Last week, the SEC announced settled charges against a company and two of its former officers related to revenue recognition practices that caused the company to file materially misstated financial statements. Here’s an excerpt from the administrative summary:

According to the SEC’s order, under which USAT neither admitted nor denied the SEC’s findings, USAT attempted to maximize end-of-quarter revenue and meet its internal sales targets in two ways. First, they entered into purported bill-and-hold sales transactions that did not conform to the relevant accounting standards at the time of the transactions or the company’s publicly-stated sales and revenue recognition policies. Second, they inflated quarterly sales revenue by deliberately shipping devices to its customers that the customers had not ordered or explicitly told USAT they did not want in the face of inventory shortfalls.

With respect to the bill-and-hold practice, the order explains that, on two occasions during the period in question, the company billed customers for payment (even though it didn’t expect to collect until after delivery), held the related devices for future delivery (even if it had them in stock) and treated these purported sales as a bill-and-hold transaction. But these transactions didn’t actually meet the criteria to recognize revenue from a bill-and-hold transaction — in that the company initiated the bill-and-hold treatment, there was no fixed commitment to purchase, and the transactions lacked a fixed delivery date — plus the company didn’t disclose its use of such transactions.

With respect to shipping the wrong inventory, the company lacked inventory to fulfill customer orders for one device and allegedly engaged in various shenanigans involving shipping another device to meet sales goals for the quarter — including sending the unwanted device and allowing future exchanges, shipping the unwanted devices to a third party when a customer wouldn’t accept the delivery and shipping the wrong devices and blaming “shipping mistakes.” In each case, the company knew the devices would be returned when the correct product became available and shouldn’t have recognized revenue at the time of shipment. Eventually, the issues were identified and the company restated past financials.

While this enforcement action may be more a case of alleged wrongdoing than a trap for the unwary, these types of accounting fraud proceedings are a good reminder of the topics that continue to top the list of focus areas for the Enforcement Division.

– Meredith Ervine 

The D&O Diary recently shared a guest post from Ed Whitworth and Yera Patel of Inigo summarizing the results of a recent survey they conducted of securities defense counsel. The full summary is worth a read, but here are some of the top takeaways:

– Derivative settlements are continuing to increase in severity. The Caremark standard is holding but continues to be eroded in places. Derivative cases are an increasingly attractive option for the Plaintiff Bar.

– SEC investigations are going formal much earlier and naming individuals at the outset. These cases are therefore becoming much more expensive to defend.

The report also includes some predictions for 2023, which Ingio will assess next year once the data is available:

– Dismissal rates will fall by at least 5% in 2023 relative to the average for the past 10 years.
– Securities class action filing rates will be higher in 2023 than in both 2022 and 2021.
– There will be at least five derivative settlements of more than $100m each in 2023.
– Bankruptcy filings will increase, leading to more breach of fiduciary duty and fraudulent transfer claims.
– SEC investigations will be a major exposure for companies and insurers over the next 24 months.

– Meredith Ervine 

Tune in at 2 pm Eastern today for the webcast “Pay Vs. Performance: Lessons From Season 1” to hear Weil’s Howard Dicker, Freshfields’ Nicole Foster, Aon’s Daniel Kapinos, and Mercer’s Carol Silverman discuss how companies approached pay-versus-performance disclosures in year one. This webcast will cover:

If you attend the live version of this 60-minute program, CLE credit will be available. 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 CompensationStandards.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. Email sales@ccrcorp.com – or call us at 800.737.1271.

– Meredith Ervine

There’s been a lot of chatter recently about using ephemeral messaging and off-channel communications. This topic got a lot of air time from SEC Staff members and other panelists at Securities Enforcement Forum West 2023, with the acronym “BYOD” (D for device) repeatedly used throughout the day, highlighting that some companies are rethinking BYOD policies. If this is news to you, this Holland & Knight blog reviews recordkeeping requirements that apply to broker-dealers and investment advisers and recent, related SEC and DOJ actions. Then, the blog goes on to say this:

But what about public company issuers? Currently, under the federal securities laws, issuers are not subject to direct regulations on preservation of business communications. However, much like investment advisers, these types of communications may need to be retained by public companies if they satisfy another statutory recordkeeping obligation. For example, under Exchange Act Section 13(b)(2)(A), issuers are required to make and keep certain books and records that accurately and fairly reflect the transactions and dispositions of the assets of the issuer. But the scope of messages that issuers need to consider retaining may have increased exponentially. As detailed further below, recent DOJ guidance has brought these issues to their compliance doorstep as well.

