The SEC has brought enforcement actions against a number of companies offering digital assets in which it has alleged that the assets are a “security” within the meaning of Section 2(a)(1) of the Securities Act. Much to the consternation of the crypto bros, the answer to that question is often a straightforward “yes”, based upon application of the Howey test. But the answer isn’t so simple when it comes to other digital assets.
To get a sense for the complexity of this issue for some digital assets, check out the comment letter exchange that David Kitchin & Jay Knight recently flagged on Bass Berry’s Securities Law Exchange Blog. The Staff issued a comment (see comment No. 2) on a Form 10 filing by Graystone Horizen Trust, which was organized to hold the ZEN cryptocurrency, requesting it to furnish the Staff with its analysis as to why ZEN wasn’t a security. The company’s response letter included a 30-page analysis (featuring more than 130 footnotes) of the issue from its outside counsel that reached the following conclusion:
The SEC could claim that ZEN is a security on the basis that holders would rely on the efforts of the Foundation or the Company. Even so, while not free from doubt, the Sponsor could make arguments to the contrary that, in light of the full facts and circumstances, ZEN does not meet all the elements of Howey such that it would be an investment contract.
The Staff and the company engaged in several more rounds of comments in which it requested additional disclosure concerning ZEN’s potential classification as a security. But at the end of the process, the Staff decided to kick the can down the road and issued this final comment:
Refer to your responses to comment 2 in our June 13, 2022 letter and related comments. While we do not have any further comments at this time regarding your responses, please confirm your understanding that our decision not to issue additional comments should not be interpreted to mean that we either agree or disagree with your responses, including any conclusions you have made, positions you have taken and practices you have engaged in with respect to this matter.
The result of this exchange isn’t surprising – after all, the resolution of the status of a particular cryptocurrency under the Securities Act is likely an issue that will ultimately need to be decided by the courts or by more senior SEC officials. But it does illustrate just how complicated the issues surrounding whether some digital assets are securities can be.
The SEC’s Office of the Advocate for Small Business Capital Formation just issued its 2022 Annual Report, which highlights the OASB’s activities during the year and discusses the overall state of capital formation, the capital needs of early stage and more mature businesses, and other matters. There’s a lot of interesting data in the report, but one thing in particular that I’d like to note is that on p. 6 of the Report, the OASB singles out Deputy Director Sebastian Gomez Abero’s appearance on our own Dave Lynn’s “Deep Dive with Dave” podcast as one of the year’s highlights. Check it out!
Yesterday, the SEC adopted amendments to Rule 10b5-1 imposing new conditions & disclosure requirements for 10b5-1 plans and securities transactions by companies and insiders. Here’s the 252-page adopting release, and here’s the two-page fact sheet. According to the fact sheet, the changes amend the Rule 10b5-1(c)(1) affirmative defense to include:
– A cooling-off period for directors and officers of the later of: (1) 90 days following plan adoption or modification; or (2) two business days following the disclosure in certain periodic reports of the issuer’s financial results for the fiscal quarter in which the plan was adopted or modified (but not to exceed 120 days following plan adoption or modification) before any trading can commence under the trading arrangement;
– A cooling-off period of 30 days for persons other than issuers or directors and officers before any trading can commence under the trading arrangement or modification;
– A condition for directors and officers to include a representation in their Rule 10b5-1 plan certifying, at the time of the adoption of a new or modified plan, that: (1) they are not aware of material nonpublic information about the issuer or its securities; and (2) they are adopting the plan in good faith and not as part of a plan or scheme to evade the prohibitions of Rule 10b-5;
– A limitation on the ability of anyone other than issuers to use multiple overlapping Rule 10b5-1 plans;
– A limitation on the ability of anyone other than issuers to rely on the affirmative defense for a single-trade plan to one such plan during any consecutive 12-month period; and
– A condition that all persons entering into a Rule 10b5-1 plan must act in good faithwith respect to that plan.
