Senior officials at the SEC’s Division of Enforcement have long touted the potential benefits that companies may derive by cooperating with its investigations, but it’s not always clear what companies have to do to move the needle. This K&L Gates memo looks at the terms of recent settlements and identifies some of the cooperation factors that are likely to contribute to reduced penalties – or even a decision not to impose penalties. Here’s an excerpt:
First, an important driver in whether a penalty is imposed is whether the entity promptly self-reports potential misconduct upon learning it or not. In each of the actions described above that did not impose a penalty, the entity self-reported the conduct to the SEC.
A second factor cited in the orders is the extent to which the entity provides information to the staff as it investigates the matter. Among the actions cited favorably are hiring outside counsel to conduct an independent internal investigation, providing the SEC with facts developed in that internal investigation (including presentations of interim findings and highlighting key documents and witnesses), promptly making witnesses available, providing detailed explanations of factual issues, facilitating testimony of former employees, providing relevant documents without requiring subpoenas, and providing translations of foreign-language materials.
Third, the SEC has highlighted that the entities voluntarily took remedial measures in response to the issues discovered. Such measures have included replacing management and board members, commencing an audit of compliance programs, revising procedures, holding compliance trainings with employees, creating employee guides or toolkits with commonly asked questions regarding the federal securities laws, and voluntarily ceasing the at-issue conduct.
If this sounds familiar, it probably should, because the memo points out that these are the same type of actions that the DOJ looks for when it assesses whether cooperation credit is appropriate.
Despite the SEC’s statements and the evidence provided by recent settlements, many companies are still skeptical about whether there’s much upside in going above and beyond in cooperating with the SEC. The memo acknowledges that this isn’t an irrational concern. That’s because the SEC isn’t exactly a model of consistency, and sometimes imposes significant penalties notwithstanding a high degree of cooperation by the company involved in the enforcement action.
There’s been a lot of discussion in recent months about generative AI and its implications for, well, everything. In keeping with that, we’ve added an avalanche of resources to our “Artificial Intelligence” Practice Area since the beginning of the year. There are two new additions that I think will give you a taste for the kind of really helpful materials that we’re posting in that practice area. The first is this 49-page Foley memo that takes a deep dive into the legal & operational issues associated with generative AI. This excerpt highlights some of the legal risks:
Another of AI’s most significant legal risks is the potential for bias. AI systems are as good as the data they are trained on. If that data is biased, the AI system will also be biased. This can lead to outcomes that violate anti-discrimination laws. For example, an AI hiring system trained on historical data that reflects biased hiring practices may perpetuate that bias and result in discrimination against certain groups.
Another legal risk of AI is the potential for violating privacy laws. AI systems often require access to large amounts of data. If that data includes personal information, businesses must comply with relevant privacy laws, such as the General Data Protection Regulation (GDPR) in the European Union or the California Consumer Privacy Act (CCPA) in the United States.
The second new resource is this Mayer Brown memo, which addresses the emerging legal frameworks for governing AI in jurisdictions throughout the world & their implications for corporate boards. Here’s the intro:
Currently, there are artificial intelligence (“AI”)-related legal frameworks pending or proposed in 37 countries across six continents. Even within each particular country, multiple governmental agencies are claiming AI as within their jurisdictional reach. For example, in the United States, the Consumer Financial Protection Bureau, Department of Justice, Equal Employment Opportunity Commission, Food and Drug Administration, Federal Trade Commission and the Securities and Exchange Commission each has issued guidance or otherwise indicated through enforcement activity that they view AI as within their respective purview of current regulatory and enforcement authority.
The memo goes on to discuss the policy rationale behind these legal frameworks & the importance of acquainting boards with their requirements. It also offers guidance on ways to help ensure that directors are prepared to provide appropriate oversight in this area.
The SEC has been pretty active over the past year in adopting new disclosure requirements, many of which companies are going to be required to comply with in their Form 10-Q and Form 10-K filings over the course of the next year. This Weil memo identifies these new disclosures, provides a snapshot of the compliance dates for calendar year end companies, and offers some guidance on how to prepare to comply with them. Not surprisingly, the memo’s recommendations focus on the need for companies to take a hard look at their disclosure controls and procedures:
Companies should confirm that disclosure controls and procedures have been updated and evaluated as they prepare to meet the timely disclosure of information required by the new rules. Companies also should be reviewing and updating various policies that will be required to be either filed or described publicly for the first time, such as the company’s insider trading policy, share repurchase processes and procedures, and cybersecurity risk management, strategy, and governance
The memo goes on to identify some specific actions that companies should take regarding their disclosure controls and procedures for each of these new disclosure mandates, if they haven’t already done so.