This new DOJ guidance is from earlier this year. The DOJ expects all companies — not just regulated entities — to maintain and enforce policies to ensure that business-related (note how broad this is) electronic data and communications are preserved and can be accessed. During a DOJ inquiry, it will scrutinize a company’s policy environment and risk management framework around device use and message retention. This means that using certain platforms for electronic communication creates some compliance risks. In light of this guidance, here are some suggestions from the blog for all companies to consider:

– reviewing relevant document retention and other policies to ensure electronic communications are preserved, particularly when there is a threat of litigation or a government investigation
– assessing compliance policies concerning supervisory responsibilities of managers to subordinates
– the implications of a bring your own device (BYOD) policy – whereby employees are allowed to utilize their own devices for company purposes – as such policies are increasingly becoming an early discussion point between defense counsel and government attorneys on the scope of documents under company control
– written personnel certifications that they are complying with preservation and record retention requirements
– implementing, as appropriate, technological restrictions and surveillance programs – and regularly audit them – to ensure compliance with ongoing preservation obligations
– corrective action and employee discipline matrices to address instances of non-compliance

For more information, we’re posting related memos in our “Records Retention” Practice Area.

– Meredith Ervine

Liz blogged last week that the NYSE and Nasdaq proposed amendments to their listing standards to implement the Dodd-Frank clawback rules. The amendments would extend the effective date of the rules to October 2, 2023. The consequence is that companies will have until December 1, 2023 to adopt compliant clawback policies and that they’ll apply to incentive-based compensation received by executive officers on or after October 2, 2023.

The open question was whether and how the SEC would approve these amendments, since Friday was the last day that they could act on the original proposals. The Commission came through at the 11th hour with notices for the NYSE and Nasdaq (and other exchanges) that granted accelerated approval of each exchange’s proposal, as modified by the amendment.

Although a number of companies have already adopted a Dodd-Frank clawback policy in anticipation of these listing standards, there are also a significant number who were going to be attempting to cram it into summer board agendas. This is a welcome development that gives companies & boards more breathing room to carefully consider their policies. We’ve posted several helpful samples in our “Clawbacks” Practice Area on CompensationStandards.com!

– Meredith Ervine

While companies may not need to rush out and adopt a new clawback policy over the summer, there are a few discretionary considerations that companies may be grappling with as they look to adopt the required policy. I recently discussed some of these with Ali Nardali of K&L Gates in the first episode of our new Pay & Proxy Podcast series over on CompensationStandards.com.  To better understand how companies are handling some of these considerations, we’re also running a short, anonymous survey on clawback policies. Please take a moment to participate!

For future episodes of this new podcast series, the idea is to focus on topics of interest to the members of CompensationStandards.com, including executive and director pay trends, compensation governance and disclosure considerations. Like our other podcasts, we hope to talk to folks—in the compensation space—willing to spend 15 minutes sharing a little bit about themselves, their work, or topics they find interesting. If you have something you’d like to talk about, please feel free to reach out to me via email at mervine@ccrcorp.com.

– Meredith Ervine

In a big decision last week that has immediate implications for companies facing derivative claims in the 9th Circuit and may eventually head to the US Supreme Court, the 9th Circuit Court of Appeals issued a decision in Lee v. Fisher that could have the practical impact of abolishing federal derivative suits. The court, re-hearing the case en banc after a 3-judge panel decision last year in favor of the company, once again 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.”

