At a Senate Banking Committee hearing on Tuesday, Committee Chair Christopher Dodd (D-Ct.) warned SEC Chairman Cox that he will consider legislation to resolve the question of proxy access if the SEC doesn’t adopt access rules. Here is Chairman Cox’s statement from the hearing.
ISS’ “Corporate Governance Blog” notes: “Cox, a former Republican Congressman from southern California, was questioned by Dodd on the likelihood that investors would be able to file a proposal calling for access, given the threshold of 5 percent could keep ‘even large institutional investors such as Calpers’ from filing.
Cox defended the threshold, noting it aligns with the commission’s existing 13D/G regime, which requires investors to disclose holdings above the 5 percent level and whether or not they intend to exert control. Cox also noted that groups could pool holdings to meet the threshold and questioned whether a group unable to meet the 5 percent requirement could muster 50% support to pass an access bylaw.
Echoing past assurances, Cox told committee members that the issue of access would be resolved, one way or another, within months. ‘There will be a rule in place this fall … so [investors filing proposals for the 2008 proxy season] will know how to conform their conduct to the law,’ Cox said.”
Last Sunday, the Washington Post ran this article that nicely describes how the Pink Sheets have evolved over the past decade – including the new categorization system to alert investors about the ability and willingness of individual issuers to provide adequate public disclosure in a timely manner. Beware the skulls and cross-bones!
A few months ago in our Q&A Forum, we received a question regarding the attorney letter requirement for the new Pink Sheets tiers. The Attorney Letter Agreement is now available. Learn more in our “Pink Sheets” Practice Area.
Mailed: July-August Issue of The Corporate Counsel
We just mailed the July-August 2007 issue of The Corporate Counsel. Try a no-risk trial for half-price for the rest of the year.
The July-August issue includes analysis of:
– Fixing The Rule 144 Proposals
– Majority Voting—Uncontested Elections Only?
– Section 13 Reporting of Short Positions
– Revised 8-K Items 5.02 (and 1.01)
– Accessing on Edgar Exhibits That are Incorporated by Reference—No Hyperlinking!
– Non-Voting Shares—Proxy/Information Statement Required?
– S-K Item 404—Is the Spouse of a Stepchild a Related Person?
– More Item 404—Calculating the “Amount Involved” When a Family Member is an Employee of the Issuer
– S-K Item 402—Options Assumed In Merger—Which Compensation Tables Do They Go In?
– When to Include Post-FYE Deferred Bonus in Non-Qualified Deferred Compensation Table
– Not Filing the Proxy Statement Within 120 Days After Yearend—Follow-Up on Delinquent 1934 Act Reports and S-3 Use/Eligibility
We have just posted a complimentary copy of our “Summer 2007″ issue of Compensation Standards. This issue includes articles on:
– The Debate Over “Say on Pay”
– Independence of Compensation Consultants: A Growing Issue
– Severance and Termination Payouts: A Whole New Ballgame
– Respected Consultant Calls Severance and CIC “Huge Embarrassment for Corporate America”
– The True “Walk Away Number”
– Leading By Example: The True Leaders Speak Up
You might ask: Why do we give this newsletter away for free? Because we believe in responsible compensation practices. Learn more about how to implement responsible practices by registering for our upcoming “4th Annual Executive Compensation Conference.” This Conference provides practical “how to implement” guidance – unlike any other conference.
Third Circuit Court Weighs In: The Attorney-Client Privilege in the Parent-Sub Context
A few weeks back, the U.S. Court of Appeals for the Third Circuit issued a noteworthy opinion – In re Teleglobe Comm’cns Corp., No. 06-2915, (3rd Cir. 7/17/07) – regarding the attorney-client privilege under Delaware law in the context of a parent-subsidiary joint representation. The case involved claims by subsidiaries against their former parent for abandoning them after they started faltering.
The Third Circuit held that a parent could not be compelled to produce documents on the ground that the parent and subsidiary were jointly represented. The Court reasoned that the sub cannot unilaterally waive a joint privilege with its parent – and that the parent’s consent would also be required to waive the joint privilege. We have posted a copy of the opinion and related memos in our “Attorney-Client Privilege” Practice Area.
Rule 3500? Ah, That Rule 3500…
In this recent installment of “The Sarbanes-Oxley Report” – entitled “Rule 3500 is a Crock” – Billy Broc provides some critical analysis of Rule 3500. If you don’t recall Rule 3500, this is an important rule and I recommend that you have a summer associate look it up immediately. (And it’s coincidental that “3500” is the Office of Chief Counsel’s voicemail extension.)
Internal Controls Update: AS #5, Management Reports and All that Jazz
We have posted the transcript from our recent webcast: “Internal Controls Update: AS #5, Management Reports and All that Jazz.”
I know a lot of people have been waiting a long time for the Government Accountability Office’s report on the state of the proxy advisor industry. The GAO report – which had been requested by two members of Congress – was finally released to the public on Monday.
