Developments in Securities Regulation, Corporate Governance, Capital Markets, M&A and Other Topics of Interest. MORE

The SEC provided guidance on disclosure of financial metrics in MD&A.  At the same time, the SEC proposed rules to amend other disclosure obligations of public companies.

Financial Metrics in MD&A

The guidance on financial metrics in MD&A is effective when published in the Federal Register which usually occurs shortly after announcement. Given that many companies are in the process of preparing their Form 10-Ks, the guidance will need to be considered rapidly.

The SEC noted some companies disclose non-financial and financial metrics when describing the performance or the status of their business. Those metrics can vary significantly from company to company and industry to industry, depending on various facts and circumstances. For example, some of these metrics relate to external or macro-economic matters, some are company or industry specific, and some are a combination of external and internal information. Some companies voluntarily disclose specialized, company-specific sales metrics, such as same store sales or revenue per subscriber. Some companies also voluntarily disclose environmental metrics, including metrics regarding the observed effect of prior events on their operations.

According to the SEC, a company should consider what additional information may be necessary to provide adequate context for an investor to understand any metric presented. The SEC said it would generally expect, based on the facts and circumstances, the following disclosures to accompany any metric presented:

  • A clear definition of the metric and how it is calculated;
  • A statement indicating the reasons why the metric provides useful information to investors; and
  • A statement indicating how management uses the metric in managing or monitoring the performance of the business.

The SEC advised public companies they should also consider whether there are estimates or assumptions underlying the metric or its calculation, and whether disclosure of such items is necessary for the metric not to be materially misleading.

According to the SEC, if a company changes the method by which it calculates or presents the metric from one period to another or otherwise, the company should consider the need to disclose, to the extent material:

  • the differences in the way the metric is calculated or presented compared to prior periods,
  • the reasons for such changes,
  • the effects of any such change on the amounts or other information being disclosed and on amounts or other information previously reported, and
  • such other differences in methodology and results that would reasonably be expected to be relevant to an understanding of the company’s performance or prospects.

Depending on the significance of the change(s) in methodology and results, the SEC stated public companies should consider whether it is necessary to recast prior metrics to conform to the current presentation and place the current disclosure in an appropriate context.

The SEC also noted effective controls and procedures are important when disclosing material key performance indicators or metrics that are derived from the company’s own information. When key performance indicators and metrics are material to an investment or voting decision, the company should consider whether it has effective controls and procedures in place to process information related to the disclosure of such items to ensure consistency as well as accuracy.

Proposed Rule Changes

The SEC also proposed amendments it believes are designed to modernize, simplify, and enhance certain financial disclosure requirements in Regulation S-K.  The proposed amendments are far reaching and among other things would eliminate Item 301 (selected financial data) and Item 302 (supplementary financial data), and amend Item 303 (management’s discussion and analysis).

Among other things, the proposed amendments to Item 303, the MD&A rule, would:

  • Add a new Item 303(a), Objective, to state the principal objectives of MD&A;
  • Replace Item 303(a)(4), Off-balance sheet arrangements, with a principles-based instruction to prompt registrants to discuss off-balance sheet arrangements in the broader context of MD&A;
  • Eliminate Item 303(a)(5), Tabular disclosure of contractual obligations given the overlap with information required in the financial statements and to promote the principles-based nature of MD&A;
  • Add a new disclosure requirement to Item 303, Critical accounting estimates, to clarify and codify existing Commission guidance in this area; and
  • Revise the interim MD&A requirement in Item 303(b) to provide flexibility by allowing companies to compare their most recently completed quarter to either the corresponding quarter of the prior year (as is currently required) or to the immediately preceding quarter.

The SEC recently revised Instruction 1 to Item 303(a) to allow registrants who are providing financial statements covering three years in a filing to omit discussion of the earliest of the three years if such discussion was already included in any other of the registrant’s prior filings on EDGAR that required disclosure in compliance with Item 303. Registrants electing not to include a discussion of the earliest year in reliance on this instruction must identify the location in the prior filing where the omitted discussion may be found.