In addition to the amendments to Rule 10b5-1, the SEC added new disclosure requirements, including annual disclosure relating to a company’s insider trading policies and procedures, quarterly disclosure concerning the use of Rule 10b5-1 plans by its directors & officers, and disclosure about awards of options in proximity to the release of MNPI and related policies and procedures. The new rules will also require Form 4 and 5 filers to indicate by a checkbox that a reported transaction was intended to satisfy the affirmative defense conditions of Rule 10b5-1(c)
The final rules contain a few tweaks to the SEC’s original proposal. These include modifying the duration of the mandatory cooling off period (and eliminating the proposed cooling off period for issuers), allowing officer & director certifications to be included in the plan itself rather than being separately delivered to the issuer, and permitting issuers (but not insiders) to use multiple overlapping 10b5-1 plans. Overall, however, the amendments largely track the original proposal.
I said last month that we’d let you know if the SEC adopted anything by other than a 3-2 partisan vote, so I want to note for the record that the commissioners voted unanimously to approve the amendments. We’ll be posting memos in our “Rule 10b5-1” Practice Area.
The rules go into effect 60 days after publication in the Federal Register, and we’re scheduling a webcast for next month on the implications of the changes for companies & insiders. Stay tuned for more details.
I’ve been keeping an eye out for law firm memos explaining to me what’s particularly significant about the SEC’s settlement with AT&T over alleged Reg FD violations – other than the fact that it involved the largest financial penalty ever assessed in an FD enforcement action. It’s been a week since the settlement was announced, but I still haven’t seen anything along those lines. I can’t say I’m surprised. After all, from the outset, the SEC’s allegations appeared to involve textbook examples of the kind of practices that it had long cautioned companies against.
AT&T’s 1st Amendment challenge to Reg FD was probably the most interesting part of the case, but after the SDNY shot that down along with the other arguments the defendants submitted in their motion for summary judgment, so you can see why the company was interested in settling the case. On the other hand, the SEC had something to lose if a trial went forward as well. That’s because the Court found that a jury could reasonably find for either side when it came to the issue of whether the defendants acted with scienter.
Reg FD requires companies to simultaneously make public disclosure of any MNPI that is intentionally selectively disclosed and defines the term “intentional” to include recklessness. The Court’s discussion of the scienter issue begins on p.120 of its opinion, and among the various things it pointed to in concluding that a jury might reasonably find that the defendants didn’t act recklessly was the complete absence of any inkling among AT&T personnel and the analysts who received the selective disclosure that those communications risked violating Reg FD.
What are the key takeaways from the AT&T enforcement action? This MoFo memo on the SDNY’s decision suggests the following:
Policies and procedures alone may not be enough: At AT&T, the relevant policies, procedures, and training expressly prohibited the disclosures at issue. Nevertheless, the IR defendants and executives involved apparently understood that their actions did not violate Reg FD. Companies should consider whether changes or updates are warranted in their compliance programs to help mitigate the risk of unintended Reg FD violations. Such changes could include additional targeted trainings for those employees who communicate directly with analysts.
Timing: One way that companies can reduce the risk of possible Reg FD violations is to impose a “quiet period” late in the quarter during which company employees to whom Reg FD applies are prohibited from speaking with investors and analysts.
Utilize scripts: Where IR professionals speak with analysts, they should consider using scripts to guide their conversations. Such scripts can be reviewed by counsel and senior leadership to help ensure compliance with Reg FD.
To this list, I’d add one more item. I think the Court’s comments that nobody involved had any idea that there was a Reg FD issue in their communications are important. The Court said that went to scienter, but it’s also relevant to materiality, because it indicates that none of the sophisticated market professionals involved thought they were dealing with MNPI. I think the lesson is that materiality is always a judgment call, and one that the SEC is very willing to second guess when it comes to selective disclosure. That might just be the most important thing to keep in mind when it comes to Reg FD.
