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- Recent developments demonstrate that the SEC Staff is taking to heart the “Open for Business” mantra propagated by political appointees from the recent change in administrations.
- The most significant development is the dramatic shift in receptiveness for waivers for audited financial statements where the production may be burdensome but not clearly material to investors. Such waivers are being granted specifically with respect to financial statements in cases of marginal significance tests or where fully audited financials would involve significant cost but not necessarily provide substantial incremental useful information.
- In addition, the Staff continue to emphasize eligibility for all filers (and not just “emerging growth companies” under the JOBS Act) to take advantage of confidential preliminary registration statements for IPOs as well as follow-on offerings occurring within one year of IPO.
- The number of Staff comments issued upon review of registration statements have declined significantly, in an effort toward a speedier path to encourage use of public markets.
- In a relative revolution in customer service, registrants are encouraged to call the Staff early in a process to potentially be granted relief without a labored, sclerotic timeline.
New Administration, New Focus
A change in administration has brought with it a new focus by the SEC to lessen regulatory burden on public companies. This comes as large private companies in recent years have increasingly eschewed the public markets. Such avoidance may have been for various reasons wholly unrelated to SEC regulation, and also may have been transient, given the advent of late of unicorns such as Uber that are openly espousing the benefits of public ownership. However, the SEC, to its credit, appears committed to ensuring that the Commission is not considered part of the problem – and “Open for Business” has become an overarching mantra at all levels.
Pain Relief for Accounting Waivers on Both M&A and Equity Markets
Accounting treatment can send chills through transaction participants. Two circumstances in particular have historically required fully audited financial statements – including potentially the painful need to recast prior year financials – even though their substantive worth was arguable. In recent public remarks, senior SEC accounting staff have highlighted two specific areas that in particular are the beneficiaries of increased relief in the form of accounting waivers, referred to as Section 313 waivers.
The first situation surrounds significance testing, which focuses on three tests: income, balance sheet and earnings. If any of these tests breaches the relevant significance threshold (beginning at 20% – a summary is available on our M&A checklist here), then various periods of audited financials are required. The tests are more complex than they necessarily appear on their face, involving look-back periods and twists and turns if a filer has been loss-making instead of income-recognizing. A common “foot fault” in significance testing is when a Buyer has marginal earnings per share (either negative or positive). In the situation where significance testing is not triggered with respect to the balance sheet or income tests, a relatively small and arguably immaterial transaction may trigger the earnings-per-share significance test due to rounding error. For example, if a Buyer with $0.01 EPS acquires a Target and rounding error pushes the Buyer to break-even (0) EPS, then even though the Buyer may have income and a strong balance sheet that dwarfs that of the target company, the Buyer could be required to file full financials, as the change in the EPS number on a relative basis is quantitatively material. The Staff have been explicit that in this situation they are open to discussions on the actual qualitative materiality and facts and circumstances of the transaction, and have been granting waivers for precisely this situation.
The second scenario involves where a Buyer may purchase a carved-out business from a Target, but the business was not previously held separate by the Target and thus fully audited carve-out financials are burdensome in cost and time. While the Staff may still (reasonably) request a high-level summary of the financial impact of the transaction, such as aggregate assets purchased and liabilities assumed, they may waive requiring fully broken-out financial statements with various sub-categories that would entail substantial upfront accounting judgments and work, but would thus conform completely with GAAP.
Equity Registration – Greater Availability, Easing of Comments
Further, the Staff has reinforced its relatively recently changed rule that confidential preliminary filings are available to all IPO candidates, as well as for follow-on offerings that occur within one year of IPO. While “emerging growth companies” under the JOBS Act were already eligible for this, expanding it to large enterprises means that the large unicorns that may be considering going public will also be able to avail themselves of starting the process in private.
Moreover, practice in the past year has indicated a substantial reduction in the sheer volume of Staff comments on registration statements relative to historical norms. During the technology IPO boom of the late 1990s, it was not unusual to receive a first Staff review comment letter with well over 100 comments. In recent months, that number may have fallen dramatically in a given offering – to the magnitude of 25 or so.
