Yesterday, the SEC issued a press release announcing that Corp Fin Director Bill Hinman intends to leave the SEC later this year. The range of rulemaking adopted under Director Hinman’s leadership has been impressive. As high-lighted in the press release:
The Division advanced nearly 50 mission-oriented initiatives during Director Hinman’s tenure, including efforts to modernize, streamline and improve public company disclosures, the proxy process and the securities offering framework. Mr. Hinman also guided the Division and the agency in addressing emerging issues and providing timely guidance to market participants. For example, Mr. Hinman led efforts regarding the rapid innovation in digital assets, including by providing a framework that market participants could use to evaluate whether digital assets are offered and sold as securities. In addition to these proactive engagement and modernization efforts, Mr. Hinman’s oversight of the Division’s core functions, including the disclosure review program, addressed a number of novel and complex issues leading to substantial benefits for investors.
SEC Chairman Jay Clayton released a statement commending Director Hinman for all that he’s accomplished at the agency during his tenure and thanked him for his sage advice.
Upon Director Hinman’s departure, Deputy Director Shelley Parratt will serve as Acting Director as she has done in previous transitions…
SEC Open Meeting: Harmonization of Private Offerings on the Agenda for Monday
Benjamin Franklin has been credited with many famous quotes, here’s one: “don’t put off until tomorrow what you can do today.” Keeping with that mantra, sort of, the SEC continued its forward march and scheduled an open meeting for Monday, November 2nd. The topic will be of interest to those that have been waiting for action on the proposed amendments to the private offering framework – we blogged about the proposal when it was announced back in March. Here’s an excerpt from the Sunshine Act Notice:
The Commission will consider whether to adopt rule amendments to facilitate capital formation and increase opportunities for investors by expanding access to capital for small and medium-sized businesses and entrepreneurs across the United States. Specifically, the Commission will consider whether to adopt rule amendments to simplify, harmonize, and improve certain aspects of the framework for exemptions from registration under the Securities Act of 1933 to promote capital formation while preserving or enhancing important investor protections and reducing complexities in the exempt offering framework that may impede access to investment opportunities for investors and access to capital for businesses and entrepreneurs.
Tomorrow’s Webcast: “Virtual Annual Meetings: What To Do Now”
Tune in tomorrow for our webcast – “Virtual Annual Meetings: What To Do Now” – to hear Amy Borrus of CII, Doug Chia of Soundboard Governance, Dorothy Flynn of Broadridge, Carl Hagberg Independent Inspector of Elections and Editor of The Shareholder Service Optimizer and Kate Kelly of Bristol-Meyers Squibb discuss baseline best practices for virtual shareholder meetings, investor views, getting remote technology in order, how to ensure your platform allows for shareholder entry & participation, virtual “rules of conduct”, voting & tabulation issues and contingency planning.
One open question from the Supreme Court’s Liu decision relates to determining “legitimate expenses” that must be deducted from disgorgement awards so the “net profits” can be distributed to victims. At a recent SEC Speaks conference, Enforcement Division Chief Counsel Joseph Brenner and Chief Litigation Counsel Bridget Fitzpatrick provided insight for those trying to understand what might constitute “legitimate expenses” in context of a disgorgement award. This McGuireWoods memo summarizes remarks from the conference, including these relating to determining legitimate expenses:
Chief Counsel Brenner noted that the Enforcement Division would be on the lookout for “expenses” that in its view were just wrongful gains under another name, such as expenses that furthered the scheme, or deductions for the defendant’s personal services to the fraudulent enterprise. If defense counsel believe there are legitimate expenses that should be deducted from a potential disgorgement amount, Chief Counsel Brenner recommended counsel to consider the following questions:
1. What makes the expense legitimate within Liu’s framework — in particular, did the expense provide actual value to investors, was the expense consistent with how investors understood their money would be used, or is the expense really just disguised profits?
2. If the expenses are legitimate, how closely were those expenses tied to the unlawful profits? Thus, the Enforcement Division may not view all “legitimate” expenses as deductible if they were in furtherance of the violation.
3. What is the right amount of the offset?
With respect to the third point, Chief Counsel Brenner stated that, in the Enforcement Division’s view, counsel must come prepared to demonstrate both the entitlement to a deduction for a legitimate expense and its amount. Based on practical experience gained since Liu, the Staff stated that counsel can make a more persuasive case for a reduction from the full amount of disgorgement by doing the work up front to support both the basis for the deductible legitimate expense and, critically, its amount. In the Staff’s view, it is not sufficient for counsel to claim it is too difficult or resource-intensive to quantify the expense, or to claim that the analysis supporting a request was work product that the Staff could not review.