Join us today at 2pm Eastern for the webcast, “SEC Clawback Rules: What To Do Now.” We’ll be hearing practical guidance from Cooley’s Ariane Andrade, Hunton Andrews Kurth’s Tony Eppert, Orrick’s JT Ho, Pay Governance’s Mike Kesner, and Kirkland’s Abigail Lane about what to do to prepare for the SEC’s new Dodd-Frank clawback rules that go into effect next month. Among other topics, this program will cover:
– Overview of rules
– Differences from existing requirements & practices
– Specific action items
– Compliance timeframe
– State law issues
– Interplay between ISS guidelines, institutional investor expectations and DOJ enforcement policies
– Enforcement of clawbacks
– Disclosure implications
We’re also continuing to post memos on this topic in our “Clawbacks” Practice Area. As a member of CompensationStandards.com, you get access to the live webcast, plus the on-demand archive & transcript, and all of the other resources on this topic – which we’ll be continuing to update as the compliance date nears.
Yesterday, Corp Fin issued 7 Non-GAAP Financial Measures CDIs. Several of these CDIs update or replace the language of existing CDIs, while the remainder are new. Hanukkah and Christmas are just around the corner, so as a gift I’m going to do what the Staff doesn’t & provide a markup showing the changes. Additions are in bold, while deletions are presented as strikethroughs:
Question 100.01
Question: Can certain adjustments, although not explicitly prohibited, result in a non-GAAP measure that is misleading?
Answer: Yes. Certain adjustments may violate Rule 100(b) of Regulation G because they cause the presentation of the non-GAAP measure to be misleading. Whether or not an adjustment results in a misleading non-GAAP measure depends on a company’s individual facts and circumstances.
Presenting a non-GAAP performance measure that excludes normal, recurring, cash operating expenses necessary to operate a registrant’s business is one example of a measure that could be misleading.
When evaluating what is a normal, operating expense, the staff considers the nature and effect of the non-GAAP adjustment and how it relates to the company’s operations, revenue generating activities, business strategy, industry and regulatory environment.
The staff would view an operating expense that occurs repeatedly or occasionally, including at irregular intervals, as recurring. [December 13, 2022]
Question 100.04
Question: A registrant presents a non-GAAP performance measure that is adjusted to accelerate revenue recognized ratably over time in accordance with GAAP as though it earned revenue when customers are billed. Can this measure be presented in documents filed or furnished with the Commission or provided elsewhere, such as on company websites?Can a non-GAAP measure violate Rule 100(b) of Regulation G if the recognition and measurement principles used to calculate the measure are inconsistent with GAAP?
Answer: No. Non-GAAP measures that substitute individually tailored revenue recognition and measurement methods for those of GAAP could violate Rule 100(b) of Regulation G. Other measures that use individually tailored recognition and measurement methods for financial statement line items other than revenue may also violate Rule 100(b) of Regulation G. [May 17, 2016]. Yes. By definition, a non-GAAP measure excludes or includes amounts from the most directly comparable GAAP measure. However, non-GAAP adjustments that have the effect of changing the recognition and measurement principles required to be applied in accordance with GAAP would be considered individually tailored and may cause the presentation of a non-GAAP measure to be misleading. Examples the staff may consider to be misleading include, but are not limited to:
– changing the pattern of recognition, such as including an adjustment in a non-GAAP performance measure to accelerate revenue recognized ratably over time in accordance with GAAP as though revenue was earned when customers were billed;
– presenting a non-GAAP measure of revenue that deducts transaction costs as if the company acted as an agent in the transaction, when gross presentation as a principal is required by GAAP, or the inverse,
– presenting a measure of revenue on a gross basis when net presentation is required by GAAP; and
– changing the basis of accounting for revenue or expenses in a non-GAAP performance measure from an accrual basis in accordance with GAAP to a cash basis. [December 13, 2022]
Question 100.05
Question: Can a non-GAAP measure be misleading if it, and/or any adjustment made to the GAAP measure, is not appropriately labeled and clearly described?
