Last month, the Subcommittee on Capital Markets of the House Financial Services Committee held a hearing entitled “U.S. Public Markets Built for the 21st Century: Exploring Reforms to Make Our Public Markets Attractive for Small and Emerging Companies Raising Capital.” As noted in the Committee Memorandum, the purpose of the hearing was to examine policies designed to strengthen public markets. Testifying at the hearing were: The Honorable Michael S. Piwowar, Executive Vice President of MI Finance, Milken Institute and former SEC Commissioner; Sue Washer, Former CEO of Applied Genetics Technology Corp.; Anna Pinedo, Partner and Co-Leader of Global Capital Markets, Mayer Brown; and Stacey Bowers, Professor of the Practice, University of Denver Sturm College of Law. The Committee examined the significant decline in IPOs and whether Congress could build on the success of the JOBS Act with incremental reforms that would encourage companies to go public.
A number of legislative proposals were listed for consideration, including:
– H.R. [____], the “Improving Disclosure for Investors Act of 2023”. This bill directs the SEC to promulgate rules permitting financial firms to electronically deliver certain disclosures to investors.
– H.R. [____], the “Helping Startups Continue to Grow Act”. This bill allows certain issuers of securities regulated as emerging growth companies to continue operating under such regulations, including those related to reduced disclosures and other exemptions, for an additional five years. It also raises the maximum thresholds for companies to qualify as emerging growth companies to not more than $2 billion.
– H.R. [____], to reduce the required aggregate market value of voting and non-voting common equity shares for an issuer of securities to qualify as a well-known seasoned issuer. A well-known seasoned issuer is allowed to make expedited public offerings of securities through automatic shelf registrations.
– H.R. [____], the “Encouraging Public Offerings Act”. The bill allows issuers of securities to communicate with potential investors to ascertain interest in a contemplated securities offering, either before or after the filing of a registration statement (i.e., test the waters). The bill also allows issuers to submit a confidential draft registration statement to the Securities and Exchange Commission for review prior to public filing or within one year after the initial public offering or registration.
– H.R. [____], to expand the provision for research reports in Section 2(a)(3) of the Securities Act to cover research reports about any issuer that undertakes a proposed public offering of securities.
– H.R. [____], to update the emerging growth company (EGC) financial statement requirements to clarify that any EGC may present two years, rather than three years, of audited financial statements in both IPOs and spin-off transactions.
– H.R. [____], to establish that an emerging growth company (EGC), as well as any issuer that went public using EGC disclosure obligations, only needs to provide two years of audited financial statements.
– H.R. [____], to update the SEC and PCAOB auditor independence requirements to provide that the auditor of a private company that is transitioning to public company status (via IPO, spin-off or otherwise) must comply with SEC/PCAOB independence rules for the latest fiscal year, as long as the auditor is independent under AICPA or home-country standards for earlier periods.
– H.R. [____], to clarify that a company’s market capitalization, for purposes of testing the significance of an acquisition or disposition, may include the value of all shares, including preferred stock and non-traded common shares that are convertible into, or exchangeable for, traded common shares.
– H.R. [____], to update Section 12(g) of the Exchange Act to provide that the mandatory registration threshold of 2,000 or more holders of record shall exclude Qualified Institutional Buyers (QIBs) and institutional accredited investors. This bill also prevents the SEC from revising the definition of securities “held of record” in a way that forces companies to go public sooner than they are currently required.
– H.R. [____], to exempt certain low-revenue issuers from being required to have their management’s assessment of the effectiveness of internal controls over financial reporting attested to, and reported on, by an independent auditor, as required by SOX Section 404(b).
– H.R. [____], to codify certain SEC no action letters that allow broker-dealers to continue accepting cash or “hard dollar” payments for research reports, in order to comply with international regulations such as MiFID and MiFID II.
– H.R. [____], to permit a registered investment company to omit certain fees from the calculation of Acquired Fund Fees and Expenses
Last week, SEC Chair Gary Gensler testified before the Subcommittee on Financial Services and General Government of the of the U.S. House Committee on Appropriations. Chair Gensler was testifying in support of the Administration’s budget request for the SEC, which seeks $2.436 billion for fiscal 2024. With respect to the Division of Corporation Finance, Gensler noted in his prepared testimony:
The Division of Corporation Finance oversees the disclosures of public companies so that investors can make informed investment decisions. It’s important for investors to receive useful, timely, and accurate disclosure.
