The front office of my favorite MLB team has a reputation for the effective use of analytics. Like most jaded Cleveland fans, I’ve often thought they’ve opted for that approach because the club has no money & data scientists are a lot cheaper than power hitters. Nevertheless, I give the Guardians’ brain trust a lot of credit for doing things like extracting some real value in exchange for an un-signable star like Francisco Lindor. Oh, and I also give them a lot of credit for not being the Browns brain trust. Don’t even get me started on those freakin’ guys. . .
Geez, where was I going with this – oh yeah, SEC Enforcement! Anyway, this Holland & Knight blog picks up on Liz’s recent blog about the trio of insider trading enforcement actions that the SEC brought late last month and details the role that data analysis tools may have played in each of those cases. If you read that blog, it’s hard not to conclude that when Big Brother has access to Big Data, insider trading is even dumber than it used to be.
Section 404 of the Sarbanes-Oxley Act requires companies to review their internal control over financial reporting and report whether or not it is effective. Non-accelerated filers are required to provide management’s assessment of the effectiveness of their ICFR, while larger companies are required to accompany that assessment with an attestation from their outside auditors.
Audit Analytics recently issued its annual report on the most recent round of auditor attestations & management-only assessments of ICFR. This recent blog reviews the results of the past 18 years of experience under SOX 404, and makes several interesting observations:
– In FY 2021, 5.8% of SOX 404(b) auditor attestations disclosed ineffective internal controls. In contrast, 23.7% of management reports and 41.9% of management-only reports disclosed ineffective controls. These percentages represent increases from the levels seen in FY 2020, across all three report types.
– The report includes a thorough breakdown of the control and accounting issues contributing to an ineffective control assessment. Notably, in FY 2021, a recurring control issue cited in adverse SOX 404 reports related to a lack of qualified accounting personnel. Other issues stem from this lack of highly trained company accounting professionals. This includes the inability to enforce a “segregation of duties” within the accounting function.
The blog notes that the significantly higher percentage of management-only reports disclosing ineffective controls reflect the demographics of companies required to file these reports. Large companies must file auditor attestations along with management reports on ICFR, while smaller companies are permitted to file management-only reports.
The recurring references to the lack of qualified accounting personnel are particularly troubling. Over the past few years, there have been numerous media reports about a potential shortage of accountants. It looks like the chickens have come home to roost on this issue this year, and that the shortage will continue to place stress on companies’ internal controls in the future.
A recent 2nd Circuit decision pared back the scope of the claims for which compensation may be received under Dodd Frank’s whistleblower provisions. Here’s the intro from this Sheppard Mullin blog on the decision:
In Hong v. SEC, No. 21-529 (2d Cir. July 21, 2022), the Court held that a person who provides the Securities and Exchange Commission (“SEC”) with information about potential securities laws violations is entitled to receive a whistleblower award under Section 21F of the Securities Exchange Act (15 U.S.C. § 78u-6) if the SEC itself brings a qualifying action, but not when the SEC shares the whistleblower’s information to other agencies who then bring an action in partial reliance upon it.
In this case, the whistleblower tipped the SEC off to some alleged shenanigans involving his employer bank’s portfolio of residential mortgage-backed securities. The SEC didn’t take action but shared his information with the DOJ & the Federal Housing Finance Agency. Ultimately, the bank settled with the agencies for $10 billion, so you can understand why this guy was hoping for a big payday.
However, the SEC contended that it wasn’t on the hook for whistleblower claims resulting from actions by other agencies. It said that in order for actions by other agencies to qualify as “related actions” under Section 21F, there must also be an underlying SEC action. The 2nd Circuit applied Chevron deference to the SEC’s interpretation of the scope of Dodd-Frank’s whistleblower provisions & ultimately ruled in the agency’s favor.
The blog says that the decision sets definitive limits on the reach of the Dodd-Frank Act’s whistleblower incentives and may also affect an individual’s assessment of whether to risk their career to come forward with information on potential wrongdoing.
