Yesterday, the SEC’s Office of Chief Accountant Paul Munter released this statement on the recent increase in deficiency rates found in audit inspections and the role of the auditor and audit committee in ensuring high-quality audits. The statement first addresses the role of auditors and suggests that auditors do more of the following:
– frequently and proactively engage with the audit committee, including on events that impact financial reporting and red flags arising from management responses;
– not agree to truncated or summary presentations with the audit committee regarding concerns with management or management responses;
– include specialists and other experts to assist in auditing complex areas or where specialized knowledge is needed to ensure adequate expertise;
– ensure engagement teams are trained on biases that affect auditor judgment and decision-making and undermine professional skepticism; and
– ensure that audit staff are empowered to exercise professional skepticism and challenge judgments of management by supporting audit staff in exploring areas of heightened risk and red flags, insulating audit staff from pressure to accept less than persuasive audit evidence and refusing management requests to replace audit team members.
Then the statement turned to the role of audit committees. First, it describes the importance of the committee’s role in assessing auditor performance, and suggests committees evaluate whether and how they consider the following:
– results of the auditor’s PCAOB inspections, the firm’s internal monitoring programs, or other firm audit quality reporting; – whether the engagement team has appropriate industry expertise, and whether the engagement partner is sufficiently engaged and provides leadership to the engagement team; – the engagement team’s total hours and staffing mix (such as, the use of specialists, the composition of experience within the engagement team, or portions of the engagement performed by other auditors); and – significant changes (or the lack thereof) in hours or staffing mix from previous audits.
It also encourages audit committees to build a strong professional relationship with the auditor independent of management and makes suggestions to further that goal.
Chief Accountant Munter has been sharing thoughts with the corporate and auditor communities regularly in recent months, having recently addressed the importance of the statement of cash flows, with consistent commentary at the Northwestern Securities Regulation Institute. He also recently joined this Q&A with KPMG where he highlighted the risk of what he called the “SALY” (same as last year) mentality, noting that audit committees need to pay attention to emerging risks, which are often communicated first outside of the financial statements, in risk factors or MD&A, and be thinking through what those risks mean for the financial reporting process.
Here’s something Liz shared on the CompensationStandards.com Advisors’ Blog yesterday:
It was the “moonshot” award that started it all. But last week, as you’ve probably heard, Elon Musk did not get the outcome he was hoping for in the Tornetta v. Musk litigation that has been winding its way through the Delaware Court of Chancery for several years.
The case challenged the record-breaking equity award that was granted to Musk in 2018 and – when the value of the company skyrocketed – came to be worth about $51 billion. Chancellor Kathaleen McCormick issued her 201-page opinion last Tuesday. As Tulane Law Prof Ann Lipton put it, “she took the extraordinary step of holding that Elon Musk’s Tesla pay package from 2018 was not ‘entirely fair’ to Tesla investors, and ordered that it be rescinded.” Mechanically, it looks like the options that the company had granted to Musk will now be cancelled (none of the options had been exercised). Ann’s blog walks through the complex legal standards – & burdens of proof – that led Chancellor McCormick to this outcome. Here’s an excerpt:
Formally, in Tornetta, the court concluded that Elon Musk was a controlling shareholder of Tesla, at least for the purposes of setting his compensation package. The court considered both his 21% percent stake, and his “ability to exercise outsized influence in the board room” due to his close personal ties to the directors and his “superstar CEO” status. She recounted the process by which the pay package was set, noting in particular that Musk proposed it, Musk controlled the timelines of the board’s deliberation, and he received almost no pushback – board members and Tesla’s general counsel seemed to view themselves as participating in a cooperative process to set Musk’s pay, rather than an adversarial one.
What about the stockholder vote? That, too, was tainted, because – McCormick concluded – the proxy statement delivered to shareholders contained material misrepresentations and omissions. It described Tesla’s compensation committee as independent when in fact the members had close personal ties to Musk, and it did not accurately describe the manner in which his pay package was set – again, with Musk himself proposing it and the board largely acquiescing. With those findings in hand, McCormick did not rule on the plaintiff’s additional arguments that the proxy statement was misleading for other reasons (namely, it falsely described the payment milestones as “stretches” when in fact the early ones were already expected within Tesla internally.)
