The SEC’s position in this enforcement action makes it clear that Lyft’s involvement in approving and negotiating some of the terms of the transaction was sufficient to characterize the company as a “participant” in it. This excerpt from p. 21 of our “Related Party Transactions Disclosure Handbook” provides additional color on the participation concept & some of the challenges it presents:
Being a participant encompasses situations where the company benefits from a transaction but is not technically a contractual party to the transaction. In response to concerns that the concept of a “participant” might be too broad and far-reaching, the SEC offered the following example of a case where disclosure might be required even if the company is not a contractual party: “[d]isclosure would be required if a company benefits from a transaction with a related person that the company has arranged and in which it participates, notwithstanding the fact that it is not a party to the contract.” See the 2006 Adopting Release at footnote 418.
This loose boundary may be problematic to monitor since it carries with it the possibility that disclosure could be required in a situation where the company does not have a “material interest” (as would be required for the related person) in the transaction. Presumably, the company would be aware of the transaction if it had a hand in “arranging” the transaction, but there may be other situations that are not as evident to those tasked with tracking potentially disclosable transactions.
We also have a bunch of Q&As beginning on p. 48 of the Handbook that address specific situations where “participation” is an issue that you may find helpful. The bottom line is that Item 404 of Reg S-K is designed to cast a very wide net, and the SEC expects companies to be mindful of that fact when preparing disclosure documents. In her blog last week, Meredith suggested that it may be time for companies to consider refreshing their disclosure controls and procedures for related party transactions. That seems like an even better idea this week.
Earlier this year, Liz blogged about a cert petition seeking clarification from the SCOTUS of the extent to which the failure to comply with the MD&A line-item disclosure requirements set forth in Item 303 of Reg S-K can serve as the basis for a securities fraud claim. That’s an issue that the circuits are split on, and earlier this month, a federal district judge in the Northern District of Illinois threw another log on this particular fire with his opinion in Phoenix Ins. Co. v. ATI Physical Therapy, (ND Ill.; 9/23). This excerpt from a recent Jim Hamilton blog on the decision summaries the Court’s analysis:
The Seventh Circuit has not yet decided whether a Section 10(b) or 14(a) claim can be premised on a violation of Item 303. In the Second Circuit, “positive law” (statutes or regulations, like Item 303) can give rise to an affirmative duty to disclose under Exchange Act Section 10(b) or 14(a). The Ninth Circuit, though, held otherwise, reasoning that Item 303’s disclosure requirement varies from the Basic test for materiality.
In the Illinois district court’s view, the Ninth Circuit conflated the distinct concepts of duty to disclose and materiality. The district court thus adopted the reasoning of the Second Circuit that failure to comply with Item 303 can give rise to Section 10(b) fraud liability if the omission is material under Basic and the other elements of the securities fraud claim are established. “That reasoning, which recognizes the difference between the legal concepts of duty to disclose and materiality, makes sense,” the Illinois court wrote. “It also likely—though not definitely—squares with an earlier case that the Ninth and Second Circuits both cite.”
The Court also held that non-compliance with Item 303 can serve as the basis of a claim under Rule 14a-9, which prohibits false or misleading statements in proxy materials, provided that Basic’s materiality standard is satisfied.
Although the Northern District of Illinois held that non-compliance with Item 303 can serve as a basis for a Rule 14a-9 claim, it’s becoming increasingly difficult to find a court that will entertain such a claimt. Earlier this year, in Lee v. Fisher, the 9th Cir. upheld a forum selection bylaw at Gap that designated the Delaware Court of Chancery as “the sole and exclusive forum for . . . any derivative action or proceeding brought on behalf of the Corporation.” Because Exchange Act claims can only be brought in federal court, that ruling had the effect of precluding stockholders in Delaware corporations with that exclusive forum language from bringing derivative Rule 14a-9 claims.
Now, Prof. Ann Lipton has cited a recent decision by a Texas federal magistrate that tightens the screws on Section 14(a) claims even more. Here’s an excerpt from her Twitter thread on the decision:
Shareholders of an acquiring company sued under Section 14, claiming the proxy statement misled them into approving the merger. A federal magistrate court just said Delaware law governs the direct/derivative distinction, though the injury is direct, the damages from a stock price drop are derivative, and therefore, plaintiff cannot bring claims directly. Edwards v. McDermott, 4:18-cv-04330 SD Tex.