We continue to receive questions from members in our Q&A Forum (see Topic #11109) and via email about when the SEC will announce the inflation adjustment to the emerging growth company revenue cap that the JOBS Act requires it to issue every five years. Unfortunately, we’ve not heard anything on this front, so to our knowledge, it’s still on the agency’s “to do” list as it was the last time that we blogged about it.
Yesterday, the Senate passed the 755-page Inflation Reduction Act of 2022. Among its other provisions, the legislation imposes an excise tax equal to 1% of the fair market value of any stock that a company repurchases during its fiscal year (see p. 31). I remember a tax prof in law school saying something like excise taxes are always simple, because the government just takes a slice off the top, which probably explains why this part of the statute is only about 6 pages long. This excerpt from a Congressional Research Service report provides an overview of the excise tax provision:
A provision in H.R. 5376 would impose a 1% excise tax on the repurchase of stock by a publicly traded corporation. The amount subject to tax would be reduced by any new issues to the public or stock issued to employees. The tax would not apply if repurchases were less than $1 million or if contributed to an employee pension plan, an employee stock ownership plan, or other similar plans.
The tax would not apply if repurchases were treated as a dividend. It would not apply to repurchases by regulated investment companies (RICs) or real estate investment trusts (REITs). It also would not apply to purchases by a dealer in securities in the ordinary course of business. The excise tax would apply to purchases of corporation stock by a subsidiary of the corporation (i.e., a corporation or partnership that is more than 50% owned by the parent corporation). The tax would also apply to purchases by a U.S. subsidiary of a foreign-parented firm. It would apply to newly inverted (after September 20, 2021) or surrogate firms (i.e., firms that merged to create a foreign parent with the former U.S. shareholders owning more than 60% of shares).
In general, excise taxes can be deducted to determine profits subject to the corporate tax, so that the tax is reduced by the corporate tax rate (21%). That is, for a profitable corporation each dollar of excise tax reduces profits taxes by 21 cents. The language specifies that this tax would not be deductible, so there would be no corporate profits tax offset.
You probably noticed that this summary describes the House version of the bill, but the Senate version appears to be the same. The rationale for the excise tax – beyond the horse trading required to get Senator Krysten Sinema (D – Ariz.) to support the legislation – is that dividends and repurchases should have similar tax consequences. This excerpt from the Center on Budget Policy and Priorities’ statement on the legislation summarizes that position:
Dividends are generally taxable when shareholders receive them. Under a stock buyback, in contrast, shareholders who sell their shares to the corporation at a gain owe capital gains tax but shareholders who don’t sell their shares — typically the overwhelming proportion — see the value of their shares rise but don’t pay tax on the gain until they sell. Their wealth increases but their taxes don’t. By imposing a 1 percent excise tax on share buybacks, this provision is designed to correct this tax policy inefficiency.
The legislation now goes back to the House, where it is expected to pass and subsequently be signed into law by President Biden. Check out this resource for more technical details on the legislative process.
While companies and stockholders are extremely fond of stock buybacks, many other people don’t think as highly of them. In fact, a lot of commentators are vehemently opposed to them. For instance, this excerpt from a 2020 HBR article essentially says that they’re something that only a Bond villain could love:
With the majority of their compensation coming from stock options and stock awards, senior corporate executives have used open-market repurchases to manipulate their companies’ stock prices to their own benefit and that of others who are in the business of timing the buying and selling of publicly listed shares. Buybacks enrich these opportunistic share sellers — investment bankers and hedge-fund managers as well as senior corporate executives — at the expense of employees, as well as continuing shareholders.
Critiques like these have gotten some traction, and to a certain extent are reflected in the SEC’s recent proposals for additional disclosure on buybacks. While I doubt that Ernst Blofeld would oppose a buyback of SPECTRE’s stock, a couple of recent studies have popped up suggesting that buybacks aren’t bad, just mostly misunderstood. The first study, from three finance profs, says that critics who side with the views expressed in the HBR article have it all wrong. Here’s an excerpt from the abstract:
Repurchases account for a tiny fraction of the trading volume in a typical stock, making their price impact too small to facilitate short term price manipulation. Price appreciation following repurchases is modest and does not reverse on average, suggesting prices increase due to repurchases signaling firms’ good prospects. Also, we find no evidence that CEOs of repurchasing firms are paid excessively or that repurchases crowd out valuable investment opportunities.