I guess the big surprise from the report is that there really was not much in the way of surprise. It appears that the primary purpose of the report was to hone in on ISS’ conflicts of interest (ie. taking on both investors and issuers as clients). But since ISS fully discloses its conflicts – and investors told GAO that it was comfortable with these conflicts – this proved to not be much of an issue for the report.
Here are some of the GAO’s reports “notables”:
1. There are over 28,000 public companies worldwide that send out proxy statements with over 250,000 separate issues. Nice stats to know. (pg. 6)
2. Most institutional investors report conducting due diligence to obtain reasonable assurance that ISS is independent and free from conflicts. But in many cases, this consists of just reading ISS’ conflict policy. (pg. 11)
3. Other potential conflicts consist of owners that do other business to issuers and investors (and the owners of advisory firms serving on boards of other companies). To me, this is the real conflict risk that exists in the industry. (pg. 11-12)
4. A chart shows how dominant ISS is within the industry, with more clients than the other 4 proxy advisory firms combined. I have to admit I had not heard of Marco Consulting Group before – and its been around nearly 20 years. (pg. 13)
5. Many of the investors that GAO contacted said that they do not vote their proxies; they hire asset managers to do that for them. (pg. 21)
So What Did the GAO’s Proxy Advisor Report Miss?
I would not place much stock in commentary that the GAO report means that ISS’ influence is overblown; if you have any actual experience with shareholder meetings, you know that ISS’ recommendation often is the difference between a controversial matter being approved by shareholders or not. So as many members e-mailed me yesterday, when it comes to ISS’ influence on votes, the report does not ring completely true.
Here are some “beefs” that members have sent me regarding the report:
1. Failure to interview impacted constituents – It appears that the GAO failed to talk to anyone other than investors and regulators. What about other key players? The issuer community? The proxy solicitors? Investor relations personnel?
2. Flying at a “1000 foot” level – One gets a sense that the GAO investigators didn’t really learn much. For example, the report mentions that issuers feel the need to get help from ISS to get a favorable recommendation – but then leaves it at that – without exploring what that means. The report should have clarified that this isn’t a “pay to play” (ie. vote buying) situation – and it also should have explained that the bulk of ISS’ corporate consulting money comes from equity plan design; not helping with governance rating (ie. CGQ) scores.
Given the influence that ISS has on institutional shareholders – coupled with the proprietary equity plan methodology that ISS uses – many issuers feel pressure to sign-up for ISS’ consulting services to make sure their plan will be approved by shareholders.
3. Understating the extent of ISS’ influence – In footnote 14, the GAO cites a recent study that examined the extent to which recommendations can influence vote outcomes and stock prices. But the report didn’t delve further into that important topic. Any proxy solicitor will tell you that ISS’s influence on voting issues can often be as high as 25% of the shares outstanding.
A prime example of ISS’ influence is the bumps felt by recent private equity deals when ISS recommended voting against them (egs. Clear Channel, Biomet). Not that that is a bad thing for shareholders, but it illustrates ISS’ influence.
4. Lack of investigative research – A big flaw in the report was taking at face value that many of these institutional investors said they make independent decisions. Yes, some do. But how many of them, when asked, would be expected to say: “Yep, most of the time I just vote the way they tell me.” Not any of the smart ones, because they have a fiduciary duty to vote.
Remember that most of these investors hold positions in thousands of companies; it would be a monumental task to conduct independent research about each item for each issuer’s ballot. To do so, an investor would have to have a staff along the lines of a proxy advisor to adequately do the job. The reality is that investors are trying to keep their expense ratios down – and even the larger investors typically have only a few employees dedicated to vetting voting issues.
5. Misses the “real” barrier to entry – Although the report talks about barriers to competition, it ignores the real issue connected with that topic: vote execution. No sane institutional investor is going to assume the risk inherent in moving thousands of accounts and ballots from ISS to another provider. The chance that accounts would be lost, not voted, or voted incorrectly is far too great. An ISS competitor has a rough road to try to duplicate the sophisticated vote execution platform that ISS has built over the years.
6. Short shrift to looming conflict issue – One wonders if the conclusions of the GAO report change if the rumors are true that ISS’ parent company, RiskMetrics, goes public?
I don’t blame the GAO for missing the boat; this is a complex area to tackle if you don’t have any “hands on” experience. They did better than the Washington Post, which ran an article yesterday on the GAO report with a picture of the ISS executive team from about six years ago -including Ram Kumar, who was infamously ousted because he had represented himself as a law school graduate to ISS, a degree he did not possess…
PCAOB Inspection: KPMG Not Up to Snuff on Testing
Last week, the PCAOB released its report related to a 2006 inspection of KPMG and cited the firm for 14 audit deficiencies, which occurred at seven clients. The deficiences included the failure to identify accounting errors and material weaknesses in internal controls. As noted in this CFO.com article, the firm had not identified and reported in material weaknesses on audits as it fell behind in its testing. Perhaps the pressure that Congress and the SEC has brought to bear on audit firms to reduce testing could have a systemic impact?
Our August Eminders is Posted!