Like most Americans, I have a soft spot in my head heart for conspiracy theories. Generally, the kookier they are, the more intriguing I find them to be. But I’ve got to admit that I’m having a hard time buying into one that the Chair of the House Oversight Committee, Rep. James Comer (R-KY), appears to be peddling. Check out this excerpt from a recent letter he wrote scolding SEC Chair Gary Gensler for dragging his feet in complying with Republican legislators’ demand for information about the SEC’s efforts to coordinate with EU regulators:
Senator Tim Scott and I wrote you on June 5, 2023, seeking documents and information on your agency’s involvement in the development of European social engineering initiatives disguised as disclosure and due diligence directives being developed by the European Union (EU). This Administration has hidden behind “interoperability of disclosure regimes” as its justification for global coordination. However, it is not clear that the law provides such authority and we must determine whether legislation is necessary to ensure our government works for the American taxpayer and not on behalf of foreign interests.
So, the distinguished gentleman & his Senate colleague are apparently concerned that the SEC may be conspiring with the EU to engage in a “social engineering initiative disguised as disclosure”? Well, I suppose Gary Gensler could be part of a globalist conspiracy to deprive us of our liberty, destroy our economy, make us trade in in our F-150s for electric Vespas & force us to watch soccer instead of the NFL.
On the other hand, given the US reluctance to embrace concepts like “double materiality” when it comes to financial regulation, the simpler explanation may be that the SEC’s efforts to coordinate with the EU have been motivated in part by a desire to prevent regulators there from implementing disclosure standards that the US will find unacceptable. Personally, in choosing between the two alternative explanations, I’d opt for the one that conforms with “Occam’s razor.”
As Meredith blogged back in August, disclosures concerning the impact of inflation have been getting increased attention in Staff comment letters. Now, it looks like plaintiffs’ lawyers are scrutinizing those disclosures pretty closely as well. Over on “The D&O Diary,” blog Kevin LaCroix recently blogged about a purported class action lawsuit filed against Advance Auto Parts last week premised on alleged shortcomings in the company’s disclosure about the impact of inflation and other macroeconomic factors on its business. This excerpt highlights the statements that gave rise to the lawsuit:
On November 16, 2022, in its quarterly earnings call, the company announced its “strategic pricing initiatives” aimed to help grow margins in 2023. The company’s CEO said that “our goal overall is to cover cost increases.” The CEO said that these initiatives were based on the company’s research showing that in the professional category, availability rather than prices was the more important factor in sales.
On its quarterly earnings call on February 28, 2023, the company said that it was continuing to execute “disciplined inventory and pricing actions.” During the call, the company’s CEO dismissed the impact of the U.S. economy and other macroeconomic factors on sales and margins. While acknowledging that the company remains “cautious surrounding the macroeconomic backdrop, including with respect to the pressure on low-to-middle income consumers,” the CEO confirmed the company’s 2023 guidance.
However, in its quarterly earnings call on May 31, 2023, the CEO said that “our financial results in the first quarter were well below expectations, noting that the company’s pricing initiatives produced “less price realization than plans,” and that the company had been “unable to price to cover product costs in the quarter.”
In their lawsuit, the plaintiffs allege that the company’s statements violated Rule 10b-5. They contend, among other things, that these statements misrepresented the efficacy of the company’s strategic pricing initiative and “created the false impression that inflation and macroeconomic factors had an insubstantial impact on the Company’s margins.”
Kevin addresses the issues likely to be raised by the company in its motion to dismiss and seems to think the plaintiffs may face an uphill battle to establish that the statements at issue were made with scienter. But he also points out that as companies continue to face economic headwinds associated with inflation and higher interest rates, more of them may face lawsuits like this one.
The PCAOB recently released its annual report on conversations with audit committee chairs. This FEI Daily blog highlights what that report has to say about the five biggest worries facing audit committee chairs. This excerpt says one of them is shortcomings in communications between auditors and audit committees:
A large number of audit committee chairs interviewed by the PCAOB cited “inconsistent or last-minute communication with auditors” as a growing issue and that the area needed improvement. While those leaders said that the auditor’s overall approach to communication in areas like emerging issues and education should be commended, they added there was room for improvement in audit status updates. “Audit committee chairs felt that early and ongoing communication with their auditors would help minimize the possibility of surprises throughout the audit,” the report states.
Other areas of concern include the impact of the “great resignation” on the accounting profession, the ongoing control challenges of a remote workforce, the need to prevent the determination of “Critical Audit Matters” from becoming a generic compliance exercise, and the accuracy of non-GAAP and other non-financial statement metrics.
On Friday, the SEC adopted a pair of rules mandated by Dodd-Frank & intended to enhance market transparency when it comes to short positions & securities lending activities. The SEC first announced the adoption of Rule 10c-1a, which will require certain persons to report information about securities loans to a registered national securities association and in turn require that association to make publicly available specified information about those loans. Here’s the 353-page adopting release and the 2-page fact sheet. This excerpt from the fact sheet explains why the new rule matters:
Parties to securities lending transactions are not currently required to report the material terms of those transactions. The lack of public information and data gaps create inefficiencies in the securities lending market and make it difficult for borrowers and lenders to ascertain – and to know whether the terms of their loans are consistent with – market conditions. Rule 10c-1a will provide market participants with access to pricing and other material information regarding securities lending transactions in a timely manner. Further, the rule will provide regulators with information for their market oversight functions.