The SEC recently issued three Compliance and Disclosure Interpretations, or C&DIs, that address the above instruction.  According to the C&DIs:

  • A statement merely identifying the location in a prior filing where the omitted discussion can be found does not incorporate such disclosure into the filing unless the registrant expressly states that the information is incorporated by reference.
  • The instruction does not authorize the registrant to omit the earliest of three years from its current MD&A if it believes a discussion of that year is necessary. Item 303(a) requires that the registrant provide such information that it believes to be necessary to an understanding of its financial condition, changes in financial condition and results of operations. A registrant must assess its information about the earliest of three years and, if it is required by Item 303(a), include it in the current disclosure or expressly incorporate by reference its discussion from a previous filing.
  • Merely referring to the location of the prior disclosure does not appear to be effective to update an existing registration statement. The omitted information must be expressly incorporated by reference. [Update – the earliest year need only be incorporated by reference when necessary to an understanding of financial condition and results of operation and the like.]

In McElrath v. Kalanick et al, the Delaware Supreme Court examined the liability of directors of Uber for an acquisition.  The case arose out of Uber’s acquisition of Ottomotto LLC.  Otto was founded by Anthony Levandowski, a former employee of “Waymo.” Waymo is a subsidiary of Google, and is engaged in developing selfdriving technology. Uber sought to jumpstart its own efforts to develop selfdriving vehicles by acquiring Otto. Uber executives began efforts to recruit Levandowski in June 2015, when he still worked for Google. During the “recruitment period,” Travis Kalanick, Uber’s founder personally exchanged text messages with Levandowski.  Levandowski left Google and hired over a dozen former Google employees at Otto. Weeks later, Uber and Otto signed a term sheet for Uber to acquire Otto.

After signing the term sheet, Uber and its outside counsel hired Stroz Friedberg, LLC, a computer forensic investigation firm, to conduct an independent investigation into whether Otto employees took with them Google’s proprietary information or might breach non-solicitation, non-compete, or fiduciary obligations if they moved from Google to Otto.   The merger agreement included unusual indemnification provisions.  For instance, Otto would not indemnify Uber post-closing for Otto’s breaches of representations and warranties. Also, certain Otto employees, including Levandowski, would have limited indemnification rights for pre-signing misconduct disclosed during the Stroz  investigation, but not for undisclosed pre-signing or any post-signing misconduct.

After Uber acquired Otto, a Google employee noticed that Otto was using what appeared to be Google technology. Google sued Otto and Uber for intellectual property infringement, and Uber ultimately settled for $245 million.  The plaintiff commenced litigation, purportedly on behalf of Uber, against Kalanick, the directors who approved the transaction, and others, and sought damages arising from the Otto acquisition.

The defendants challenged the plaintiff’s failure to first make a demand on the board of directors before pursuing litigation on Uber’s behalf.  This required the Court to examine whether a majority of the board was disinterested because it had no real threat of personal liability due to Uber’s exculpatory charter provision.  Given the protection from due care violations because of the exculpatory charter provision, the plaintiff must plead with particularity that the directors “acted with scienter, meaning ‘they had actual or constructive knowledge that their conduct was legally improper.’” In other words, directors are liable for “subjective bad faith” when their conduct is motivated “by an actual intent to do harm,” or when there is an “intentional dereliction of duty, a conscious disregard for one’s responsibilities.” According to the Court, pleading bad faith is a difficult task and requires “that a director acted inconsistent with his fiduciary duties and, most importantly, that the director knew he was so acting.”  Gross negligence, without more, is insufficient to get out from under an exculpated breach of the duty of care.

First, the plaintiff argued that, because Kalanick as CEO was the one who brought the transaction to the board and was involved with diligence, the directors should have been wise enough not to rely on someone with a reputation as a law breaker. As an example, the plaintiff pointed to one of Kalanick’s prior businesses, Scour, which offered music and film releases. Scour was eventually shut down for copyright violations and sued for $250 billion.