We have posted the August issue of our complimentary monthly email newsletter. Sign up today to receive it by simply inputting your email address!
Since we continue to get so many questions about voluntary e-proxy, I have decided to hold an emergency webcast – “Broadridge Speaks: Demystifying E-Proxy’s Implementation” – next Tuesday, August 7th, so that senior Broadridge executives can explain the nitty gritty about how they will help implement e-proxy.
Broadridge (formerly known as ADP) is driving the e-proxy process and will address all the items on this detailed agenda during the webcast. This is a great companion program for our popular June 2-hour webcast on e-proxy (audio archive and transcript now available).
Posted: “Mandatory” E-Proxy Adopting Release
Last Thursday, the SEC finally posted its adopting release regarding universal e-proxy. You may recall the Staff has been avoiding using the term “mandatory” with this rulemaking because that term implies that a company would have to deliver electronically. This is not true, companies can still deliver in paper under universal e-proxy – the only thing mandatory about it really is that companies will have to post their proxy materials on their website. And most companies already do that. The other change wrought by universal e-proxy is that the proxy materials would have to include another half-page worth of content, the “Notice of Internet Availability of Proxy Materials.”
There continues to be a lot of misinformation out there about what mandatory e-proxy really means. In fact, there even is a bit of misinformation out there about voluntary e-proxy. I hear that some folks are recommending that companies sit out the first couple of years to see how things shake out. Remember that significant cost savings are available – although the calculations can be complex – and that a bi-furcated approach is allowable (ie. you can deliver paper and use access for different shareholders). Tune in to next Tuesday’s webcast to learn more about how to conduct your e-proxy cost-benefit analysis.
Last Call: Executive Compensation Disclosure Tips
Don’t forget that the deadline for our new game – “Executive Compensation Disclosures: 51 Tips” – is this Wednesday, August 1st (we will accept stragglers). We have had many great tips submitted so far, as well as some funny and curious ones. But we know a lot of you out there have more.
What’s In It For You? Four things:
1. You participate in a fun game.
2. You learn practical tips to improve your compensation disclosure skills.
3. You share some practical tips with an eager audience.
4. You achieve fame (if you want). You get points and – if you are one of the five top scorers – get your name placed in the Hall of Fame. If you wish to remain anonymous, that is fine too. No one will be acknowledged publicly unless they consent.
How to Play: Send us some practice tips on how to best navigate or improve the compensation disclosure drafting process or draft better disclosures, including things that you have seen a lot of companies do wrong this proxy season. Keep your tips brief (three or four sentences and not more than 50 words). Send us at least one tip and not more than five tips before the deadline.
How to Win: Any tip earns you 10 points. The best tips receive a bonus score of 50 points, the second-best ones earn 30 points, and the third-best ones earn 15 points. If you are among the top five scorers, your name is added to our Hall of Fame (if you consent to being named). All participants will be sent an email with their point total.
How to “Cheat”: Reflect on your own experience and derive important tips. We also encourage you to borrow ideas from your friends and coworkers. This really isn’t cheating – but my kids are always looking for the “game cheats,” so I felt compelled to act like there might be “cheats” involved.
How to Send Your Tips: Just email them to broc@naspp.com. Remember the limit of five tips. The deadline is close of business on Wednesday, August 1, 2007.
Late Friday, the SEC posted its dueling shareholder access proposals: this proposing release that would turn back the clock on Rule 14a-8 regarding director elections (even though some have called it the “status quo”) – and this proposing release that would give 5% shareholders the ability to submit binding bylaw amendments regarding access. We have begun posting memos regarding these proposals in our “Shareholder Access” Practice Area.
Such a quick turnaround from Wednesday’s open Commission meeting is odd given that the SEC still hasn’t posted a press release about these access proposals, something that traditionally happens no later than a day after the related open Commission meeting. As one member remarked, this is almost as unexpected as the posting of the release that amended the executive compensation rules just before Christmas.
Congrats to Corp Fin Staffers Lily Brown, Tamara Brightwell and Steven Hearne for shepparding these proposals through the SEC HQ. Having witnessed the “aircraft carrier” proposal being pushed out a decade ago, I know moving controversial proposals through HQ can’t be easy…
Today Marks 5th Anniversary of Sarbanes-Oxley
Today is the fifth anniversary of the signing of the Sarbanes-Oxley Act into law. I have a long tradition of marking this occasion by either barely blogging or not blogging at all, as it cause for those of us in the legal publishing business to celebrate as a piece of “full employment” legislation…
Are the Reviews Funnier Than the “Billy Broc” Videos?
Dave and I started the celebration of the 5th anniversary early last month, with the launch of our “The Sarbanes-Oxley Report” videos. Some of the comments on them have been pretty hilarious. Here are my three favorite so far:
– “Billy Broc EP was raw, pilot grade episode. Dave in the suit and looking scared for his career works as the straight guy to the LSD scarred Billy Broc. You guys damaged some stiff securities lawyers out there, who won’t be the same hereafter.”
