This newsletter discusses noteworthy updates, key regulatory decisions and upcoming compliance reminders. You are welcome to contact us to discuss any of the topics. In this edition, we review:
Planning for the 2018 Proxy Season
Staff Issues New Guidance on Excluding Shareholder Proposals
Enhanced Audit Reports: New PCAOB Rule Requires Disclosure of “Critical Audit Matters”
Companies May Need to Consider the Impact of Changes to U.S. Tax Law in Their Financial Statements
Prosecutors Regain Leverage in Insider Trading Cases
SEC Proposes Regulation S-K Disclosure Changes
Supreme Court Limits SEC Ability to Seek Disgorgement
Supreme Court Will Review Scope of Dodd-Frank Whistleblower Protections for Internal Reports
$2.5 Million SEC Whistleblower Award Goes to Government Employee
Planning for the 2018 Proxy Season
There are number of important considerations that public companies should be aware of as they begin preparing for the 2018 proxy season, including potential changes in law, pay ratio disclosure, Rule 14a-8 shareholder proposals, ISS proxy voting polices and potential proxy statement improvements.
Choice Act
On June 8, 2017, the House of Representatives passed a revised version of the Financial Creating Hope and Opportunity for Investors, Consumers, and Entrepreneurs (“CHOICE”) Act. The CHOICE Act is intended to, among other things, encourage economic growth, provide regulatory relief, impose new measures to end taxpayer bailouts of complex financial institutions, and help manage systemic risks. It seeks to repeal many of the measures enacted under Dodd-Frank, including pay ratio and the proposed changes to clawbacks and hedging disclosure. In addition, the CHOICE Act would make changes to SEC Rule 14a-8, including increasing the ownership and holding period requirements and potentially limiting the aggregation of shares, effectively making it harder for shareholders to submit proposals under the rule.
The Senate Banking, Housing, and Urban Affairs Committee recently began holding hearings on the CHOICE Act. Although 60 votes for passage of the full bill may not be possible, Senate Republicans may still pass portions of the Act through budget reconciliation. However, such changes are unlikely to occur before the start of the proxy season.
Pay Ratio Disclosure
Therefore, most companies (other than emerging growth companies and smaller reporting companies) will be required to provide pay ratio disclosure for the first fiscal year beginning on or after January 1, 2017, with the result that most companies will begin making disclosures in early 2018. On September 21, 2017, the SEC issued helpful guidance to assist companies with the rule. Among other things, the guidance emphasizes SEC flexibility on the use of internal records to identify the median employee, even if every element of compensation is not included in such records; the use of internal records to determine the availability of the 5% de minimis exemption; and allowing companies to use more widely recognized definitions of “employee.” The new guidance was issued in the form of an interpretive release, SEC staff guidance and revised Compliance and Disclosure Interpretations.
Actions companies should be considering include analyzing the company’s employee population, including by country; determining what method the company will use to identify the median employee; considering whether the company can, or should, attempt to rely on an exemption; and planning the company’s disclosure and communication strategy with respect to shareholders, employees and others. For additional information, please see our prior alert.
Rule 14a-8 Shareholder Proposals
Companies should continue to be mindful of the potential for activist shareholder proposals under Rule 14a-8. Proxy access proposals were very common in 2017, leading many companies to adopt some form of proxy access. As a result, companies that have not yet adopted proxy access should be prepared for such proposals. Companies that have already adopted proxy access should be prepared for “fix it” proposals focused on broadening applicable thresholds for nomination such as shareholders’ ability to aggregate ownership. Other popular shareholder proposals are expected to include proposals that address independent board chairs, majority voting, board diversity and various other social, environmental and political proposals.
The SEC recently issued additional guidance on certain issues under Rule 14a-8, including guidance that may expand the bases companies may use to exclude proposals, but also may change companies’ processes in building their cases for exclusion. Please see “Staff Issues New Guidance on Excluding Shareholder Proposals” below.