During the last three years alone, the number of reporting companies the Division oversees has increased by 18 percent to 7,836, primarily due to initial public offerings. In addition, merger activity has more than tripled 2020 levels in the last two fiscal years. In contrast, the Division’s staff is still approximately 17 percent below FY 2016.
Today’s budget request would grow the team to 454 FTEs. With this increase, the Division still would be five percent smaller than it was in FY 2016. Nonetheless, additional resources would allow the Division to serve investors more ably as markets grow and evolve.
As is always the case, the SEC faces the daunting prospect of regulating a vast landscape with very limited resources, although Gensler acknowledges that recent increases to the agency’s budget have helped bring the SEC’s staffing back up above where it was seven years ago.
Last week, the PCAOB issued for public comment a proposed new auditing standard, AS 1000, General Responsibilities of the Auditor in Conducting an Audit. In the press release announcing the proposed standard, the PCAOB describes it as follows:
If adopted, AS 1000 would reorganize and consolidate a group of standards that were adopted on an interim basis by the PCAOB in April 2003 and that address the core principles and responsibilities of the auditor, such as reasonable assurance, professional judgment, due professional care, and professional skepticism.
The proposal would also amend certain other standards that address responsibilities fundamental to the conduct of an audit. Among other changes, the amendments would (1) reinforce and clarify the engagement partner’s responsibility to exercise due professional care related to supervision and review and (2) accelerate the documentation completion date by reducing the maximum period for the auditor to assemble a complete and final set of audit documentation from 45 days to 14 days.
The PCAOB requests public comment on the proposal by May 30, 2023.
The Center for Audit Quality (CAQ) recently released its report: Audit Quality Reports Analysis: A Year in Review. In the report, the CAQ review audit quality reports voluntarily published by accounting firms. According to the CAQ, in the last three years, eight of the 14 annually inspected accounting firms issued audit quality reports. The CAQ report notes:
Audit quality reports provide stakeholders with various qualitative and quantitative firm-level audit quality metrics and other information. The metrics and other information in audit quality reports are not necessarily determinative of audit quality; however, when considered in context and in combination, they provide valuable information to stakeholders at the firm level about how an accounting firm defines, approaches, and executes its audit quality mission.
The CAQ report provides an overview of the qualitative and quantitative disclosures observed in the audit quality reports and explains how that information may be useful to stakeholders.
One of the takeaways from the CAQ’s recent analysis of audit quality reports is that recently, some firms have included discussion on how they employ data analytics and artificial intelligence or machine learning to further enhance audit quality. This trend is reflective of a larger conversation about just how artificial intelligence will fit into our professional lives going forward. I have been saying for some time that the robots will be coming for my job at some point, and I can imagine that auditors have been wondering whether the same is true for them.
In this recent article from Forbes, Joseph Brazel, who is the Jenkins Professor of Accounting at NC State University, describes a recent study published in the Review of Accounting Studies which “demonstrates that the use of artificial intelligence is significantly improving the quality and efficiency of financial statement audits, as well as displacing audit professionals.”
The study looked at investment in artificial intelligence at audit firms from the period 2010 to 2019, well before the current AI splash made by ChatGPT. One of the study’s authors notes: “Our main result is that when audit firms invest in AI, their audit quality goes up. There are fewer restatements, including material restatements, and fewer SEC investigations related to audits performed by AI-investing firms.”
The downside is that greater levels of AI adoption were followed by reductions in the audit firms’ workforces. The study noted that this effect was most prominent with audit professionals at the more junior levels of the firms. With that piece of information in mind, I guess I will continue to worry about those robots coming for me!
Earlier this month, the DOJ announced that five directors resigned from four corporate boards and one company declined to exercise board appointment rights in response to the Antitrust Division’s efforts to enforce Section 8 of the Clayton Act’s prohibition on interlocking directorates.