Chancellor McCormick said that the process leading to the approval of the compensation plan was “deeply flawed.” Advisors will also find it interesting that she reviewed an early draft of Tesla’s proxy statement and found it to be the “most reliable (indeed, the only) evidence” of the substance of the discussion that established the terms of Musk’s equity grant. Over the course of several drafts, the existence of that conversation was edited out – so, it was not mentioned in the as-filed proxy. The judge also took issue with this statement:
The Proxy disclosed that, when setting the milestones, “the Board carefully considered a variety of factors, including Tesla’s growth trajectory and internal growth plans and the historical performance of other high-growth and high-multiples companies in the technology space that have invested in new businesses and tangible assets.” “Internal growth plans” referred to Tesla’s projections.
According to the court’s findings, the proxy was misleading because it didn’t disclose that the company had projections that would show that the milestones would be achieved. As Ann explained in her blog, the court also took issue with describing compensation committee members as “independent” when – according to the record – they in fact had relationships that gave rise to potential conflicts of interest that should have been disclosed, and a “controlled mindset.” So, Chancellor McCormick concluded:
The record establishes that the Proxy failed to disclose the Compensation Committee members’ potential conflicts and omitted material information concerning the process. Defendants sought to prove otherwise, and they generally contend that the stockholder vote was fully informed because the most important facts about the Grant—the economic terms—were disclosed. But Defendants failed to carry their burden.
The case shows that process, common-sense thinking, and disclosure matter. If you’re involved in the compensation-setting and/or proxy drafting process, you may not win friends if you read everything with a critical eye and ask unwanted questions. It can be hard to find a way to do that tactfully. But now you have a case to point to that shows why it’s important.
The latest issue of The Corporate Executive has been sent to the printer. It’s also available online to members of TheCorporateCounsel.net who subscribe to the electronic format. This issue is particularly timely as we head into proxy season and focus on proxy advisor policies:
– ‘Now What Do We Do?’ Dealing with Negative Proxy Advisor Recommendations
Read it now for practical tips for advance preparation and keep it handy for the future if you find yourself facing a surprise negative recommendation. Don’t miss out on all the practical guidance that The Corporate Executive has to offer. Email sales@ccrcorp.com to subscribe to this essential resource.
This post on the CS Blue Sky Blog highlights findings from “A Comparison of Direct Listings and Initial Public Offerings,” a study by Anna Bergman Brown of Clarkson University, Donal Byard of Baruch College, and Jangwon Suh of Queens College. Given suggestions by SEC commissioners and other regulators that direct listings present greater risk to investors than IPOs, the study assessed the types of companies that listed via IPO versus direct listing and the average price volatility post-listing.
The study used a sample of IPOs and direct listings on European stock exchanges given the historically few direct listings in US markets, despite their increasing popularity since Spotify’s in 2018. Here’s an excerpt summarizing the findings:
The first significant finding is that, on average, DL firms are significantly larger, more profitable, and less leveraged than IPO firms – all of which suggest that, on average, DL firms are less risky than IPO firms.
Our second significant finding is that, when we compare the post-listing price volatility of DLs with similar IPOs, consistent with some regulators’ suspicions, we find that DLs are riskier than IPOs in the immediate post-listing period: DLs have higher price volatility than similar IPOs in the immediate post-listing period. However, we find that this excess price volatility dissipates rather quickly: On average, it lasts for only 20 trading days.
We also find that, in industries with a richer “industry information environment” – i.e., where the existing listed firms in that industry already provide relatively high-quality public disclosures – there is no difference in post-listing price volatility across DLs and IPOs.
There is still the issue of traceability…and there’s more to come on that. For now, for more on direct listings, take a look at our “Direct Listings” Practice Area.
