We’ve seen people in the “sustainability” industry starting to call for a uniform ESG disclosure framework – like this article from the CEO of the Global Reporting Initiative (GRI). A few bills on that topic also have been introduced. Now, a recent McKinsey study says that investors are also calling for change.
This Cooley blog summarizes the findings – here’s the intro:
Although there has been an increase in sustainability reporting, McKinsey’s survey revealed that investors believe that “they cannot readily use companies’ sustainability disclosures to inform investment decisions and advice accurately.” Why not? Because, unlike regular SEC-mandated financial disclosures, ESG disclosures don’t conform to a common set of standards—in fact, they may well conform to any of a dozen major reporting frameworks and many more standards, selected at the discretion of the company.
That leaves investors to try to sort things out before they can make any side-by-side comparisons—if that’s even possible. According to McKinsey, investors would really like to see some type of legal mandate around sustainability reporting. The rub is that, ironically, it’s the SEC that isn’t on board with that idea—at least, not yet.
As this blog from Elm Sustainability Partners points out, executives also aren’t enthralled with the current approach – they spend a ton of time responding to specialized surveys for what is essentially the same info – e.g. emissions data that is tabulated in different ways to conform to different standards.
Of course, “something is better than nothing” – so companies need to continue to attempt to meet investors’ information demands by providing relevant sustainability info. To get the scoop how companies that may have fewer resources are implementing sustainability initiatives – and making their disclosure as usable as possible – tune in to our October 16th webcast, “Sustainability Reporting: Small & Mid-Cap Perspectives.”
Making Sense of ESG Reporting Frameworks
Until we get a standardized approach to ESG disclosure, companies (and investors) will continue to wade through the current “alphabet soup” of reporting frameworks – and this issue of “Corporate Secretary” is worth a read to make sense of it all. Starting on page 5, it details how companies can use the GRI, SASB and other approaches to ESG disclosure. Here’s an excerpt from the write-up on SASB’s recent work:
In March 2019, SASB and the Climate Disclosure Standards Board published “Laying the groundwork for effective TCFD aligned disclosures,” which includes on page 8 a checklist of 11 preliminary steps companies can take to start integrating the recommendations of the Task Force on Climate-related Financial Disclosures. This is a hands-on, how-to resource that can help both directors and management get started.
Companies can also start their reporting journey by conducting a materiality assessment with the SASB materiality map, an interactive tool to look up industry-specific disclosure topics and metrics and identify and compare disclosure topics across different industries and sectors. SASB’s Engagement Guide for Asset Owners & Asset Managers can be a valuable resource for companies just starting to think about sustainability disclosures.
EU Credit Ratings: Impact of ESG Factors
I’ve blogged about how some credit rating agencies are voluntarily committing to look at ESG criteria in a more systemic way, and are starting to offer one-off explanations of how social issues can diminish or enhance credit ratings. In the EU, regulators appear to be imposing a more uniform approach. This announcement from the European Securities & Markets Authority says that credit rating agencies aren’t required to consider sustainability in their assessments (as explained in more detail in this 38-page document). But if they do, they need to follow new guidelines in explaining how ESG factors impact the rating.
Page 26 of the guidelines say that if ESG factors are a “key driver” behind a change to a credit rating or rating outlook, the rating agency’s accompanying press release or report should:
– Outline whether any of the key drivers behind the change to the credit rating or rating outlook correspond to that CRA’s categorisation of ESG factors
– Identify the key driving factors that were considered by that CRA to be ESG factors
– Explain why these ESG factors were material to the credit rating or rating outlook
– Include a link to either the section of that CRA’s website that includes guidance explaining how ESG factors are considered as part of that CRA’s credit ratings or a document that explains how ESG factors are considered within that CRA’s methodologies or associated models
Yesterday, SEC Commissioners Rob Jackson & Allison Herren Lee issued this joint statement about the “modernization” amendments to Reg S-K that were proposed several weeks ago. Although they’re in favor of the proposed addition of human capital disclosure requirements, they want to encourage comments on the shift towards principles-based disclosure and the absence of the topic of climate risk. Here’s the body of their statement:
The proposal favors a principles-based approach to disclosure rather than balancing the use of principles with line-item disclosures as investors—the consumers of this information—have advocated. The flexibility offered by principles-based disclosure makes sense in some cases, but the benefits of that flexibility should be carefully weighed against its costs.
One concern with principles-based disclosure is that it gives company executives discretion over what they tell investors. Another is that it can produce inconsistent information that investors cannot easily compare, making investment analysis—and, thus, capital—more expensive. Our concern is that the proposal’s principles-based approach will fail to give American investors the information they need about the companies they own.
For example, the proposal takes a crucial step forward for investors who have long asked for transparency about whether and how public companies invest in the American workforce. But, because it favors flexibility over bright-line rules, the proposal may give management too much discretion—sacrificing important comparability—when describing a company’s investments in its workers.
That’s why investors representing trillions of dollars, and our Investor Advisory Committee, have urged the SEC to require specific, detailed disclosures reflecting the importance of human capital management to the bottom line. We hope that commenters will make sure we get this balance right by letting us know what, if any, specific measures would be useful for investors.