This is the next step in allowing Delaware law to supersede federal securities law. Previously, CA9 held that derivative 14(a) claims – – can functionally be waived in bylaws, bc they really shouldn’t exist at all. Which means, if this decision stands, we’re really cutting off most avenues for Section 14 claims, outside the target-side merger context.
The bottom line is that the SCOTUS has done everything but formally overrule its 1964 decision in J.I. Case v. Borak finding an implied private right of action under Section 14(a), and it looks like the federal courts are determined to finish the job.
In a recent blog, Perkins Coie’s Allison Handy points out that rumors of ESG fatigue are greatly exaggerated – at least when it comes to ISS’s Globla Benchmarking Survey:
Globally and in the US, the main focus of this year’s survey is on “Environmental & Social” topics with 15 questions addressing a range of issues, including:
– Application of E&S policies on a global basis or using a market-specific approach.
– How organizations consider “double” or “dynamic” materiality.
– Assessments of company responses to and disclosures regarding environmental and social risks.
– Assessment of GHG reduction targets and climate transition plans, both with respect to management plans and shareholder proposals.
The survey period closes on September 21st, so if you want to weigh in on these or other topics raised in the survey, you’d better get moving.
Last week, the Center for Audit Quality posted the final highlights from the June 15th Joint Meeting of the SEC Regulations Committee and the SEC Staff to its website’s SEC Regulations Committee page. One of the topics addressed in the highlights related to the new Form 10-K clawbacks-related checkboxes. The CAQ highlights address whether the restatement checkbox should be checked if there is disclosure in the financial statements about an error in previously issued quarterly financial statements, but not for any annual periods. Here’s an excerpt from the notes:
In connection with the new rule and rule amendments for the recovery of erroneously awarded compensation in the event of a required accounting restatement, a check box with the following language was added to the cover page of Form 10-K:
If securities are registered pursuant to Section 12(b) of the Act, indicate by check mark whether the financial statements of the registrant included in the filing reflect the correction of an error to previously issued financial statements.
A similar check box was not added to the cover page of Form 10-Q.
The retrospective correction of a material error in a registrant’s previously filed interim financial statements might be presented in the disclosure required by Item 302(a) of Regulation S-K within an unaudited note to the annual financial statements included in a Form 10-K. However, those financial statements might not disclose the correction of an error to any annual periods as the error being corrected only existed in the interim periods.
For example, assume a registrant presents (in an unaudited note to the financial statements for the fiscal year ended 20X3 in Form 10-K) the correction of material misstatements in its financial statements for the interim periods ended 03/31/X3, 06/30/X3, and 09/30/X3. The error only affected those interim periods. The annual periods presented in the 20X3 Form 10-K were not impacted by the errors. The Committee asked the staff whether the registrant in this example would need to select the check box.
The staff indicated that in the above scenario, it would not object if the checkbox referred to above was not checked. The staff noted that the registrant should provide the disclosures required by S-K 402(w).
Earlier this week, the SEC announced settled charges against Maximus, Inc. “for failing to make required disclosures that it employed the siblings of one of its executive officers” and that Maximus agreed to pay a civil penalty of $500,000. According to the order, in late 2019, the company’s board promoted a business segment leader and longtime employee to be an executive officer of the company. Maximus’s annual reports and proxy statements for 2019 through 2021 disclosed that the company had no related person transactions even though the newly-appointed officer’s two siblings were also longtime company employees and both received annual compensation of greater than $120,000. The order includes the following reminder:
Disclosure of related person transactions “involving the employment of immediate family members” is required “when the threshold for disclosure has been met and the immediate family member has or will have a direct or indirect material interest.” Information required to be disclosed concerning any such related person transaction includes the name of the related person, the basis on which the person is a related person, the related person’s interest in the transaction, and the approximate dollar amount of the related person’s interest in the transaction.
