SEC UPDATE

SEC Adopts Final Rules for Disclosure of Hedging Policies. On December 18, 2018, the SEC approved final rules regarding the disclosure of a company’s hedging practices or policies, as mandated by the Dodd-Frank Act. This disclosure will be required in any proxy statement or information statement relating to the election of directors. The new rules, which will be set forth in a new Item 407(i) of Regulation S-K, require a company to describe any practices or policies it has adopted with respect to the ability of its employees and directors to purchase securities or other financial instruments (or otherwise engage in transactions) in connection with the hedging or offsetting of any decrease in the market value of equity securities granted as compensation, or held directly or indirectly by the employee or director. Companies have the option of either providing a fair and accurate summary of the applicable practices or policies or by disclosing the practices or policies in full. To the extent that a company does not have any such practices or policies, the rules will require the company to disclose that fact or state that hedging transactions are generally permitted. Companies are required to provide the new hedging disclosure for their first fiscal year beginning on or after July 1, 2019 (or July 1, 2020 for smaller reporting companies and emerging growth companies).

Disclosure Simplification Adopting Release. Effective November 5, 2018, the SEC adopted amendments to certain “redundant, duplicative, overlapping, outdated or superseded” disclosure requirements. The changes include substantive amendments to Regulation S-K and Regulation S-X. While the amendments work in large part to reduce a registrant’s disclosure requirements, certain registrants may find their disclosure requirements expanded due to a new requirement to include in quarterly reports certain disclosures about stockholders’ equity and noncontrolling interests that were previously only required in annual reports. Generally, the amendments to Regulation S-X and Regulation S-K eliminate certain disclosures where substantially the same information is also required to be disclosed under GAAP, International Financial Reporting Standards (IFRS) or other SEC disclosures. The result will likely be more streamlined disclosures, but not a reduction in the aggregate information required to be disclosed.

Cybersecurity Disclosures. In February 2018, the SEC issued an interpretive release making explicit its position that cybersecurity risks and incidents can be material issues triggering reporting obligations in registration statements, periodic reports and other filings as part of the disclosure of risk factors, management’s discussion and analysis, internal and disclosure controls, and descriptions of the company’s business and legal proceedings. Around the same time, the SEC initiated two first-of-its-kind enforcement actions against companies that had suffered cybersecurity breaches for (i) failure to report a cybersecurity incident, in the first instance and (ii) failure to maintain an up-to-date program for preventing identity theft, in the second instance.

Proposal to Reduce Financial Statement Requirements Relating to Guaranteed and Collateralized Debt. In July 2018, the SEC proposed amendments to Rule 3-10 of Regulation S-X that would ease the financial disclosure requirements applicable to registered debt offerings for guarantors and issuers of guaranteed securities, as well as for affiliates that collateralize debt offerings in which the affiliates’ securities are a substantial portion of the collateral. The proposed changes are intended to reduce compliance costs and burdens and allow for alternative disclosures in certain cases.

Possible Elimination of Quarterly Reporting. In August 2018, President Trump asked the SEC to study eliminating quarterly reporting. President Trump said that public companies should report their financial results twice a year instead of quarterly and indicated he ordered the SEC to study the feasibility of the proposal. While criticized by certain consumer groups, the proposal aligns with SEC Chairman Clayton’s deregulatory agenda to make the market more inviting for companies considering going public. On December 18, 2018, the SEC published a request for comments to solicit input on the nature, content, and timing of earnings releases and quarterly reports made by reporting companies, which will remain open for 90 days. In particular, the request seeks input on how the SEC can reduce burdens on reporting companies associated with quarterly reporting while generally maintaining (or even enhancing) disclosure effectiveness and investor protections. Additionally, the SEC is seeking comments on how the existing periodic reporting system, earnings releases, and earnings guidance, alone or in combination with other factors, may foster an overly short-term focus by managers and other market participants (i.e., “short-termism”).

Smaller Reporting Company Thresholds Amended. In June 2018, the SEC adopted amendments to the definition of “smaller reporting company” that became effective on September 10, 2018. Pursuant to the new definition, a company can generally qualify as a smaller reporting company if (i) it has public float of less than $250 million or (ii) it has less than $100 million in annual revenues and either no public float or public float of less than $700 million. As a result of these amendments, the number of companies that may qualify as a smaller reporting company is expected to increase significantly. These newly qualified smaller reporting companies are eligible to avail themselves of certain scaled disclosure requirements applicable to smaller reporting companies. This includes being able to omit certain otherwise required compensation tables in the proxy statement, the CD&A, and the pay-ratio disclosure. However, companies that find themselves in this position should consider the potential impacts from switching to the scaled disclosure, such as institutional investor and proxy advisory firm sentiment, along with the effect on share price due to the market perception of a company providing less disclosure.