Second, the plaintiff argued that the allegedly unusual indemnification clauses in the merger agreement put the board on notice that Kalanick wanted to steal Google’s proprietary information. The agreement indemnified certain Otto employees for pre-signing misconduct disclosed during the Stroz investigation, but prevented Uber from seeking indemnification from Levandowski for violating noncompete and infringement claims. And, as the plaintiff alleged, Uber hired Stroz to investigate whether Otto employees stole Google’s intellectual property, but the board approved the transaction without personally reviewing the preliminary or final Stroz reports. The plaintiff argued that, viewed holistically, these facts entitle him to a reasonable inference that the board’s failure to inquire or inform themselves about the scope of potential legal and financial risk faced by Uber in connection with the Otto transaction amounted to bad faith.

The Court rejected the Plaintiff’s arguments.  The complaint alleged that Uber’s directors heard a presentation that summarized the transaction, reviewed the risk of litigation with Google, generally discussed due diligence, asked questions, and participated in a discussion. The inference from these allegations shows a functioning board that did more than rubberstamp the transaction presented by Uber’s CEO. The Court noted there is a vast difference between an inadequate or flawed effort to carry out fiduciary duties and a conscious disregard for those duties. It is not enough to allege that the directors should have been better informed as this is a due care violation exculpated by the corporation’s charter provision.

The Court noted Kalanick might have a background that would lead a reasonable board member to dig deeper into representations he made about the transaction. But there were no allegations that Kalanick had a history of lying to the board.

The Court noted the indemnification provisions were unusual but those provisions were clearly explained to the board.  The indemnification provisions did provide some protection for Uber— Uber would not have to indemnify Levandowski and others for conduct that was not disclosed to Uber before closing. The allegations as pleaded did not support a reasonable inference that the directors knew the transaction was nothing more than a vehicle to steal Google’s proprietary information.  Instead, the reasonable inference is the board should have done more, not that it acted in bad faith. Thus, the unusual indemnification provisions approved by the board did not lead to any inference other than the board approved a flawed transaction.

On January 13, 2020, the U.S. Department of Treasury published final regulations relating to the Committee on Foreign Investment in the United States, or CFIUS.  The regulations implement the Foreign Investment Risk Review Modernization Act of 2018, or FIRRMA.  The regulations become effective on February 13, 2020.

As required by FIRRMA, however, the regulations limit the application of CFIUS’s jurisdiction over non-controlling “covered investments” and certain real estate transactions by certain foreign persons, defined as “excepted investors,” from certain “excepted foreign states.” Any such eligible investor and foreign state must meet specific criteria to qualify for this status.

CFIUS has identified Australia, Canada, and the United Kingdom as the initial excepted foreign states and excepted real estate foreign states. CFIUS identified these countries due to certain aspects of their robust intelligence-sharing and defense industrial base integration mechanisms with the United States. Because this is a new concept with potentially significant implications for U.S. national security, CFIUS is initially identifying a limited number of foreign states and may expand the list in the future. Note that in order for each of these countries to remain an excepted foreign state and an excepted real estate foreign state after February 13, 2022, the Committee must make a determination regarding an eligible foreign state’s national security based foreign investment review processes and bilateral cooperation with the United States on national security-based investment reviews.

Importantly, under the regulations CFIUS retains the authority to review a transaction that could result in foreign control of any U.S. business. CFIUS’s jurisdiction is limited for excepted investors only for non-controlling investments.

Under the regulations, the term excepted investor means a foreign person who is, as of the completion date of the transaction:

  • A foreign national who is a national of one or more excepted foreign states and is not also a national of any foreign state that is not an excepted foreign state;
  • A foreign government of an excepted foreign state; or
  • Certain foreign entities.

For a foreign entity to qualify as an excepted investor it must meet each of the following conditions with respect to itself and each of its parents (if any):