NYSE Proposes Changes to Shareholder Approval Requirements for Certain Equity Issuances
In early October, the NYSE proposed changes to its rules on shareholder approval requirements relating to certain equity issuances set forth in Section 312.03 of the NYSE Listed Company Manual. In the proposed amendments, the NYSE notes that the changes would make the NYSE’s rules for cash sales to related parties substantively identical to those of Nasdaq. This Mayer Brown blog walks through the proposed amendments that would affect Section 312.03(b) and 312.03(c), here’s an excerpt:
The NYSE proposes to amend Section 312.03(b) to limit the class of related parties that would require shareholder approval. Section 312.03(b) as amended would require prior shareholder approval only for sales to directors, officers and substantial security holders and would no longer require approval for sales to such related party’s subsidiaries, affiliates or other persons closely related or to entities in which a related party has a substantial interest. Further, Section 312.03(b) as amended would no longer require shareholder approval of issuances of more than 5% of outstanding shares to a related party so long as they are issued at a minimum price. The NYSE proposes to require that any listed company obtain shareholder approval for a transaction in which a director, officer or substantial security holder has a 5% or greater interest (or such persons collectively have a 10% or greater interest) in the company or assets to be acquired or in the consideration to be paid in the transaction and the issuance of shares could result in an increase in outstanding shares of 5% or more.
With respect to Section 312.03(c), the NYSE proposes to replace the reference to “bona fide private financing” with “other financing in which the company is selling securities for cash.” This change would effectively eliminate the 5% limit for any single purchaser but retain the minimum price requirement.
Refreshing Governance Documents – Recent Trends
As companies start preparing now for the coming proxy season, a common to-do item involves reviewing governance documents for any potential updates. Many companies monitor peer companies for governance document changes and a recent Sullivan & Cromwell memo provides a good recap of recent trends in governance documents. The memo acknowledges that many companies have revised governance documents in response to Covid-19 to ensure they’re able to operate remotely.
Among other provisions, the memo discusses refreshment trends for advance notice bylaws, ESG oversight, and federal exclusive forum provisions. One area getting a lot of attention these days is board composition. As companies take steps to ensure governance documents are current and say the right things, the memo is a good reminder to make sure the governance provisions synch with your company’s actual practices. Here’s an excerpt about provisions relating to board leadership and evaluation guidelines:
Shareholders, institutional investors and proxy advisors are now calling for enhanced transparency around why a company’s independent board leadership structure is appropriate for the company. In response, many companies are providing more detail in their corporate governance guidelines regarding their processes for determining their leadership structures, the roles and responsibilities of their board leader(s) and their board evaluation practices.
Acknowledging several of the recent board diversity lawsuits, the memo notes that the plaintiffs’ complaints referenced statements that were included in corporate governance documents, including committee charters and proxy statements. The plaintiffs allege these disclosures do not accurately represent the companies’ practices. As more companies consider whether to provide enhanced transparency around their leadership structures and evaluation practices in their corporate governance guidelines and other governing documents, it is important to ensure that any disclosures remain consistent not only with the company’s other public disclosures, but also with the company’s actual practices.
Earlier this fall, Liz blogged about Corp Fin’s increased scrutiny of supply-chain finance arrangements. Last June, in Topic 9A Disclosure Guidance, Corp Fin called out supply-chain finance arrangements and now last week, this WSJ article reports that the FASB voted to add a project to its agenda to explore greater disclosure on the use of supply-chain finance arrangements. Cydney Posner posted a blog entry detailing some of the recent focus on supply-chain finance disclosure and suggests that companies engaged in this type of financing might want to take the opportunity now to revisit the adequacy of their disclosure.
The WSJ article says a joint letter from the Big Four accounting firms is what led to the FASB’s decision to work on the matter as more transparency could lead to a better understanding of a company’s financial position. It’s unclear exactly what additional disclosure would entail but today there are questions about whether the arrangements should be classified as debt or accounts payable and it’s generally understood that disclosure is lacking:
Board members during Wednesday’s meeting highlighted the growing use of supply-chain finance among companies as well as the lack of disclosure. Fewer than 5% of the nonfinancial companies that Moody’s Investors Service rates globally disclose supply-chain financing in their financial statements, the ratings firm said last year. Companies generally aren’t required currently to disclose that information.
One result could be requiring companies to add footnotes to their financial statements explaining the nature of the programs they use.
ISS’ Proposed Board Diversity Policy Change: Aggregated Data Won’t Cut It
The comment period for ISS’ policy changes closes at 5 pm Eastern Time today and when Liz blogged about the potential changes a couple of weeks ago, one U.S. change that has received a fair amount of attention is the proposed change relating to board diversity. Under that proposed policy, beginning in 2022, at companies where there are no identified racial or ethnically-diverse board members, the proposed U.S. policy will be to recommend voting against the chair of the nominating committee (or other relevant directors on a case-by-case basis). If the proposed policy is adopted, all companies in the Russell 3000 and S&P 1500 indexes would be subject to it.
As stated in ISS’ proposed policy changes document, as of Sept. 21, 2020, 1,260 of the Russell 3000 companies, 492 of the S&P 1500 and 71 of the S&P 500 do not have minority ethnic and/or racial board representation. The document also states that in 2021, ISS research reports will highlight boards that lack racially or ethnically diverse board members (or lack disclosure of such) to help investors identify companies they may want to engage with to foster dialogue on the topic. A recent AgendaWeek piece (subscription required) includes commentary from Marc Goldstein, head of U.S. research at ISS, that sheds more light on information ISS wants to see:
‘The real problem for us is when companies disclose diversity and then aggregate race, ethnicity and gender all together and say, for example, that ‘30% of our board is diverse,’ but then they don’t say what that means,’ says Goldstein. ‘We don’t consider that good enough.’
