I recognize that many folks involved in the “D&O questionnaire” process view this annual exercise as no more than a “necessary evil” that must be tolerated and made as painless as possible (that’s why we have a “D&O Questionnaire Handbook” with an annotated questionnaire for members). But this recent blog from Woodruff Sawyer’s Lenin Lopez points out that it could be a good opportunity for discussion & training on conflicts of interest:
It’s easy to ask directors to disclose any potential conflicts of interest. The challenge is how to do so in a way that translates into directors openly disclosing any potential conflicts of interest to the company. This is not to say that directors would intentionally look to avoid disclosure. Rather, it is more a matter of education about what types of director-level conflicts they should be on the lookout for. A brief walkthrough of a case like the one discussed in this article can be the basis for a fruitful discussion with the board well in advance of any actual potential conflict of interest arising. As a practice point, this type of discussion may be worthwhile holding in parallel with your company’s annual director and officer questionnaire process or review of the company’s code of conduct.
Why is it worth having these conversations when “fiduciary duties” can also put folks to sleep? Well, every corporate lawyer is bound to face thorny director conflicts of interest at one point or another – and courts continue to interpret the types of relationships that could be problematic. If a director’s loyalty is challenged, you don’t want to be the one who failed to tell them about the issue on the front end – or failed to create a supportive record. The blog summarizes a scenario that the Delaware Supreme Court recently addressed. Here’s an excerpt:
We have previously covered developments in Delaware courts’ view of director independence, including in the context of business and personal relationships. Delaware courts continue to look beyond traditional situations where independence was historically questioned, like financial relationships, and expand their view to include personal relationships, involvement with charities, overlapping business networks, and even shared ownership of aircraft. Two additional situations where Delaware courts have focused their independence assessment, and which may come as a surprise, are personal admiration and director income. In Re BGC Partners, Inc. Derivative Litigation addressed both situations.
On its way to upholding a ruling in favor of the company to dismiss the case (which John wrote about on DealLawyers.com), the court considered a creative argument from the plaintiff that a “teary-eyed” deposition cast doubt on a director’s willingness to consider a demand to sue the company’s Chair & CEO. In doing so, the court considered whether the record showed that the director’s respect for the Chair & CEO was so personal or of such a “bias producing” nature that it would have clouded his judgment.
The blog goes on to offer strategies to help ensure that board decisions get the benefit of the business judgment rule if they are challenged. In addition to encouraging transparency through training, Lenin notes that it’s important to maintain a contemporaneous written record that demonstrates directors were disinterested in their decision making. The court’s commentary shows that it will review this record.
Last month, the House Financial Services Committee’s Capital Markets Subcommittee held a hearing on “Examining the Agenda of Regulators, SROs, and Standards-Setters for Accounting, Auditing” – with testimony from PCAOB Chair Erica Williams, FASB Chair Richard Jones, and FINRA President & CEO Robert Cook. The livestream is here – and at approximately the 30-minute mark, Subcommittee Chair Ann Wagner (R-Missouri) recaps “deep concerns” with the costs & diversion of attention that are likely to occur if the PCAOB moves forward with its recently proposed standards on “Noncompliance with Laws & Regulations” and individual accountant liability.
In her testimony, PCAOB Chair Erica Williams defended the proposals and says that the PCAOB is considering feedback that has been provided. Here’s an excerpt:
We also proposed a new standard on noncompliance with laws and regulations, or NOCLAR. When auditors fail to identify noncompliance with laws and regulations that have a material impact on a company’s financial statements – or fail to take the proper steps to evaluate and communicate that noncompliance – investors pay the price.
Unfortunately, the current standard is 35 years old, and we have seen far too many examples of investors getting hurt due to noncompliance with laws and regulations since it was adopted.
Well-publicized issues relating to Wells Fargo offer just one example. Earlier this year, Wells Fargo agreed to pay $1 billion to settle a class-action lawsuit from investors alleging it made misleading statements about compliance with consent orders imposed by federal regulators. A lawyer for those investors underscored just who gets hurt when these incidents happen: “state employees, nurses, teachers, police, firefighters and others – whose critical retirement savings were impacted by Wells Fargo’s fraudulent business practices.”
When these kinds of incidents happen, the question almost inevitably follows, “where was the auditor?” In fact, our PCAOB advisory groups, made up of investors and other stakeholders, have cited to at least one study that shows auditors are currently only finding about 4% of fraud – which is certainly not consistent with what most investors expect.
In the fall, we issued a proposal on a rulemaking project that would hold associated persons accountable when they negligently, directly, and substantially contribute to firms’ violations. The proposal is designed to make sure PCAOB rules match what investors already expect: that when an associated person’s negligence directly and substantially contributes to firm violations that can put investors at risk, the PCAOB has the tools to hold them accountable.