The second study, from the Bipartisan Policy Center, says that greater attention should be paid to the good things that buybacks enable companies to accomplish, and that repurchases should be evaluated under a dynamic approach that takes into consideration the best ways to ensure the most efficacious use of capital in the U.S. economy:
When one looks at repurchases through a dynamic, instead of a static, approach, the benefits appear to have a much broader impact on society. Repurchases provide investors, including those beneficiaries with 401ks and pensions that are invested market wide, with additional financial resources that they otherwise would not have had. These additional resources may in turn be reinvested or saved, which can provide needed capital for small companies and others to facilitate innovation and growth.
Your mileage may vary when it comes to the arguments on the relative merits of stock repurchases, but there’s one thing that nobody’s arguing about – the amounts involved are huge & getting bigger all the time. According to S&P Global, buybacks by companies in the S&P 500 during the first quarter of 2022 were $281.0 billion. That’s a 4% increase over the record $270.1 billion expended during the 4th quarter of 2021. Furthermore, S&P said that over the 12-month period ending in March 2022, companies spent a record $985 billion on buybacks, up 97.2% from the prior12-month period’s $499 billion.
I’m generally agnostic about buybacks, but those numbers give me pause, because at their current rate, they suggest that our largest public companies can’t more productively deploy nearly $1 trillion of their assets per year in their own businesses. The magnitude of those numbers makes me wonder whether buybacks are a solution to a capital misallocation problem or whether they’re just evidence that our capital markets have a huge capital misallocation problem.
In the May-June 2022 issue of The Corporate Counsel, we covered the disclosure implications of the war in Ukraine and the SEC’s guidance on the topic in the form of a Sample Comment Letter (you can also listen to a Deep Dive with Dave podcast on this topic). We continue to see comments from the Staff that are very much focused on this topic, and the WSJ recently reported on Corp Fin’s efforts in this area using data from Audit Analytics. The article notes that the Staff has pressed several issuers about the financial impact of the ongoing war and their level of continuing investment in Russia, Belarus and Ukraine. As discussed in the Sample Comment Letter, the Staff has particularly noted that companies should provide detailed disclosure, “to the extent material or otherwise required,” regarding:
Exposure to Russia, Belarus or Ukraine, either directly or indirectly, through the company’s operations, employee base, investments in Russia, Belarus or Ukraine, securities traded in Russia, sanctions against Russian or Belarusian individuals or entities, or legal or regulatory uncertainty associated with operating in or exiting Russia or Belarus;
The company’s reliance on goods or services sourced, directly or indirectly, in Russia or Ukraine or, in some cases, in countries supportive of Russia;
Any actual or potential disruptions in the company’s supply chain; or
Business relationships, connections to, or assets in, Russia, Belarus or Ukraine.
The war in Ukraine is also intertwined with global economic conditions, and we have noted that the Staff is particularly focused on disclosure about the impact of these economic conditions on public companies. In particular, in recent comment letters the Staff has been seeking additional disclosure about supply chain disruptions brought about by the war in Ukraine and the lingering effects of the global pandemic, as well as risk factor and MD&A disclosure regarding the impact of inflation and higher interest rates. We predicted the Staff’s focus on disclosure about inflation in the November-December 2021 issue of The Corporate Counsel:
One topic that had largely gone the way of the dinosaur in risk factor disclosure and in MD&A has been the impact of inflation, obviously because we have lived in a particularly prolonged period of very low inflation and interest rates. As the negative impact of inflation has waned from our collective consciousness, the need for specific disclosure about inflation has likewise diminished over time. This is perhaps demonstrated by the fact that Item 303 of Regulation S-K included a specific requirement to address inflation up until a year ago, when the SEC felt comfortable turning to a more principles-based approach because having a specific requirement referencing inflation and changing prices “may give undue attention to the topic.”