Instead, says Goldstein, ISS wants to see companies that haven’t provided specific disclosure to disclose what percentage of the board is composed of women, what percentage is racially diverse, and what percentage is ethnically diverse. ‘We want to see gender diversity separated out from racial and ethnic diversity. And obviously, there are other ways to define diversity too, including background, thought, nationality — lots of things. But we’re specifically interested in racial and ethnic diversity for the purposes of this policy.’
ISS expects to announce its final 2021 benchmark policy changes in the first half of November, so we’ll find out soon if the proxy advisory firm adopts this board diversity policy. In the event ISS adopts this policy change, given that ISS research reports will begin flagging companies for lack of disclosure in 2021, even companies that have historically included aggregated director diversity information in their proxy statements might want to consider updating their disclosure or prepare for potential questions from investors.
ISS to Expand QualityScore with FICO Cyber Risk Score
For more on ISS, the proxy advisory firm issued a press release late last week announcing it entered into an agreement to acquire FICO cyber risk score business. With FICO cyber risk score, ISS’ announcement says that institutional investors will be able to use cyber risk scores as part of ISS’ Governance QualityScore ratings in 2021 to evaluate portfolio company risk. ISS also says that it will integrate the cyber risk score into other product offerings such as ISS ESG ratings.
What else can you say when the SEC announces that somebody just rang the whistleblower bell to the tune of $114 million? Here’s an excerpt from the SEC’s press release:
The Securities and Exchange Commission today announced an award of over $114 million to a whistleblower whose information and assistance led to the successful enforcement of SEC and related actions.
The $114 million award consists of an approximately $52 million award in connection with the SEC case and an approximately $62 million award arising out of the related actions by another agency. The combined $114 million reward marks the highest award in the program’s history, and eclipses the next highest award of $50 million made to an individual in June 2020.
It sounds like the award came at the end of a tough road for the whistleblower. The SEC’s press release says that the individual repeatedly reported that person’s concerns internally, and then, “despite personal and professional hardships,” the whistleblower alerted the SEC and the other agency of the wrongdoing and provided ongoing assistance that was critical to the success of the proceeding.
Now for the fun part – guessing which company is involved in the underlying case. For what it’s worth, here’s the SEC’s order, but it won’t be much help. The order contains more redactions than the average CIA response to a FOIA request.
Given the size of the award & the reference to another agency’s involvement, I’m sure some might guess that it’s related to the Goldman Sachs 1MDB settlement that was also announced yesterday, but I’m pretty sure that this doesn’t relate to that proceeding. For one thing, the SEC hasn’t yet issued a Notice of Covered Action for that case, which is required for any potential whistleblower case in which more than $1 million in sanctions have been imposed.
I have far too much journalistic integrity to speculate on such matters – but not enough to prevent me from pointing you to a Twitter thread where lots of people are doing just that.
Human Capital: Addressing the New Disclosure Requirement
One of the problems with adopting a principles based disclosure requirement is that you often end up with some poor soul staring at a blank sheet of paper trying to come up with something to say. If you’re worried about finding yourself in that position, this Freshfields blog provides some advice about how to address the SEC’s new human capital disclosure requirement. This excerpt lays out some potential disclosure topics:
– Diversity and inclusion: Programs or initiatives related to recruitment and retention of diverse candidates and other corporate partners, programs or initiatives to mentor and ensure equal opportunities at the company for diverse employees, unconscious bias trainings, and community involvement. For instance, if a company has adopted the Rooney Rule for directors or other positions, it could be helpful to provide that disclosure.
– Workforce compensation and pay equity: Company-wide compensation program design and implementation more generally, including incentive structures, internal minimum rates of pay, as well as efforts to promote gender and diversity pay equity. This may include involvement of outside compensation advisors or use of benchmarking data. This coming year, we expect to see disclosures around changes made to compensation programs in response to COVID-19 and the considerations that were involved.
In the case of companies that had to reduce compensation or furlough employees, we expect to see disclosure of actions taken to ease departures or reduced wages that demonstrate a commitment to the workforce. For example, many companies provided severance packages, extended health insurance to part-time employees or furloughed employees, offered paid sick leave, or established wellness initiatives and mental health services.
– Talent acquisition and retention: Competitive trends affecting recruitment and retention of employees (including, if material, voluntary and involuntary turnover rates), trends in overall workforce composition and talent needs, and succession planning for senior leadership roles.
Other potential topics include employee engagement and wellness, development and training, company culture, and oversight and governance. If you’re looking for more insights into the new human capital disclosure requirement, we’re posting memos in our “Human Capital Management” & “Regulation S-K” Practice Areas.
Corporate Governance: Preparing for “Black Elephants”
This year has been a barrel of laughs. Pandemic, lockdowns, recession, divisive politics – and now to top it all off, I’m going to have to subscribe to Apple TV if I want to watch Charlie Brown! Thanks for nothin’ 2020.
I guess my point is that we live in interesting times, where unexpected and downright extraordinary events happen with alarming regularity. That’s why I thought that this recent HBR article made for interesting reading. The article discusses how corporate boards can build the resilience necessary for companies to address the “black elephants” that they’re likely to encounter in the future. According to the authors, these creatures are a cross between a “black swan” and the “elephant in the room,” and describe a “looming disaster that’s clearly visible, yet no one wants to address.”