SEC Comment Letter Trends. During the 12 months ended June 30, 2018, the most common comment area by the SEC was Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”), followed by non-GAAP financial measures.^[1] In the prior year, non-GAAP financial measures was the top comment area, followed by MD&A. According to Ernst & Young, other common comment areas include fair value measurements, segment reporting and revenue recognition.^[2] When commenting about MD&A, common themes include: results of operations (including, for example, requests that companies explain their results of operations in greater detail, such as identifying and discussing the underlying factors driving significant changes and details about significant components of, and changes in, revenue and expense categories); critical accounting estimates; and liquidity and capital resources (especially where there is higher indicated risk for debt covenant default or insufficient liquidity).

Also of note, comments about accounting for, and disclosure of, loss contingencies reemerged on the top 10 list in 2018. In addition to comments that focus on disclosures about possible losses (including failure to disclose the amount or range of reasonably possible losses), the SEC has challenged prior disclosures and even prior accounting and accruals for losses incurred upon settlement or judgment but not disclosed or accrued in prior periods.

ANNUAL MEETING AND PROXY CONSIDERATIONS

Environmental, Social and Governance Issues Moving Mainstream and Taking Center Stage. As reflected in the shareholder proposal trends and expectations discussed below, environmental, social and governance (“ESG”) issues have moved into the mainstream and are increasingly at the center of attention. ESG concerns cover a wide range of topics, including sustainability, climate change, gender pay equity, board and workforce diversity, water management, political and lobbying expenditures, the opioid crisis and gun control, among others. Further, investors and other corporate governance advocates continue to push for greater transparency and expanded disclosure of companies’ policies on these issues.

Earlier this year, Institutional Shareholder Services (“ISS”) implemented their Environmental & Social QualityScore, which is meant to be a data-driven approach to measure the quality of a company’s public disclosure on environmental and social issues, including sustainability governance, and to identify disclosure shortfalls. Glass Lewis also recently announced that guidance on material ESG topics from the Sustainability Accounting Standards Board (SASB) will be integrated into its research reports and on its voting platform.

Importantly, some large institutional investors are using ESG data in their assessment of potential investments. For example, BlackRock’s proxy voting and shareholder engagement FAQ states that its portfolio managers routinely consider potential economic risks or opportunities related to ESG issues when making investment decisions.

Given the rising importance of ESG issues and the potential reputational impacts to the company, companies should work to identify the ESG issues that are most relevant to their businesses while determining a plan of action to strategically address matters related to these issues, including pertinent ESG disclosures.

Trends and Considerations Relating to Board Composition. Continuing the momentum from prior years, board composition continues to be a high-profile topic among investors, boards of directors, regulators and proxy advisory firms. Accordingly, a growing trend has been for companies to address board composition matters through enhanced disclosure in the proxy statement as it pertains to board refreshment plans, diversity, tenure and expertise. The proxy statement commonly serves as the primary communication tool for the board to convey its philosophies and values with regard to these matters.

In light of the current social climate, disclosure regarding a company’s diversity profile will be subject to increased attention. Public companies subject to California bill SB-826, which promotes equitable and diverse gender representation on corporate boards, should be especially mindful of disclosing how they comply or intend to become compliant with the new law. With regard to highlighting the skills and expertise of its board members, companies may consider including a board skills matrix in the proxy statement to convey how each member contributes to a critical function of the board. Including more robust and transparent disclosure relating to board refreshment policies is also an increasingly important approach to address investor concerns. Ultimately, it remains critical for a company to have processes in place to optimally refresh the board as needed in order to help ensure that the board has the necessary balance of skills, perspectives and experiences.

Shareholder Proposals: Trends in 2018 and Expectations for 2019. The volume of shareholder proposals has continued a slow and steady decline over the past few years, with the 788 proposals submitted during the 2018 proxy season representing a 14% decline from the 2016 volume. Social and environmental proposals continued to lead the pack, representing over 40% of submitted proposals, with corporate governance proposals slightly behind. Other areas of focus included civic engagement proposals and executive compensation proposals. Within the social and environmental category, climate change proposals continued to lead the pack, with board diversity proposals also representing a healthy share (prompted, in part, by the “Me Too” movement, and newer themes, such as opioid accountability proposals directed at the drug manufacturing companies, starting to emerge). Proxy access proposals, which were a hot button issue over the past few years, declined in 2018, both in terms of number of submissions and support from shareholders. 2018 did, however, see an increase in proposals relating to special meeting and written consent rights. Lastly, while down year-over-year, the number of proposals related to political contributions and lobbying remained strong in 2018. We would expect many of these trends to continue into 2019, particularly proposals related to gender diversity on boards, which is an issue that has garnered increased attention from ISS of late. Climate change will likely remain a hot topic, and with the growing divisive political environment approaching an important 2020 election, we expect proposals related to political contributions and lobbying to remain prominent.