The Q&A portion of the meeting suggests that the PCAOB will be holding a public roundtable for additional feedback on the NOCLAR proposal. Stay tuned!
Happy New Year! As Dave says, “For securities lawyers, every year is a roll-forward of the last one.” I take that to mean we get better every year – with incremental improvements & updates to our disclosures (and with any luck, ourselves). When it comes to your upcoming “risk factors” update, this White & Case memo identifies 6 key trends to consider:
– Cybersecurity
– Artificial Intelligence
– Macroeconomic Considerations: Uncertainty, Interest Rates and Inflation
– International Geopolitics
– Climate
– Internal Controls
In addition to considering whether the above developments have had – or are expected to have – a material impact on your company’s business, financial condition and operating results, now is also the time to make sure your existing risks are appropriately described. The memo shares these 5 drafting reminders:
– Avoid boilerplate disclosures
– Carefully Scrutinize Hypothetical Statements
– Review for Internal Consistency
– Update or Delete Risk Factors That Have Changed in Importance or Are No Longer Relevant
– Consider the order & organization of your risk factors, and don’t forget a “Risk Factor Summary” if your disclosure exceeds 15 pages
Check out the full memo for more color on each of these topics, as well as our “Risk Factors” Handbook and Practice Area for members.
In this 3-page memo released last month, the Vanguard Investment Stewardship team gives insight into how it analyzed shareholder proposals at 4 companies calling for third-party audits of workplace safety practices.
Vanguard emphasizes its case-by-case approach to these shareholder proposals, based on the relevant company’s facts & circumstances. The asset manager explains factors – e.g., disclosure about board oversight and quantitative improvements in safety metrics, etc. – that led to it voting against the proposals at each of the companies. The “against” votes occurred even though Vanguard determined that worker health & safety was a material risk for all 4 of the companies, so for other companies where this is a big issue, these examples are worth checking out. Here’s what Vanguard looks for from all portfolio companies on this topic:
On behalf of the investors in Vanguard-advised funds, we believe that companies should focus on issues that are material to their business. We look for boards to have the appropriate skills and expertise to identify and oversee material risks, to understand how risks could affect shareholder value creation at the companies they oversee, and to provide clear, decision-useful disclosure on oversight and management of the company’s material risks.
Portfolio companies should adhere to applicable labor laws and, where material, maintain oversight of workplace health and safety risks. We further look for boards to appropriately challenge management and regularly reevaluate risk-mitigation practices if the degree of financial materiality or the manifestation of a specific risk changes over time.
In engagements with portfolio companies, we seek to understand how boards oversee material risks, including those that relate to human capital management. Although the Vanguard-advised funds do not seek to dictate company strategy or day-to-day operations, we continue to engage boards on how they define materiality related to human capital risks, their oversight process for mitigating material risks, and how they disclose material risks to investors.
We’ve posted the transcript for our recent webcast – “More on Clawbacks: Action Items and Implementation Considerations” – during which Compensia’s Mark Borges, Ropes & Gray’s Renata Ferrari, Gibson Dunn’s Ron Mueller and Davis Polk’s Kyoko Takahashi Lin continued their excellent discussion from our 20th Annual Executive Compensation Conference on complex decisions and open interpretive issues that unlucky companies faced with a restatement will need to tackle. They covered:
– What to do if a restatement occurs
– Whether to amend other policies and agreements, or update other disclosures
– Maintaining your policy going forward (we are all going to get smarter about these policies over time!)
Members of this site or of CompensationStandards.com can access the transcript to this program and all of our other webcasts by visiting the “archives page“. If you’re not a member, sign up today to get access to this essential guidance!
Also, if you are a member, make sure to confirm with your knowledge management folks that your subscription has been renewed. Many of our subscriptions run on a calendar-year basis, and you don’t want any interruption in access as we head into proxy season.
Yesterday, the Center for Audit Quality announced the publication of its 10th annual “Audit Committee Transparency Barometer.” The report is compiled by the CAQ and Audit Analytics to measure disclosures about financial oversight and other audit committee responsibilities. This year’s report also takes a look back at big-picture changes to audit committee disclosures over the past decade. Here’s an excerpt:
After a decade of analyzing audit committee disclosures, we have seen disclosure rates increase across the majority of the questions and topics being tracked. In the current environment of economic uncertainty, geopolitical crises, and new ways of working, it remains as important as ever for audit committees to tell their story through tailored disclosures in the proxy statement. Investors and other stakeholders use these disclosures to understand how the audit committee is exercising oversight to navigate the challenges of this current environment.
