Last week on CompensationStandards.com, I blogged about approaches that some companies are taking to incentivize compliance & ethics. But even “good” companies are regularly dealing with complaints, which may or may not be valid. Management & the board then face the difficult question of what to do – and recent experience shows that the decision can have important implications for officer & director liability.
This 4-page Skadden memo gives a roadmap that audit committees & boards can follow when deciding whether to launch an internal investigation, and what form it should take. Here are the key takeaways:
– When a complaint reaches a company’s board, directors need to assess how serious and detailed it is, and how credible it is at first glance, before deciding how to investigate it.
− If similar complaints have been lodged in the past, that could suggest systemic problems and greater risk for the company.
− An investigation will take on added urgency if the regulators or external auditors are aware of the allegations, or if those may affect pending financial or strategic transactions.
− Other complicating factors: any allegations against management, conduct the company has a duty to report and the potential for financial restatements.
If you find yourself answering “yes” to most of the questions in the memo, the Skadden team says that the board should strongly consider conducting an investigation, with help from outside experts.
The SEC has extended the comment period for Nasdaq’s proposal to require notice & disclosure of reverse stock splits, which John blogged about in July. This means that, under Exchange Rules, November 1st is the date by which the Commission will either approve or disapprove, or institute proceedings to determine whether to disapprove, the proposed rule change. You can use this form to submit comments.
Whether you spent the weekend as outside counsel frantically finalizing registration statements in order to claim your spot in “the backlog review queue,” a corporate employee worrying whether delayed regulatory approvals could cost you budget or even your job, or a federal employee attempting to plan for a month or more without pay, it likely was welcome news that, with mere hours to spare on Saturday, our legislators came to a last-minute compromise to keep our government running.
Unfortunately, the SEC’s operating plan and Corp Fin’s guidance on how the Commission and Staff will operate during a shutdown could still become relevant, because the resolution only funds the government for the next 45 days – through November 17th. Let’s all hope for the best!
On Friday, the SEC posted the notice & request for comment for a proposed listing standard from the NYSE that would create a new asset class for “Natural Asset Companies.” Here’s an excerpt that defines what an “NAC” is:
For purposes of proposed Section 102.09, a NAC is a corporation whose primary purpose is to actively manage, maintain, restore (as applicable), and grow the value of natural assets and their production of ecosystem services. In addition, where doing so is consistent with the company’s primary purpose, the company will seek to conduct sustainable revenue-generating operations. Sustainable operations are those activities that do not cause any material adverse impact on the condition of the natural assets under a NAC’s control and that seek to replenish the natural resources being used. The NAC may also engage in other activities that support community well-being, provided such activities are sustainable.
NYSE announced that it was working to develop this new asset class way back in 2021, so it’s been at least two years in the making. A lot has changed since then! ESG sentiment has become more discerning, and many companies have become more transparent over the past two years about environmental risks and emissions. But the proposal predicts that demand for this separate type of investment opportunity exists and will continue to grow because “investors still express an unmet need for efficient, pure-play exposure to nature and climate.”
Under the proposed standard, in addition to GAAP financial reporting provided in SEC filings, NACs would be required to periodically publish an “Ecological Performance Report.” Here’s more detail:
The EPR provides statistical information on the biophysical measures (e.g., tons of carbon, acre feet of water produced), condition, and economic value of each of the ecosystem services produced by the natural assets managed by the NAC. This will allow investors to gauge the effectiveness of management. The information will be consistently produced and periodically reported, following best practices from accepted valuation methodologies, as outlined in the Reporting Framework (as defined below).
The EPR produced by a NAC must follow IEG’s Ecological Performance Reporting Framework (the “Reporting Framework”). The Framework, in turn, is based on the natural capital accounting standards established in the United Nations System of Environmental- Economic Accounting – Ecosystem Accounting Framework (“SEEA EA”).
The EPR will measure, value, and report on the ecosystem services and natural assets managed by a NAC. Under the proposed amendments to the Manual, NACs will conduct a Technical Ecological Performance Study (“Technical EP Study”) annually, following the Reporting Framework. This Technical EP Study will generate the information used to prepare and publish the EPR. The EPR and Technical EP Study must be examined and attested to by a public accounting firm that is registered with the Public Company Accounting Oversight Board (“PCAOB”) and is independent from the NAC and NAC licensor, if applicable, under the independence standard set forth in Rule 2-01 of Regulation S-X (“Independent Reviewer”).
NACs would also be required to adopt policies on biodiversity, human rights, and other matters and post those on their website. The proposal gives more detail on the reporting framework, license, charter & policy requirements, corporate governance standards, and more. The standard, if adopted, will also come with a bunch of new terms to add to your “ESG glossary,” because it includes a whole section dedicated to definitions. The SEC is requesting comments on the proposal.