Call Them Early
As part of an overall initiative to encourage interaction with the regulator, the SEC is explicitly inviting early discussion of waiver requests or other areas of particular concern. SEC officials have noted that in more than one case, a Buyer could have avoided the cost and time delay of a lengthy treatise letter from outside counsel by simply calling the Staff first. Moreover, the Staff publishing the telephone numbers for key waiver request areas in the Commission’s Financial Reporting Manual.
These tweaks are cumulatively important – and at the same time, the Staff appears to continue with its statutory duties to protect investors, lately and most notably including its growing levels of concern on the increasingly frothy and grey-operating world of initial coin offerings. With respect to bread and butter regulation of equity offerings, clearly the Commission is focused on tweaking the regulatory formula to grease the wheels of offerings, with the intended effect of stimulating what has been a relatively lackluster crop of offerings in recent years.
A perfectly legal, but on its face very predatory, practice is increasingly hitting major public companies and likely confusing and taking advantage of their small individual investors: the “mini” tender offer. Thus far, the practice has hit Silicon Valley household names, particularly in the past year, such as Gilead (2011), Intel (2013), PayPal (2015), Yahoo! (2015) and AT&T (2015), all of which issued press releases recommending against these dubious tenders. READ MORE
Check under the “Resources” tab for the following downloadable PDF documents, updated for 2014:
M&A Issues Checklist
Short Primer on Public Company Issues
Public Company Reporting Checklist
At a recent meeting, a senior Securities and Exchange Commission official reviewed various aspects of interest for public company reporting and compliance purposes. As is customary, such Staff comments were on a non-attribution basis and were represented to be personal views only and not those of the SEC as a whole. Nonetheless, such informal commentary continues to offer contextual perspective on both current matters and, equally important, indicates areas of less current significance at the SEC.
Notably, the Staff has been exceeding the Sarbanes-Oxley-mandated goal of reviewing financial statements at least once every three years. The Corporate Finance division has 500 members, a number that has not changed since before the adoption of Sarbanes-Oxley. The Staff reviews the largest companies annually and, in the case of financial services firms, reviews multiple times per quarter. The growing volume has led to a reduction in the sheer number of comments and an intentional emphasis on the judgment of the professional staff in both accounting and legal reviews.
In terms of substance, the focus remains on consistency, particularly among earnings calls, press releases and actual filings. In addition, the Staff has much greater access to third-party analyst reports. Staff are reviewing such reports when probing disclosure, such as MD&A.
Among the key points:
- LIBOR risk factor: The Staff member opined that only companies with material exposure to LIBOR-linked credit facilities or derivative instruments should contemplate a risk factor on the recent LIBOR scandal.
- Loss contingencies: The Staff understands the inherent uncertainty surrounding loss contingencies for pending litigation. At the same time, it views with skepticism sudden announcements of settlements that are not foreshadowed. In other words, having a string of public disclosure documents that goes from a complete lack of boundaries on a potential settlement to a finalized settlement in one fell swoop is problematic.
- Overseas cash: The Staff believes there needs to be sufficient disclosure of the amount of a reporting company’s cash stationed offshore and the potential tax cost to repatriate such cash back to the US.
- Cybersecurity: The Staff continues to pay close attention to publicly announced breaches of a reporting company’s computer systems. Once a breach has occurred, disclosures of risk factors should no longer refer to a breach hypothetically. At the same time, the Staff is cognizant of the need to keep disclosure of breaches at a generalized level without revealing potential vulnerabilities.
- Stockholder proposals at annual meetings: Net neutrality was the only new significant policy issue of this past year (that thus becomes a valid topic for a stockholder proposal). On the subject of verification of ownership for a stockholder’s eligibility to present proposal, the Staff continues to reinforce its existing guidance that a reporting company has a duty to describe in specific detail any potential deficiencies in the stockholder’s proof of stock ownership. For example, if a stockholder proposal presents proof from an introducing broker, rather than a clearing broker as required under current rules, then a reporting company should indicate the lack of a clearing broker, identify the relevant rule for reference and be responsive to attempts from the stockholder to correct the deficiency.
- Proxy plumbing: The Staff continues to consider an interpretative release regarding proxy advisory firms and, for example, to date has been interested in how such firms compose peer groups for comparison to a reporting company, in addition to any potential conflicts of interest involving such firms. However, beyond this limited area, the lack of bandwidth at the Staff continues to hamper a more thorough examination of the overall US proxy plumbing system.
