Late last month, the roof came crashing down on Nikola Corporation’s founder & former CEO Trevor Milton, when his indictment for securities fraud was announced by the U.S. Attorney for the SDNY & the SEC announced an enforcement action against him arising out of the same alleged conduct. The former CEO is alleged to have repeatedly misled investors about the status of the company’s electric vehicles & technology.
Both the SEC & SDNY claim that this guy engaged in a pretty massive fraud, and in situations involving a complete train wreck like this one, it’s usually hard to draw a lot of helpful insights for other public companies aside from “don’t do massive frauds.” However, this Locke Lord blog says that this case is an exception, and provides some valuable lessons for other public companies. This excerpt says that one of those lessons is that every word that comes out of a corporate officer’s mouth carries with it the potential for liability:
The actions against Milton are a reminder that public statements by corporate officers in relatively informal settings, outside of SEC filings, can be used as a basis for Rule 10b-5 sanctions. A company’s lawyers may scrutinize annual and quarterly reports to ensure that they contain appropriate cautionary statements. In contrast, private tweets, other social media postings and statements in podcasts or interviews are often made without compliance in mind.
In Milton’s case, he encouraged investors to follow him on Twitter to get “accurate information” about Nikola “faster than anywhere else.” In practice, he used Twitter to announce corporate initiatives that he had not vetted internally, to answer investor questions with misleading or outright false information, and even to double down on prior false statements.
Moreover, according to the allegations, Milton responded to other senior executives’ expressions of concern about his social media presence and his public statements by asserting that these other executives “did not understand current capital market dynamics or what he was trying to accomplish with retail investors, and that he needed to be on social media to put out good news about Nikola to support its stock price.” Retail investor frenzy driven by social media and retail-oriented trading platforms such as Robinhood does not give companies a pass from the application of the securities laws. The SEC has emphasized that it will monitor these situations for manipulation or other misconduct.
The blog also says that the case also provides a reminder of the importance of strong board oversight, as well as the importance of the “tone at the top” and a strong compliance culture.
I’ve been reviewing the Staff’s 2021 comments on non-GAAP disclosures. As you might expect, most of them fall under the heading of “blocking & tackling,” and focus on discrete compliance issues regarding the content and reconciliation of non-GAAP numbers. But “equal or greater prominence” issues also haven’t gone away, and in a couple of instances, the Staff asked companies to re-order the presentation of sections of their periodic reports in order to give greater prominence to GAAP information.
An example of this is Bill.com Holdings, which included a subsection in the forepart of the MD&A section of its 2020 10-K captioned “Non-GAAP Financial Measures.” As you might expect, this section included the required Reg G disclosures & reconciliations for the non-GAAP numbers that the company used in its MD&A discussion. The Staff’s comment letter included the following comment on this disclosure:
Please revise the first table on page 58 to disclose the comparable GAAP measure with greater prominence. Also, to avoid giving undue prominence to your non-GAAP financial measures, please move this section so that it follows the results of operations section. Refer to Item 10(e)(1)(i)(A) of Regulation S-K and Question 102.10 of the Non-GAAP Compliance and Disclosure Interpretations (“C&DIs”).
This was one of those Staff comments that didn’t mention whether an amendment to the prior filing was required. However, Bill.com indicated in its response that it would comply with the Staff’s comment in future filings. The Staff didn’t comment further.
A recent Watchdog Research blog reports that there’s been a dramatic uptick in the use of Form 10-K/As as the vehicle for making initial disclosures of internal control deficiencies, going concern qualifications, and restatements. According to the blog, over the past decade, an average of 19 ineffective internal controls disclosures, 3 going concern opinions and less than 1 non-reliance restatement were initially reported on Form 10-K/A filings during each year. In contrast, so far in 2021, there have been 80 ineffective internal controls disclosures, 31 going concern opinions and 5 non-reliance restatements initially reported on Form 10-K/As.