ISS Proxy Voting Policies
Recently, ISS released its revised policy voting guidelines for 2018. The updates are effective for meetings on or after February 1, 2018. Topics covered include updates on:
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voting every year against all directors of companies with unilaterally-adopted shareholder rights plans with terms of longer than one year, with commitments to put a rights plan to a vote the following year no longer considered a mitigating factor;
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beginning in 2019, voting against committee members responsible for approving “excessive” non-employee director compensation over two or more consecutive years without a compelling rationale or other mitigating factors;
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voting against relevant committee members (or the full board) where a significant level of pledged stock raises concerns, taking into account certain specified factors;
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specifying the types of disclosure of shareholder engagement efforts that ISS will consider in determining how to vote if prior say-on-pay votes receive less than 70% support;
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highlighting boards with no gender diversity, without triggering an adverse vote recommendation; and
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in connection with its pay-for-performance analysis, adding the rankings of CEO total pay and company financial performance versus a peer group over a three-year period to the items it considers.
ISS also updated its policy on certain shareholder proposals, including gender pay gap, board diversity and climate change.
Previously, ISS issued its 2018 policy survey. It included a focus on gender diversity and also covered shareholder authorization for share issuances and buybacks, implications of virtual/hybrid shareholder meetings and disclosure of pay ratios.
Proxy Statement Communication
With the recent focus on proxy access and board composition, the trend toward emphasizing the experience, skills and diversity of backgrounds of directors is likely to continue. Companies may consider skills charts or graphics showing diversity. Companies might also consider highlighting shareholder engagement, improving readability and adding graphics and executive summaries to their proxy statements.
Staff Issues New Guidance on Excluding Shareholder Proposals
On November 1, 2017, the staff of the Division of Corporation Finance issued a new staff legal bulletin (SLB 14I), providing guidance on the excludability of shareholder proposals under the "ordinary business" exclusion and the "economic relevance" exclusion, as well as other issues arising under Rule 14a-8. The guidance is effective immediately and therefore will be relevant to companies seeking to rely on those provisions to exclude shareholder proposals from their proxy materials for the 2018 proxy season. SLB 14I gives rise to significant new requirements and leaves many questions open as to how these two exclusions will be applied in practice.
To access our Nov. 3 alert on this topic, click here.
Enhanced Audit Reports: New PCAOB Rule Requires Disclosure of “Critical Audit Matters”
On October 23, 2017, the SEC approved a new PCAOB auditing standard (AS 3101) and related amendments that will require significant new disclosures of “critical accounting matters,” or CAMs, while still preserving the traditional pass-fail audit report that accompanies a public company’s financial statements. A CAM is defined as a matter that was communicated or required to be communicated to the audit committee and that: (1) relates to accounts or disclosures that are material to the financial statements and (2) involve especially challenging, subjective, or complex auditor judgment.
In determining whether a matter involved especially challenging, subjective, or complex auditor judgment, the auditor must consider, alone or in combination, certain factors, including, but not limited to:
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the auditor’s assessment of the risks of material misstatement, including significant risks;
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the degree of auditor judgment related to areas in the financial statements that involved the application of significant judgment or estimation by management, including estimates with significant measurement uncertainty;
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the nature and timing of significant unusual transactions and the extent of audit effort and judgment related to these transactions;
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the degree of auditor subjectivity in applying audit procedures to address the matter or in evaluating the results of those procedures;
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the nature and extent of audit effort required to address the matter, including the extent of specialized skill or knowledge needed or the nature of consultations outside the engagement team regarding the matter; and
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the nature of audit evidence obtained regarding the matter.
Under AS 3101, audit reports must:
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identify the CAM (or state that there are no CAMs);
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describe the principal considerations that led the auditor to determine that the matter is a CAM;
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describe how the CAM was addressed in the audit; and
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refer to the relevant financial statement accounts or disclosures.
For each matter in the audit that was communicated or required to be communicated to the audit committee and relates to accounts or disclosures that are material to the financial statements, the auditor must document whether or not the matter was determined to be a CAM and the basis for that determination.
The new standard becomes effective for fiscal years ending after June 30, 2019 for large accelerated filers, and December 15, 2020 for all other covered companies. These changes do not apply to emerging growth companies.
In anticipation of the new CAM requirements companies should consider:
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discussing with their auditors their approach to the new standard, the types of matters they may consider as CAMs and the impact on the audit schedule
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the timing for determination of CAMs during the audit process and whether the auditor can provide prior notice and examples of CAM disclosures, particularly in light of potential liabilities
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the consistency of any CAM disclosures with the company’s other public reports and statements.