While the controversial subject of conflicts minerals disclosure was raised, the Staff member demurred, given that the coming SEC meeting on the subject is August 22.
The SEC has released its final rule under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 concerning listing standards for equity securities (i.e. publicly traded companies) related to compensation committees.
The rule, published in the Federal Register on June 27, is divided into three key areas:
- the independence of compensation committee members
- their role in retaining and supervising outside compensation consultants and legal counsel and
- evaluation of potential conflicts of interest for outside compensation consultants and legal counsel, and disclosure of such conflicts in a company’s annual proxy statement.
The rule will be effective on July 27.
Within 90 days of June 27, the national securities exchanges (such as NYSE and NASDAQ) must propose changes to listing standards to the SEC for review.
Such listing standards must be finalized and adopted by the national securities exchanges by June 27, 2013.
Disclosure changes under Item 407 of Regulation S-K (described below) shall apply to any proxy or information statement for a meeting at which directors are elected occurring on or after January 1, 2013.
The cumulative effect of the changes to is to begin to apply similar, though less rigid, standards that are already applicable to audit committees and company auditors (evaluating auditor independence and compensation) to compensation committees, including their retention of advisers.
Compensation committee members not only must be independent, but further must meet heightened independence tests, be vested with the authority to retain outside advisers, and evaluate the independence of such advisers. However, there is no mandate per se that such advisers meet any specific independence test. Certain companies, such as those in bankruptcy, controlled companies and foreign private issuers who do not maintain a compensation committee, are exempted from one or more of the various provisions of the rule.
Compensation committee member independence
In addition to independence standards that already apply under NYSE and NASDAQ listing standards, the rule requires exchanges to maintain listing standards that require compensation committee members to meet heightened independence requirements that exchanges must develop based on relevant factors, including but not limited to:
- a director’s source of compensation, including any consulting, advisory or compensatory fee paid by the issuer, and
- whether a director is affiliated with the issuer, a subsidiary of the issuer, or an affiliate of a subsidiary of the issuer
While we wait to see what heightened standards exchanges elect to adopt, for the majority of public companies, such standards may not materially impact them. As these mandatory factors cover the same matters as the heightened independence standards for audit committees, it seems possible that exchanges may apply the same heightened standards to compensation committee membership. Accordingly, companies may wish to consider whether their compensation committees include any members who are “affiliates” of the company or who receive fees that would prohibit them from audit committee service, as such persons may also find themselves ineligible to serve on compensation committees.
Compensation consultants and outside counsel
The rule requires that the compensation committee has full discretion and authority to retain outside compensation consultants as well as independent legal counsel, although there is no mandate to retain either set of advisers. Compensation committees “shall be directly responsible for the appointment, compensation and oversight of the work of any compensation adviser retained by the compensation committee; and each listed issuer must provide for appropriate funding for payment of reasonable compensation, as determined by the compensation committee, to any compensation adviser retained by the compensation committee.” The compensation committee does not need to be directly responsible for compensation consultants, outside counsel, or other advisers retained by management.
Considering compensation consultant independence
The rule requires exchanges to adopt rules requiring compensation committees to consider Dodd-Frank’s five enumerated factors in evaluating the independence of a compensation consultant or other adviser, plus one additional factor. However, it is important to note that there explicitly is no requirement that the compensation consultant or other adviser to actually be independent. As a result, none of the enumerated factors constitute a “bright line test” for retaining a compensation consultant or other adviser. The six factors are:
- The provision of other services to the issuer by the person that employs the compensation consultant, legal counsel or other adviser
- The amount of fees received from the issuer by the person that employs the compensation consultant, legal counsel or other adviser, as a percentage of the total revenue of the person that employs the compensation consultant, legal counsel or other adviser
- The policies and procedures of the person that employs the compensation consultant, legal counsel or other adviser that are designed to prevent conflicts of interest
- Any business or personal relationship of the compensation consultant, legal counsel or other adviser with a member of the compensation committee
- Any stock of the issuer owned by the compensation consultant, legal counsel or other adviser and
- Any business or personal relationship of the compensation consultant, legal counsel or other adviser or the person employing the adviser with an executive officer of the issuer.