Our “Related Party Transactions Disclosure Handbook” has tons of practical guidance on this topic, including how to calculate the amount paid to the family member employee, and reminds companies to thoroughly vet contextual disclosure, such as statements that the “individual received compensation ‘commensurate with that provided to other employees in similar positions.’”
In late August, the SEC announced charges against Impact Theory, LLC, an LA-based media and entertainment company, for conducting an unregistered offering of crypto asset securities in the form of NFTs. The cease-and-desist order is novel, in that this is the first time that the SEC has applied the Howey test to NFTs. But, guess what? There’s already been a second time! (More on that below.)
This Dechert alert describes the Impact Theory order, but first starts with this reminder:
NFTs are digital asset tokens similar to cryptocurrency. However, each NFT possesses unique characteristics that distinguish NFTs from each other, such as being tied to ownership of a specific piece of art. Many NFTs operate on the Ethereum (“ETH”) blockchain.
The SEC cited a number of statements by company representatives when discussing the elements of the Howey test:
[T]he SEC provided facts purporting to show that the sale of KeyNFTs constituted a “common enterprise” or “scheme” between investors. Specifically, according to the SEC, Impact Theory claimed that a purchase of a KeyNFT constituted an investment in what would be a “thriving community” in Impact Theory’s vision.
Last, the SEC claimed that investors possessed an expectation of profits to be derived from the efforts of Impact Theory because the company repeatedly told investors that their money would be put into development efforts and create additional projects to add value to the company. Per the SEC, Impact Theory expressed that such development efforts would enrich investors, including statements that NFTs were the “mechanism by which communities will be able to capture economic value from the growth of the company that they support” as well as claims that investors would be ecstatic that they would be “getting all this value” from their investment.
As a result of these findings, the SEC concluded that investors “understood Impact Theory’s statements to mean that the company’s development of its projects could translate to appreciation of the KeyNFTs’ value over time.”
In accepting the settlement offer, the SEC considered remedial actions taken by the company — including instituting repurchase programs in December 2021 and August 2022, in which it offered to buy back NFTs — and the company’s undertaking to revise programming code underlying the NFTs to eliminate any royalty that Impact Theory might otherwise receive from any future secondary market transactions.
The second NFT enforcement action I alluded to above involved an $8 million offering of “Stoner Cat NFTs” to finance an animated web series — each of which “was associated with a unique still image of one of the characters in the Stoner Cats web series, with different expressions, apparel, accessories, and backgrounds.” SEC Enforcement Division Director, Gurbir S. Grewal, is quoted in the press release as saying: “Regardless of whether your offering involves beavers, chinchillas or animal-based NFTs, under the federal securities laws, it’s the economic reality of the offering – not the labels you put on it or the underlying objects – that guides the determination of what’s an investment contract and therefore a security.”
Commissioners Peirce and Uyeda, who dissented in both settlements, fear that this stifles fan crowdfunding, which is much needed by artists, creators, and entertainers. Pointing to the unique images and exclusive content that purchasers received, the dissent likened these NTFs to 1970s Star Wars collectibles:
To the delight of millions of children that holiday season, the toy company Kenner sold “Early Bird Certificate Packages,” redeemable for future Luke Skywalker, Princess Leia, and R2-D2 action figures and membership in the Star Wars fan club. The sales of these certificates helped to build a die-hard community of Star Wars fans. Would those I.O.U. certificates, which could be re-sold, constitute investment contracts? Using the analysis of today’s enforcement action, the SEC should have parachuted in to save those kids from Star Wars mania.
Yesterday, the SEC announced proposed amendments to Rules 10 and 11 of Regulation S-T and Form ID. The amendments relate to potential technical changes to EDGAR, which the SEC is collectively referring to as “EDGAR Next.” The proposal was informed by public input and feedback provided in response to the SEC’s September 2021 request for information. As Liz noted when she blogged about that request, EDGAR changes seemed necessary to put an end to “fake SEC filings” and to make the filing process more reliable. This is the SEC’s response to those issues.