– “I like your new S.E.R.I.O.U.S. video, if I play it backwards will I find out the hidden meaning of S.E.R.I.O.U.S. (or if I spin my computer monitor at a certain speed while reciting the ’33 Act?) The best I could come up with is: “Shareholders Exercising Rights In Our United States” but I bet you or your readers can think of something better…”
– “I wanted to thank you for providing your profound commentary in “The Sarbanes-Oxley Report.” In the midst of preparation to deliver a firmwide training session on the new e-proxy rules, I cannot tell you how helpful it will be to incorporate your sagacious insight into my training materials. The corporate department of our firm (and the securities bar in general) owes a debt of gratitude to “Billy Broc” and “the Animal” for raising awareness and sparking serious debate on the crucial issues of the day. Your thought leadership will make a significant contribution to the development of the securities laws. Please keep up the good work!”
What Song Is It That You Want to Hear?
Maybe “Free Bird”? Anyways, here are the results from our recent survey on what types of issues that you want to see addressed by “Billy Broc” and Dave “The Animal” going forward:
1. What is the oddest thing about the first installment of “The Sarbanes-Oxley Report”?
– I thought “Billy Broc” would have bigger teeth – 22.6%
– Dave “The Animal” smells pretty nice – 35.5%
– I thought this video would have real members of Congress involved – 25.8%
– The whole thing is completely ridiculous, geesh… – 16.1%
2. Future installments should tackle the topic(s) of:
– The future of backdating litigation – 23.3%
– The future of shareholder access – 50.0%
– The future of the world – 70.0%
– The future of the legal profession – 30.0%
The SEC has finally approved the consolidation of the member firm regulatory functions of the NASD and the NYSE. This combined organization will be responsible for regulating all securities firms that do business with the public, as well as operating things like trade reporting facilities and other over-the-counter operations. The new self-regulatory organization also regulates The Nasdaq Stock Market, the AMEX, and the International Securities Exchange under contracts with those organizations. NYSE Regulation, Inc. will continue to be responsible for the regulatory oversight of trading on the NYSE. This regulatory consolidation will not affect the individual exchanges’ regulation of their own listed companies.
The new SRO will be called the Financial Industry Regulatory Authority, or FINRA. It was originally contemplated that the entity would be known as the Securities Industry Regulatory Authority, or SIRA. Unfortunately, as this WSJ article notes, SIRA sounded too much like the Arabic word commonly spelled Sirah, which refers to the biographies of the Prophet Muhammad. After receiving complaints from those who found the SIRA acronym offensive, the already embattled regulator quickly scrapped the name in favor of the more catchy “FINRA.”
Now FINRA is coming under fire, as the National Association of Professional Financial Advisors (with an acronym of NAPFA that doesn’t exactly roll off the tongue) complained in a press release that investors will be confused by the broad scope of the new regulator’s name. NAPFA believes that the sweeping name implies FINRA will have authority over all professionals offering financial products and services, when in fact FINRA has no regulatory sway over financial planners and registered investment advisers. A similar complaint was raised by the Financial Planning Association (FPA).
Caught up in the spirit of all this complaining, I will register a couple of my concerns with this new name. First off, if you didn’t know any better, it sounds like the Financial Industry Regulatory Authority regulates the SEC, rather than the other way around. Second, I am not too crazy about the term “authority.” I guess it reminds me too much of names like “port authority.” Ultimately, I suppose the name won’t matter too much as long as this new SRO regulates the industry in a way that promotes investor confidence in our brokers and markets.
Reverse Mergers: Latest Developments
We have posted the transcript from our recent DealLawyers.com webcast: “Reverse Mergers: Latest Developments.”
Using Technology to Manage Rule 10b5-1 Plans
In this podcast, Greg Besner of Restricted Stock Systems provides some insight into how the latest technologies can facilitate administering Rule 10b5-1 plans, including:
– What are the latest tweaks to the Restricted Stock System’s compliance software?
– How does it work with Rule 10b5-1 plans?
– What questions do clients typically ask regarding these plans and your software?
Hotel Nearly Full: Call Now
Even though we are several months from the Conference dates, the San Francisco Marriott is nearly sold out for all nights related to these four Conferences:
Here is information about Hotel/Travel Discounts; use this to make your reservation TODAY – and make sure you mention the NASPP to get a discount.
If you call for a room and the Marriott tells you it is sold out, we have reserved rooms at the Westin Market Street (which is located on the same city block as the Marriott). If you are having any problems at all, it is important that you contact us at info@compensationstandards.com or 925.685.5111. Of course, you should also register for the Conferences you plan to attend.
Member Appreciation Package: For those watching via webcast, don’t forget the Member Appreciation Package to catch these October Conferences by video webcast.
Catch Corp Fin Director John White and Associate Director Paula Dubberly talk about how you should be preparing your executive compensation disclosures for next proxy season, among many other hot topics and key speakers. This will be three days of practical guidance that you will want to refer to over and over again.