Answer: Yes. Non-GAAP measures are not always consistent across, or comparable with, non-GAAP measures disclosed by other companies. Without an appropriate label and clear description, a non-GAAP measure and/or any adjustment made to arrive at that measure could be misleading to investors. The following examples would violate Rule 100(b) of Regulation G:
Failure to identify and describe a measure as non-GAAP.
Presenting a non-GAAP measure with a label that does not reflect the nature of the non-GAAP measure, such as:
– a contribution margin that is calculated as GAAP revenue less certain expenses, labeled “net revenue”; – non-GAAP measure labeled the same as a GAAP line item or subtotal even though it is calculated differently than the similarly labeled GAAP measure, such as “Gross Profit” or “Sales”; and – non-GAAP measure labeled “pro forma” that is not calculated in a manner consistent with the pro forma requirements in Article 11 of Regulation S-X. [December 13, 2022]
Question 100.06
Question: Can a non-GAAP measure be misleading, and violate Rule 100(b) of Regulation G, even if it is accompanied by disclosure about the nature and effect of each adjustment made to the most directly comparable GAAP measure?
Answer: Yes. It is the staff’s view that a non-GAAP measure could mislead investors to such a degree that even extensive, detailed disclosure about the nature and effect of each adjustment would not prevent the non-GAAP measure from being materially misleading. [December 13, 2022]
Question 102.10
Question 102.10(a): Item 10(e)(1)(i)(A) of Regulation S-K requires that when a registrant presents a non-GAAP measure it must present the most directly comparable GAAP measure with equal or greater prominence. This requirement applies to non-GAAP measures presented in documents filed with the Commission and also earnings releases furnished under Item 2.02 of Form 8-K. Are there examples of disclosures that would cause a non-GAAP measure to be more prominent?
Answer: Yes. Although whether a non-GAAP measure is more prominent than the comparable GAAP measure generally depends on the facts and circumstances in which the disclosure is made, the staff would consider the following examples of disclosure of non-GAAP measures as more prominent:Yes. This requirement applies to the presentation of, and any related discussion and analysis of, a non-GAAP measure. Whether a non-GAAP measure is more prominent than the comparable GAAP measure generally depends on the facts and circumstances in which the disclosure is made. The staff would consider the following to be examples of non-GAAP measures that are more prominent than the comparable GAAP measures:
Presenting a full income statement of non-GAAP measures or presenting a full non-GAAP income statement when reconciling non-GAAP measures to the most directly comparable GAAP measures;Presenting an income statement of non-GAAP measures. See Question 102.10(c).
Omitting comparable GAAP measures from an earnings release headline or caption that includes non-GAAP measures;Presenting a non-GAAP measure before the most directly comparable GAAP measure or omitting the comparable GAAP measure altogether, including in an earnings release headline or caption that includes a non-GAAP measure.
Presenting a ratio where a non-GAAP financial measure is the numerator and/or denominator without also presenting the ratio calculated using the most directly comparable GAAP measure(s) with equal or greater prominence.
Presenting a non-GAAP measure using a style of presentation (e.g., bold, larger font, etc.) that emphasizes the non-GAAP measure over the comparable GAAP measure.
A non-GAAP measure that precedes the most directly comparable GAAP measure (including in an earnings release headline or caption);Describing a non-GAAP measure as, for example, “record performance” or “exceptional” without at least an equally prominent descriptive characterization of the comparable GAAP measure.
Presenting charts, tables or graphs of a non-GAAP financial measures without presenting charts, tables or graphs of the comparable GAAP measures with equal or greater prominence, or omitting the comparable GAAP measures altogether.
Providing discussion and analysis of a non-GAAP measure without a similar discussion and analysis of the comparable GAAP measure in a location with equal or greater prominence. [December 13, 2022]
Question 102.10(b): Are there examples of disclosures that would cause the non-GAAP reconciliation required by Item 10(e)(1)(i)(B) of Regulation S-K to give undue prominence to a non-GAAP measure?
Answer: Yes. The staff would consider the following examples of disclosure of non-GAAP measures as more prominent than the comparable GAAP measures:
Starting the reconciliation with a non-GAAP measure.