  • Such entity is organized under the laws of an excepted foreign state or in the United States;
  • Such entity has its principal place of business in an excepted foreign state or in the United States;
  • Seventy-five percent or more of the members and 75 percent or more of the observers of the board of directors or equivalent governing body of such entity are: (A) U.S. nationals; or (B) Nationals of one or more excepted foreign states who are not also nationals of any foreign state that is not an excepted foreign state;
  • Any foreign person that individually, and each foreign person that is part of a group of foreign persons that in the aggregate (subject to the aggregation rule noted below), holds 10 percent or more of the outstanding voting interest of such entity; holds the right to 10 percent or more of the profits of such entity; holds the right in the event of dissolution to 10 percent or more of the assets of such entity; or otherwise could exercise control over such entity, is: (A) A foreign national who is a national of one or more excepted foreign states and is not also a national of any foreign state that is not an excepted foreign state; (B) A foreign government of an excepted foreign state; or (C) A foreign entity that is organized under the laws of an excepted foreign state and has its principal place of business in an excepted foreign state or in the United States; and
  • The minimum excepted ownership of such entity is held, individually or in the aggregate, by one or more persons each of whom is: (A) Not a foreign person; (B) A foreign national who is a national of one or more excepted foreign states and is not also a national of any foreign state that is not an excepted foreign state; (C) A foreign government of an excepted foreign state; or (D) A foreign entity that is organized under the laws of an excepted foreign state and has its principal place of business in an excepted foreign state or in the United States.

The term minimum excepted ownership means:

  • With respect to an entity whose equity securities are primarily traded on an exchange in an excepted foreign state or the United States, a majority of its voting interest, the right to a majority of its profits, and the right in the event of dissolution to a majority of its assets; and
  • With respect to an entity whose equity securities are not primarily traded on an exchange in an excepted foreign state or the United States, 80 percent or more of its voting interest, the right to 80 percent or more of its profits, and the right in the event of dissolution to 80 percent or more of its assets.

For purposes of the 10% ownership rule set forth above, foreign persons who are related, have formal or informal arrangements to act in concert, or are agencies or instrumentalities of, or controlled by, the national or subnational governments of a single foreign state are considered part of a group of foreign persons and their individual ownerships are aggregated.

The regulations contain certain “bad actor” type disqualifiers that prevent qualifications as an excepted investor.

The Federal Trade Commission has issued an administrative complaint challenging Axon Enterprise, Inc.’s consummated acquisition of its body-worn camera systems competitor VieVu, LLC from parent company from Safariland. Before the acquisition, the two companies competed to provide body-worn camera systems to large, metropolitan police departments across the United States.

According to the complaint, Axon’s May 2018 acquisition reduced competition in an already concentrated market. Before their merger, Axon and VieVu competed to sell body-worn camera systems that were particularly well suited for large metropolitan police departments. Competition between Axon and VieVu resulted in substantially lower prices for large metropolitan police departments, the complaint states. Axon and VieVu also competed vigorously on non-price aspects of body-worn camera systems. By eliminating direct and substantial competition in price and innovation between dominant supplier Axon and its closest competitor, VieVu, to serve large metropolitan police departments, the merger removed VieVu as a bidder for new contracts and allowed Axon to impose substantial price increases, according to the complaint.

As part of the Merger, Safariland entered several non-compete and customer non-solicitation agreements covering products and services not related to the merger, and both Axon and Safariland entered into company-wide non-solicitation agreements that all run for 10 or more years (together, “Non-Competes”). According to the FTC the Non-Competes are not reasonably limited to protect a legitimate business interest.  Some of the provisions of the Non-Competes include:

  • Safariland agreed not to engage in (a) body worn video products and services, (b) in-car video products and services, (c) digital evidence management products and services provided to third parties that ingest digital evidence audio and video files, and (d) enterprise records management systems provided to third parties, anywhere in the world for 10 years.
  • In an ancillary exclusive supply agreement for conducted electrical weapons, Safariland agreed not to compete in the conducted electrical weapons industry, body worn camera industry, fleet or vehicle camera industry, surveillance room camera industry, and digital evidence management system and storage industry, with regard to law enforcement, military, security or consumers, anywhere in the world for 12 years.
  • Safariland agreed not to solicit or entice any of Axon’s customers or potential customers for purposes of diverting business or services away from Axon, for 10 years.
  • Safariland agreed not to hire or solicit any of Axon’s employees, or encourage any employees to leave Axon, or hire certain former employees of Axon, except pursuant to a general solicitation for a period of 10 years. Axon agreed to a similar prohibition.