It was high drama over at SEC headquarters yesterday, as the Commissioners staged a lively debate about how best to address the issue of shareholder access to company proxy materials. Much like the situation with pre-release “spoilers” about “Harry Potter and the Deathly Hallows,” the SEC’s approach on this front was widely anticipated – as it appears that the major newspapers may have had more time than perhaps some of the Commissioners to review the draft releases. Here is Corp Fin’s opening statement.
The SEC took the unusual step of approving alternative proposing releases going in opposite directions. The 3-2 votes on both releases were right along party lines, except for Chairman Cox, who, in a remarkable display of dexterity, voted for both proposing releases. While this two-track approach will certainly buy some more time in what has already been a long and drawn out process since last fall’s AFSCME v. AIGdecision, it is not clear at this point how the SEC will ever decide on which approach to adopt or whether it will adopt any approach at all. It is hard to imagine that commenters will sway the Commissioners from their hardened positions, particular since most of the pros and cons of these proposed approaches have already surfaced through the extensive comments on the 2003 access proposal and in the more recent Proxy Roundtable Month.
The actual details of these proposals are of course still a little sketchy – perhaps even for the Commissioners who voted on them. Commissioner Nazareth complained at the open meeting about the fact that she had received a brand new draft proposing release on Tuesday which she termed the “Shareholder Non-Access Proposal.” Given the amount of time that the SEC has been considering these issues, it is certainly notable that the proposals were so fluid in advance of the meeting.
Rep. Barney Frank (D., Mass.) promised back in June that the House Committee on Financial Services will hold hearings on shareholder access once the rules are proposed. Yesterday’s alternative proposals should give the Committee plenty to talk about. We can only hope that the SEC’s indecision on this issue does not result in some sort of rash Congressional action that could ultimately make life more difficult for both companies and shareholders.
Status Quo versus Access by Significant Shareholders
Based on the Staff’s description, one of the proposing releases debated at yesterday’s meeting looks like something that the SEC might have done last fall, when the agency confidently announced that it was calendaring a proposal to address the uncertainty created in the wake of the AIG decision. This proposing release will include a Commission interpretation of Exchange Act Rule 14a-8(i)(8) confirming the long-standing position that companies may exclude from their proxy materials any proposals that would result in an election contest, or that would initiate a process whereby shareholders could conduct a future election contest by requiring that the company’s proxy materials include director candidates nominated by shareholders. The proposing release will also include proposed changes to the text of Rule 14a-8(i)(8) reflecting the Commission’s interpretive position.
The second proposing release will contemplate a fairly straightforward procedure that would enable significant shareholders to include binding access proposals in company proxy materials. Chairman Cox noted at the meeting that lessons were learned from the aborted effort to adopt a new Rule 14a-11 governing shareholder access back in 2003, and the same mistakes were to be avoided with these proposed amendments to Rule 14a-8. Under the proposed amendments, a shareholder would be able to include a shareholder nomination bylaw proposal in the company’s proxy materials only if:
– the proposal relates to a change in the company’s bylaws that is binding on the company if approved;
– the proposal is submitted by a shareholder or shareholder group that has continuously held more than 5% of the company’s securities for at least one year; and
– the shareholder or shareholder group is eligible to, and has, filed a Schedule 13G that would contain expanded disclosure about the shareholder proponent(s) and the proponent(s) and prior interactions with the company (Schedule 14A will also require this comprehensive disclosure).
Not surprisingly, the release is going to include proposed amendments to the proxy rules that would encourage the use of electronic shareholder forums, a much-maligned approach that was floated during the May proxy roundtables. Finally, the proposing release will include questions about the Rule 14a-8 process generally, which could potentially open the door for broader changes to shareholder proposals.
Some further insights on the shareholder access proposals are provided by good ole’ Billy Broc in this week’s Sarbanes-Oxley Report entitled “Shareholder Access: S.E.R.I.O.U.S.” Watch the short vidcast through to the credits (if you can bear it) for a special treat.
SEC Adopts the PCAOB’s Auditing Standard No. 5
One highlight of yesterday’s meeting is that the SEC hopefully closed the book on the most contentious aspect of the Sarbanes-Oxley Act’s implementation, by approving the PCAOB’s Auditing Standard No. 5 governing the audit of internal controls. Everyone is counting on this shorter, more principles-based and less prescriptive auditing standard as providing the basis for more reasonable and appropriately scaled audits of internal controls. The PCAOB has pledged to focus on ensuring that implementation of this standard by auditors is consistent with everyone’s noble vision, and the SEC has said it will keep up the heat on the PCAOB through the SEC’s oversight of the PCAOB inspection process. Here is Corp Fin Director John White’s opening statement.
The SEC also adopted a definition of “significant deficiency” for the purposes of SEC rules. Surprisingly, no 3-2 vote there.
Concept Release on Use of IFRS by US Companies
The SEC also voted to publish a concept release that will solict comments on the topic of permitting US issuers to prepare their financial statements using International Financial Reporting Standards as published by the International Accounting Standards Board. This concept release is going to be out for an unusually long 90-day comment period.