Proxy Statement as a Communication Tool. Another noteworthy trend we’ve seen in the proxy arena is that companies are increasingly viewing their proxy statements as a tool for shareholder engagement. Historically, proxy statements were viewed as a mere formality comprised of nothing more than SEC-mandated disclosures. However, in recent years, companies have been using their proxy statement as a means to solicit input from shareholders on matters of corporate governance and social responsibility. This evolution of the proxy statement in this manner was triggered, in many respects, by Dodd-Frank, which through provisions, such as say-on-pay, has put proxy statements in the spotlight. From there, the trend was fueled by an uptick in shareholder activism, which prompted companies to take a much more proactive approach to shareholder engagement. Today, we are seeing more and more companies use the proxy statement to advocate for their corporate governance philosophy and values, outline efforts they have taken to serve as an effective steward of the environment, and promote their efforts to achieve a diverse board and delineate their succession planning efforts.

Trend Toward Virtual Meetings. 2018 also saw a continuation of the trend toward virtual shareholder meetings, with approximately 300 companies hosting virtual annual meetings in 2018. Despite arguments from a few outspoken shareholder advocates who assert that virtual meetings actually discourage substantive shareholder engagement by enabling management to screen questions in advance or avoid answering them altogether, the consensus seems to be to the contrary. Most companies that have gone virtual have found that such meetings have, in fact, facilitated greater shareholder engagement by allowing shareholders who otherwise likely would not have traveled to participate in the meeting. We expect to see a modest to meaningful uptick in the number of companies opting to go virtual in 2019.

SEC Guidance on Exempt Solicitations. As the volume of exempt solicitations has increased in recent years, in mid-2018 the SEC issued two C&DIs on the topic of exempt solicitations, sometimes referred to as “just vote no” campaigns. As background, SEC Exchange Act Rule 14a-6(g) requires that persons who hold more than $5 million of a company’s stock and who conduct a solicitation in which they do not seek to have proxies granted to them file with the SEC the written materials used in the solicitation. The notices appear on EDGAR as PX14A6G, and serve as a platform for promoting shareholder views and counterarguments to positions advocated by management. The filings, however, are often confusing. First, it is not always clear that the notice is not being filed by the company. Then, even if the identity of the filer is clear, it is often still unclear whether the filer has any interest in the matter beyond its capacity as a shareholder. Finally, it’s not even clear how many shares the filer owns, given that historically there was nothing restricting a shareholder with fewer than $5 million of shares from making a filing.

In the first C&DI issued on the topic, the SEC confirmed that voluntary filings by holders of less than $5 million of securities are permissible, but the SEC now requires that the filer specifically state that the filing is voluntary. In the second C&DI, the SEC indicated that any exempt solicitation filing must include a notice page disclosing the name of the subject company and the name and address of the person making the exempt solicitation. Specifically, the SEC indicated that a filing consisting only of the text of the soliciting material and that is not attached to such a cover page may be misleading under Exchange Act Rule 14a-9.

PROXY ADVISORS UPDATE

ISS and Glass Lewis have been busy updating their voting guidelines, even as the SEC's withdrawal of two no-action letters relating to proxy advisory firms introduced a degree of uncertainty about the role they will play in future proxy seasons.

SEC Withdraws No-Action Letters for Proxy Advisory Firms; Hosts “Roundtable on the Proxy Process”

On September 13, 2018, the SEC announced that it would withdraw its Egan-Jones Proxy Services (May 27, 2004) and Institutional Shareholder Services, Inc. (September 15, 2004) no-action letters, effective immediately. In announcing its withdrawal of the letters, the SEC’s Division of Investment Management stated that its primary rationale was to “facilitate the discussion” at the “Roundtable on the Proxy Process” subsequently held on November 15, 2018.

The Egan-Jones and ISS letters contained guidance on the extent to which investment advisers could rely on the recommendations of proxy advisory firms to fulfill their fiduciary duties, and how investment advisers should evaluate the independence of proxy advisory firms, respectively.