Presenting a non-GAAP income statement when reconciling non-GAAP measures to the most directly comparable GAAP measures. See Question 102.10(c).
When presenting a forward-looking non-GAAP measure, a registrant may exclude the quantitative reconciliation if it is relying on the exception provided by Item 10(e)(1)(i)(B) of Regulation S-K. A measure would be considered more prominent than the comparable GAAP measure if it is presented without disclosing reliance upon the exception, identifying the information that is unavailable, and its probable significance in a location of equal or greater prominence. [December 13, 2022]
Question 102.10(c): The staff considers the presentation of a non-GAAP income statement, alone or as part of the required non-GAAP reconciliation, as giving undue prominence to non-GAAP measures. What is considered to be a non-GAAP income statement?
Answer: The staff considers a non-GAAP income statement to be one that is comprised of non-GAAP measures and includes all or most of the line items and subtotals found in a GAAP income statement. [December 13, 2022]
I’d have to check with Broc to be sure, but I think this may be the longest blog in the history of this blog. Anyway, Happy Holidays!
Yesterday, the SCOTUS granted Slack Technologies’ cert petition in a case raising the issue of whether Section 11 and Section 12(a)(2) of the 1933 Act require a plaintiff to be able to trace their shares to those sold in the registered offering at issue. Slack asserted this tracing requirement – which has been recognized by several circuit courts – as a defense to Section 11 claims arising out if its 2019 direct listing.
That defense was rejected by a California federal court and by the 9th Circuit, but now Slack will get another bite of the apple in the Supreme Court. The stakes are very high here – if the tracing requirement survives, then the high-profile companies for which a direct listing is a viable alternative will have significant advantages over those that take the traditional IPO route. If it doesn’t survive, then we may see a lot more Section 11 litigation involving follow-on offerings by public companies.
When Audit Analytics last looked at the universe of going concern opinions, it found that they reached an all-time low in 2020, but according to the firm’s latest report, 2021 was a very different story. Here’s an excerpt with the highlights:
The number of companies that received a going concern opinion during fiscal year (FY) 2021 increased to1,674, around the number of going concerns last seen in FY2016. The percentage of companies that received a going concern opinion during FY2021 was 21.3%, higher than the 18.4% seen in FY2020. Going concern opinions have been declining since they peaked during FY2008 with 2,853 – during the height of the financial crisis. FY2008 also saw a high of 28.3% of companies that received a going concern opinion.
The report says that the percentage of non-accelerated filers reporting a going concern qualification rose by 3.9%, while the percentage of large accelerated filers included in this group increased by 0.7%. Those were the largest increases experienced by those groups of companies in more than a decade. In contrast, going concern qualifications among accelerated filers declined by 5.6% – which was the biggest decline among the members of that group in 15 years.
The report’s most jarring statistic is that while the number of newly public companies increased by 54% last year, the number of going concern opinions issued to those companies increased by 148% over the prior year and was the driving force behind the overall increase in the number of going concern opinions.
Over on “The D&O Diary”, Kevin LaCroix recently flagged this Jones Day whitepaper on lessons US companies can learn from European climate change litigation. Kevin points out that litigation has been a component of climate change activists’ strategy in Europe for several years, and that they’ve targeted not just companies, but also “decision-makers in government and in business.” This excerpt from the whitepaper provides the key takeaways from this litigation:
For claimants, the objective is not only to win at trial: NGOs and activists are pursuing novel and inventive litigation strategies. Many of the routes to liability are far from straightforward and difficult to bring successfully. But success at trial often is not the point. Litigation is being used to attract publicity, obtain disclosure of documentation and information, and pressure businesses to change corporate behavior. And not just the behavior of the defendant, but the behavior of other businesses and decision-makers observing the risk of litigation and the direction of judicial travel.