Additionally, the proposal does not seek comment on whether to include the topic of climate risk in the Description of Business under Item 101. Estimates of the scale of that risk vary, but what is clear is that investors of all kinds view the risk as an important factor in their decision-making process. Yet it remains tough for investors to obtain useful climate-related disclosure. One argument against mandating such disclosure is that climate risk is too difficult to quantify with acceptable accuracy. Whatever one thinks about disclosure of climate risk, research shows that we are long past the point of being unable to meaningfully measure a company’s sustainability profile.
For example, recent work shows that some sustainability measures reveal material information to the market. Despite early skepticism about the utility of those measures, recent efforts to refine them through engagement with issuers and investors have borne real fruit. We hope commenters will weigh in as to whether and how this topic should be included in a final rule. In addition, to the extent the SEC may consider whether and how additional rules should be updated to provide more transparency on climate risk, we hope commenters will provide data and analysis to help guide that important work.
Audit Committee Disclosure: Cyber Risks Getting More Play
Deloitte’s annual survey on audit committee disclosure shows that large companies are continuing to increase the amount of information they voluntarily provide – with more than half now explaining why the audit committee decided to appoint the independent auditor, and nearly 80% explaining how the independent auditor is evaluated.
As has been the case for a few years, 99 companies in the S&P 100 also disclose the audit committee’s role in risk oversight. What’s new on that front is that a growing number specifically describe whether & how the audit committee is involved in overseeing cyber risks.
Deloitte gives these suggestions to further enhance transparency & usefulness of the proxy (also see our newly updated “Audit Committee Disclosure Handbook“):
3. Discuss issues encountered during the audit and how they were resolved (see KMI’s 2019 proxy statement)
4. Enhance readability by using graphics, or personalize the audit committee with photos or other messages tailored to readers (see Visa’s 2019 proxy statement)
Transcript: “Company Buybacks – Best Practices”
We’ve posted the transcript for our recent webcast: “Company Buybacks – Best Practices.”
Last week, the SEC issued this fee advisory that sets the filing fee rates for registration statements for fiscal 2020. Right now, the filing fee rate for Securities Act registration statements is $121.2 per million (the same rate applies under Sections 13(e) and 14(g)). Under the SEC’s new order, this rate will increase to $129.8 per million, a 7.1% increase.
Although we saw a modest 2.6% reduction in fee rates last year, this price hike puts fees back on the upward trajectory – they increased by 7-15% in fiscal 2018 and 2017. And since the annual adjustments to the SEC’s fee rate have been made under a formula prescribed by the Dodd-Frank Act since 2010, the “politics” of the timing and amount have been removed for a while.
As noted in the SEC’s order, the new fees will go into effect on October 1st (as has been the case since 2011, and as mandated by Dodd-Frank). That’s a departure from the old way of doing things – before Dodd-Frank, the new rate didn’t become effective until five days after the date of enactment of the SEC’s appropriation for the new year – which often was delayed well beyond the October 1st start of the government’s fiscal year as Congress and the President battled over the government’s budget.
Low-Cost Index Funds: Management’s “Absentee” Best Friend?
John’s blogged a couple of times about efforts by large institutional investors to avert a gathering storm of criticism. Maybe they can add this research to their fodder – it says that index funds are 12.5% more likely than “active” funds to vote with management’s recommendations when they differ from ISS, with that percentage being even higher for funds with low expense ratios (presumably, because they have fewer resources to spend on monitoring).
The research acknowledges that funds could be voting with management and still monitoring to ensure corporate governance – by either selling their shares, or by engaging with the company and then supporting pre-negotiated proposals. Sales are rare, as you’d expect from an index fund. But here’s the surprising part: in a complete departure from all anecdotal evidence and company complaints about the outsized influence of institutional investors, the researchers conclude that there’s no evidence of engagement. Zero!
If they’re right, maybe companies really can rest easy about the prediction that the “Big 3” will control 40% of the S&P 500 within the next 20 years. In my opinion, though, they’ve reached that conclusion based on a flawed understanding of Schedule 13D filing requirements and the shareholder proposal & engagement process. Specifically:
– They ignore the fact that engagement on executive compensation, social issues and corporate governance doesn’t disqualify a shareholder from filing a Schedule 13G
– They assume that there’s no engagement in the absence of a fund submitting its own proposal or voting against the company in a proxy contest
Glass Lewis Going “All In” With CGLytics…And Considering Pay-for-Performance Changes
Here’s something I blogged yesterday on on CompensationStandards.com: In June, I blogged that Glass Lewis is now using CGLytics (instead of Equilar) for compensation & data analysis of North American companies. According to this Georgeson blog, Glass Lewis has now elaborated on what that means – and confirmed that its new business partner will be its exclusive global provider of peer groups, compensation data and analytics.