As explained in the 146-page proposing release, if adopted, the amendments would require EDGAR filers to identify and authorize two to twenty individuals to serve as account administrators, responsible for managing a filer’s EDGAR accounts through a dashboard on the EDGAR Filer Management website. The role of the account admins is distinguished from the role of tech admins and users with more limited access but permitted in larger numbers. The release also describes the proposed mechanics of delegating administrator and user roles. These mechanics are intricate enough that the release has four org charts/diagrams describing the authorization of the different roles and a table setting out the functions of each role — including account admins, users, tech admins, delegated admins and delegated users.
Maybe most importantly, each individual would need to use individual account credentials (obtained through Login.gov, a secure sign-in service of the General Services Administration) and multi-factor authentication to access the account and make filings, which will go along way in helping the SEC Staff and registrants identify any individuals making potentially problematic filings. EDGAR Next would also offer filers “optional Application Programming Interfaces (‘APIs’) for machine-to-machine communication with EDGAR, including submission of filings and retrieval of related information.” Think custom software used by companies and financial printers/filing agents, for example, to schedule filings and make bulk submissions.
The proposal will be subject to a 60-day comment period following publication in the Federal Register. In addition to seeking comments on the proposed release, the SEC is encouraging testers to provide feedback on technical functionality. The press release also announced that the SEC plans to open to the public a beta software environment for filer testing and feedback in just a few days, on September 18, 2023. The EDGAR Next—Filer Access and Account Management page on SEC.gov has information about signing up for beta testing and lots more information about the proposal and related technical changes.
In his supporting statement, Chair Gensler highlights that the most recent meaningful update to EDGAR account access protocols was over a decade ago and equates the current process of having one login per company to “having a family passing around one shared login and password for a movie-streaming app.” He touts that these actions “would further secure login protocols by requiring every person filing something into EDGAR to login with individual credentials and to use multi-factor authentication.”
Last week, the SEC announced another enforcement action against a company for using separation agreements that violated whistleblower protection rules. The SEC’s Enforcement Division has been on the lookout for these provisions for years — in 2016, the SEC launched a campaign to enforce these rules and brought another enforcement action on this topic as recently as last year.
In this latest enforcement action, the SEC took issue with the company’s use of separation agreements that included a waiver of rights to monetary awards in connection with filing claims or participating in government agency investigations. The order found that those waivers impeded participation in the SEC’s whistleblower program since employees were required to forgo “important financial incentives that are intended to encourage people to communicate directly with SEC staff about possible securities law violations.”
I’m not positive that this was the first of this type of enforcement action against a privately held company, but the SEC highlighted that the respondent in this enforcement action was privately held in its announcement. The press release included this quote from a Regional Director:
“Both private and public companies must understand that they cannot take actions or use separation agreements that in any way disincentivize employees from communicating with SEC staff about potential violations of the federal securities laws,” said Jason J. Burt, Regional Director of the SEC’s Denver Office. “Any attempt to stifle or discourage this type of communication undermines our regulatory oversight and will be dealt with appropriately.”
As Liz blogged last week, this year Glass Lewis is running a policy survey seeking feedback on specific governance, sustainability, and executive compensation topics, which is a departure from its less formal approach in prior years. NYSE’s ESG Advisory group recently highlighted in its ESG Top 5 newsletter that the survey is open to the broader community. The newsletter summarizes the survey’s topics as follows:
[G]overnance themes covered focus heavily on overboarding (should committee chair roles count as more than one board), mitigating factors for allowing multi-class shares, and one of our favorites, the validity of the “loyalty share” voting classes that give extra voting rights to long-term holders. On the E&S front, GL asks about the non-financial inputs to exec comp programs, as well as how to evaluate biodiversity and company GHG targets.
For valuable insight from ISS and Glass Lewis, sign up for our “Proxy Disclosure & 20th Annual Executive Compensation Conferences,” and do it soon because they’re happening next week already! As Liz recently highlighted, our panel on “Navigating ISS & Glass Lewis” features a conversation with Rachel Hedrick – who is VP of US Executive Compensation Research at ISS – and Krishna Shah – who is Director of North America Executive Compensation at Glass Lewis – moderated by Davis Polk’s Ning Chiu.