Earlier this month, I blogged about the potential Section 404 delay for non-accelerated filers that could result from the so-called Garrett-Feeney amendment to the Financial Services and General Government Appropriations Act (H.R. 2829). While the appropriations bill (including the Garrett-Feeney amendment) quickly passed in the House and was referred to the Senate, nothing further has apparently happened with the piece of the legislation regarding Section 404.
The Garrett-Feeney amendment specifically provides that “[n]one of the funds made available under this Act may be used by the Securities and Exchange Commission to enforce the requirements of section 404 of the Sarbanes-Oxley Act with respect to non-accelerated filers, who, pursuant to section 210.2-02T of title 17, Code of Federal Regulations, are not required to comply with such section 404 prior to December 15, 2007.” I thought that the language of this legislation was curious, because to date there really has been little evidence of SEC efforts to actually enforce the requirements of Section 404. In fact, I think that the SEC has generally sought to make implementation of Section 404 go as smoothly as it possibly could by not resorting to more drastic measures – such as delistings and Enforcement actions – as the means for compelling companies to finish their internal control assessments on time.
This “honeymoon” period with Section 404 may be coming to an end, as it looks like there is at least one ongoing Enforcement investigation involving a company that may not have completed its Section 404 work when required. In a Form 8-K filed last December, Hawk Corporation announced that the SEC Staff had made an informal inquiry requesting information about: Hawk’s preparations for complying with Section 404; transactions in the company’s common stock on June 30, 2006 by a stockholder not affiliated with the company and the impact of those transactions on when Hawk needed to comply with Section 404 (Hawk notes on its Form 10-K that it is a non-accelerated filer – therefore, it would have to complete its first Section 404 internal control assessment for next year’s 10-K absent any further extension); and communications between Hawk and a third parties regarding Section 404 compliance. Hawk also noted in the Form 8-K that it had been contacted by the Justice Department regarding that agency’s related investigation of the company. At the end of May, Hawk filed another Form 8-K announcing that Enforcement had obtained a formal order to investigate this matter, which was expanded to look at the company’s maintenance and evaluation of effectiveness of disclosure controls and procedures and internal controls over financial reporting, as well as Hawk’s periodic disclosure requirements related to these matters.
There is no telling if the SEC or DOJ will ultimately bring any charges as a result of their investigations, but Hawk’s situation certainly signals that, nearly five years following enactment of Sarbanes-Oxley, any forbearance in actually enforcing the requirements of Section 404 has probably run its course.
PCAOB Proposes Independence Rule Changes
Yesterday, the PCAOB proposed a new ethics and independence rule entitled “Communications with Audit Committees Concerning Independence.” This rule would replace the PCAOB’s interim independence requirement, Independence Standards Board Standard No. 1 (and two related interpretations), and would require independence communications with the audit committee prior to commencement of an engagement and then annually for continuing engagements. The Board also proposed amendments to current PCAOB Rule 3523, “Tax Services for Persons in Financial Reporting Oversight Roles,” as a follow-up to a favorably-received concept release issued earlier this year.
As Edith Orenstein notes in FEI’s “Financial Reporting” Blog, the proposed amendments to the tax services rule “would exclude the portion of the audit period that precedes the beginning of the professional engagement period, from being deemed a ‘prohibited service’ under Rule 3523. As explained by PCAOB Assistant Chief Auditor Bella Rivshin, this will be accomplished by striking the words “audit and’ from the current text of Rule 3523. A number of PCAOB board members said they support this proposal, as it would not unduly limit choice among potential audit firms based on tax services provided to individuals at the company prior to commencing the audit engagement. PCAOB staff noted that registered audit firms would be still need to look at facts and circumstances and determine if independence is impaired under the SEC’s audit independence rules.”
The FEI Blog goes on to note that the proposed new rule on independence communications with the audit committee would “change the threshold of what needs to be communicated from matters which – in the auditors’ professional judgment – could impair independence, to matters that a reasonable investor (i.e. third party) may perceive as impairing the auditors’ independence.” The PCAOB will seek comment on whether there should be a specific look-back period for providing information about services that could impair independence, as well as the extent to which information about the independence of non-affiliated secondary auditors must be included in the communications with the audit committee.
These PCAOB proposals will be out for a 45-day public comment period.
Chuck Nathan on Appraisal Rights
In this DealLawyers.com podcast, Chuck Nathan of Latham & Watkins provides some insight into a recent Delaware case – In re: Appraisal of Transkaryotic Therapies(Del. Ch. Ct., 5/2/07) – dealing with appraisal rights, including:
– What happened in the recent Transkaryotic Therapies case?
– How might the case impact appraisal rights going forward?
– What might it mean in terms of the strategies that hedge funds pursue?