According to the FTC, by prohibiting Safariland from competing against Axon–in terms of products and services Safariland can offer as well as customers Safariland can solicit–these provisions harm customers who would otherwise benefit from potential or actual competition by  Safariland. By prohibiting Axon and Safariland from affirmatively soliciting each other’s employees, these provisions eliminate a form of competition to attract skilled labor and deny employees and former employees of Axon and Safariland access to better job opportunities. They restrict workers’ mobility, and deprive them of competitively significant information that they could use to negotiate better terms of employment.

The FTC also alleged the Non-Competes are not reasonably limited in scope to protect a legitimate business interest. A mere general desire to be free from competition is not a legitimate business interest. The Non-Competes go far beyond any intellectual property, goodwill, or customer relationship necessary to protect Axon’s investment in VieVu. Moreover, even if a legitimate interest existed, the lengths of the Non-Competes are longer than reasonably necessary, because they prevent Safariland from competing for products and services, customers, and employees for 10 years or longer.

The conduct is merely alleged in a complaint and no court or administrative tribunal have found the parties violated any law.

Morrison v. Berry considers Plaintiff’s claims for damages following the purchase of a grocery-store chain, The Fresh Market, Inc. (“Fresh Market” or the “Company”) by Apollo investment entities. The Plaintiff was a former stockholder of the Company, purportedly acting on behalf of the stockholder class. She alleges that certain Fresh Market fiduciaries breached their duties in negotiating the sale and in obtaining the assent of the stockholders. The matter was previously the subject of a motion to dismiss, which was granted based on the fact of the approval of the merger by a majority of disinterested stockholders.    The Plaintiff appealed that decision, and the Supreme Court reversed and remanded, finding that the Defendants failed to show the stockholder vote was fully informed, and thus the business judgment rule did not apply under Corwin.  The Complaint was amended and the matter was again before the Court on additional motions to dismiss, alleging failure to state a claim under Chancery Court Rule 12(b)(6).

While the Court’s opinion is wide ranging and considers a number of issues, it addresses Scott Duggan’s, the General Counsel of Fresh Market, motion to dismiss for the claims against him.  As an officer of Fresh Market, Duggan was not exculpated by the Company’s 102(b)(7) provision.  The Court noted Plaintiff must plead either a breach of the duty of loyalty or care to overcome Duggan’s motion to dismiss.

To state a claim for breach of the duty of loyalty the Plaintiff must plead Duggan was interested in the transaction, lacked independence, or acted in bad faith.  To state a claim for bad faith conduct, the Plaintiff must allege Duggan knowingly and completely failed to undertake his responsibilities.

A breach of the duty of care exists if Duggan acted with gross negligence. Gross negligence involves more than simple carelessness. To plead gross negligence, a plaintiff must allege “conduct that constitutes reckless indifference or actions that are without the bounds of reason.”

Change-in-Control Benefits

The Court noted the Plaintiff did not plead a claim for breach of the duty of loyalty related to change-in-control benefits.  The Court primarily based this conclusion on the fact that  change-in-control benefits arising out of a pre-existing employment contract do not create a conflict.  Nothing in the alleged facts suggests Duggan’s single-trigger bonus was unique or specially negotiated in anticipation of the Apollo transaction. The change-in-control benefit was not exclusive to a purchase by Apollo, and would not predispose Duggan to encourage a sale to Apollo exclusively, nor a sale at an unfair price.

Alleged Knowledge of Wrongdoing

The Court noted as a general rule, an officer does not have a duty to probe into wrongdoing unless he has reasonable suspicion that such activity is afoot. According to the alleged facts, Duggan first received news of Apollo’s interest from Ray Berry, Fresh Market’s Chairman of the Board and former CEO, and a few days later from  Apollo. Thus, Duggan knew that Berry and Apollo had communicated and that Apollo’s bid was forthcoming.  When that bid arrived, it stated as fact that Berry and Apollo were in an exclusive relationship. At that point, Duggan went to Berry and asked him about this purported relationship, and Berry denied it. Duggan reported Berry’s version to the Board, which declined further inquiries. When Berry later made a contrary disclosure, Duggan reported it in full to the Board.  The Court found it may have been wise to explore further, but that the pleaded facts did not support gross negligence.