This environment provides an opportunity for audit committees to revisit their disclosures to ensure that they are up to date and tailored to the specific events and circumstances that the audit committee currently faces. Providing detailed and relevant disclosures, instead of relying on boilerplate language, provides investors with useful information about the processes, considerations, and decisions made by the audit committee. Every year, each audit committee has a unique story to tell, and detailed disclosures in the proxy statement relay the extent of engagement of the audit committee, which contributes to audit quality.
However, while audit committees & disclosure teams have overall earned a “gold star,” the report notes that there is always room for improvement. To support that effort, the appendices to the report include disclosure examples and questions for consideration. Among other suggestions, the CAQ suggests that companies could consider discussing not just “what they do” but also “how they do it,” and enhancing disclosure about audit fees in the upcoming year:
Another area where we continue to see lower rates of disclosure is the discussion around audit fees, particularly disclosures about the connection between audit fees and audit quality (Q3) and explanation for a change in fees paid to the external auditor (Q6). For audit committees to enhance their disclosures, they should provide more robust disclosures about how the audit committee considers the appropriateness of the audit fee, including key factors affecting changes to the audit fee year over year. For example, it may be helpful for stakeholders to understand efficiencies achieved, such as the auditor’s use of new technologies, or changes in the scope, such as a major transaction during the year, that could lead to changes in the audit fee.
Audit fees can be an indicator of audit quality for stakeholders because abnormally low fees may indicate that not enough time or resources are spent on the audit engagement, which could contribute to low audit quality. On the other hand, abnormally high audit fees could indicate inefficiencies, which may also be a red flag for stakeholders. In selecting, retaining, and evaluating the independent auditor, the audit committee should always be focused, in the first instance, on audit quality. Describing the audit committee’s views on the audit fee’s appropriateness can help stakeholders understand what contributes to the audit fee and can provide stakeholders further insights into how the audit committee considers audit quality throughout its engagement with the external auditor.
The report concludes with this encouragement to keep moving onward & upward:
We applaud audit committees for their efforts to increase disclosures over the past 10 years and continue to encourage audit committees to consider how their disclosures can be enhanced to provide further transparency for investors regarding the critical oversight work that audit committees perform.
The “Audit Committee Transparency Barometer” released yesterday by the Center for Audit Quality and Audit Analytics says that 59% of S&P 500 companies are disclosing that the audit committee is responsible for oversight of cybersecurity risk – up from 54% last year. Here’s an excerpt describing how to communicate what that role involves and how the audit committee members are well-equipped to carry it out:
As the audit committee’s role continues to expand, it is increasingly important for boards to monitor the skill set and composition of committee members to ensure that audit committee members have appropriate expertise to exercise their oversight. Beyond disclosing the expertise of certain committee members, audit committees may also consider disclosing how all members of the committee stay abreast of emerging areas. In the 2022 Audit Committee: The Kitchen Sink of the Board report, researchers interviewed audit committee members and found that more than half of them consider their continuing education to be a critical part of their ability to manage evolving responsibilities, and they often strategically select continuing education that focuses on emerging risk areas, such as cybersecurity, ESG, and risk management. Telling this story to stakeholders demonstrates the audit committee’s commitment to the oversight role.
The same study also found that investors want to understand the roles and responsibilities assigned to the audit committee, why audit committee members are appropriate for the specific company, examples of continuing education for audit committee members, how audit committees address key risks, and details that reflect broader audit committee responsibilities.
As the SEC has recently adopted its Cybersecurity Disclosure rule and is continuing to work on its Climate Disclosure rule, we expect that these topics will continue to be relevant for audit committees, particularly as this information is included in SEC filings. Audit committees play an important role in the oversight of these areas given their expertise and experience in oversight of financial reporting and internal controls.
Even though a lot of companies are disclosing the audit committee’s role in some dimension of cyber risk oversight, the CAQ also notes that this broad responsibility is parceled out among existing committees at 85% of S&P 500 companies, according to the latest Spencer Stuart Board Index. Yesterday on CompensationStandards.com, Meredith highlighted why even the Compensation Committee can’t escape involvement.
Yesterday, the PCAOB announced three settled disciplinary orders relating to China-based audit firms & individuals involved with auditing US-listed companies. These are the PCAOB’s first enforcement settlements under the protocol established last year that finally granted the Board’s longstanding demand to inspect & investigate registered public accounting firms headquartered in mainland China and Hong Kong.
Three firms & four individuals were fined a total of $7.9 million for alleged training exam misconduct and violations of quality control and independence standards, among other things. As part of the settlements, the targets of the proceedings – who have not admitted or denied the findings – have also agreed to take steps to improve their policies & procedures (in the case of the firms) and remedial undertakings & restrictions (in the case of the individuals). PCAOB Chair Erica Williams said the settlements are a big deal:
These sanctions represent the highest civil money penalties the Board has ever imposed against firms in mainland China and Hong Kong, some of the highest penalties the Board has imposed against any firm around the globe, and the first time ever that the PCAOB has been able to bring enforcement action against a mainland Chinese firm based on its audit deficiencies.