The article addresses how boards can build the resilience necessary to deal with these stygian pachyderms through effective corporate governance, leadership development and compensation program design. Here’s an excerpt on governance:
Boards have a variety of means for promoting resilience and monitoring potential black elephant events. They can encourage stress tests in comprehensive risk reviews. They can press management on the worst-case scenarios for each black elephant, including when the threat becomes existential for the company. They can then suggest “war games” to develop principles for effective responses — with lessons brought back to the board for assessment and discussion.
The authors also highlight some of the operational steps that the board can take on the governance front, including pushing management to fortify the company’s physical & digital defenses, taking actions to improve resilience in supply chains, and promoting technological solutions to minimize potential disruptions.
Earlier this year, Liz blogged about an SEC enforcement action targeting the “Simple Agreement for Future Tokens,” a once popular method of structuring crypto-financings that was intended to avoid securities law compliance issues. Well, it obviously didn’t, and if one SEC enforcement proceeding wasn’t enough to drive that message home, this Brian Cave memo discusses a second one:
On September 30, 2020, Judge Alvin Hellerstein, of the Southern District of New York granted summary judgment to the Securities and Exchange Commission in its enforcement action against Kik Interactive Inc., in which the SEC contended that Kik’s 2017 $100 million Initial Coin Offering was an unregistered securities offering. The Kik decision marks the second time this year that a federal judge in the SDNY has determined that an ICO involving the “Simple Agreement for Future Tokens” (“SAFT”) framework constituted an unlawful unregistered securities offering, establishing a daunting precedent for both potential and past SAFT issuers.
Yesterday, Kik officially threw in the towel and settled with the SEC. One of the interesting things about this case is that the defendant was postively itching to fight the SEC. In fact, as I blogged last year, Kik even went out and raised a war chest from the crypto crowd to fund the litigation. I was skeptical that courting an enforcement proceeding was a particularly good strategy, and now that Kik has gotten its clock cleaned, perhaps the folks behind it don’t think so either.
Although the SAFT was a popular structure, people raised concerns about it from the start. Now that it’s been swatted down twice in the space of a few months, it’s probably time to concede that the SAFT structure doesn’t cut the mustard.
Insider Trading: Enforcement Numbers Way Down Last Year
According to an NPR report, the number of insider trading enforcement actions brought by the SEC declined dramatically in 2019:
The government agency responsible for policing Wall Street brought the fewest number of insider trading cases in decades, according to the most recent available data. That decline came just before the COVID-19 pandemic hit. The Securities and Exchange Commission now warns that the pandemic has created wild swings in the market and more opportunities for insider trading.
NPR reviewed data from the 1980s through last year and found that under the Trump administration, the SEC brought just 32 insider trading enforcement actions in 2019, the lowest number since 1996.The SEC charged 46 defendants as part of those cases. That was the lowest number of defendants in insider trading cases since Ronald Reagan was president, and about half of the annual average over the last three decades. The decline has alarmed experts and advocates, who worry that flagrant illegal trading may go unchecked.
I suppose this report wouldn’t have been aired without including allegations that “flagrant illegal trading” was going unchecked but the report also includes commentary to the effect that the decline reflects the current regime’s enforcement focus, which has emphasized issues impacting “Main Street Investors.” That seems to me to be a more likely explanation for the drop in insider trading cases during a year where overall enforcement activity was near an all-time high.
Sustainability: A Random Walk All Over ESG Funds
Burton Malkiel’s book, “A Random Walk Down Wall Street”, has probably done more to promote index funds as an investment option than any other work. In a recent WSJ opinion piece, he comes down hard on the concept of ESG funds. Here’s an excerpt:
Some ESG providers have also claimed that social investing can enhance returns. During particular periods, some funds with specific ESG mandates have outperformed. In the first half of 2020 funds with no oil but high tech stocks did well as the price of oil plummeted and tech stocks soared. But no credible studies show that ESG investing offers consistently higher long-term returns. Such funds are less diversified than broad-based index funds and thus are riskier. They also have higher expense ratios, which tends to lower investment returns.
Further, ESG investing is inherently at odds with the goal of earning higher returns. Investor taste does influence asset prices. But as a thought experiment, suppose that oil stocks are so abhorred that they now sell at low prices relative to their earnings and prospects. That means they will offer higher future returns, and portfolios excluding them might underperform.
So what should investors interested in ESG investing do? Not surprisingly, Malkiel says that low-cost, broad-based index funds should be the core of any investment portfolio. Investors that want to invest in funds with particular mandates should do this as an add-on to their core portfolios.
It has been a couple of years since California enacted a statute requiring listed companies headquartered in the Golden State to have women on their boards. That statute was controversial and questions about its legality remain, but is it working? According to a recent study from the California Partners Project, the answer seems to be yes, although many companies still have work to do to reach the levels of female board representation required by the end of 2021. Here are some of the highlights:
– Of the 650 California-headquartered companies subject to the legislation, 29% did not have a single female director in 2018. Today, only about 2% lack female board representation.