The blog says that SPACs are driving the increased reliance on Form 10-K/As as the vehicle for these disclosures. They have accounted for 70 of the 80 10-K/A internal controls disclosures, 30 of the going concern opinions and all of the restatements this year. The blog points to troubled electric vehicle start-up Lordstown Motors as the poster-child for this trend:
For public companies, it is not just about when the disclosure is made, but how it is made. We are seeing a concerning trend in 2021 where companies are waiting to make their initial disclosures of bad news such as going concern opinions, ineffective internal control disclosures, and financial restatements in an amended annual 10-K filings (10-K/As), instead of 8-Ks and other traditional methods and long after the original “clean” 10-K was filed with the SEC.
Lordstown Motors is an electric car company that went public via SPAC. On June 8th, Lordstown Motors filed a 10-K/A, more than two months after it released its annual report on March 25th. As reported by Francine McKenna in The Dig, Lordstown disclosed a going concern opinion, an ineffective internal control assessment by management, and two subpoenas from the SEC (indicating that the SEC was conducting a formal investigation, not an informal inquiry). Lordstown also disclosed that their restatement announced in May would include an additional charge of $23.5 million, perhaps what tipped it into the “going concern” warning range.
The blog characterizes SPACs approach to making initial disclosures of this “bad news” trifecta in 10-K/A filings as “novel” and “a bit sneaky.” The approach is definitely novel, but I’m not so sure that it’s sneaky. That’s because these disclosures were themselves prompted by a novel set of circumstances – namely, the SEC’s highly publicized guidance on the proper accounting treatment of SPAC warrants & the consequences of that guidance.
This guidance prompted almost 90% of SPACs to restate their financial results. I’m guessing that for most SPACs, the 10-K/A disclosures concerning internal controls deficiencies and the addition of going concern qualifications were a direct result of those warrant restatements. A conclusion that internal controls were deficient flows almost inevitably from a decision to issue a non-reliance restatement, and the going concern opinions may (as in the case of Lordstown Motors) have been prompted by the financial statement impact of the warrant restatements.
I can see why a company might not feel compelled to disclose an inevitable internal control deficiency when it filed an 8-K announcing a non-reliance restatement. A decision to defer disclosure of a going concern qualification would be more troubling, assuming the company knew that such a qualification would be required. But in the case of the warrant restatements, it’s not clear when many SPACs first became aware of this issue. The decision to add a going concern qualification sometimes turned on the results of a complex valuation process, and was likely the last piece of the puzzle to be completed before the 10-K/A was filed.
It does seem inappropriate to defer reporting a decision to restate financials until the filing of Form 10-K/A that includes those financials. If a company decides that its financial statements need to be restated & should no longer be relied upon, it has to file an Item 4.02 Form 8-K. Five SPACs apparently didn’t – but that’s out of a universe of more than 500 SPAC restatements and more than 300 non-reliance restatements.
We’ve previously blogged about Covid-19 related securities litigation, but this Proskauer blog flags something a little different – derivative litigation targeting comp awards that the plaintiffs essentially claim were “spring loaded” due to the pandemic-related market volatility:
While we are growing accustomed to pandemic-based shareholder actions relating to improper health and safety disclosures or misrepresentations relating to COVID-19 treatments and tests, this month brings a novel variant of the COVID-19 lawsuit. A Universal Health Services Inc. investor has filed a derivative suit against company officers and directors, claiming they took advantage of a pandemic-related drop in the company’s stock price to grant and receive certain stock options that were unfair to the company and its stockholders.
The plaintiff investor claims that “company insiders took advantage of the temporary drop in the company’s stock price to grant and receive options to buy the company’s stock at rock bottom prices, thereby showering themselves in excessive compensation.” The complaint alleges that the drop in stock price was “not caused by any changes in the company’s fundamentals or business prospects,” but instead was entirely attributable to the effect of the pandemic on the markets writ large.