In light of this move and client & company feedback, the proxy advisor is considering changes to its pay-for-performance peer review and scoring methodology. We’ll know more about the potential changes in a few months. For now, effective January 1st, Glass Lewis will:
– Use CGLytics as the sole provider of compensation data and analytical tools globally
– Provide model access exclusively through Glass Lewis and CGLytics
– No longer use Equilar’s peer groups
– No longer use Equilar data in any of their products
– Be the exclusive access point to Glass Lewis research reports and vote recommendations
FASB is taking pity on smaller reporting companies – who are finding it especially challenging to implement the slew of recent changes to accounting standards. According to this Proposed Accounting Standards Update, the Board has tentatively approved a new philosophy that will extend how effective dates are staggered between larger public companies and all other entities – including smaller reporting companies, private companies and employee benefit plans. This Deloitte blog explains:
The FASB tentatively decided that – subject to the Board’s discretion – a major accounting standard would become effective for entities in Bucket 2 (SRCs, etc.) at least two years after the effective date applicable to entities in Bucket 1 (large public companies). Further, the FASB indicated that entities in Bucket 1 would apply the new accounting standard to interim periods within the fiscal year of adoption while entities in Bucket 2 would apply it to interim periods beginning in the fiscal year after the year of initial adoption.
Historically, the FASB has issued standards with different effective dates for (1) public companies and (2) all other entities. Note that the Board’s tentative decisions would not affect the relief granted under SEC rules related to the adoption of new accounting standards by emerging growth companies.
For smaller reporting companies, this new philosophy would apply to the standard on current expected credit losses – so the proposal would extend the effective date by three years, to 2023. A lot of companies stand to benefit, especially in light of the SEC’s recent expansion of the SRC definition. But not everyone thinks this new philosophy is a good approach. This “Accountancy Daily” article reports on Moody’s anxiety about the change:
The proposal – initiated to give smaller companies more time to implement the new accounting changes – would hinder the credit analysis process by compromising comparability between public and private issuers and delaying, for adoption laggards, the enhanced disclosures these new standards bring.
New PCAOB Staff Guidance: Auditing Estimates & Use of Specialists
Last week, the PCAOB announced Staff guidance on four requirements that will be effective at the beginning of 2021. Here are the new guidance documents:
According to the announcement, the first two documents explain aspects of the PCAOB’s new auditing standard for accounting estimates & fair value measurements (AS 2501). That standard enhances the process for auditors to assess the impact of estimates on the risk of material misstatements. The other two documents highlight aspects of new requirements in AS 1201 and AS 1210 that apply when auditors use the work of specialists in an audit and when an auditor uses the work of a company specialist as audit evidence.
Report From the SEC’s “Small Business Capital Formation” Meeting
The SEC held its 38th annual “Small Business Forum” a couple weeks ago, along with a meeting of the “Small Business Capital Formation Committee” the day before. This Cooley blog summarizes some of the happenings – including a tentative timetable for revising the “accredited investor” definition and this background on the SEC’s proposal to change the definition of “accelerated filer”:
Director Hinman said the question was whether to pursue the SEC’s more nuanced approach or to just conform the non-accelerated filer definition with the SRC definition? Is an attestation worthwhile for companies with public floats over $75 million? According to Hinman, the reason the SEC proposed the narrowly tailored exception for low-revenue companies—“fine-tuning” as Hinman characterized it—was that the DERA analysis was more supportive of that approach: the DERA analysis showed that the risk of problems was greater for companies with revenues in excess of $100 million.
In any case, even without the auditor attestation, the auditors still need to review the quality of the controls as part of the audit, he noted, and the management is still required to perform a SOX 404(a) assessment of internal controls. And there are certainly costs associated with the attestation, especially “system upgrades” that are needed when the attestation process commences. A number of comments received on the proposal argued that, while an attestation can add to the company’s cost, it also saves funds by reducing the cost of capital. As structured, the proposal allows low-revenue companies to make that decision.
Chair Clayton observed that, first, it was important to emphasize that high-quality financial statements are the bedrock of our system. But, with more than a decade of experience with SOX 404(b) and over five years of experience with the JOBS Act and its exemption from 404(b) for EGCs, he suggested, the market is telling us something. With many EGCs now starting to “age out” of that exemption, is the market just “rubbing its hands” in anticipation of 404(b) attestations for these post-EGC companies? He wasn’t seeing it (and some of the company representatives later indicated that, although they were aging out of EGC status, their investors were not asking for 404(b) attestations). Was there a “Wild West” premium for non-accelerated filers?
Although the SEC cancelled its open Commission meeting that had been scheduled for yesterday, the Commissioners voted to issue this 116-page proposing release to modernize parts of Regulation S-K – specifically, Item 101 (business description), Item 103 (legal proceedings) and Item 105 (risk factors).