As revised, Item 303 still requires companies to discuss the impact of inflation or changing prices if they are part of a known trend or uncertainty that had, or is reasonably likely to have, a material impact on net sales, revenue, or income from continuing operations. Further, Item 303 requires that, where the financial statements reveal material changes from period-to-period in one or more line items, companies must describe the underlying reasons for these material changes in quantitative and qualitative terms, which could result in a discussion of inflation and changing prices.
Rising prices in many sectors, whether ultimately transitory or more permanent, could have a significant impact on the results of operations and financial condition of public companies, and as a result we expect to see more discussion of this topic in both risk factors and MD&A. Some companies may choose to include a separate risk factor regarding risks from inflation, or rather incorporate the discussion into the broader topic of general economic risks. We also expect the inflationary trend to prompt more discussion of the risks associated with rising interest rates, including the risk of increased costs of variable rate debt and refinancing risks for fixed rate debt.
We expect that the Staff may be focused on risk factor and MD&A disclosure about inflation in its upcoming filing reviews, to see if companies heeded the guidance from the adopting release for the 2020 MD&A amendments that such matters must still be addressed even absent the specific line item requirement when such matters represent a known trend or uncertainty that had, or is reasonably likely to have, a material impact on net sales, revenue, or income from continuing operations.
Finally, the Staff’s comments continue to focus on non-GAAP financial measures, including in particular non-GAAP financial measures that seek to adjust for the impact of the war in Ukraine, supply chain issues and inflation or other economic fallout. I often analogize the Staff’s level of interest in non-GAAP financial measures to a swinging pendulum, and it certainly seems from recent comment letters that the pendulum has swung into heightened scrutiny mode in recent months. You can find a comprehensive overview of recent non-GAAP financial measure comments in the September-October 2021 issue of The Corporate Counsel.
If you do not subscribe to The Corporate Counsel to receive all of the latest insights on what is going on at the SEC and in public company disclosure, please email us at sales@ccrcorp.com or call us at 800-737-1271.
I look forward to joining Mark Borges, Principal, Compensia and Editor, CompensationStandards.com; Ron Mueller, Partner, Gibson Dunn & Crutcher LLP; and Greg Arnold, Managing Director, Semler Brossy for our upcoming webcast on CompensationStandards.com titled “Executive Compensation & Equity Trends in a Volatile Environment.” The webcast will take place on Tuesday, August 16 from 2:00 to 3:00 pm eastern time. This promises to be a very interesting discussion of the compensation challenges that we are all facing in the midst of volatile financial markets.
As I recently noted in the May-June 2022 issue of The Corporate Executive, for the many companies that utilize equity as a key component of their overall employee, director and executive compensation programs, the current spate of volatile markets can upset carefully laid plans and programs. For the participants in those equity compensation programs, volatile markets can create a whole host of issues that must be carefully considered. In that issue of The Corporate Executive, we address the approach that often rears its ugly head in times of significant market volatility: option repricing. The practice of option repricing has long been disfavored by institutional investors and proxy advisory firms, but companies can find themselves attracted to the approach when stock prices drop for an extended period of time. We also revisit the topic of hedging and pledging of company stock by directors and executives, given how that topic comes into sharper focus when stock prices decline, and we explore some of the issues that market volatility can cause when implementing Rule 10b5-1 plans.
As we continue to face volatile markets, our CompensationStandards.com webcast and The Corporate Executive will provide you with the information and tools that you need to respond to your clients, management and directors. If you are not already a member of CompensationStandards.com with access to all of the great resources available on that site, sign up now and take advantage of our no-risk “100-Day Promise” – during the first 100 days as an activated member, you may cancel for any reason and receive a full refund. The prices for an annual membership increase on September 1st, so act now to lock in the best deal! If you do not subscribe to The Corporate Executive, please email us at sales@ccrcorp.com or call us at 800-737-1271.
The SEC recently announced the appointment of Anthony (Tony) C. Thompson to a second term as a Board Member of the PCAOB. Thompson joined the Board at the beginning of this year, and his second term will run until October 24, 2027.