Mind the gap between aspiration and execution: Any gap between a company’s aspirations and its actions creates litigation risk. It is not enough for an organization to make aspirational commitments, however well intentioned. In order to mitigate litigation risks, commitments should be backed up by action—whether that is a credible plan for achieving net-zero pledges, or proper oversight of a subsidiary’s activities to ensure group policies are being adhered to in practice—and adequate justification needs to be made available to the public in order to demonstrate the accuracy of the company’s communications and the seriousness of its plans.
The importance of robust, credible, and scientifically verifiable evidence: Companies making “green” claims about their products or services will need to ensure they can justify those claims by reference to robust, verifiable evidence based on recognized scientific methodologies. Statements that give only part of the story have been found to be misleading, so care needs to be taken to ensure that environmental claims reflect, for example, the full life cycle of a product, or the overall impact of an organization’s activities on the environment or climate (rather than just one of its business lines).
Supporting decision-makers: Evidencing board decision-making is good practice in any event, but directors and other decision-makers within a business will be particularly keen to ensure proper records are kept that they have complied with all relevant obligations when making decisions with potential environmental impact.
Diligence, diligence, diligence: When it comes to ESG and climate change, lines between corporate entities are increasingly blurred. Financial institutions find themselves having to rely on data disclosures provided by corporate issuers to meet their own ESG-related reporting requirements. Supply chain due diligence legislation codifies what was in any event a growing responsibility on parent companies to be alert to the activities not just of their subsidiaries but of those with whom they do business. Robust processes to diligence information and business practices and to audit compliance are essential.
European regulators and businesses have taken the lead on ESG regulation and in corporate commitments to addressing climate change. That’s created an environment where litigation surrounding those commitments has flourished. As the US catches up, activists and others may increasingly use litigation as a key component of their own strategies.
For some reason, I’ve got a real weakness for articles about best practices for keeping board minutes – which is kind of strange because of all the routine tasks I did as a corporate lawyer, this was the one I disliked most. Anyway, whatever bizarre neurosis may be the cause, I’m always very interested in pieces like this recent Skadden memo, which has plenty of good advice about board minutes.
Writing minutes is drudgery, but it’s important to get them right – and doing that often requires a lot of judgment calls. One area that requires judgment is how to handle legal advice provided to the board at a meeting. You want the minutes to reflect that the board sought and received legal advice at the meeting, but you also don’t want to do anything to inadvertently waive privilege in the event that you have to produce the minutes through a books and records request or otherwise. This excerpt from Skadden’s memo highlights a potential pitfall that may arise by the way a lawyer’s advice to the board is characterized in the minutes:
It is important to ensure that the fact that legal advice was given to the board is reflected in the minutes at least at a high level, but boards need to guard against waiving the attorney-client privilege. Although privileged information is typically redacted when minutes are produced to plaintiff stockholders, legal advice may at some point become an issue in litigation if the board asserts that it relied on that advice.
To protect privileged information from disclosure, minutes reflecting legal advice should be characterized as an outside attorney or in-house counsel “providing legal advice” about a matter as opposed to “advising the board” to take a certain action, because advice from a lawyer that is not legal in substance — say, advice on business strategy — potentially may not be protected by the privilege.
The memo’s point about the possibility that legal advice may at some point become an issue in litigation is an important one to keep in mind. That means that when thinking about privilege, you need to think about not only how to protect privilege in board minutes, but also how best to use the minutes to help manage a decision to waive privilege as part of a litigation strategy.
Why might a company do that? Well, one reason is that Delaware courts have made it clear that the advice directors receive from lawyers and other professionals is often central to determining the reasonableness of the board’s actions, and an unwillingness to share the substance of that advice can have significant negative consequences, including a prohibition on asserting the content of the legal advice that the board was provided in the defense of the plaintiffs’ claims. See, e.g., Chesapeake v. Shore (Del. 2/00).
In light of this position, some practitioners suggest referencing the fact that legal advice was given in the minutes, but also providing a summary of the advice in separate privileged minutes. Writing that summary presents challenges of its own, but in appropriate circumstances, that approach may both help avoid inadvertent production and enable the board to provided contemporaneous evidence of the advice provided by counsel if the company determines to waive the privilege.