I speculated on Monday that some parts of the proposal might be somewhat based on the SEC’s Reg S-K concept release from 2016 – and it appears that they are (though the proposal doesn’t cover everything that was in the concept release). Another part of the proposal relates to human capital – a topic that SEC Chair Jay Clayton has indicated in recent speeches may be growing in importance. The “Fact Sheet” in the SEC’s press release highlights these proposed changes (also see this Cooley blog):
Item 101(a) (Development of Business):
– Make the Item largely principles-based by providing a non-exclusive list of the types of information that a registrant may need to disclose, and by requiring disclosure of a topic only to the extent such information is material to an understanding of the general development of a registrant’s business;
– Include as a listed disclosure topic, to the extent material to an understanding of the registrant’s business, transactions and events that affect or may affect the company’s operations, including material changes to a registrant’s previously disclosed business strategy;
– Eliminate a prescribed timeframe for this disclosure; and
– Permit a registrant, in filings made after a registrant’s initial filing, to provide only an update of the general development of the business that focuses on material developments in the reporting period, and with an active hyperlink to the registrant’s most recent filing that, together with the update, would contain the full discussion of the general development of the registrant’s business.
Item 101(c) (Business Narrative):
– Clarify and expand its principles-based approach, by including disclosure topics drawn from a subset of the topics currently contained in Item 101(c);
– Include, as a disclosure topic, human capital resources – including any human capital measures or objectives that management focuses on in managing the business – to the extent such disclosures would be material to an understanding of the registrant’s business,such as, depending on the nature of the registrant’s business and workforce, measures or objectives that address the attraction, development, and retention of personnel; and
– Refocus the regulatory compliance requirement by including material government regulations, not just environmental provisions, as a topic.
Item 103 (Legal Proceedings):
– Expressly state that the required information about material legal proceedings may be provided by including hyperlinks or cross-references to legal proceedings disclosure located elsewhere in the document in an effort to encourage registrants to avoid duplicative disclosure; and
– Revise the $100,000 threshold for disclosure of environmental proceedings to which the government is a party to $300,000 to adjust for inflation.
Item 105 (Risk Factors):
– Require summary risk factor disclosure if the risk factor section exceeds 15 pages;
– Refine the principles-based approach of that rule by changing the disclosure standard from the “most significant” factors to the “material” factors required to be disclosed; and
– Require risk factors to be organized under relevant headings, with any risk factors that may generally apply to an investment in securities disclosed at the end of the risk factor section under a separate caption.
This proposal was based on seriatim action taken by the Commissioners. As to the issue of whether the SEC is required to propose (or adopt) rules at an open Commission meeting, see Broc’s blog entitled “When is the SEC Required to Hold an Open Commission Meeting?”
Shareholder Proposals: Big Year for “Political Spending”
In March, Broc blogged on our “Proxy Season Blog” that lobbying & political spending proposals were “coming up big” this year. And now that the height of proxy season is behind us, the Center for Political Accountability is elaborating on their recent successes in this blog. Here’s an excerpt:
The average vote was 36.4 percent at 33 companies that held annual meetings. That was up from 34 percent last year, when 18 resolutions went to a vote. In 2017, the resolution averaged 28 percent over the 22 resolutions that went to a vote. CPA and its shareholder partners reached disclosure agreements and withdrew resolutions at 13 companies this year. That compares with three in 2018 and seven in 2017.
The 2019 Proxy Season breakdown is as follows:
– Two majority votes in support of the resolution at Cognizant Technology Solutions Corp. (53.6%) and Macy’s Inc. (53.1%).
– Eleven votes in the 40% range, including Kohl’s Corp. (49.8%), NextEra Energy Inc. (48.7%), Allstate Corp. (46.9%), Chemed (46.2%), Western Union Co. (44.3%), Fiserv Inc. (43.8%), Alaska Air Group (43.5%), Roper Technologies Inc. (43.0%), Netflix Inc. (41.7%), Centene Corp. (41.6%) and Nucor Corp (40.6%).
– Twelve votes in the 30% range. The companies included Illumina Inc. (37.7%), Simon Property Group Inc. (37.1%), American Water Works Company Inc. (37.0%), Duke Energy Corp. (35.8%), Wyndham Destinations (35.6%), American Tower Corp. (35%), Royal Caribbean Cruises Ltd. (34.5%), Wynn Resorts Ltd. (34.4%) CMS Energy Corp. (34.3%), Equinix Inc. (34.2%), DTE Energy Co. (33.6%), and J.B. Hunt Transport Services Inc. (31.7%).
This Cooley blog explores why companies might be coming around to greater oversight of this type of spending, and discusses some of the CPA’s recommendations…
Just Mailed: July-August Issue of The Corporate Counsel
1. Early Returns From the Fast Act Rule Changes
– Changes to the Form 10-K Cover Page
– Item 102 of S-K—Description of Property
– Item 303 of S-K—MD&A- Item 601 of S-K—Exhibits: Description of Securities
– Some Takeaways
2. Unpacking Stock Splits
– Stock Split v. Stock Dividend: What’s the Difference?
– Companies Need “Surplus” To Pay Dividends
– Do You Have Enough Shares?
