 500 granted options worth a total of $11 billion – a figure that rose to $119 billion by 2000. Boards & comp committees undervalued equity awards. In fact, as one director quoted in this 2016 NPR podcast put it, “we thought they were free.”
Changes in accounting rules subsequently made it clear that equity awards aren’t free – but big equity awards have become part of the executive comp landscape, and this recent Stanford study says that they continue to play an outsized role in executive pay, and an even more outsized role in its explosive growth.
Now, Congress is considering eliminating the “performance-based” pay loophole. What’s going to happen to equity awards & executive comp if this becomes law? You’ve got me – but history says that the consequences are unlikely to be what’s intended.
Activism: CEOs In the Crosshairs
This “Forbes” interview with Skadden’s Rich Grossman discusses the implications of an increasingly popular activist tactic – targeting CEOs for removal from the board through proxy contests. Here’s an excerpt from Rich’s comments:
I think most practitioners and governance experts would agree that one of the most important responsibilities of a board is the selection of the CEO, and the removal of the CEO from the board sends a very strong message, especially a board made up of a majority of independent directors.
While shareholders do not have the right to directly remove board-selected officers, if a CEO gets removed from the board in a contest, it’s a vote of no confidence. In those circumstances, I can’t imagine a board not looking at the situation and saying, “should we rethink our decision regarding the CEO?” It certainly makes for an awkward situation.
Why are CEOs being targeted? The approach ISS takes toward proxy contests seeking minority board representation is a big part of the reason:
Under the current ISS analytical framework, recommendations are made depending on whether the dissident is seeking a minority or a majority position on the board, with the standard for a dissident seeking minority representation being significantly easier to meet than if control is sought. The ISS minority contest standard — what I’ll call the “what’s the harm” standard — for replacing directors seems to apply regardless of whether the CEO is targeted.