Last week, in Grabski v. Andreessen (Del. Ch.; 2/24), Chancellor McCormick denied a motion by directors and officers of Coinbase Global to dismiss claims that arose from Coinbase’s 2021 direct listing on Nasdaq. The plaintiff acquired stock in the direct listing and filed suit derivatively, alleging the defendants breached their fiduciary duties by selling $2.9 billion worth of stock in the direct listing based on MNPI and were unjustly enriched by the sales. A month after the listing, the company announced quarterly earnings and a capital raise through a notes offering and the stock price dropped.
Defendants sought to dismiss on the basis that the plaintiff failed to show the directors’ personal interest for demand futility purposes. Chancellor McCormick disagreed. After listing the amounts of sales by the director defendants, she states:
Plaintiff argues that it is reasonably conceivable that this amount of money was material to each Director Defendant such that none could impartially consider a pre-suit litigation demand attacking the sales. Plaintiff need not allege facts concerning each Director Defendant’s personal wealth to support this conclusion—$50 million is presumptively material. […] In the real world, the billions of dollars made by the Director Defendants constitutes a material personal benefit that would render a director incapable of impartially considering a demand attacking those sales. Demand is excused on this basis.
The opinion also found demand to be excused on the basis that the director defendants face a substantial likelihood of liability. The opinion only addresses one of the four categories of information plaintiff claims is MNPI — a 409A valuation approved by the board the same day as the direct listing. As to its materiality, the opinion declines to make any defendant-friendly inferences at the pleadings stage.
The defendants argued against the inference of scienter due to the proportion of their holdings represented by the sales and that they could have made more by selling more stock shortly after the initial sales but chose not to. To this, Chancellor McCormick said, “Plaintiff need not allege that Director Defendants maximized the value gained from their alleged impropriety” to infer scienter at the pleadings stage.
What does this mean for direct listings? The opinion says this:
Although the defendants’ briefs read like a philosophical apology for direct listings, the plaintiff’s claims do not place that relatively nascent transactional structure on the chopping block. Rather, this is yet another instance where a stockholder plaintiff calls on this court to deploy “well-worn fiduciary principles” to a new transactional setting.
2023 once again saw near-record levels of shareholder activism, and 2024 is already off to an interesting start! As activist strategies continue to evolve, it’s as important as ever to understand who the activists are and what makes them tick.
Tune in tomorrow at 2 pm ET for the webcast – “Activist Profiles & Playbooks” – to hear Juan Bonifacino of Spotlight Advisors, Anne Chapman of Joele Frank, Sydney Isaacs of H/Advisors Abernathy and Geoffrey Weinberg of Morrow Sodali discuss lessons from 2023, the evolution of activist strategies, UPC, what to expect from activists this proxy season and how to prepare.
We are making this DealLawyers.com webcast available on TheCorporateCounsel.net as a bonus to members – it will air on both sites.
If you attend the live version of this 1-hour program, CLE credit will be available in most states. You just need to fill out this form to submit your state and license number and complete the prompts during the program. All credits are pending state approval.
Members of TheCorporateCounsel.net and DealLawyers.com are able to attend this critical webcast at no charge. The webcast cost for non-members is $595. If you’re not yet a member, try a no-risk trial now. Our “100-Day Promise” guarantees that during the first 100 days as an activated member, you may cancel for any reason and receive a full refund. If you have any questions, email sales@ccrcorp.com – or call us at 800.737.1271.
Securities lawyers aren’t exactly known to be “early adopters” of new technology. We tend to be skeptical. But the latest leap in “AI” capabilities is hard to ignore. This Gibson Dunn memo gives examples of how data analytics and artificial intelligence can make disclosure compliance work easier and better – and explains why you should get up to speed sooner rather than later. Here’s an excerpt:
There are several ways companies could use data analytics technology to assess and mitigate the risks posed by current and coming disclosure requirements. As an initial matter, companies could use some of the third-party tools described above to test their data and disclosures.[45]
Companies could use existing data sets of SEC comment letters and enforcement actions to develop their own lists of SEC hot topics and trends. Companies could use data analytics technology to compare the disclosures of peer companies and compare those disclosures against their own. This type of analysis could help companies identify whether peers are handling their disclosures differently and inform changes to their disclosures if the analysis identifies gaps. Especially in uncertain or new regulatory environments, such as the SEC’s new cybersecurity reporting rules and its proposed emissions reporting rules, evaluating and learning from the disclosures of peer firms is an important way to mitigate risk. Data analytics technology can make that process more efficient and dynamic.