The plaintiff in this case had brought a derivative suit in federal court in California, alleging that the company and its directors violated Section 14(a) of the Exchange Act and Rule 14a-9 by making false or misleading statements to shareholders about the company’s commitments to diversity. The decision affirmed the district court’s dismissal of the case on the basis of the exclusive forum bylaw. Since Delaware courts don’t have jurisdiction to hear federal claims, this case could essentially eliminate this type of shareholder suit, at least in the 9th Circuit.

In this blog and her related paper, Tulane law prof Ann Lipton walks through in detail why she believes this decision is problematic:

As a policy matter, my problem with the decision is that, contra the Ninth Circuit, in fact, direct claims do not function as a complete substitute for derivative claims. Suppose an acquiring company needs a shareholder vote to complete a merger, and the proxy statement is misleading. Suppose the merger is a bad deal for the company. Under Delaware law, that’s an injury to the company, not the shareholder – and, in fact, in the very Delaware cases cited by the Ninth Circuit for the proposition that these should be brought as direct claims, Delaware also held that it could not identify any injury that would justify an award of damages directly to the stockholders, because the only harms were derivative.

…All of which to say: There is no remedy under Delaware law for negligent proxy statements whether the claim is brought directly or derivatively (with an asterisk), and if federal law is following Delaware, there’s no remedy for shareholders suing directly under federal law for transactions that harm the company, at least not unless shareholders manage to act quickly enough to halt the transaction entirely. That’s the hole that derivative Section 14(a) claims can fill.

The Court of Appeals took a different view – one that tracks with the arguments from U Oregon Law Prof Mohsen Manesh and Stanford Law’s Joe Grundfest set forth in this amici brief and reiterated post-decision in this blog on UCLA Law Prof Steve Bainbridge’s site. (Yes, we have a “who’s who” of corporate governance scholars who all make compelling arguments about what the proper outcome should be here.) Here’s the view that Mohsen Manesh shared:

As Grundfest and I have explained, in recent years, as Delaware courts have cracked down on meritless shareholder litigation, the plaintiff’s bar has sought refuge in federal courts by bringing derivative Borak claims. These federal derivative suits allege corporate harm arising from the board’s mismanagement of matters ranging from executive compensation, to oversight of regulatory compliance, to corporate policies concerning diversity, equity and inclusion.

Stated differently, these derivative suits concern internal corporate affairs—matters that are traditionally governed by state corporate law and, therefore, more sensibly litigated in the Delaware Chancery. But rather than bringing a state law claim for breach of fiduciary duty in Delaware courts, these federal derivative suits make the more tortured argument that the alleged corporate harm was a result of the shareholders being misled by the company’s proxy statement. In doing so, derivative Borak lawsuits transparently aim to establish federal court jurisdiction and, thereby, avoid the likely fate that such suits would face before a skeptical Delaware judge.

The suit in Lee exemplified this trend. In Lee, the plaintiff-shareholder brought a derivative Borak claim in federal court against the directors and officers of The Gap, alleging failures in the management’s efforts to promote racial diversity within the company’s leadership ranks. As a derivative suit, the Lee plaintiff alleged that The Gap’s proxy statements had included materially false or misleading statements about the company’s efforts to pursue diversity, which in turn harmed The Gap by enabling the re-election of the company’s incumbent directors and approval of the officers’ compensation packages.

This side of the argument emphasizes that the decision doesn’t affect direct claims under Section 14(a) and advocates that those are still a distinct and valuable way that shareholders can pursue recovery.

There is one thing that everyone agrees on, though: the Ninth Circuit’s holding squarely conflicts with the 2022 Seventh Circuit ruling in Seafarers v. Bradway. John blogged about that case last year when it was issued. This is a significant circuit split that SCOTUS eventually may be interested in resolving, if & when it gets asked to do so. Ann Lipton lays out a parade of horribles that could follow if SCOTUS takes up this topic and affirms the 9th Circuit’s view, culminating in:

…leaving aside what the effect might be on private contracts, the whole mess is dumped back into Delaware’s lap. Delaware will have to decide how far companies can go in charters and bylaws to waive private securities fraud claims. Delaware will have to decide when enforcing such waivers is a violation of directors’ fiduciary duties, and when directors are conflicted in enforcing such waivers, and whether enforcement of a waiver is a conflict transaction that needs to be reviewed under entire fairness.