Also on Friday, the SEC posted notice & request for comment for a proposed NYSE rule change that would make it easier for companies to raise money from existing shareholders. Long story short, under the proposed amendment, companies would no longer have to get shareholder approval before issuing shares at a discount to “passive” (non-controlling) shareholders, even if the shareholder is buying more than 1% of currently outstanding shares and even if the shareholder owns 5% or more of the company’s outstanding stock or voting power at the time of the transaction – as long as they aren’t part of a control group. Here’s the rationale:
Certain NYSE listed companies are significantly dependent on their ability to regularly raise additional capital to fund their operations or acquire new assets. For example, pre-revenue stage biotechnology companies regularly seek additional capital to fund their research and development activities and real estate investment trusts seek to fund the acquisition of new properties by selling equity securities in private placements or direct registered sales priced at a small discount to the prevailing market price.
It is the Exchange’s understanding that, in many cases, existing shareholders of the listed company are willing purchasers of securities in such circumstances, as they already understand the company’s business and have a positive view of its future prospects. Sales to existing shareholders can also be advantageous to both the issuer and the shareholders because of the speed with which a direct sale to an existing shareholder can be completed if no shareholder approval is required.
However, the benefits of low transaction costs and speed of execution that typically exist when conducting these transactions with existing shareholders face countervailing factors if the counterparty is deemed to be a substantial securityholder for purposes of Section 312.03(b)(i). In such cases, to mitigate potential conflicts of interest, Exchange rules require that any sale below the Minimum Price can relate to no more than one per cent of the shares of common stock or one percent of the voting power outstanding before the issuance. Any such transaction that relates to more than one per cent of the common stock is subject to shareholder approval, which imposes significant delay and additional costs on the issuer, thereby often making the sale impracticable.
The NYSE notes that it is currently the only U.S. exchange with this requirement, which puts its listed companies at a disadvantage. The Exchange believes that transactions with these kinds of passive holders do not give rise to the potential conflicts of interest in the determination of transaction terms that exist where the purchaser has a role in the listed company’s board or management.
The shareholder approval requirement for issuances that exceed 1% of outstanding shares or voting power (other than cash sales for at least the “Minimum Price”) would continue to apply to issuances to officers or directors. In addition, it would apply to any controlling shareholder or member of a control group or any other substantial security holder of the company that has an affiliated person who is an officer or director of the company. The proposal emphasizes that other shareholder approval requirements also would continue to apply:
The Exchange notes that any listed company selling securities in a private placement that does not meet the Minimum Price requirement to a passive investor will remain subject to the shareholder approval requirement of Section 312.03(c) if such transaction relates to 20 percent or more of the issuer’s common stock. In addition, any such transaction would remain subject to shareholder approval under Section 312.03(e) if it resulted in a change of control. Finally, the Exchange notes that Section 312.03(b)(i) as proposed to be amended would continue to provide a significant protection to shareholders against conflicts of interest in sales of securities to related parties and that no other listing venue has such a protection in its rules.
The SEC is seeking comments on the proposal. We have resources in our “NYSE” Practice Area for anyone who is trying to navigate approval requirements or other compliance issues.
I confess that my eyes glaze over when I see anything relating to XBRL, and I suspect I’m not the only one who suffers from this weakness. Apparently, the Corp Fin Staff has noticed that “structured data” is getting short shrift, because they posted a wake-up call yesterday in the form of a sample comment letter.
Corp Fin has been providing guidance in the format of “Dear Issuer” letters on a somewhat regular basis since at least 2021. The letters tend to be issued when the Staff notices an emerging disclosure or market-related issue that is affecting a lot of companies. Topics have included market volatility, China-based disclosure requirements, and crypto fallout. But for this instance of sample comments, with XBRL being required since 2009 and Inline XBRL since 2018, you might wonder, “Why now?” The Staff gives a couple of reasons:
1. Comments on the pay versus performance rule provided increased evidence that this data format is useful to investors.
2. The Financial Data Transparency Act (FDTA) became law at the end of last year and requires the SEC to establish a program to improve the quality of the corporate financial data filed or furnished by companies under the ’33 and ’34 Acts.
In addition, new XBRL requirements have accompanied several recent SEC rulemakings (clawbacks, pay vs. performance, repurchases, insider trading), so there actually are new practices to watch out for right now. The sample comment letter flags these issues:
1. Item 405 of Regulation S-T: Your filing does not include the required Inline XBRL presentation in accordance with Item 405 of Regulation S-T. Please file an amendment to the filing to include the required Inline XBRL presentation.