That proceeding follows one last October, in which the Antitrust Division’s Section 8 enforcement efforts prompted the resignation of seven directors. It also follows close on the heels of a letter from Senate Judiciary Committee Chair Dick Durbin (D-IL) urging the DOJ & FTC to investigate interlocks in the life sciences industry.
This Norton Rose Fulbright memo addresses the DOJ’s enforcement program and the recent Congressional interest in interlocking directors. This excerpt notes the DOJ’s broad interpretation of the prohibition and the potential implications for companies singled out for enforcement:
DOJ’s recent enforcement is significant beyond the numerical increase in resignations. Importantly, it illustrates the agencies’ commitment to a broad interpretation of Section 8. DOJ has not limited enforcement to the most obvious interlocks, such as where a director serves simultaneously on competitor boards or a company nominates its own officer to a competitor’s board. DOJ secured a resignation under Section 8 against an interlocked director who was nominated to both boards by an investment firm8 and also secured resignations of two directors where the alleged interlocks were only “affiliated” with the competitor (i.e. not officers or directors).9
Although enforcement of Section 8 is mostly limited to resignation of board members or abstention from exercising appointment rights, interlocking directors are relatively low-hanging fruit that can serve as the launch pad for a broader antitrust investigation.
The memo says that with the uptick in enforcement and antitrust regulators’ commitment to a broad interpretation of the prohibition on interlocks, Sen. Durbin’s letter “serves as a reminder for companies in the life sciences industry: a compliance program to actively monitor board membership and appointments is a crucial precautionary step to avoid Section 8 liability.” Sen. Durbin may have targeted the life sciences industry, but given the current climate, the memo’s advice about the need for a solid compliance program addressing interlocks is something that companies in all industries should heed.
This Perkins Coie blog provides an overview of the role that fairness opinions can play in helping boards of directors fulfill their fiduciary duties. This excerpt summarizes why boards should consider fairness opinions in appropriate circumstances:
Courts give special deference to Boards that seek truly independent third-party advice, such as that of an investment bank, valuation consultant or law firm, to assist disinterested directors in assessing a transaction. An opinion from a reputable third-party financial advisor that a transaction is fair to the company and its shareholders from a financial point of view may substantially reduce the risk of a successful challenge to the Board’s decision under any standard of review. A fairness opinion can also help independent directors make an informed decision.
Fairness opinions are typically thought of as coming into play in connection with M&A, but in some cases they may also have a role to play in the board’s evaluation of related party transactions. As someone who represented investment banks in a lot of fairness opinion engagements over the years and who sat in on more fairness opinion committee meetings than I care to recall, I would like to throw in a few caveats when it comes to fairness opinions.
The reason for engaging an investment bank to furnish a fairness opinion is that, in fulfilling their fiduciary duties, state corporate statutes typically permit boards to rely in good faith on expert guidance, but only if the directors reasonably believe that the matter is within the expert’s professional competence. That can be a problem when it comes to framing what the opinion will cover.
Many lawyers representing boards want the banker to opine as broadly as possible about the fairness of the deal. This “sprinkling holy water on the deal” approach to the opinion is counterproductive and – in the unlikely event that the bank would agree to do that – could undermine the board’s ability to rely on the bank’s opinion, because it’s easy to challenge whether the bank is truly an expert with respect to such matters. Investment banks’ expertise is in the financial aspects of a transaction, and so what they are generally willing to address is the fairness, from a financial point of view, of the price to be paid or received in the transaction. And that’s really what it’s appropriate for boards to ask them to cover.
Another issue that sometimes comes up in negotiating a fairness opinion is the “fair to whom?” question. Some lawyers will press for the opinion the fairness of the consideration to the company’s stockholders in situations that don’t involve a sale of the company.
That’s standard language in an opinion addressing a sale, but bankers usually won’t agree to this in buy side or other opinion engagements addressing transactions in which stockholders aren’t being paid. The bankers’ position is that whether the transaction is in the best interests of stockholders is a board decision, and so their opinion should address only the fairness to the company of the consideration to be paid or received.