The blog points out that the timing of the awards was pretty terrific from the recipients’ standpoint. The stock popped 25% the day after they were granted and by 47% within a week. According to the complaint, in just twelve days, the defendants reaped over $30 million in gains. The complaint alleges that the officers who received the grants unjustly enriched themselves and that the comp committee committed waste in making the awards.
General Electric recently completed a reverse stock split. That’s a pretty unusual transaction for an S&P 500 company – as this Barron’s article notes, GE’s only the 5th S&P 500 company to engage in a reverse split since 2012. For most people, that’s an interesting piece of corporate trivia, but for securities lawyers, it means we’ve got a fresh template for a reverse split that’s likely been vetted by some pretty high-powered lawyers. That’s gold!
Anyway, here’s the relevant language from GE’s proxy statement, the Form 8-K it filed in connection with the reverse split, the Certificate of Amendment to its charter, and the press release announcing the reverse split. If you’re looking for more information on reverse stock splits, check out our article, “Unpacking Stock Splits,” that appears on p. 4 of the July-Aug. 2019 issue of The Corporate Counsel.
On Friday, the SEC voted to approve Nasdaq’s board diversity listing standard. Here’s a copy of the SEC’s 82-page approval order. As usual, the SEC was divided, with Commissioner Peirce dissenting and Commissioner Roisman dissenting in part. SEC Chair Gary Gensler issued a brief statement in which he said that Nasdaq’s diversity disclosure rules “are consistent with the requirements of the Exchange Act,” and that they “reflect calls from investors for greater transparency about the people who lead public companies.”
If that sounds a little defensive, that’s probably because dissenting statements from Commissioners Peirce & Roisman contend that Nasdaq hasn’t satisfied its burden of showing that the rule is consistent with applicable Exchange Act requirements. Furthermore, as this excerpt from Hester Peirce’s lengthy dissenting statement points out, she questions the relevancy of the disclosure called for by the new standard to investors:
[T]his reasoning either begs the very question that needs to be asked—whether the information is relevant to investors in a way that matters under the Exchange Act—or suggests that an exchange may impose any obligation on issuers for which “commenters representing a broad array of investors” are clamoring. To the extent that it is begging the question, it fails under the D.C. Circuit’s decision in Susquehanna International Group LLC v. SEC, in which the Court held that the Commission’s “unquestioning reliance” on a self-regulatory organization’s analysis in approving a rule filing violated both the Exchange Act and the Administrative Procedure Act.
The Commission is obliged to critically assess the “self-serving views of the regulated entit[y],” and it cannot evade this obligation by assuming that the Proposal imposes disclosures and other obligations that are meaningful to investors (and “commenters representing” them) in a way that is relevant under the Exchange Act.
Commissioner Peirce raises a number of other legal issues in her statement (which reads like a brief), but her comments on the relevancy of information on board diversity to investors may be a preview of coming attractions. My guess is that we’ll likely hear similar arguments from dissenters when it comes to climate change & other ESG-related rule proposals that are likely to come down the pike over the next few years.
Commissioner Roisman issued a statement explaining why he supported the provisions of Nasdaq’s listing standard that would offer support to companies looking to add diversity to their boards, but dissented from the standard’s disclosure requirements for listed companies. Commissioners Crenshaw and Lee issued a brief joint statement in support of the approval order.
Be sure to check out this Goodwin memo on the new rules. We’ll be posting this and other memos in our “Nasdaq Guidance” Practice Area.
Shortly after the SEC issued its approval order, Nasdaq posted updated guidance on how the new listing standard’s disclosure requirements will work and the timeline for its implementation. This excerpt discusses the transition period for compliance with the new standard, which is generally based on a company’s listing tier:
– Nasdaq Global Select Market and Nasdaq Global Market companies will have, or explain why they do not have, one diverse director by the later of two years of the SEC’s approval date (August 7, 2023), and two diverse directors within four years (August 6, 2025), or the date the company files its proxy or information statement (or, if the company does not file a proxy, in its Form 10-K or 20-F) for the company’s annual shareholder meeting in that year.