The days of China-based firms evading accountability are over. The PCAOB is demonstrating that we will take action to protect investors in U.S. markets and impose tough sanctions against anyone who violates PCAOB rules and standards, no matter where they are located.
The PCAOB thanked the SEC for its assistance in this effort, and Chair Gensler issued a statement applauding the protection of American investors.
I warned last month that the SEC is going after companies for allegedly sub-par whistleblower carveouts in NDAs and various other agreements, which violates Exchange Act Rule 21F-17. The spate of enforcement actions has prompted companies to revisit their forms of agreement or even undertake an internal compliance audit. This Troutman Pepper memo gives the “Top 10” tips for getting your existing & future agreements and policies into compliance:
1. Carveout for Government Agency Contact
2. Allow Voluntary Disclosure
3. Broadly Construe the Information Disclosable
4. No Representation As to Prior Reporting
5. Do Not Limit Monetary Awards
6. No Reporting Penalties
7. Take a Holistic Approach
8. Ensure Internal Consistency
9. Ensure Organization-wide Consistency
10. Consider Third Party Agreements
Check out the memo for more color on each of these steps.
Nearly 2 million companies are incorporated in Delaware, and many of them employ “choice of law” and “exclusive forum” provisions to give themselves the benefit of the state’s specialized expertise in matters of corporate governance. Apparently, though, companies these days are liking Delaware a little too much. In response to a growing number of lawsuits that call on the Court of Chancery to rule on matters outside the scope of its mission – specifically, trying to shoehorn employment disputes into matters of internal affairs – Vice Chancellor Laster leads off this 68-page opinion with a plea to make it stop.
The dispute here related to whether incentive compensation awards were forfeited upon breach of a contractual restrictive covenant included in an LLC agreement. The various individuals and entities were scattered across 4 states (none of them being Delaware). VC Laster said it’s not the first time he’s seen this approach:
But Sunder filed suit here—in Delaware—because Sunder is a Delaware LLC and its lawyers deployed the now widespread legal technology of inserting restrictive covenants into an internal governance document. Businesses and their lawyers do that so they can invoke Delaware’s contractarian regime and argue that it should override how other jurisdictions regulate restrictive covenants.
That legal technology calls on the Delaware courts to adjudicate postemployment disputes for the country and potentially the world. In the past five years alone, the Court of Chancery has issued written decisions addressing disputes over restrictive covenants for businesses operating in Hong Kong, Italy, Alabama, Arizona,4 California, Colorado, Idaho, Illinois, Louisiana, Nebraska, New Jersey, New York, Oklahoma, and Texas. Only two businesses operated in Delaware, one of which filed two cases. That list excludes transcript rulings.
The Chancellor expresses several concerns with this trend, including: it will undermine the deference that other states accord to Delaware law, it’s unsustainable from a resource perspective, and it diverts the court’s attention from its core mission. VC Laster then notes that there are times when Delaware won’t enforce a choice of law provision:
This is an example of drafters attempting to use Delaware law to set the rules for what are effectively employment relationships. Other jurisdictions often have a more significant interest in regulating those relationships, which affect how their citizens living there can earn a living and how a business operating there can compensate its work force.
Delaware follows the Restatement (Second) of Conflict of Laws, and Delaware courts consequently will not enforce choice of law provisions when doing so would circumvent the public policy of another state that has a greater interest in the subject matter.
Consequently, when a different state’s law would govern in the absence of a choice of law provision, and if that state has established legal rules reflecting a different policy toward restrictive covenants than Delaware’s, then this court will defer to that state’s law notwithstanding the presence of a Delaware choice of law provision.
Applying that formula, VC Laster couldn’t toss this case. Here is his scream into the void:
A solution needs to be found, and the market is unlikely to provide it. This is an area where Delaware’s interests and the interests of its bar as a whole conflict with the individual interests of clients and their lawyers. For any single business, it makes sense for a lawyer to advise the client to embed restrictive covenants in an internal governance document. And for any single business faced with a dispute over those restrictions, it makes sense for a lawyer to advise the client to file a lawsuit in the Court of Chancery. In the aggregate, that is a recipe for a tragedy of the commons.
A judicial solution is also unlikely, because judges decide specific cases. Doubtless there are many combinations of fixes involving choice of law, personal jurisdiction, and subject matter jurisdiction that could address this burgeoning problem. But a cure requires the involvement of policymakers beyond the courts.
In an ideal world, this case would have been filed in Utah, Nevada, or Texas. But the case is here, and it must be decided.
He’s right that things are unlikely to change. Delaware is just too good.