– The number of California public company board seats held by women has grown from 766 in 2018 to 1,275 today – an increase of 67%
– 28% of California companies subject to the legislation currently meet the requirement for female board membership that will apply effective 12/31/21, while 72% need one or more additional female directors to come into compliance.
The law required all companies to have at least one female director by the end of 2019. By the end of 2021, companies with six or more directors must have at least three female directors, companies with five or more directors must have at least two, and companies with four or fewer directors must have at least one.
S-K Modernization: The Questions Just Keep Coming. . .
We continue to get a lot of questions on the SEC’s recent amendments to Item 101, 103 & 105 of Regulation S-K. As Liz blogged last month, some of these questions have focused on potential disconnects between the amended language of Item 101 of S-K & the language of Item 1 of Form 10-K. More recently though, we’ve been getting some interesting questions on our Q&A Forum on how the rules apply to Securities Act filings – and Form S-3 registration statements in particular. Here’s one question that we received:
Any thoughts on how the amendments will apply to outstanding shelf registration statements? If after November 9, 2020, a prospectus supplement incorporates by reference the risk factor discussion from a previously filed Form 10-K and that risk factor discussion does not comply with the amended rule (e.g., because it fails to include headings), must the prospectus supplement restate all risk factors in compliance with the amended rule?
Although Form S-3 does not specifically require disclosure of Items 101 and 103, Form S-3 incorporates prior disclosure of these items because of the required incorporation by reference if the Form 10-K. Must the Form 10-K disclosures be updated to conform to the rule changes?
Here was my response:
That’s an interesting question. For what it’s worth, here are my two cents: In the case of an already effective S-3, I don’t think that updating to address the new requirements would be required. That’s because the registration statement contained everything “required to be stated therein” under the rules applicable at the effective time, and that’s when Section 11 speaks. The fact that information incorporated by reference into that registration statement no longer complies with the amended requirements of Item 105 wouldn’t implicate Section 11.
I think the obligation to update the prospectus would instead be governed by the obligations imposed by the undertakings in Item 512 of S-K, Rule 10b-5, and Section 12(a)(2) of the Securities Act. My guess is that in most instances, issuers would likely conclude that the existing disclosure incorporated by reference into the filing doesn’t need to be updated to conform to the requirements of amended Item 105 in order to comply with any of these potential updating obligations.
There have been follow-up questions addressing situations involving Form S-3s filed before the new rules went into effect, but declared effective afterward, as well as whether existing 10-K language addressing Item 101 would need to be updated in the case of a Form S-3 filed after the S-K amendments. If you’d like to check those out, they’re all in Topic #10475.
I’ve taken a stab at answering these questions, but who cares what I think? The bottom line is that there are a lot of questions about the application of the S-K amendments, and with the effective date just around the corner, guidance from Corp Fin would be very helpful.
Political Spending: Transparency & Accountability on the Rise
According to the latest CPA-Zicklin Index, corporate disclosure of and accountability for political spending is on the rise. Here are some of the stats:
– In 2020, 228 (over 60% of the 378 “core” companies that have been in the S&P 500 since 2015) had policies for general board oversight of political spending. Meanwhile, core companies with specific committee review of different types of political spending increased between 32% and 48% depending on the recipient type between 2016 and 2020.
– 240 companies, or nearly two-thirds of core companies, had policies in 2020 for fully disclosing or prohibiting donations to candidates, political parties and committees; 224 companies had them for donations to 527 groups; and 211 companies had them for independent expenditures.
– The biggest increase in any category – 50% to 135 companies from 90 in 2016 – came in disclosure or prohibition of donations to tax-exempt 501(c)(4) groups also known as “social welfare” organizations, often a focus of scrutiny over their “dark money” spending.
– The average score evaluating overall political disclosure and accountability for the core companies has risen steadily from 46% in 2016 to 57% in 2020, an increase of nearly 25%. In 2020, 144 core companies placed in the first Index tier (scoring from 80% to 100%) a dramatic increase of almost 80% compared to 79% of core companies in 2016.
The report says that the Trump years (2016-2020) have proven to be a boom time for corporate political disclosure and accountability, and that increases in adoption of board oversight and more detailed committee review of political spending are “especially striking.”
Last week, Liz blogged about ISS’s benchmark policy document. In addition to the ESG & diversity policy changes that she mentioned, page 34 of the document sets forth a proposed policy under which ISS would generally endorse Delaware exclusive forum bylaws for Delaware corporations. Here’s an excerpt from Wachtell Lipton’s memo on the proposed policy:
Institutional Shareholder Services (ISS) has released its proposed 2021 voting policy updates and, for the first time, proposes expressly recognizing the benefits of Delaware choice of forum provisions for Delaware corporations and generally recommending in favor of management-sponsored proposals seeking shareholder approval of such charter or bylaw provisions. Under the new ISS policy, ISS would:
(1) generally vote for charter or bylaw provisions that specify Delaware, or the Delaware Court of Chancery, as the exclusive forum for corporate law matters for Delaware corporations, “in the absence of serious concerns about corporate governance or board responsiveness to shareholders” (and continue to decline to vote against the directors of Delaware companies who adopt such bylaw provisions “unilaterally”);
(2) continue to take a case-by-case approach with respect to votes regarding exclusive forum provisions specifying states other than Delaware; and
(3) generally vote against provisions that specify a state other than the state of incorporation as the exclusive forum for corporate law matters or a specific local court within the state (and apply withhold vote recommendations to a board’s “unilateral” adoption of such a provision).