2. Cover Page: The common shares outstanding reported on the cover page and on your balance sheet are tagged with materially different values. It appears that you present the same data using different scales (presenting the whole amount in one instance and the same amount in thousands in the second). Please confirm that you will present the information consistently in future filings.
3. Pay versus Performance: Disclosure under Regulation S-K Item 402(v) must be in Inline XBRL, in accordance with Item 405 of Regulation S-T and the EDGAR Filer Manual. Please ensure that you have provided the appropriate Inline XBRL tagging for all the required Item 402(v) data points.
4. Pay versus Performance: Refer to the [relationship disclosures] graph. Although it is permissible to combine one or more sets of relationship disclosures under Regulation S-K Item 402(v)(5) into one graph, table, or other format, note that you must still provide separate XBRL tags for each required item. Please ensure that you have provided the appropriate Inline XBRL tagging for all the required Item 402(v) data points.
5. Financial Statements and Supplementary Data: You have used different XBRL elements to tag the same reported line item on the income statement from period to period. Please provide us your analysis as to how you concluded that the results reported necessitated the change in the element. Alternatively, if you conclude that the change from period to period was not necessary to communicate a change in the nature of the line item, confirm that you will ensure that your choice remains consistent for line items from period to period.
6. Financial Statements and Supplementary Data: We note that instead of using an XBRL element consistent with current U.S. GAAP in your income statement, you instead used a custom tag. Custom tags are to be used by filers when an appropriate tag does not exist in the standard taxonomy. See Item 405(c)(1)(iii)(B) of Regulation S-T. Please tell us why the current U.S. GAAP tag is not applicable, or alternatively revise your disclosure, beginning with your next filing, to correctly tag this disclosure.
Yesterday’s sample comment letter says that more investors are using XBRL data, but they aren’t the only ones: Corp Fin is also putting this info to work. In the SEC’s most recent “Semi-Annual Report to Congress on Machine Readable Data for Corporate Disclosures” – which John flagged in July – the Staff gave a heads up that they had been issuing comment letters about tagging requirements. In addition, the report says that Corp Fin is using the data in these ways:
– To help identify issuers that are subject to the disclosure and submission requirements of, and potentially subject to a trading prohibition under, the Holding Foreign Companies Accountable Act (Commission-Identified Issuers). Specifically, the staff uses data in Forms 10-K, 20-F and 40-F identifying the auditor (or auditors) who provided opinions related to the financial statements presented in the registrant’s annual report, the location where the auditor’s report has been issued, and the Public Company Accounting Oversight Board (PCAOB) ID Number(s) of the audit firm(s) or branch(es) providing the opinion(s).
– To identify, count, sort, compare, and analyze registrants and their disclosures (e.g., to identify more readily and accurately issuers that are listed on a specific exchange or that have identified themselves as well-known seasoned issuers), based on several items of machine-readable data that appear on the cover pages of registrants’ annual reports (Forms 10-K, 20-F, and 40-F).
– To make preliminary assessments of compliance with the Commission’s recently adopted pay-versus performance disclosure requirements.
With XBRL creeping in to proxy statements, will it also come for ESG? Only time will tell.
I have to say that I never thought I would write three blogs in one day on the topic of XBRL, but if the Staff thinks it is important, I will do my part to get on board. And here is something that truly caught my eye from the SEC’s 2023 Semi-Annual Report to Congress on structured data disclosures:
Enforcement utilized risk-based data analytics to uncover potential accounting and disclosure irregularities caused by, among other things, earnings management practices. Machine-readable data enabled Enforcement staff to review the financial data of thousands of public issuers in order to detect indicia of earnings management or other types of financial misconduct. The initiative resulted in charges against six public companies and several related individuals for violations of the federal securities laws for engaging in certain practices that gave the appearance of meeting or exceeding consensus earnings-per-share (EPS) estimates.
I blogged about the latest of those cases back in February – and I pointed out that the SEC’s data analytics tools are now sensitive enough to flag potential “earnings management” situations even when the adjusted dollar amounts are small. That’s because of XBRL! Now that the SEC has a solid dataset in its toolbox, it is becoming easier for the Enforcement Division to detect and pursue accounting issues.
Board composition is always a hot topic. During the past several years, investors have pushed for skills matrices & diverse backgrounds – in order to provide some comfort that the board is well-positioned to address dynamic business risks & opportunities. But, board quality is difficult to measure. This 47-page report from JamesDruryPartners’ takes a stab at it.
The report offers a number of public company board stats that could be useful for benchmarking, and even ranks companies based on their “average director weight” (fortunately, this is referring to business acumen, not body mass). The report also offers commentary and recommendations. Here are a few points that jumped out:
1. The the number of board seats filled by active & retired CEOs has been declining:
The percentage of CEOs serving on external boards ticked lower, continuing a prolonged decline that began decades ago. Examining the 582 boards common to both this report and our last report, the number of board seats filled by CEOs (active and retired) decreased by 4.9% (from 2,079 to 1,978). Board seats filled by active CEOs decreased by 11.8% (from 536 to 473); those filled by retired CEOs decreased by 2.5% (from 1,543 to 1,505).