– Directors’ Fiduciary Duties
– Reverse Splits: Appraisal Rights & Fair Value of Fractional Shares
– Federal Income Tax Treatment of Splits & Reverse Splits
– Federal Securities Law Compliance
– Exchange Act Compliance
– Stock Exchange Rules
– 5 Key Takeaways
3. A Few Words About Delaware’s “Legal Capital” Requirements
A couple weeks ago, Broc blogged about some confusion around the Inline XBRL requirements that will be required for Form 10-Q filings by large accelerated filers this quarter. And with the 10-Q deadline looming for those with a June 30th quarter-end (tomorrow!), the dialogue has continued in our “Q&A Forum” (see #9960). Yesterday, Bass Berry also shared this blog about how to handle the iXBRL requirements. Here’s an excerpt about Form 10-Q – as well as Form 8-K (and see this Gibson Dunn blog for even more pointers):
Form 10-Q Question: As a large accelerated filer, should our 10-Q exhibit list include a separate reference to Exhibit 104?
Based on our discussions with SEC Staff within the SEC’s Division of Corporation Finance, we understand the position of the Staff in Corp Fin’s Office of Chief Counsel is that a registrant should explicitly reference an Exhibit 104 in the list of exhibits. And because the recent EDGAR Filer Manual makes clear that a registrant meets its obligation under Exhibit 104 by providing the cover page interactive data file using an Inline XBRL document set with Exhibit 101, the registrant should simply cross-reference to Exhibit 101.
For example, Exhibit 104 could include a cross-reference as follows: “104 Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101).”
We also remind large accelerated filers that the recent instructions to Item 601(b)(101) of Regulation S-K were amended to require that for interactive data files, the Exhibit Index must include the word “Inline” within the title description for any XBRL-related exhibits. See Instruction 1 to Paragraphs (b)(101)(i) and (ii) of Regulation S-K.
Form 8-K Question: In a Form 8-K, are you required to explicitly reference Exhibit 104 in the Exhibit Index?
Answer: In discussions with SEC Staff within the SEC’s Division of Corporation Finance, we received the following guidance related to a registrant’s Exhibit 104 reference obligation in 8-Ks:
– If the 8-K does NOT otherwise have an exhibit being filed or furnished under Item 9.01(d), then the company does not need to include Item 9.01(d) in the 8-K solely for the Exhibit 104 reference. (The cover page tagging is still required in the background, but there is no standalone Exhibit 104 reference in an Item 9.01.)
– In contrast, if the 8-K does have another exhibit being filed or furnished under Item 9.01(d) (e.g., there is a material contract), then the company should include a reference to Exhibit 104 in the Item 9.01(d) disclosure because there is already disclosure being provided under this Item. For example, the reference could be as follows: “104 Cover Page Interactive Data File (embedded within the Inline XBRL document)”
– The principle behind this position is that Item 9.01 is intended to have an informational component to it, and if an Exhibit 104 reference is required in every 8-K then the informational benefit of item 9.01 is weakened.
Fast Act: SEC Issues “Technical Corrections”
A couple weeks ago, Broc noted in his Inline XBRL blog that an incorrect eCFR of the Item 601(a) table was causing some confusion about iXBRL requirements. The SEC has now issued this 18-page release, which corrects the exhibit table and a few other items from the original Fast Act amendments. The technical corrections to the final rules do the following:
– Reinstate certain item headings in registration statement forms under the Securities Act of 1933 that were inadvertently changed
– Relocate certain amendments to the correct item numbers in these forms and reinstates text that was inadvertently removed
– Correct a portion of the exhibit table in Item 601(a) of Regulation S-K to make it consistent with the regulatory text of the amendments
– Correct certain typographical errors and a cross-reference in the regulatory text of the amendments
Today’s Open Commission Meeting: Cancelled
The SEC has cancelled the open meeting that it had previously scheduled for today to consider whether to propose additional Regulation S-K disclosure reforms. No word on rescheduling yet.
Next Wednesday: SEC’s “Small Business Forum”
The SEC will hold its 38th annual “Small Business Forum” next Wednesday – August 14th – in Omaha, Nebraska (and if you’re like me, you now have this ‘Counting Crows’ song stuck in your head). The SEC’s announcement summarizes what topics will be covered and explains how to access the meeting (you need to register by tomorrow if you want to attend or listen in on any of the breakout sessions):
As in past years, the format of the Forum will include a live webcast informational morning session followed by an afternoon working session where participants will formulate specific policy recommendations in groups. The morning panels will cover capital formation (“success stories from the Silicon Prairie”) and efforts to harmonize the offering framework, based on the SEC’s June concept release.
The afternoon breakout group sessions will not be webcast but will be accessible by teleconference for those not attending in person. Anyone wishing to participate in a breakout group either in person or by teleconference must register online by August 9.
Also, about a month ago, the SEC posted its final report from last year’s Forum – which included recommendations about modernizing disclosure requirements and harmonizing private offering exemptions.
Here’s something from Dan Goelzer’s latest newsletter: A challenge faced by a company under non-public SEC investigation is whether to publicly disclose the investigation before the company knows whether it will result in any charges. There are no firm rules on whether investigations must be disclosed. The decision is inherently a judgment call and depends on an assessment of materiality after considering the costs and consequences of the investigation, the issues underlying the inquiry, the likelihood and potential impact of any eventual SEC enforcement proceeding, and other factors. It is frequently assumed that transparency is the more conservative approach and that, in the long run, the market rewards candor.