The SEC then announced the adoption of Rule 13f-2, which is intended to increase the public availability of information about short sale activity. Here’s the 315-page adopting release and here’s the 2-page fact sheet. This excerpt from the fact sheet explains why this new rule matters:
Section 13(f)(2) of the Securities Exchange Act of 1934 (“Exchange Act”), added under Section 929X of the Dodd-Frank Wall Street Reform and Consumer Protection Act, requires the Commission to prescribe rules to make certain short sale related data publicly available. The data reported in Form SHO filings and the aggregated data from Form SHO filings that are published by the Commission pursuant to Rule 13f-2 will among other things, help inform market participants regarding the overall short sale activity by reporting Managers and will bolster the Commission’s and other regulators’ oversight of short selling.
The rules were adopted by the now customary 3-2 party line vote. The new rules may increase the transparency of short activity & securities lending – which typically go hand in hand – but as the WSJ points out, the final rules don’t require disclosure of the kind of granular information that could compromise the anonymity of hedge fund short sellers. I guess that means that the downtrodden stocks of corporate America will still need to pin their hopes from time-to-time on the intervention of the Dumb Money crowd for relief from short sellers’ depredations. For some of these companies, the meme stock folks may not be the heroes they need, but they’re almost always the ones they deserve.
The disclosure implications of the horrific terrorist attacks on Israel & the war that those attacks spawned are rightfully pretty far down the list of concerns raised by those events, but they are nevertheless something that public companies and those who advise them must keep in mind. This recent Goodwin blog addresses those implications, and points out that the Staff’s prior guidance concerning the implications of Russia’s invasion of Ukraine provides some insights about what the SEC is likely to expect from public companies impacted by the current hostilities in the Middle East:
Given the recency of the War, the Securities and Exchange Commission’s (the “SEC”) Division of Corporation Finance is yet to provide specific disclosure guidance related to the War. For context,when the geopolitical situation in Eastern Europe intensified in February 2022, with Russia’s invasion of Ukraine, the Securities and Exchange Commission’s (the “SEC”) Division of Corporation Finance released a sample letter reflecting comments it may issue to a registrant regarding compliance withthe SEC’s disclosure obligations.
The sample letter underscores the need for registrants to evaluate both direct and indirect impacts of wars, including potential or actual disruptions to suppliers, customers, or employees, among other considerations. The sample comments within the letter primarily focus on (1) risk factors, (2) Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A), (3) internal control over financial reporting, (4) disclosure controls and procedures, and (5) non-GAAP measures.
The blog points out the importance of considering a company’s direct and indirect exposures to the impact of the conflict, particularly for those companies with material business ties to the region and those that lend to or borrow from entities in Israel or Gaza. It also notes that the war may impact an even wider range of public companies given its potential ramifications for the global economy and financial markets.
The comment period for the PCAOB’s controversial “NOCLAR” proposal expired in August, and that means the big question is “what happens now?” This Bass Berry blog has some thoughts on the answer to that question:
Now that the comment period has closed, the PCAOB will determine whether or not to adopt final rules and whether or not the final rules will make changes to the Proposal. Any final rules adopted will be submitted to the Securities and Exchange Commission (SEC) for approval. Pursuant to Section 107 of the Sarbanes-Oxley Act, proposed rules of the PCAOB do not take effect unless approved by the SEC.
Given that the Proposal has majority support at the PCAOB and that even the two dissenting members expressed support for certain aspects of the Proposal, we expect any final rules submitted to the SEC for approval to expand auditors’ responsibilities with respect to NOCLAR. In the meantime, the PCAOB’s clear focus on NOCLAR might cause auditors to be more demanding with respect to these matters, even under the current standard.
The blog recommends that companies reevaluate their existing legal compliance policies and procedures, consider how their audit committee will evaluate information that auditors may provide about potential non-compliance with laws and regulations and how the company will respond for requests from auditors dealing with non-compliance, particularly if the information sought is privileged.
According to PwC’s latest annual director survey and highlights, directors are frequently critical of the performance of some of their peers but that hasn’t driven much board turnover. Specifically, the survey found that:
– 45% of directors think someone on their board should be replaced
– 39% say their boards have not made any changes as a result of their last board assessment
– Only 11% of directors say their board’s assessment processes resulted in the decision to not renominate a director
This is not a new problem, but the responsiveness rates haven’t markedly improved over the years. PwC notes that “annual rates of turnover in the S&P 500 were approximately 7% in 2023” and refreshment rules — like mandatory retirement ages and term limits — have not been very popular or effective at addressing the issue.
In the survey, directors point to ineffective assessment processes and board leadership often being unwilling to have hard conversations with underperforming directors. Interestingly — but not surprisingly — the response to an assessment differed depending on the independence of board leadership. 68% of directors on boards with independent chairs said their boards took action as a result of an assessment, while only 56% of directors on boards with executive chairs answered this question in the affirmative.