Commentary on the background—and potential implications—of the SEC’s withdrawal of its longstanding guidance on those topics has been wide-ranging since the September 2018 announcement. Some have observed that, in scheduling the Roundtable, the SEC wanted to discuss the proper role of proxy advisory firms in aggregating data and making voting recommendations, and also hinted that rulemaking may be on the horizon for proxy advisory firms. On the day before the Roundtable was held, the Corporate Governance Fairness Act was introduced in the U.S. Senate, which would have made proxy advisory firms subject to the Investment Advisers Act of 1940 and further regulation by the SEC.

Others (including the proxy advisory firms themselves) have downplayed the importance of the SEC’s recent action, noting that Staff Legal Bulletin No. 20 (Proxy Voting Responsibilities of Investment Advisers and Availability of Exemptions from the Proxy Rules for Proxy Advisory Firms, June 30, 2014), which affirmed much of the guidance contained in the Egan-Jones and ISS letters, remains in effect.

The SEC received approximately 100 comment letters in advance of the Roundtable, many of which focused on “proxy plumbing” issues and topics relating to shareholder proposals. With respect to proxy advisory firms, some Roundtable panelists seemed more inclined to tweak the current system than to overhaul it. In that regard, some panelists observed that enhanced regulation of proxy advisory firms would likely result in increased costs for investment advisers.

The impacts of the SEC’s withdrawal of the Egan-Jones and ISS letters—and the Roundtable—may not become clear for some time. Meanwhile, ISS and Glass Lewis appear to be proceeding with “business as usual” for the 2019 proxy season.

RECENT DEVELOPMENTS AND OTHER CONSIDERATIONS

Director Compensation. As we have written about previously, in response to the Delaware Chancery Court’s 2012 and 2015 decisions in Seinfeld v. Slager and Calma v. Templeton and Facebook’s 2016 settlement of Espinoza v. Zuckerberg, some public companies have added separate annual sublimits on director equity awards. In both Seinfeld and Calma, the Delaware Chancery Court refused to grant board members of the companies subject to the litigation the protection offered by the business judgment rule because the challenged shareholder-approved equity compensation plans did not impose meaningful limits on the amounts the directors could award themselves under the plans. The Chancery Court’s failure to review the challenged director equity awards using the deferential business judgment rule standard meant that both shareholder derivative actions could proceed to trial under a more plaintiff-friendly standard of review. In December 2017, the Delaware Supreme Court issued the decision In re Investors Bancorp, Inc. Stockholder Litigation. This decision limited shareholder ratification as a defense for director equity awards that were made on a discretionary basis. Similar to the earlier decisions, the equity plan at issue in In re Investors Bancorp had been approved by shareholders. The court held, however, that because the plan did not ratify specific awards, the directors must demonstrate the entire fairness of the awards to the company.

We believe litigation over director compensation continues to be a threat and that public companies should consider amending existing director compensation plans (or adopting new plans) to include shareholder approved annual limits or specific formula-based awards and, to the extent that they do not already do so, consider engaging a compensation consultant to assist in setting director compensation. Regardless, public companies should document director compensation decisions in anticipation of objection to one or more of the various aspects of their director compensation program. The documentation should demonstrate that the directors (or compensation committee members) exercised due care in determining director compensation (for example, indicating that they had assistance from an outside compensation consultant, reviewed adequate information (including peer group data), and asked questions about various alternatives). Finally, public companies should consider revisiting their disclosures in the proxy statement about their director compensation programs and consider whether they should move toward a more fulsome discussion along the lines of the compensation discussion and analysis for executive officers.

In addition to litigation risk, we also note that proxy advisors have begun to turn their focus to director compensation. ISS previously indicated that it would begin issuing negative vote recommendations for excessive director compensation in 2019, however, in light of feedback received from investor roundtables and its policy survey, ISS recently announced that it would delay adverse vote recommendations on excessive director compensation to 2020. In its 2019 policy guidelines, Glass Lewis indicates that director compensation should be competitive but should not be performance-based to ensure that directors are not incentivized in the same form as executives. If an equity plan allows a company to grant performance-based awards to directors, Glass Lewis may issue a negative vote recommendation, particularly in situations in which a company has granted performance-based director awards in the past.

New Standard for Accounting for Leases. The Financial Accounting Standards Board’s (“FASB”) new leases standard is now in place and is effective for public companies for fiscal years beginning after December 15, 2018. For calendar year-end companies, they must begin applying the new standard on January 1, 2019. As with the new revenue recognition rules, the SEC is expecting companies to provide robust transition disclosures in their 2018 annual reports explaining to investors the anticipated effects of the new standard, including the method of adoption and the expected quantitative and qualitative impacts upon adoption.