Dan goes on to say that a recent paper by David H. Solomon, of Boston College’s Carroll School of Management, and Eugene Soltes, of Harvard Business School, casts doubt on these assumptions. Professors Solomon and Soltes conclude:
– Even if no charges are ultimately filed, companies that voluntarily disclose an SEC financial fraud investigation have “significant negative returns, underperforming non-sanctioned firms that stayed silent by 12.7% for a year after the investigation begins.”
– Disclosing in a “more prominent manner” (e.g., in a press release as distinguished from an SEC filing) is associated with worse returns.
– A CEO whose company discloses an investigation is 14 percent more likely to “experience turnover” within two years than a CEO whose company opts to remain silent, regardless of the outcome of the SEC investigation.
These findings won’t come as a surprise to anyone who’s been involved in responding to fraud allegations. Even if the SEC ultimately drops their inquiry, a years-long investigation can tear apart the company and make it pretty hard for management to stay focused on their day jobs. But in his newsletter, Dan notes that:
The circumstances which lead to SEC financial fraud investigations vary widely, as do the pros and cons of voluntary disclosure. The Solomon and Soltes research, while intriguing, should not be a factor in deciding whether to disclose an investigation. The paper does, however, underscore how seriously the markets are likely to take news of a financial fraud investigation. The audit committee needs to treat such a matter equally seriously.
Securities Class Actions: M&A Filings Down, But Plaintiffs Still Loving Disclosure Fraud
Last week, Cornerstone Research published its midyear assessment of securities class action filings. Here’s a few takeaways from the press release:
– Plaintiffs filed 126 “core” class actions (excluding M&A claims) – that’s just one shy of the record set in the first half of 2017 – due to delayed market volatility in late 2018 and an uptick in filings against consumer-focused and tech companies
– Plaintiffs have filed more than 1,000 securities class actions in the last 2.5 years – accounting for more than 20% of the total number of filings since 1997
– M&A-related filings declined more than 20% since last year – to 72 – and dropped below 90 for the first time since the second half of 2016
– Six mega-dollar disclosure loss (DDL) filings (at least $5 billion) and 11 mega maximum dollar loss (MDL) filings (at least $10 billion) propelled aggregate market capitalization losses to the highest and fourth-highest levels on record, respectively
– Due to the Supreme Court’s 2018 Cyan decision, plaintiffs continue to shift securities fraud claims against IPOs from federal to state court – 61 new 1933 Act filings have appeared post-Cyan, which consists of 23 parallel filings, 12 filings in federal courts only, and 26 filings in state courts only
’33 Act Class Actions: NY State May Not Be So Plaintiff-Friendly After All
People have been predicting that SCOTUS’s 2018 Cyan decision – which held that class actions alleging claims under the Securities Act of 1933 may be heard in state court – would be a boon for the plaintiffs’ bar…and a big problem for IPO companies & their D&O carriers. Cornerstone’s midyear assessment of securities class action filings certainly suggests that plaintiffs have found the decision encouraging.
But this D&O Diary blog points to a glimmer of hope in New York – where many post-Cyan suits are being filed because the state’s pleading standards are less onerous than at the federal level. The blog explains that a New York State trial judge recently dismissed a case brought against an IPO company & its underwriters under Sections 11 and 12(a)(2) of the Securities Act. Here’s an excerpt (and here’s a call for reform):
To the extent that the plaintiffs’ lawyers were motivated to file in state court based on perceived advantages at the motion to dismiss stage, Judge Borrok’s decision represents something of a reality check. Judge Borrok’s opinion is thorough, sure-handed, and shows no discomfort in working with the federal securities laws and relevant case law. (In that regard, Judge Borrok’s reliance on the Omnicare decision underscores the importance of that ruling in opinion cases.) The state court pleading standard does not seem to have been a factor in the ruling. And no one would mistake Judge Borrok’s opinion as plaintiff friendly.
The decision in the Netshoes case is of course just one ruling by one trial court judge. It has no precedential value and may have only limited value as an indicator of how New York state courts generally may deal with the new influx of securities cases. Moreover, Judge Borrok’s dismissal of the Netshoes case was without prejudice; the plaintiffs will have an opportunity to try to cure the shortcomings Judge Borrok noted in his decision. For all we know, the plaintiffs might well succeed in amending their complaint and in surviving the next round of dismissal motions.
However, one can hope that Judge Borrok’s ruling may help send a message that the plaintiffs may need to reconsider whatever perceived advantages they may think they have in proceeding in state court rather than federal court.
Back in December, Stinson’s Steve Quinlivan spotted the first CAM. Now we owe him another hat tip for finding the first few CAMs in audits issued by the “Big 4” accounting firms – see page 93 of Microsoft’s Form 10-K and page 107 of Open Text’s Form 10-K. Both companies had a CAM relating to revenue recognition. Steve noted in his blog (also see his follow-up entry):
The CAM is straightforward and does not reflect negatively on the company or its audit committee or cast doubt on its financial reporting. If anything, it most likely reflects an attitude by the auditor that “we have to find something to protect us in the case of a PCAOB inspection.” I think revenue recognition CAMs are going to become somewhat boiler plate and not likely to attract a lot of attention absent special circumstances.