Companies could also employ data analytics technology to learn from the mistakes peer companies have made with their disclosures. For example, companies could analyze SEC or Environmental Protection Agency (EPA) enforcement actions and identify the issues that triggered regulatory scrutiny. Data analytics technology could enable analysis of a vast number of relevant enforcement actions to discern key compliance errors or patterns of enforcement. Companies could also cross reference the disclosures of peer companies against SEC or EPA enforcement actions to identify which disclosures triggered investigation and enforcement.
Looking inward to the company’s own data, data analytics technology could be used to evaluate internal controls and monitor and analyze hotline or whistleblower complaints. Similarly, companies could employ data analytics technology to analyze their own historical disclosures and compare them against current enforcement priorities and new regulations to determine what the potential risks are and what, if any, sections of the disclosures need to be updated or modified.
The memo also shares ways that data analytics can be used to mitigate activism and litigation risks, address fraud and non-compliance, combat corporate misinformation, and more. The memo cautions that AI still has plenty of shortcomings and cannot be fully trusted. That said, regulators, activists, and plaintiffs are already using this technology – so companies (and their advisors!) will be at a disadvantage if they don’t understand its capabilities. I, for one, will be welcoming our robot overlords with open arms.
Earlier this week, the U.S. Chamber of Commerce announced that it had teamed up with other business organizations to file a lawsuit against the state of California over its new climate disclosure laws. Here’s what my colleague Zach Barlow shared about this development on PracticalESG.com (also see this WSJ article):
California Climate Disclosure Bills SB 253 and SB 261 are being challenged in a new lawsuit brought by the American Chamber of Commerce. The lawsuit argues that the bills are unconstitutional on two main grounds:
1. The laws violate the First Amendment by compelling speech.
2. The federal government preempts California through the Clean Air Act and the Dormant Commerce Clause.
“Both laws unconstitutionally compel speech in violation of the First Amendment and seek to regulate an area that is outside California’s jurisdiction and subject to exclusive federal control by virtue of the Clean Air Act and the federalism principles embodied in our federal Constitution. These laws stand in conflict with existing federal law and the Constitution’s delegation to Congress of the power to regulate interstate commerce. This Court should enjoin the Defendants from carrying out the State’s plan.”
This case is not only important to the California laws, but could also shed light on what a challenge to the SEC’s upcoming Climate Related Disclosures could look like. In a case against the SEC’s rule, compelled speech will certainly be raised as an issue and this case could give us an idea of how persuasive that argument will be for the courts. Additionally, point number 2 is likely to be inverted in a future SEC challenge. Instead of arguing that the state is preempted because the federal government has the sole power to regulate emissions, the argument could invoke the Major Questions Doctrine and argue that the SEC as a federal agency doesn’t have statutory authority to regulate emissions – an argument made in comments to the SEC proposal.
The arguments here are interesting and success on either point could mean the end of SB 253 and SB 261 and introduces more uncertainty about the future of the laws. In January, it was revealed that a budget shortfall would hamstring funding for the bills’ implementation. It’s unlikely that we’ll have concrete answers about the bills’ future anytime soon as the legal challenge will take time. Whatever the initial outcome, the losing party is likely to appeal.