When it comes to federal forum bylaws, ISS’s proposed policy would would generally support charter or bylaw provisions that specify “the district courts of the United States” as the exclusive forum for federal securities law matters. However, the memo notes that ISS would recommend against against provisions that limit the forum to a particular federal district court. As with ISS’s other proposed policy changes, the time period to submit comments on this proposal ends on October 26th.
Financial Reporting: About Those Covid-19 One-Time Charges. . .
We’ve blogged quite a bit about the financial reporting issues created by the pandemic (here’s a recent one), but this WSJ article raises another one – how long can companies characterize Covid-19 related costs as “one time charges”? Here’s an excerpt:
More than six months into the pandemic, company executives say they expect to be dealing with the effects of Covid-19 for much longer than they initially anticipated. Still, some companies continue to treat virus-related costs as special, one-time items, which can give the impression that a business’s costs are lower than they actually are. This in turn can boost its non-GAAP financial results. Companies often highlight these metrics when also reporting earnings figures that comply with generally accepted accounting principles as required.
Some investors and accounting professionals suggest that after two quarters of reporting Covid-19-related costs, companies should consider treating these items as regular costs of doing business as they close the books for the third quarter and not adjust their non-GAAP earnings.
The article says that many prognosticators suggest that current conditions – and the heightened expenditures for PPE and other Covid-19 related costs – are going to continue at least until a vaccine becomes widely available. In that kind of environment, the appropriateness of continuing to back out these costs from non-GAAP numbers on the basis that they’re “one-time charges” is questionable.
Non-GAAP & KPIs: A Primer From the CAQ
The Center for Audit Quality recently published a report that supposedly deals with the role of auditors in non-GAAP financial measures and key performance indicators. Sure, there’s a section in there that addresses this topic, but most of the document is really a primer on the use of non-GAAP financial measures and KPIs. It’s pretty good too – particularly for someone who doesn’t deal with disclosure & other issues relating to these metrics on a regular basis.
On Friday, the SEC announced amendments to the auditor independence requirements set forth in Rule 2-01 of Regulation S-X. Here’s the 130-page adopting release. The amendments are intended to update the independence rules to address recurring fact patterns that triggered technical independence rule violations without necessarily impairing the auditor’s objectivity and impartiality.
Among other things, the amendments address independence issues that arise when sister companies with a common PE fund owner have engaged an audit firm to provide non-audit services that could impair the independence of the audit firm with respect to another sibling company. The amendments also shorten the look-back period for auditor independence from three years to one year for first time filers, which will provide increased flexibility for IPO companies to address potential disqualifying relationships with their audit firms.
The SEC’s press release summarizes the changes implemented by the amendments & provides a couple of examples of how they will work. According to the release, the amendments will:
– Amend the definitions of “affiliate of the audit client,” in Rule 2-01(f)(4), and “investment company complex,” in Rule 2-01(f)(14), to address certain affiliate relationships, including entities under common control;
– Amend the definition of “audit and professional engagement period,” specifically Rule 2-01(f)(5)(iii), to shorten the look-back period, for domestic first time filers in assessing compliance with the independence requirements;
– Amend Rule 2-01(c)(1)(ii)(A)(1) and (E) to add certain student loans and de minimis consumer loans to the categorical exclusions from independence-impairing lending relationships;
– Amend Rule 2-01(c)(3) to replace the reference to “substantial stockholders” in the business relationships rule with the concept of beneficial owners with significant influence;
– Replace the outdated transition provision in Rule 2-01(e) with a new Rule 2-01(e) to introduce a transition framework to address inadvertent independence violations that only arise as a result of a merger or acquisition transactions; and
– Make certain other miscellaneous updates.
I’ll give you three guesses how the SEC’s vote on this went down – and the first two don’t count. Anyway, here’s Chair Clayton’s statement on the adoption of the amendments, and here’s the customary dissenting statement from Commissioners Lee and Crenshaw. The dissenters expressed concern with the increased discretion provided to audit firms when assessing their own independence and the lack of any mechanism to provide visibility into how auditors are exercising this discretion. We’ll be posting memos in our “Auditor Independence” Practice Area.
Enforcement: SEC Provides $20MM Reminder That You’d Better Know What You Know. . .
In addition to the SEC’s amendment of Rule 2-01 of S-X, there was also some interesting news on the enforcement front last Friday. The SEC announced a settled enforcement proceeding against Andeavor LLC arising out of alleged internal controls violations that resulted in the company engaging in a stock buyback while it was engaged in preliminary merger negotiations with a potential buyer.
According to the SEC’s order, the company’s CEO directed its CFO to initiate a $250 million stock buyback two days before the CEO was scheduled to meet with his counterpart at Marathon to resume confidential discussions about Marathon’s potential acquisition of Andeavor at a significant premium. The next day, Andeavor’s law department approved a Rule 10b5-1 plan to repurchase $250 million of stock. It made that authorization after concluding that these discussions did not constitute MNPI.