While yesterday’s blog provided an example of one professional’s good fortune to dodge serious sanctions for securities law violations in two separate cases, I don’t think that means the SEC is likely to be going soft on “gatekeepers” any time soon, particularly when the gatekeepers have a direct hand in the violations. This is probably no better demonstrated than in an action the SEC filed earlier this year against Enron’s former in-house attorneys. The defendants in this ongoing civil case are Jordan Mintz, who was an in-house Enron tax lawyer and ultimately General Counsel to Andy Fastow’s Enron Global Finance department, and Rex Rogers, who was Enron’s principal in-house securities lawyer and a former SEC Staffer. In the complaint, the SEC charged both lawyers with primary violations of anti-fraud and reporting provisions. Mintz was also charged with books and records violations and lying to auditors, while Rogers was charged with aiding and abetting Ken Lay’s violations of Exchange Act Section 16(a).
This case focuses on violations arising from Enron’s failure to disclose, or to otherwise adequately disclose, related party transactions pursuant to Item 404 of Regulation S-K, as well as under the financial statement requirements. The allegations focus on efforts by the lawyers to hide the nature and scope of the related party transactions occurring between the company and the LJM partnerships, as well as the role of Enron executive officers in the transactions. As Enron’s stock price declined in 2001, pressure to avoid disclosure about the details of the related party transactions increased, and the lawyers are alleged to have come up with ways to delay or avoid the required disclosures, or ways to have omit or misrepresent material facts when disclosures were made. The SEC is going all out in seeking disgorgement, civil money penalties and officer and director bars in this proceeding.
Even though the outcome of this case is yet to be decided, the complaint in this matter is notable for its descriptions of the ways in which the in-house lawyers allegedly participated in the scheme to avoid disclosures – including their efforts, as Mintz wrote in an email to Rogers “to be ‘creative’ on this point [disclosure of Fastow’s compensation from the LJM partnership] within the contours of Item 404 so as to avoid any type of stark disclosure, if at all possible.” [Are people still writing emails like this?]
With the clock ticking, this case may be among the last that we will see filed against Enron defendants. Given that the SEC has pursued relatively few notable related-party transaction cases in the past, this one is certainly a must-win for the SEC.
The New Related Person Transaction Disclosure Rules: Life After Enron
The efforts to be “creative” at Enron likely had a big hand in shaping the changes that the SEC made to Item 404 of Regulation S-K last summer. In this way, the Enron complaint is a good guidance for what not to do when preparing your related person transaction disclosures under the new rules.
While Item 404 had really been a principles-based rule before “principle-based” was cool, the SEC attempted to make the rule more principles-based by stripping off some of the instructions and provisions that it thought could lead to outcome-oriented, tortured readings of the rule. The SEC also very purposely revised the wording to broaden the requirement, changing the old “related party” to “related person” and calling for disclosure if a company is a “participant” in (rather than a “party” to) a transaction. As the Staff has noted, these changes were designed to elicit disclosure about more than just contractual parties, and should reach arrangements – such as the side deals highlighted in the Enron complaint – that are not necessarily memorialized in deal documents or signed up on a dotted line.
The SEC also tried to clarify the broad scope of the term “transaction” as used in Item 404 – a transaction is defined to include, but not be limited to, any financial transaction, arrangement or relationship (including any indebtedness or a guarantee of indebtedness) or any series of similar transactions, arrangements or relationships. The new rules also make it much clearer that you have to disclose the dollar value of the amount of the related person’s interest in the transaction, which is to be computed without regard to the amount of profit or loss, removing the “where practicable” exception from the rule that could be used to creatively avoid disclosure.
The SEC also expanded the related persons covered by the rule to include stepchildren, stepparents and any person (other than a tenant or employee) sharing the household of a related person. The rule now requires disclosure of transactions involving the company and a person (other than a significant shareholders or immediate family member of a significant shareholder) that occurred during the last fiscal year, if the person was a “related person” during any part of that year, in an apparent effort to prevent folks from avoiding the disclosure requirements by artificially timing transactions or appointments. Finally, the SEC seemed to adopt the Item 404(b) disclosure requirement regarding review and approval of related person transactions as a means of encouraging companies to adopt some management or director oversight of related person transactions, which was starkly lacking at Enron based on the allegations in the complaint.
Compliance with Item 404 has always been tough, because the rule requires significant materiality judgments about very sensitive transactions, without a lot of helpful guidance or parameters. Following the SEC’s efforts to “streamline and modernize” the rule, compliance was certainly made even more difficult, now that some of the guidelines disappeared. Nonetheless, the principles-based nature of the rule is not going to prevent folks from figuring out creative ways to avoid sensitive disclosures, nor will it prevent the SEC from continuing to bring cases questioning judgments about related person transaction disclosures. Be sure to check out our “Related Party Disclosures” Practice Area and our “Related Party Transactions” Practice Area for the latest developments in this area.
Early Bird Expires Tomorrow: 3rd Edition of Romeo & Dye Section 16 Treatise
Peter Romeo and Alan Dye are hard at work updating their two-volume Section 16 Treatise. The Treatise is the definitive work in this area with thousands of pages of reference material.
Order your set by tomorrow, July 25th to receive a pre-publication discount now – you can order online or by fax/mail with this order form. The Treatise will be completed and delivered to you in the Fall.