It’s podcast week! I am happy to share another “Timely Takes” podcast – which is indeed very timely as we enter the height of proxy season. In this 13-minute episode, John interviews Alexander McClean and Margaret Rhoda of Harter Secrest & Emery about:
1. Significant new SEC disclosure requirements
2. Recently adopted disclosure requirements that won’t apply in 2024
3. ISS & Glass Lewis 2024 policy updates
4. Advice for companies tackling their annual disclosure obligations
I’m finding that these episodes are perfect for the morning commute. If you’d like to join John or Meredith for a podcast to share insights on a securities law, capital markets or corporate governance topic, please reach out to them at john@thecorporatecounsel.net or mervine@ccrcorp.com.
Since 1972, the SEC has had a policy that defendants that settle civil claims with the Commission can’t go out afterwards and deny the allegations – which is not-so-affectionately known as the “gag rule.” Earlier this week, the Commission swatted down the latest attack on that rule – by denying a rulemaking petition from the “New Civil Liberties Alliance.” Those are the very same folks who are leading the charge against the Chevron defense in Relentless v. Dept. of Commerce – and who have engineered the SEC v. Cochran challenges to the SEC’s administrative law judge system.
SEC Chair Gary Gensler took the opportunity to make a statement about the benefits of the settlement policy. Here’s an excerpt:
Entering into a settlement is a consequential choice for both the SEC and the defendant. The Commission, in agreeing to settle a case, is relinquishing the opportunity to present the case in court. The defendant, on the other hand, relinquishes the right to defend the case in court, in the press, and in the eyes of the public. Both parties are agreeing to a set of terms based upon this 1972 policy.
More than 50 years on, I think this policy has served the public and the Commission well. I believe that amending this policy in the manner proposed by the Petitioner would alter the impact of enforcement settlements if defendants could deny any wrongdoing in the court of public opinion and dismiss sanctions as the cost of doing business without the Commission being able to revive its ability to have its day in court.
He also implies that the settlement orders are “required reading” for anyone else who wants to stay out of trouble:
Further, an essential component of settlements is the public recitation of the facts. It informs the market as to what conduct is violative of the securities laws. It alerts investors that the Commission seeks to deter that conduct, and it helps other market participants comply with the law. A settlement that allows the denial of wrongdoing undermines the value provided by the recitation of the facts, and it muddies the message to the public.
As you can imagine, the “neither admit nor deny” policy is not roundly supported by companies and other defendants. It’s also drawn harsh criticism – on 1st Amendment grounds – from a federal court. You know who else isn’t a fan? SEC Commissioner Hester Peirce. Here’s an excerpt from her lengthy dissent from this week’s decision to deny the NCLA rulemaking petition:
The demand by the government that a defendant waive a fundamental constitutional right as a condition of settlement ought to be supported by a compelling rationale. Yet, as discussed above, the Commission’s rationale of record—that the no-deny policy is necessary to “avoid creating, or permitting to be created, an impression that a decree is being entered or a sanction imposed, when the conduct alleged did not, in fact occur”—lacks firm footing. It would look bad if the SEC’s settlements were shown to be baseless, unfairly negotiated, or legally flawed. The most logical solution to that concern, however, is to make sure that settlements are rooted in fact, are fairly negotiated, and are legally sound. Employing superior bargaining power to extract an agreement that defendants agree not to denigrate the settlement is a suboptimal solution.
In the end, far from shoring up the Commission’s integrity, the reliance on these no-denial conditions undermines it. More than a decade ago, a court aptly explained the problematic perceptions that flow from the Commission’s practice of settling without admissions and prohibiting denials:
[H]ere an agency of the United States is saying, in effect, “Although we claim that these defendants have done terrible things, they refuse to admit it and we do not propose to prove it, but will simply resort to gagging their right to deny it.”
Keep in mind that when it comes to the “neither admit nor deny” policy, things could be worse! I don’t know the extent to which this materialized, but a couple years ago, Enforcement Director Gurbir Grewal indicated that the Staff and Commission might get more aggressive in requiring admissions as a condition to settlement, meaning that defendants would end up with a one-sided condition of “no deny.” My guess is that this is little consolation to the NCLA. Given their recent track record in court, perhaps there will be more to come…