It will add a whole separate layer of state litigation on top of the federal, where Delaware will decide the contours of the federal right. And it will be doing so in the shadow of jurisdictions like Nevada, which may very well adopt permissive rules.

We might even start with whether Delaware does, in fact, agree that directors may, consistent with their fiduciary duties, completely bar derivative Section 14(a) claims, especially if a situation comes up where, whether due to 102(b)(7) or Delaware’s vision of the direct/derivative distinction, Delaware would not provide any remedy but federal law would provide a derivative one. And of course, arbitration provisions may make a comeback – even apart from the FAA, Delaware then gets to decide whether and to what extent invoking arbitration for securities claims is consistent with Delaware-imposed fiduciary duties. This is the race to the bottom on the Autobahn.

– Liz Dunshee

The requirement under Reg S-K Item 303 to describe “known trends & uncertainties” is one of the trickier items to navigate in periodic reporting. As our “MD&A Handbook” discusses, that’s especially true if you are trying to evaluate the risk of not discussing a matter that, in management’s view, may not be “reasonably likely” to have a material impact at the time the report is filed.

A cert petition filed last week is asking the Supreme Court to clarify the boundaries of private rights of action in these situations. This blog from “Jim Hamilton’s World of Securities Regulation” explains:

In the cert petition, Macquarie and the other petitioning defendants argue that a Section 10(b) claim cannot rest entirely on a failure to provide a disclosure required under Item 303; there needs to be some affirmative statement rendered misleading by the omission. While the SEC can inquire and bring an enforcement action for a violation of Item 303, the violation should not “open the floodgates to potentially crippling private class action liability.”

The petition argues that the Second Circuit has acknowledged its split from the Ninth Circuit’s 2014 holding in In re NVIDIA Corp. Securities Litigation, which in turn had cited a Third Circuit decision. Subsequently, the Eleventh Circuit wrote that a violation of Item 303 does not ipso facto indicate a violation of Section 10(b), and the Fifth Circuit said in dicta that it has never held that Item 303 creates a duty to disclose under the Exchange Act. Resolving the split is important because it involves the three dominant circuits for securities litigation and because different standards should not apply depending on where a plaintiff files suit, the petition asserts.

It would be nice to get more clarity here, but only if the answer is the one I want…

– Liz Dunshee

Earlier this week, at an open meeting, the PCAOB issued its long-awaited “NOCLAR” proposal – which for those not in the biz, stands for “non-compliance with laws or regulations.” The proposal is a big deal because it would enhance the responsibility of auditors to consider corporate non-compliance with laws & regulations, including financial statement fraud. The PCAOB’s press release summarizes the key points:

Broadly, the proposal seeks to strengthen and enhance auditor obligations related to a company’s noncompliance with laws and regulations in three key respects:

– Identify – The proposal would establish specific requirements for auditors to proactively identify – through inquiry and other procedures – laws and regulations that are applicable to the company and that could have a material effect on the financial statements, if not complied with. The proposal also makes explicit that financial statement fraud is a type of noncompliance with laws and regulations.

– Evaluate – The proposal would strengthen requirements related to the auditor’s evaluation of whether noncompliance with laws and regulations has occurred, and if so, the possible effects on the financial statements and other aspects of the audit. For example, the proposed standard would require the auditor to consider whether specialized skill or knowledge is needed to assist the auditor in evaluating information indicating noncompliance has or may have occurred.

– Communicate – The proposal would make it clear that the auditor is required to communicate to the appropriate level of management and the audit committee as soon as they are made aware that noncompliance with laws or regulations has or may have occurred. Additionally, the proposal would create a new requirement that the auditor must communicate to management and the audit committee the results of the auditor’s evaluation of such information. Specifically, this communication would address which matters are likely noncompliance and the effect on the financial statements for those matters that are likely noncompliance.