For most senior executives, in particular top legal officers, an SEC action can often be considered the ultimate CLM – a Career Limiting Maneuver. Apparently that is not the case for David Drummond, who serves as Senior Vice President, Corporate Development and Chief Legal Officer of Google. With two SEC actions now behind him, Drummond seems to be going strong.
Last week, the SEC announced a settlement of its actions against four former executives of SmartForce PLC, its former outside auditor, and the company’s former audit engagement partner. In what boiled down to a revenue recognition case, the SEC alleged that SmartForce’s senior financial personnel had prepared financial statements that recognized revenue improperly from various types of transactions, including multiple-element arrangements, reciprocal transactions and reseller agreements. The SEC noted that Drummond, who served as Chief Financial Officer of SmartForce, was ultimately responsible for the financial statements and violated the Exchange Act reporting provisions by failing to determine whether SmartForce was improperly recognizing revenue on reseller agreements, failing to communicate information about a reciprocal transaction to accounting staff, and failing to determine whether the reciprocal transaction complied with GAAP. As noted in an article from Friday’s WSJ, David Drummond’s attorney stated: “In retrospect, Mr. Drummond acknowledges that he would have been better served in his role at SmartForce had he possessed an accounting background.” In the settlement, Drummond agreed to disgorgement and a civil penalty totaling over $600,000 plus a cease & desist order, but he faces neither an officer and director bar nor any improper professional conduct penalty.
David Drummond also got caught up in a 2005 SEC action involving Google’s failure to register employee option transactions under the Securities Act and to provide required information to option recipients. That proceeding focused on Drummond’s role, this time as General Counsel of Google, in determining whether Rule 701 or another Securities Act exemption applied to the company’s employee stock options transactions prior to its IPO. The company filed a rescission offer for those options transactions after it determined that the claimed exemptions were not available. In settlement of that Enforcement proceeding, Drummond agreed to a cease and desist order for Securities Act registration violations.
With those serving in the roles of General Counsel and Chief Financial Officer seemingly in the SEC cross-hairs with the recent spate of options backdating cases, these two cases demonstrate that settling an SEC action is not always the end of the world. You really need to examine the circumstances of each case, and the penalties imposed, in judging the overall impact of the case on the individuals involved.
Disclosing the SEC’s Enforcement Interest in an Executive Officer
The then-pending SEC investigation of David Drummond’s role at SmartForce surfaced shortly before Google’s high profile IPO back in 2004. The company’s prospectus included somewhat ugly disclosure about the Staff’s intention to recommend that the SEC bring a case against Drummond, and noted that the Staff had offered him the chance to make a Wells submission and that he intended to make such a submission.
This situation highlights the often difficult question: “When is the right time to disclose an SEC investigation against the company and/or one of its executive officers?” While Item 103 of Regulation S-K provides that governmental proceedings “known to be contemplated by governmental authorities” against the company need to be disclosed, Item 401(f) of Regulation S-K – which covers legal proceedings involving officers and directors – includes no such language about “contemplated” proceedings. Practices continue to vary as to when companies will choose to disclose pending SEC investigations involving a company, its officers and directors, although certainly a “Wells” call from SEC Staff is more likely today than ever to result in public disclosure about the investigation. In the absence of a bright-line test for determining when to disclose a pending investigation, some have criticized how long it takes for ongoing investigations to come to light. In fact, last summer an individual sent a rulemaking petition to the SEC asking that it adopt a rule requiring a Form 8-K filing shortly after the company receives a Wells notice. I suspect that, given all of the other things on Corp Fin’s plate and the general sense of “8-K fatigue,” this petition won’t be acted on anytime soon.
As demonstrated by the situation with David Drummond, disclosing the SEC’s interest in an executive at the Wells stage can result in disclosure that the company may have to live with for some time. Three years have gone by since the initial disclosure in Google’s IPO prospectus about the investigation, and Google has included the same disclosure in each 10-K for the last three years about the existence of the Wells request and Drummond’s Wells submission – with no update as to the status of the investigation. Had the case not been settled, this disclosure could have certainly gone on indefinitely.
For more information about disclosure of SEC investigations, check out our “FAQs re: Disclosure of Enforcement Proceedings” and our “Sample Disclosures of SEC Actions” in our “SEC Enforcement” Practice Area.
Posted: July-August issue of Deal Lawyers print newsletter
We have just sent our July-August issue of our new newsletter – Deal Lawyers – to the printer. Join the many others that have discovered how Deal Lawyers provides the same rewarding experience as reading The Corporate Counsel. To illustrate this point, we have posted the July-August issue of the Deal Lawyers print newsletter for you to check out. This issue includes pieces on:
– The Leveraged Buy-Out with a Public Stub: Deals So Far and Factors to Consider
– “I’ll Swap Two Derek Jeters and a Pack of Cherry Bazooka for Five Barry Bonds”
– Taming the Tiger: Difficult Standstill Agreement Issues for Targets
– Drafting Forum Selection Provisions
– The “Sample Language” Corner: Joint Governance Provisions in Merger of Equals Transactions
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