Changes to Definition of Materiality (GAAP). In August 2018, the FASB issued Amendments to Statement of Financial Accounting Concepts No. 8, Conceptual Framework for Financial Reporting, which amends the definition of materiality provided in its Conceptual Framework. The amendments essentially reinstate the prior definition contained in FASB Concepts Statement No. 2, Qualitative Characteristics of Accounting Information, which was superseded in 2010 by another amendment. As amended, the omission or misstatement of an item in a financial report is material if, in light of the surrounding circumstances, the magnitude of the item is such that it is probable that the judgment of a reasonable person relying upon the report would have been changed or influenced by the inclusion or correction of the item. The FASB stated in the amendment that the revised definition is intended to be consistent with the definition used by the SEC, the Public Company Accounting Oversight Board (“PCAOB”), the American Institute of Certified Public Accountants and the judicial system.

Critical Audit Matters. In October 2017, the SEC approved the PCAOB’s new audit report standard. The new standard is intended to make the auditor’s report more informative by requiring new information be provided about “critical audit matters.”

A critical audit matter is defined under the new standard as any matter that arises from the audit of the financial statements that was communicated, or required to be communicated, to the audit committee that (i) relates to accounts or disclosures that are material to the financial statements and (ii) involves especially challenging, subjective or complex judgment. The new standard provides a nonexclusive list of factors the auditor should consider when determining whether a matter involves especially challenging, subjective or complex judgment.

For each critical audit matter identified, the auditor must describe the principal considerations that led the auditor to determine that the matter was a critical audit matter, describe how it was addressed in the audit, and refer to relevant financial accounts and disclosures that related to the critical audit matter. If the auditor determines there are no critical audit matters, that finding must be disclosed in the audit report. It is noted, however, that the PCAOB has indicated that it expects the auditor will determine there is at least one critical audit matter.

In addition to the disclosures about critical audit matters, the new standard requires several other changes to the audit report, including disclosure of the auditor’s tenure with the company. The new audit report standard was effective for audits of fiscal years ending on or after December 15, 2017, except for the provisions relating to disclosures about critical audit matters, which are effective for audits of fiscal years ending on or after June 20, 2019 (for large accelerated filers) and on or after December 15, 2020 for all other filers. This means for calendar year-end large accelerated filers, the new critical audit matters disclosures will be effective for the audits of their 2019 financial statements (to be issued in early 2020).

Corporate Governance—The Evolution of a New Paradigm. In July 2016, a group of 13 executives from Fortune 500 companies and leading investment managers, including Warren Buffett, published a report titled “Commonsense Corporate Governance Principles” (the “Commonsense Principles”). The Commonsense Principles were intended to initiate a dialogue on the governance of U.S. public companies and provide a model for a sustainable framework for corporate governance that supports an emphasis on creating long-term value and resisting short-termism. Importantly, the Commonsense Principles represent a new paradigm of replacing shareholder primacy with stakeholder primacy. Thus, rather than the traditional corporate governance framework that is centered on managing the corporation for the benefit of only shareholders, the new paradigm would embrace a concept that corporations should be managed in the public interest, considering the interests of employees, customers, suppliers, communities, the environment, and the economy, as well as shareholders. This movement stems from a general consensus about the dangers of rising inequality and that there has been a precipitous decline in the number of public companies over the last two decades.

In addition to the Commonsense Principles, other groups have published similar frameworks and principles, including the Framework for U.S. Stewardship and Governance, published by the Investor Stewardship Group (ISG), Principles of Corporate Governance, published by the Business Roundtable, and The New Paradigm, published by the International Business Council of the World Economic Forum (collectively, the “Alternative Principles”).

In October 2018, the group that published the Commonsense Principles published “Commonsense Corporate Governance Principles 2.0” (the “Open Letter”). The updated principles acknowledge that a meaningful dialogue is occurring. The authors also endorsed the Alternative Principles as “counterweights to unhealthy short-termism.”^[3] We believe this movement toward a new paradigm of corporate governance that considers the interest of various stakeholders, versus just shareholders, is continuing to gain momentum. What remains unclear is whether a single generally accepted model or set of principles will ultimately be agreed upon. In the Open Letter, the group suggests that there is a risk that “dueling or competing” principles could impede, rather than promote, healthy corporate governance and calls for the various sets of model principles currently in circulation to be “harmonized and consolidated.”^[4]

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Notes:

^[1] See Ernst & Young LLP, SEC Comments and Trends, An Analysis of Current Reporting Issues (Sept. 2018). [back]

^[2]See id.  [back]

^[3] Open Letter: Commonsense Corporate Governance Principles 2.0, Margaret Popper and Sard Verbinnen, published by Columbia Law School, Milstein Center for Global Markets and Corporate Ownership (October 23, 2018). [back]

^[4]See id.