By requiring auditors to identify and communicate noncompliance sooner, the proposed amendments, if adopted, would encourage companies to take more timely remedial actions and thereby reduce investor harm caused by legal and regulatory penalties. Another potential benefit would be to lower the likelihood that financial statements are materially misstated due to noncompliance with laws and regulations.

Here is the PCAOB’s page that tracks the status of this project. The deadline for public comment on the proposal is August 7th, and I imagine that the legal community will be weighing in.

– Liz Dunshee

At their scheduled open meeting yesterday, the SEC Commissioners unanimously approved changes to Reg M to remove and replace references to “credit ratings” from the existing exceptions provided in Rule 101 and Rule 102, which had referred to certain securities being rated “investment grade” by at least one nationally recognized statistical rating organization and will now refer to alternative standards of creditworthiness. Specifically, according to the SEC’s Fact Sheet, the amendments:

– Remove existing rule exceptions that reference credit ratings for nonconvertible debt securities, nonconvertible preferred securities, and asset-backed securities included in Rule 101 and Rule 102 of Regulation M;

– Replace those rule exceptions with new standards that are based on alternative standards of creditworthiness; and

– Add an amendment to a recordkeeping rule applicable to broker-dealers in connection with their reliance on the new exceptions.

As Dave blogged last week, this is the culmination of years of consideration, dating all the way back to the Dodd-Frank Act, and that history is also mentioned in the SEC’s press release and the various Commissioner statements about the rule change. The amendments fulfill the mandate from Section 939A(b) of the Dodd-Frank Act.

You may be wondering what “alternative standards of creditworthiness” actually means. The Fact Sheet explains:

New Rule 101(c)(2)(i) and Rule 102(d)(2)(i) except nonconvertible debt securities and nonconvertible preferred securities of issuers having a probability of default of 0.055 percent or less, as estimated as of the sixth business day immediately preceding the determination of the offering price, over the horizon of 12 full calendar months from such day, as determined and documented in writing by the distribution participant acting as the lead manager, using a “structural credit risk model,” as newly defined in Rule 100 of Regulation M. In addition, new Rules 101(c)(2)(ii) and 102(d)(2)(ii) except asset-backed securities that are offered pursuant to an effective shelf registration statement filed on the Commission’s Form SF-3.

Clear as mud, right? My first thought was that this seems to just move reliance from credit ratings agencies to distribution participants. I admittedly have not parsed through the entire adopting release – certainly not as deeply as the Staff who put this together. And I am not familiar with credit assessment services, although I’m sure I’ll come to know and love them. Point being though, that on its face, I am not sure that legal counsel, investors or others have the skills (or desire?) to figure out structural credit risk models, even if they are “commercially or publicly available” – or to easily determine whether a model meets the requirements to be used under the rule.

While all the Commissioners supported the rule, they acknowledged it wasn’t perfect – and in her statement, Commissioner Peirce raised three questions that seem worth considering:

– One commenter suggested that the Commission’s proposed use of a structural credit risk model for determining eligibility for the exception under Rule 101(c)(2)(i) was unnecessarily complex and suggested using a simpler alternative, such as whether the securities are offered pursuant to an effective registration statement filed on one of several specific forms. Another alternative this commenter suggested was to limit the exception to securities issued by well-known seasoned issuers. Why doesn’t the final rule take one of these approaches?

– How confident is the staff that we’ve gotten the threshold right for this exception?

– The International Institute of Law and Finance submitted a comment letter that asked the Commission to consider allowing market participants more flexibility in estimating probability of default. Among the alternatives IILF suggested would be appropriate were statistical models and market measures of credit risk, such as debt security prices and yields, credit spreads, and credit default swap spreads. Why doesn’t the final rule provide this extra flexibility?

The final rules go effective 60 days following the date of publication of the adopting release in the Federal Register (which usually takes about a month, depending on the volume of what needs to get published). For those who are gluttons for punishment, here’s the 120-page adopting release. We’ll be posting memos in our “Regulation M” Practice Area.

– Liz Dunshee