2. Only 52% of “financial experts” have CFO or public accounting expertise. The report urges boards to consider CFOs for board seats:
We remain concerned that boards undervalue the disciplined financial perspective that CFOs and Public Accountants can bring to boardroom deliberations. When we ask boards about the underrepresentation of CFOs, the most common reply is, “If we were to consider a CFO for our board, they would have to have a broad-gauged, strategic business mindset, not a corporate controller’s perspective – perhaps a CFO who is now, or might become, a CEO.” We certainly agree with the strategic mindset requirement; however, in our experience, other than the CEO, CFOs are very often the second ranking corporate executive most engaged in the company’s total business operations. Therefore, we strongly encourage boards to challenge this outdated thinking.
Directors designated as Financial Experts should truly be independent financial experts, not professionals who qualify simply because they work in the finance industry or are P&L executives who have a finance department reporting to them. One board in our study even designated a director as a Financial Expert based solely upon their service on another board’s Audit Committee.
3. Based on the number of mentions in a survey of experienced directors, page 14 of the report identifies the “Top 10 Most Essential Attributes of Effective Board Directors.” Here are the top 3:
– Communication Skills (73%): Thoughtful, logical, and articulate. Doesn’t dominate boardroom conversation. Knows when to speak. Understands the impact of words and tone. Not compelled to contribute to every topic discussed. Does not comment just to get credit. Listens more than speaks. Speaks only when has something valuable to contribute. Able to build on the commentary of others and take it to the next level. Focuses discussion on the right strategic level. Does not rush to conclusions. Objective in their commentary.
– Professional Collegiality (67%): Good social and people skills. Likeable. Proactive in developing relationships. Collaborative. A team player. Contributes to the success of others. Not a “gotcha” type. Discreet, diplomatic, and tactful. Respectful of tradition. Sensitive to the views of others.
– Relevant Experience and Knowledge (63%): Track record of high accomplishment and success, ideally in business. Leads from competency. CEO experience is considered most valuable, ideally in a large, complex organization. Business intelligence is most relevant, compared to intelligence in non-business fields. Best directors tend to be all-around athletes with significant breadth. Can grasp a broad range of business issues. Seasoned, mature, and resilient. Understands risk. Able to deal with the good and the bad. Capable of boardroom leadership impact when necessary and appropriate.
4. Governance capacity & “average director weight” aren’t necessarily correlated to company size.
Some large companies score poorly and some small companies score very well. Page 24 offers a “governance capacity worksheet” to use when filling a board vacancy.
5. Expanding your board size and replacing retiring directors with individuals who have more substantive experience are two steps that can help improve your board’s governance capacity & board weight.
We cover a lot of “shareholder activism” developments over on DealLawyers.com,* and last week, Meredith blogged about a recent Delaware case that came down in favor of a company that relied on an advance notice bylaw to reject a dissident nominee. This MoFo memo says that case is part of a broader trend of companies being sticklers for compliance with “advance notice” provisions. In the past 18 months, 17 companies rejected dissident director nominations for failure to comply with advance notice bylaws – and Delaware courts are tending to uphold those decisions.
The memo urges companies to make sure that their advance notice bylaws incorporate the latest protective features, without going so far that the bylaw will be struck down when it’s enforced. This excerpt outlines what to consider when you’re dealing with these provisions:
– Review the company’s bylaws and, in particular, advance notice provisions regularly. The recent introduction of the “universal proxy card” provides a good point of departure for a bylaw review, if one has not been undertaken already.
– Adopt any changes to the advance notice bylaws on a “clear day,” if possible, i.e., before any dissident stockholder surfaces.
– Advance notice bylaws should be clear and unambiguous, as any ambiguity or lack of clarity may be resolved in favor of the dissident.
– The board must act reasonably when it considers whether a stockholder nomination complied with the advance notice bylaws. “Inequitable acts towards stockholders do not become permissible because they are legally possible.”
– Advance notice bylaws should be in line with market standards. Courts see standard advance notice bylaws as commonplace and as serving a legitimate purpose. However, if they are overly aggressive or burdensome compared to market standards, they may be subject to challenge.
*ICYMI, our daily DealLawyers.com blog is free and you should subscribe to get the headlines in your inbox. And if you regularly handle hostile – or friendly – M&A, the site is full of very useful & practical info that will come in handy when you’re on a tight time frame. It’s also a great training resource for new associates!