The new standard also includes certain other changes to audit reports intended to clarify the auditor’s responsibilities related to the audit and to make their reports easier to read, requiring that the opinion appear in the first section of the report and adding section titles. Additional disclosures include a statement of the auditor’s tenure, a statement regarding the requirement for the auditor to be independent and that the report is addressed to the company’s shareholders and the board (with additional addressees permitted). These changes are effective for audits of fiscal years ending on or after December 15, 2017, including for emerging growth companies.
Companies May Need to Consider the Impact of Changes to U.S. Tax Law in Their Financial Statements
If the proposed changes to U.S. tax law currently under consideration by Congress were passed before the end of this year, calendar-year companies may need to consider the impact to their 2017 financial statements under financial accounting rules.
Proposed legislation has recently passed the U.S. House of Representatives and is pending in the U.S. Senate (“Proposed Tax Legislation”). The Proposed Tax Legislation would make significant changes to the current U.S. tax code including a reduction in the corporate tax rate from 35% to 20%, required inclusion in taxable income of deferred foreign earnings (at a reduced taxable rate) and modification or changes to a number of other provisions applicable to both corporations and individuals.
In general, under applicable financial accounting rules a company’s financial statements must take into account the impact of legislative changes that are enacted on or prior to relevant reporting date of the financial statements, e.g. December 31, 2017 for calendar year companies. Further, legislation enacted subsequent to the relevant reporting date, but prior to the issuance of the financial statements, is considered a non-recognized subsequent event and the impact would not need to be accounted for in the financial statements, but would likely need to be disclosed within the financial statements.
In accordance with financial accounting rules, if the Proposed Tax Legislation were enacted a reporting entity would be required to consider the impact of the legislation on its financial statements and in particular its measurement of any deferred tax assets or liabilities as of the date of enactment as well as the financial impact of any foreign earnings that were considered permanently reinvested and not subject to U.S. income tax. The effect of the Proposed Legislative Changes if enacted would be reflected in the applicable financial statements with appropriate disclosure. For example, a significant reduction in corporate tax rates could have a material impact on reported earnings, to the extent companies are carrying sizeable deferred tax assets or liabilities.
Prosecutors Regain Leverage in Insider Trading Cases
Despite a decision by the Second Circuit in 2014 that stripped away some of the government’s leverage in prosecuting insider trading cases, the pendulum has swung fully back in favor of the government.
As explained by the SEC, illegal insider trading generally refers to buying or selling a security in breach of a fiduciary duty or relationship of trust and confidence, while in possession or aware of material, non-public information about the security. Additionally, illegal insider trading includes, among other conduct, tipping material non-public information to others whereby the tipper receives a personal benefit from such disclosure. On its face, determining whether an individual’s trading is illegal based upon these tests may appear relatively straightforward. However, the judiciary has struggled over the years to reach a consensus on how best to evaluate various aspects of insider trading elements. Most recently, the judiciary has attempted to tackle what is sufficient to establish a personal benefit in exchange for a tipper’s divulgence of material, non-public information.
Just three years ago, the case of United States v. Newman endeavored to alter the landscape by taking a new approach to “personal benefit”. 773 F. 3d 438 (2d Cir. 2014). In Newman, two hedge fund managers were charged with insider trading in the stock of Dell and NVIDIA. The Government alleged that “a cohort of analysts at various hedge funds and investment firms obtained material, nonpublic information from employees of publicly traded technology companies, shared it amongst each other, and subsequently passed this information to the portfolio managers at their respective companies.” It was proven that each of the defendants obtained insider information and traded on it through a tipping chain; however, the Second Circuit did not agree with the prosecution that a social relationship between the tipper and tippees was sufficient to create a personal benefit, even though they attended church together and exchanged career advice. The Second Circuit held that to the extent a personal benefit may be inferred from a relationship, “such an inference is impermissible in the absence of proof of a meaningfully close personal relationship that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature.” Many felt that the decision would “dramatically limit the Government’s ability to prosecute some of the most common, culpable, and market-threatening forms of insider trading.” Quoting the Petition for United States Rehearing and Rehearing En Banc in United States v. Newman at 3 (Jan. 23, 2015).