Item 407(e)(3)(iii) of Regulation S-K already now requires disclosure:
- identifying the consultants
- stating whether such consultants were engaged directly by the compensation committee or any other person
- describing the nature and scope of the consultants’ assignment, and the material elements of any instructions given to the consultants under the engagement and
- disclosing the aggregate fees paid to a consultant for advice or recommendations on the amount or form of executive and director compensation and the aggregate fees for additional services if the consultant provided both and the fees for the additional services exceeded US$120,000 during the fiscal year.
The final rule adds an additional disclosure obligation: “With regard to any compensation consultant identified in response to Item 407(e)(3)(iii) whose work has raised any conflict of interest, disclose the nature of the conflict and how the conflict is being addressed.”
The enumerated factors that the compensation committee must consider in retaining a compensation consultant or other adviser are among the factors that must be considered in determining whether a conflict of interest exists.
At a recent meeting, staff members of the Securities and Exchange Commission offered their views on a variety of public company disclosure and compliance issues.
As is customary, the Staff comments were on a non-attribution basis and were represented to be personal views only and not those of the SEC as a whole. Nonetheless, such informal commentary offers contextual perspective on both current matters and, equally important, indicates areas of less current significance at the SEC.
Currency and consistency in disclosures
The Staff continued to emphasize the need to avoid “boilerplate” disclosure. They noted that too often public reports (especially more generally staid language, such as that covering risk factors) are not reviewed afresh on a regular basis. Staff suggested that public disclosure teams (both legal and finance) convene at least quarterly to scrub disclosure and not take regular quarterly disclosures for granted. The process should not be relegated to an “it’s just another quarter” attitude.
In addition, following a recurring theme over the years, Staff members indicated the need for consistency among (1) press releases, (2) earnings releases and earnings call comments, (3) an issuer’s website and (4) periodic reports. To the extent that, for example, management goes into significant detail or emphasis during an earnings call on a particular issue, the expectation would be that the issue would also be addressed within the management discussion and analysis (MD&A) section of a periodic report.
Cybersecurity is receiving almost feverish regulatory attention these days. In the wake of several high-profile computer system breaches against major corporations, commentators have observed an upswing in Staff comments on periodic reports focused on cybersecurity.
The Staff informally reaffirmed that the trend was likely to continue, whether or not an issuer’s business was technology oriented. The SEC expects that a material breach of cybersecurity will be discussed in risk factors, particularly if the breach received public attention. Any prior incidents that may not have become public knowledge should be mentioned too.
Accordingly, issuers would be well advised to first determine whether mention of a cybersecurity risk factor on its own is warranted, separate from the typical generic risk factor bucket list dealing with the usual specter of calamities and business interruptions. In addition, any actual breach of cybersecurity and privacy information should be examined for public disclosure ramifications.
Although it is near the two-year mark since the SEC issued a concept release on the underpinnings of the proxy voting system used for publicly traded companies (colloquially referred to by the SEC and others as proxy plumbing), the SEC has failed to propose any clear rules. In fact, the Staff indicated that in light of other regulatory developments, including in particular the Jumpstart Our Business Start-Ups (JOBS) Act, it is unlikely that the SEC will have sufficient bandwidth to prioritize an omnibus concrete proxy plumbing rule proposal in the immediate future. This is unsurprising, given (1) the spaghetti-chart complexity of the current system, (2) the long tenure of the current system and thus its understanding among broad constituent groups and (3) the strong views of entrenched members of the current system, in particular the primary proxy intermediary.
However, the Staff did indicate that the SEC would likely take on the narrower subject of enhancing disclosure by proxy solicitation firms of commercial relationships among issuers and such firms. For example, there has been much public debate on the appropriateness of a solicitation firm, the most prominent example being RiskMetrics, providing consulting services to issuers on the same corporate governance topics for which it grades issuers for its financial firm customers. It would seem that, at the very least, the SEC will require that such proxy solitication firms will need to disclose their financial ties with issuers. Even more may be required.
That said, the subject is low-hanging fruit and will not provoke discussions anywhere as dramatic as those surrounding some of the current outside proxy plumbing proposals that approach proxy voting from a more generalized systemic viewpoint.