– Nasdaq Capital Market companies will have, or explain why they do not have, one diverse director by the later of two years from the SEC’s approval date (August 7, 2023), and two diverse directors within five years (August 6, 2026), or the date the company files its proxy or information statement (or, if the company does not file a proxy, in its Form 10-K or 20-F) for the company’s annual shareholder meeting in that year.
Companies with five or fewer directors represent an exception to the tier-based transition period. Regardless of their listing tier, these companies will be required to have at least one diverse director or explain why they don’t by the later of August 7, 2023 or the date the company files its proxy statement for the company’s annual shareholder meeting in that year. For companies that don’t solicit proxies, the compliance date will be the date of filing their 10-K or 20-F for that year.
UCLA’s Stephen Bainbridge recently blogged that, in his view, the 11 pending or adopted state board diversity statutes don’t pass constitutional muster. He points out that “9 of the 11 statutes apply not just to companies incorporated in the adopting state but also to companies headquartered in the state.” New York and Ohio’s legislation goes even further, with New York’s law applying to all companies authorized to do business in the state, and Ohio’s pending legislation extending to all companies “doing business” in the state.
Bainbridge says provisions in these statutes that purport to apply to companies not incorporated in the state in question run afoul of the internal affairs doctrine, which as he discussed in an earlier blog, he views as a constitutional requirement.
The theory behind the proxy advisory industry is that it helps its clients fulfill their fiduciary duties by allowing them to vote their shares in accordance with what their informed preferences would have been if they did their own research. A recent study suggests that this isn’t how it works in practice. Here’s an excerpt from the abstract:
Our main finding, for the period 2004-2017, is that proxy advice did not result in funds voting as if they were informed – more often than not it pushed them in the opposite direction – and this distorting effect was particularly noticeable for ISS. The finding is robust to several strategies designed to control for endogeneity of acquiring information and seeking proxy advice, including fixed effects and instrumental variables.
We also show that advice distorted votes toward policies favored by socially responsible investment (SRI) funds, and provide suggestive evidence consistent with the idea that proxy advisors slanted their recommendations toward the preferences of SRI funds because of pressure from activists.
The study started by looking at how informed funds (those that accessed proxy materials on EDGAR) voted, and compared that to how the funds that relied on proxy advisors voted across a range of 9 common governance-related proposals (these included board declassification, independent chair, majority vote, political contributions and proxy access proposals). With the exception of declassification proposals, the study found that those funds that relied on proxy advisors voted more frequently in favor of these proposals than did their informed counterparts. The study found that ISS’s advice moved its customers in the “wrong” direction on 7 out of the 9 proposals. Glass Lewis fared better, with its advice moving customers in the same direction as informed funds on 6 out of the 9 proposals.
So, this study suggests that proxy advisor voting recommendations are slanted because of activist pressure, which results in their non-SRI clients often voting in ways that are contrary to what their informed preferences would have been. If that holds up, it’s not a good look for the proxy advisors or the fiduciaries that hire them.
Here’s another study that’s sure to honk off the governance-industrial complex. Critics of some of the corporate governance reforms put in place over the past two decades like to suggest that the increased “navel gazing” required of corporate boards in the name of good governance makes public companies less innovative. According to a recent study, they may be on to something. Here’s the abstract:
In this study, we investigate the effect of corporate governance reforms on corporate innovation by constructing a comprehensive firm-level panel dataset across 58 countries from 2000 to 2015. We find that both the quantity and quality of innovation decrease after the initiation of the reforms. Affected firms also conduct less innovation that explores new knowledge versus that exploits existing knowledge.
The effect is more pronounced for firms operating in more competitive industries or with higher operational uncertainty. The results suggest that corporate governance reforms may induce managerial myopia and mitigate long-term investment in risky innovation.
Maybe this explains why we get a billion new smart phone apps every year but I’m still waiting for my jetpack.