Shortly thereafter, the Supreme Court took its first insider trading case in nearly two decades and reshaped the Newman holding. In United States v. Salman, a tipper worked for an investment bank and provided confidential information regarding future mergers and acquisitions to his brother, who ultimately tipped his soon to be brother-in-law. 137 S.Ct. 420 (2016). The defense urged the Court to adopt the Newman rule, but the Court opted to regard a close personal relationship as a sufficient personal benefit and held the defendant guilty. The Court reasoned that liability exists where the “insider makes a gift of conditional information to a trading relative or friend.” This decision severely undercut the holding in Newman and suggested that prosecutors need only prove that the information was provided as a gift to a close friend or relative.
On August 23, 2017, guided by the Supreme Court’s ruling in Salman, the Second Circuit affirmed in the case of United States v. Martoma, 869 F. 3d 58 (2d Cir. 2017), that the logic of Salman abrogated Newman’s “meaningfully close personal relationship” requirement. In 2014, Martoma was convicted of masterminding what was once called the most lucrative insider trading scheme of all time, which profited his firm $275 million based on inside information received from a doctor working on clinical trials of an Alzheimer’s treatment. In light of the Supreme Court’s ruling in Salman, Martoma appealed his case. However, the Second Circuit followed the Supreme Court and concluded that “Salman fundamentally altered the analysis underlying Newman’s ‘meaningfully close personal relationship’ requirement such that the ‘meaningfully close personal relationship’ requirement is no longer good law.”
“Because insider trading undermines investor confidence in the fairness and integrity of the markets, the SEC has treated the detection and prosecution of insider trading violations as one of its enforcement priorities.” However, according to Forbes, Preet Bharara, the former United States Attorney for the Southern District of New York, chose to drop numerous insider trading charges in 2015 after Newman imposed its evidentiary hurdle on prosecutors. With that hurdle effectively removed by Salman and Martoma, it seems likely that we will begin to see an increase in insider trading charges brought as the SEC attempts to re-solidify insider trading prosecutions as one of its priorities.
SEC Proposes Regulation S-K Disclosure Changes
The SEC issued a proposing release on October 11, 2017 to amend a wide variety of disclosure rules, primarily under Regulation S-K, in an effort to modernize, and in some cases, simplify disclosure requirements for public companies, investment advisers and investment companies. The proposal is intended to implement the Congressional mandate under the Fixing America's Surface Transportation (FAST) Act.
To access our Oct. 19 alert on this topic, click here.
Supreme Court Limits SEC Ability to Seek Disgorgement
The Supreme Court held that a five year statute of limitations applies to actions by the SEC for disgorgement. The decision imposes a significant new limit on the SEC’s ability to seek recoupment of defendants’ profits in enforcement actions. The decision brings an end to a regulatory regime in which the SEC has applied separate time limits to its claims to monetary recovery depending on the theory of recovery, with SEC actions for “civil penalties” subject to the five-year statute of limitations of 28 U.S.C. § 2462, but its actions for “disgorgement” of profits not subject to any time limit.
Additional information on the case and ruling can be found here.
Supreme Court Will Review Scope of Dodd-Frank Whistleblower Protections for Internal Reports
In June, the Supreme Court announced it will consider whether the Dodd-Frank whistleblower protections extend to corporate insiders who blow the whistle on their employers by reporting the alleged misconduct internally only rather than to the SEC. The Court will hear the appeal of Digital Realty Trust Inc. arising from an opinion of the 9th Circuit that held that the whistleblower protections of Dodd-Frank applied when the company allegedly fired its former executive for reporting alleged misconduct of his supervisor internally, but not to the SEC.
Additional Information on the case can be found here.
$2.5 Million SEC Whistleblower Award Goes to Government Employee
On July 25, 2017, the SEC announced another whistleblower award – this one for almost $2.5 million. What sets this award apart from earlier awards is its recipient – “an employee of a domestic government agency.” This award shows that it is not only a company’s employees who may take internal issues to the SEC. Instead, outside contractors and even government employees may go to the SEC. This award suggests that the SEC will continue to publicize large monetary awards to encourage whistleblowers to provide evidence of larger-scale issues.
Additional information on the whistleblower award and order can be found here.
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