Auditor Attestations: No Shortage of Comments on SEC Proposal
The comment letters have been rolling in on the SEC’s proposed amendments to the “accelerated filer” definition – which would make fewer companies subject to the auditor attestation requirement. Predictably, accounting firms aren’t in favor of the change and say that it would weaken the quality of financial reporting (here’s EY’s letter as an example). CII has also joined that camp – its letter argues that the amendment may cause investors to lose confidence in the integrity of financial statements.
CII also takes issue with the SEC’s economic analysis of the proposal – by citing to another recent comment letter from four B-School profs. That letter adds data to the assertion that some companies can’t be trusted to report material weaknesses when left to their own devices (as does this blog about Canada’s experience with a similar rule). Here’s an excerpt from this WSJ article about the letter and its underlying study:
More than 100 companies that could get relief have reported restatements that altered combined net income by $295 million from 2014 through 2018, according to a comment letter from researchers at Stanford University, the University of Pennsylvania, the University of North Carolina and Indiana University. Eleven of the restatements occurred in 2018 and wiped out about $294 million in market value, the researchers wrote.
One company in the group is Insys Therapeutics Inc., said Prof. Taylor, who co-wrote the letter. Insys, an opioid manufacturer whose market value peaked at $3.2 billion in 2015, sought bankruptcy protection in June after pleading guilty to bribing doctors to boost use of its spray version of fentanyl, a synthetic opioid. It agreed to pay $225 million in fines and forfeiture.
Insys effectively failed the internal-controls audits in 2015 and 2016, according to securities filings. The company later restated results for several quarters in 2015 and 2016. The company said at the time that neither fraud nor misconduct caused the errors. Auditors in 2017 and 2018 reported its internal controls were free from material weaknesses.
The comment letter emphasizes that the analysis in the SEC proposal quantifies the cost of internal control audits – but not the potentialbenefits. Of course, there are two sides to this heated debate – and the WSJ article also emphasizes the high cost of compliance for smaller companies, and that investing that money in the core business rather than compliance could improve returns for shareholders…there are letters supporting the proposal from Nasdaq, the Chamber, Proskauer and a score of life science companies, among others.
Sarbanes-Oxley Compliance: Still a Lot of Work, But Automated Controls Might Help
There was a slight decrease in Sarbanes-Oxley compliance costs last year – according to Protiviti’s annual survey on the topic – but spending remains significant ($1.3 million on average among large accelerated filers – and that excludes external audit fees). In addition, hours & control counts continue to increase. Protiviti predicts that new technologies – along with a desire to strengthen controls and (finally) lower costs – will usher in “SOX Compliance 2.0.” Here’s an excerpt:
A growing number of SOX executives recognize that more dramatic improvements, fueled by a new mindset and advanced technologies, are required. To illustrate, our results reveal that the use of analytics has jumped significantly and that a broader range of compliance activities are being subjected to advanced technology — with even more plans to do so in the future. It also appears many organizations are huddling with their external auditors to figure out how the auditor’s use of advanced automation can deliver greater compliance effectiveness.
Protiviti also found that the use of automated controls testing is increasing, more companies are using outside providers for Sarbanes-Oxley compliance, and cybersecurity is substantially increasing compliance hours. Nearly half of companies said they were now required to issue a “cybersecurity disclosure” based on guidance from the SEC & Corp Fin.
The SEC announced that it’s holding an open Commission meeting this Thursday – August 8th – to consider whether to propose rule amendments to modernize these Regulation S-K disclosure requirements:
1. Business Description
2. Legal Proceedings
3. Risk Factors
I’ll admit that my first reaction to this news was, “Didn’t they already do this (twice) last year?” But then I remembered that the 341-page Reg S-K concept release from 2016 went well beyond the Fast Act and Disclosure Update & Simplification amendments. We don’t know yet whether a proposal coming out of this meeting – if any – will address any of those ideas (the agenda just says that any proposal would be intended to update these rules to account for developments since their adoption or last amendment, to improve these disclosures for investors, and to simplify compliance efforts for companies). We’ll keep you updated in any event.
By the way, we’ve overhauled about 4000 pages of our “Handbooks” to reflect the latest disclosure requirements, accommodations and best practices – including all of the Fast Act and Disclosure Update & Simplification amendments. They’re a great resource for making sure that your forms & disclosures are up to date.
Board Diversity: S&P 500 No Longer Has Any All-Male Boards
A couple weeks ago, the WSJ reported that all S&P 500 boards now include at least one female director – a pretty significant milestone, given that one in eight boards in that index were all male as recently as 2012. The “Thirty Percent Coalition” – which coincidentally was formed by investors in 2012 with the goal of improving female representation – also announced that 85 companies appointed a woman to their board for the first time during the last year and that more company boards include a woman now than at any other time since the campaign launched.