This recent Lowenstein Sandler memo highlights the obligation that certain companies with foreign investors have to submit BE-12 survey filings to the Dept. of Commerce’s Bureau of Economic Analysis. The BE-12 benchmark survey is required for all U.S. entities in which a foreign investor directly or indirectly owns or controls a 10% or greater voting interest and asks for information related to fiscal year 2022. This excerpt from the memo provides additional details about what companies are required to file:
All U.S. business enterprises (including real estate held for nonpersonal use) in which a foreign individual or entity owns or controls, directly or indirectly, at least 10 percent of the voting interest or equivalent. Complex business structures file on a consolidated basis, so U.S. affiliate entities should be included in a parent company’s filing when a parent holds at least 50 percent of the affiliate’s voting rights.
Even if a business is contacted by the BEA to submit a filing, exemptions are available if foreign ownership is less than 10 percent, the business is consolidated with another U.S. affiliate, or the business was liquidated or dissolved. Note, the business must still file a form to claim the exemption.
Additionally, certain private funds1 that do not hold direct or indirect interests in any operating companies2 may be automatically exempt or may qualify to file a claim for exemption. When assessing the direct or indirect voting interest of foreign entities in funds, note that limited partner interest is not considered to be voting interest.
The survey is due by May 31, 2023, and the memo also provides an overview of what the information is used for and what other BEA filing requirements might apply to particular companies.
Yesterday, Vice Chancellor Laster issued an oral ruling holding that companies with multiple classes of stock don’t have to hold a separate class vote on officer exculpation charter amendments. This Wilson Sonsini memo addresses the plaintiff’s allegations and the Vice Chancellor’s reasoning:
The plaintiffs argued that the right to sue is a “power” of stock and that the defendants’ charter amendments adversely affected that power of the non-voting stock, such that a separate class vote of such stock was required. The court rejected that argument, determining that the companies did not need class votes and could instead rely on a majority of stockholder voting power to adopt officer exculpation.
The court concluded that the case was controlled by established Delaware case law interpreting Section 242 and also cited the expectations of practitioners and the market based on that case law. Under that case law, and accompanying legislative history, the phrase “powers, preferences, or special rights” of a class refers to the intrinsic, peculiar rights assigned to a class or series in the corporation’s capital structure, and Section 242(b)(2) is designed to protect class- or series-based interests.
For example, a liquidation preference given to a particular class of stock or the right of a particular class of stock to elect a board seat would be a class-based power, preference, or special right. Applying that precedent here, the right to sue and seek monetary damages against officers is not a peculiar “power” or “special right” of any given class but is instead a generalized right of all stockholders that exists at common law.
The decision provides some certainty to multi-class companies that are seeking to adopt these amendments and avoids opening the kind of can of worms with respect to prior charter amendments that many SPACs have had to deal with as a result of Vice Chancellor Zurn’s decision in Garfield v. Boxed(Del. Ch.; 12/22).
Nasdaq’s board diversity listing standards required companies to include the Board Diversity Matrix in their proxy statement or on their website for the first time in 2022. This Wilson Sonsini blog provides some tips to companies with respect to the requirements applicable to the second year of these disclosures. Here’s an excerpt:
Under Nasdaq Rule 5606(a), after the first year of disclosure, “all companies must disclose the current year and immediately prior year diversity statistics using the Board Diversity Matrix.”
Nasdaq later published FAQ 1753 clarifying that “if the immediately prior year data is publicly disclosed elsewhere (i.e., a proxy statement, information statement or company website), then the company can choose to disclose the current year data only.” Accordingly, so long as the prior year statistics are still publicly available, a company can continue disclosing only the current year statistics in its Board Diversity Matrix.
However, it’s important to note that if a company complied with Rule 5606 by posting its Board Diversity Matrix on its website (instead of in a proxy statement or information statement), it must maintain the prior year statistics on its website, or otherwise publish it alongside the current year statistics in its next proxy statement.
The blog says that before deciding how to proceed, companies should assess whether there are any advantages to disclosing two years of board diversity statistics, either because they can demonstrate year-over-year improvement or because their investors may want to see the two years of diversity statistics in the same location.