According to the order, that conclusion was “based on a deficient understanding of all relevant facts and circumstances regarding the two companies’ discussions.” As this excerpt from the order notes, the SEC contended that this deficient understanding was the result of a breakdown in internal accounting controls:
This lack of understanding was the result of Andeavor’s insufficient internal accounting controls. Andeavor used an abbreviated and informal process to evaluate the materiality of the acquisition discussions that did not allow for a proper analysis of the probability that Andeavor would be acquired. Andeavor’s informal process did not require conferring with persons reasonably likely to have potentially material information regarding significant corporate developments prior to approval of share repurchases.
In particular, nobody involved in the process discussed with the CEO the prospects that the two companies would reach a deal, which the SEC said resulted in a miscalculation of its probability (remember, we’re in Basic v. Levinson territory here). The company ultimately consented to a C&D against violations of the book & records provisions of the Exchange Act and a $20 million penalty.
The trouble with contingency cases is that there’s a huge potential for hindsight when you know how things ended up, and this case is no exception. The parties ultimately did agree on a deal at a valuation of $150 per share in April 2018 – compared to an average price of $97 paid for shares acquired in the buyback during February & March of the same year. That’s not exactly an ideal fact pattern for defending a position that the preliminary merger negotiations weren’t material.
A key takeaway from this proceeding seems to be that one of the key functions of internal controls – whether you’re talking about disclosure controls & procedures or ICFR – is to enable companies to “know what they know.” That’s even more important when dealing with contingency disclosure. Companies that want to defend claims that are brought with the benefit of hindsight need to demonstrate that their control procedures were robust & well-functioning at the time a critical judgment call was made.
Virtual Meetings: P&G Gets It Right
Soundboard Governance’s Doug Chia has attended a slew of virtual annual meetings this year, and he says that Procter & Gamble’s recent meeting was among the best he’s seen. Check out his recent blog for the details.
Doug will also be participating in our webcast next Thursday, October 29th – “Virtual Annual Meetings: What To Do Now” – along with CII’s Amy Borrus, Dorothy Flynn of Broadridge, Independent Inspector of Election Carl Hagberg and Bristol-Myers Squibb’s Kate Kelly. Don’t miss it!
Now that the threat of “cancel culture” is omnipresent, many of us spend a lot of time thinking about how to prevent or respond to current missteps. But today’s blunders are only part of the risk. According to this recent survey of 50 C-suite execs, only 8% felt comfortable that their company hasn’t previously engaged in practices that would be deemed unseemly under today’s ethics or standards – that broke down into 76% knowing of problematic practices or events, and 16% being unsure. Here’s an excerpt:
Executives might know what’s included in documented corporate histories, but not about matters that were not publicized or documented. Instances that, at the time were both legal and standard practices, but are now threats both in the courts of law and public opinion may be especially difficult for executives to get their arms around. Two acute examples of such practices are companies (or predecessor companies they acquired) that: 1) once owned, insured, or used slaves as assets for collateral and 2) participated in manufacturing or other industrial practices that contributed to the climate crisis.
Forty-two percent of respondents said they thought the broader public was aware of past actions by their company that conflict with today’s ethics or standards, but just as many were unsure. That more than four in 10 respondents don’t have a good grasp of the public’s awareness of their company history means too many companies haven’t done enough work to understand their own pasts or how their pasts are perceived by the public.
You can’t change the past – and ethics standards will likely keep evolving. But you can – and should – have a plan for addressing your history. According to the survey, only 26% of execs said they were “very prepared” to respond if problematic actions came to light, so there is room for improvement. In addition, there are differences in how executives and investors are viewing these threats. Here’s more detail on that:
• C-suite executives are far more concerned about the impact of unknown past racial injustices and somewhat more concerned about sex or gender discrimination than investors, who are significantly more concerned about past support for divisive social or political causes.
• Executives are more concerned about the damage that unseemly revelations may do to their brand equity. But investors are more concerned with the potential for media and customer backlash and lower valuations.
• More than half of investors surveyed would put specific contingencies on a deal after a problematic discovery was made and one in four would require the company to respond in writing to the claims. More significantly, 29 percent of investors said they would dismiss the investment opportunity outright.
• Among investors, 32 percent said they are very or somewhat unlikely to regain confidence in a company following the revelation of a past bad action – even if the company addressed the past action in ways the investors deemed appropriate.
IPO Governance Trends: Takeover Defenses Remain Common
According to the latest survey of IPO governance trends by Davis Polk, there’s been “widespread and generally increasing adoption” of takeover defenses at both controlled and non-controlled companies in advance of IPOs – even as seasoned public companies have been abandoning the same defenses due to shareholder pressure. The survey looked at the Top 46 “controlled company” IPOs and the Top 50 “non-controlled company” IPOs by deal size from April 1, 2018 through July 10, 2020. Here are some other findings:
– Exclusive Forum Provisions: The number of both controlled and non-controlled companies that adopted exclusive forum provisions (another governance attribute disfavored by some shareholder advocates) during the current survey period continued to grow from past survey periods. In the current survey, 91% of controlled companies and 98% of non-controlled companies adopted exclusive-forum provisions. These included both exclusive forum provisions addressing claims under the Securities Act of 1933 (the “’33 Act”) and exclusive forum provisions addressing other claims against the company. This is a substantial increase from the 14% and 26% of controlled and non-controlled companies, respectively,that adopted such provisions in our 2014 survey.