Of course, there are plenty of companies outside of the S&P 500 that haven’t diversified – and as this Korn Ferry blog points out, business benefits are best realized when 20-30% of the board is “diverse.” The Thirty Percent Coalition’s investors will be asking companies to undertake the following:
1. Disclosure in the Proxy of board composition inclusive of gender, race, and ethnicity
2. Language committing to diversity in Governance charter
3. Disclosure of future plans to make progress on board diversity
4. Adaptation of the “Rooney Rule” for board candidates and senior leadership (investors want each company to commit to include women & people of color in every pool from which Board nominees are chosen and to state this in their Board Refreshment Policies and/or Nominating & Corporate Governance Committee Charter)
5. Consideration of candidates outside of CEOs for board positions.
Tomorrow’s Webcast: “Joint Ventures – Practice Pointers (Part II)”
Tune in tomorrow for the DealLawyers.com webcast – “Joint Ventures: Practice Pointers (Part II)” – to hear Troutman Sanders’ Robert Friedman, Proskauer’s Ben Orlanski, Cooley’s Marya Postner and Aon’s Chuck Yen provide an encore to our popular June webcast with even more practical advice on navigating your next joint venture. The topics include:
1. Joint Ventures vs. Contractual Collaboration
2. IP Issues: JVs Based on An Owner’s Platform Technology
3. Negotiating “Divorce” Up Front
4. Consider Piloting a JV Before Full Commitment
5. Majority/Minority Dynamics
6. Acting By Written Consent
7. Clarifying JV’s Purpose
8. Pay Principles: Benchmarking & Long-Term Incentives
9. How Key Pay Decisions Are Made
Every proxy season, Corp Fin responds to somewhere between 200-400 no-action requests about shareholder proposals. Earlier this year, we blogged several times about how the government shutdown upended the process. And even though the Staff got back to “business as usual” when the shutdown ended, they had to be even more efficient given the time constraints – and that experience might have contributed to Corp Fin considering whether to rethink their approach to Rule 14a-8 no-action requests.
As you can hear at the 29-minute mark of this taping of a Chamber event a few days ago, SEC Chair Clayton & Corp Fin Director Hinman commented that they’re considering changing some aspects of their “referee” role (my word, not theirs) – so that, like other types of no-action requests, Corp Fin wouldn’t respond to every Rule 14a-8 submission. Rather, they’d focus on requests that involve “novel” issues and encourage companies & proponents to work things out themselves. Bill says they’re seeking input from the community on how they might change their approach.
As I blogged during the shutdown, companies continue to be very cautious about excluding proposals without first obtaining Staff no-action relief. Some speculate that we’ll see more litigation if Corp Fin does change their role and isn’t as involved – especially on matters that involve tough judgment calls. Any changes in Corp Fin’s role is bound to have a variety of views as this area is always contentious when change is considered, particularly if the SEC’s role might change.
How Asset Managers Feel About “Activists”
John’s blogged on DealLawyers.com that activist hedge funds don’t actually do much to improve company performance. But according to this SquareWell Partners survey (download required), the perception – at least among “active” asset managers – is that these funds are a useful market force, even if they have a short-term, selfish interest.
For that reason, it’s becoming more common for asset managers to align with activists on proxy fights and proposals if they agree with the substance of the activist’s argument – especially on governance & strategic matters. Here’s some interesting takeaways that can help you form alliances when you need them (this was also a topic covered earlier this week in our DealLawyers.com webcast – “How to Handle Hostile Attacks” – stay tuned for the transcript):
– 81% of investors expect companies to engage after they’ve analyzed the analyst’s arguments & formed a strategic response – i.e. don’t rush into a “PR War” – but also know that investors will engage with an activist even before the campaign is public
– 64% of active managers expect to engage with independent directors
– Investors consider a number of factors when assessing a targeted company – the top ones are company performance versus peers, management & board quality, and engagement history – they also look to broker reports, proxy advisors, media outlets & social media
– Investors are mixed on whether poor TSR is a dealbreaker – they’ll also consider ratios that show profitability, efficiency, debt & liquidity
– In addition to capital allocation decisions, active managers are most attuned to governance issues such as collective board expertise, board independence, chair quality and executive pay
Convertible Debt: Still a Good Way to Raise a Buck (or a Million)
This Fenwick survey looks at the terms of 100 convertible debt deals last year – for first-money and early- and late-stage bridge deals. Here’s some key findings:
– Year over year, deal sizes have continued to increase. The median overall deal size this year is up 14%, from $1.4 million to $1.6 million
– Conversion discounts are increasingly common, even in later-stage debt issuances, as is the practice of pairing the discount with a valuation cap
– In change-of-control situations, such as the sale of a company, most deals provide for a premium payout that is a multiple on top of the repayment of the principal balance. The number of deals giving a premium, as well as the median premium amount has remained steady year over year; however, this year the low end of the premium spectrum dropped from 25% to 10%
– Only 11% of deals used a valuation cap as a standalone provision in the absence of a conversion discount