– Direct Listings: When we compared the one comparable direct listing during the current survey period (Slack Technologies, Inc.) to the non-controlled companies, we found similar governance provisions. Slack’s takeover defenses were identical to the vast majority of non-controlled companies, including a staggered board, prohibitions on shareholder action by written consent, shareholder ability to call a special meeting, the requirement of a super majority to amend the bylaws and plurality voting for uncontested director elections.
– Dual-Class Shares: Over 25% of controlled companies, and 28% of non-controlled companies, had a class of shares with unequal voting rights.
– Shareholder Written Consent: 9% of controlled companies and 12% of non-controlled companies permitted shareholder action by written consent. We’ve blogged on The Proxy Season Blog about how this is becoming a “hot topic.”
Check out the full 60-page survey for info on board & committee structure, advance notice bylaws, board & shareholder rights, equity awards, employment agreements, and more.
Direct Listings: CII Urges SEC to Deny Nasdaq Proposal
Last week, the CII sent this letter in response to the SEC’s request for comments on Nasdaq’s “primary direct listings” proposal. In line with the points raised in its September petition to stay the NYSE’s similar proposal, the Council urged the Commission to disapprove the proposal for two reasons:
1. It would compound problems shareholders face in tracing their share purchases to a registration statement (i.e., “proxy plumbing” issues)
2. It may lead to a decline in effective governance at public companies, by allowing companies to sidestep IPO governance checks (the letter looks at Palantir’s recent deal as an example)
These mid-year stats from Broadridge show what a watershed year it’s been for virtual shareholder meetings. Here’s some highlights:
– 1,494 VSMs hosted on Broadridge technology – 98% of those were virtual-only
– Average meeting attendance was 30 for small-caps, 37 for mid-caps and 122 for large-caps – higher if a shareholder proposal was being presented
– When it came to shareholder questions, 97% allowed live questions, 11% allowed pre-meeting questions, 5 questions were asked on average and one company somehow fielded 316
– Average duration was 34 minutes if a shareholder proposal was presented and 18 minutes if not
Check out this Skadden memo and other resources in our “Virtual Shareholder Meetings” Practice Area as you plan for the possibility of another virtual shareholder meeting in 2021. And don’t forget to tune into our October 29th webcast with CII’s Amy Borrus, Doug Chia of Soundboard Governance, Dorothy Flynn of Broadridge, Independent Inspector of Election Carl Hagberg and Bristol-Myers Squibb’s Kate Kelly to hear what you should be doing right now to prepare.
ISS Proposes Diversity and E&S Policy Changes: Comment By October 26th!
Yesterday, ISS announced a public comment period for proposed policy changes that would apply to annual meetings taking place on or after February 1, 2021. For the US, the proposed changes include:
– Board Diversity, Race and Ethnicity: Beginning in 2022, at companies where there are no identified racial or ethnically-diverse board members, the proposed ISS U.S. policy will be to recommend voting against the chair of the nominating committee (or other relevant directors on a case-by-case basis). Mitigating factors will be considered and the proposed coverage universe is all companies in the Russell 3000 and S&P 1500 indexes.
– Director Accountability: ISS policies globally will explicitly note that significant risk oversight failures related to environmental and social concerns may, on a case-by-case basis, trigger vote recommendations against board members.
– Shareholder Litigation Rights: ISS proposes modifications in the U.S. policy regarding management proposals to establish exclusive forums.
Submit comments to policy@issgovernance.com by 5 pm Eastern Time on Monday, October 26th. Unless otherwise specified in writing, all comments will be disclosed publicly upon release of final policies – which is expected during the first half of November.
COVID-19: Audit Committee Questions for the “New Normal”
COVID-19 disclosures remain a top area of focus for audit committees, according to this KPMG survey. Specifically, the uncertainty caused by the pandemic – along with expectations for companies to deliver forward-looking information and analysis – are leading to substantial discussion on disclosures about the pandemic’s effect on business, the preparation of forward-looking cash flow estimates, impairments, use of non-GAAP financial metrics and other topics.
This Deloitte memo suggests questions that audit committees should ask to ensure that disclosure is accurate and transparent. Here are a few:
– Is data from the 2008 financial crisis being used to benchmark the timing and pattern of recovery from the current pandemic? Has management carefully considered the differences between the two economic periods?
– What “new normal” conditions or future trends are included in the forecast assumptions?
– In considering the use of non-GAAP measures, has the company considered what costs might be part of the “new normal” and how certain non-GAAP adjustments may impact comparability in the future?
– Has the company reassessed its volatility assumption when valuing new stock awards in light recent market volatility?
– Has the company modified any significant contracts, particularly contracts with customers and leases?
Both memos note that audit committees are also focusing on reassessing or changing internal controls due to return-to-work plans, virtual working and cybersecurity – and that internal auditors are adjusting audit plans and activities to identify emerging risks posed by the pandemic. The KPMG survey says that audit committee members also indicated that they expect employee safety and diversity issues, as well as supply chain resilience and corporate reputation, to get significantly more attention from the board as a result of COVID-19 and recent protests against systemic racism.