Process Related to Revised Projections

Plaintiff also alleged Duggan breached his fiduciary duties by organizing a scheme to obtain downward revised projections from the Company’s financial adviser without allowing input from Richard Noll, a Board member and a member of the Strategic Transaction Committee. Duggan’s motive, according to the Plaintiff, was to create a lower price range that would justify the Board’s decision to sell, thus completing a sham process. In the Plaintiff’s scenario, Duggan’s behavior was intentional and implicated a breach of loyalty. The Court discounted the allegations, noting that Noll was travelling on business during a Committee meeting in question.  Communications indicated that Duggan intended to share all materials and plans with Noll.

The Court found Duggan’s process did not evince a breach of loyalty or bad faith. Nor were there sufficient allegations from which to infer gross negligence. Suggesting additional financial scenarios to prepare the Board for bids—particularly when the last projections were three months old—reasonably suggests Duggan was fulfilling his duties on behalf of the Company, not acting outside the bounds of reason.

Disclosures in Schedule 14D-9

The Delaware Supreme Court found four omissions in the Schedule 14D-9 to be material.  The Plaintiff argued that the omissions suggested that Duggan intended to disguise his disloyal actions.  However, the allegations related to Duggan’s conduct in the sales process, as noted above, did not adequately plead disloyalty on Duggan’s part.

Turning to the claim of gross negligence, the Court noted “Because fiduciaries . . . must take risks and make difficult decisions about what is material to disclose, they are exposed to liability for breach of fiduciary duty only if their breach of the duty of care is extreme.” Given the omissions noted by the Supreme Court, the Court observed the Schedule 14D-9 offers stockholders a version of events that left them lacking information material to a decision. Such a distortion of events creates a reasonable inference for the Plaintiff at this stage that Duggan conceivably acted with gross negligence in his role as Fresh Market’s General Counsel with regard to the 14D-9.  Given Duggan’s role as General Counsel, and given the sales process as pled, the Court stated it inferred that the omitted facts were omitted with Duggan’s knowledge. According to the Court it is reasonably conceivable that crafting such a narrative to stockholders, while possessed of the information evincing its inadequacy, represents gross negligence on Duggan’s part.

The Court concluded noting another reasonable interpretation is that the Schedule 14D-9 represents a good faith but failed effort to make reasonable disclosures, but given the pleading stage, the Court must choose the inference favoring the Plaintiff. Therefore, the motion to dismiss was denied.

The SEC has issued new guidance it believes will assist public companies both in assessing materiality and in drafting disclosure related to risks to technology and intellectual property that may result from conducting business outside the United States.  The SEC believes that this is important for jurisdictions that do not have comparable levels of protection as the United States of corporate proprietary information and assets such as intellectual property, trademarks, trade secrets, know-how and customer information and records.

The SEC believes companies should consider their disclosure obligations regarding risks related to the potential theft or compromise of data, technology and intellectual property within the context of the federal securities laws and its principles-based disclosure system.  The SEC notes that although there is no specific line-item requirement under the federal securities laws to disclose information related to the compromise (or potential compromise) of technology, data or intellectual property, the SEC has made clear that its disclosure requirements apply to a broad range of evolving business risks in the absence of specific requirements.

The guidance states among the risks faced by companies is the risk of theft of technology, data and intellectual property through a direct intrusion by private parties or foreign actors, including those affiliated with or controlled by state actors. While not exclusive, examples of situations in which technology, data or intellectual property may be stolen or compromised through direct intrusion include cyber intrusions into a company’s computer systems and physical theft through corporate espionage, including with the assistance of insiders.

In addition, a company’s technology, data and intellectual property may be subject to theft or compromise via more indirect routes. For example, a company’s products or components may be reverse engineered by joint venture partners or other parties, including those affiliated with state actors, and the company’s patents subsequently infringed or know-how or trade secrets stolen. Companies may be required to compromise protections or yield rights to technology, data or intellectual property in order to conduct business in or access markets in a foreign jurisdiction, either through formal written agreements or due to legal or administrative requirements in the host nation. By limiting or otherwise negatively impacting a company’s rights to protect its own technology, data or intellectual property, these types of agreements and requirements may impede both the company’s ability to compete today as well as its ability to retain and improve on this intellectual property, thereby inhibiting chances of future success.

The SEC encourages companies to assess the risks related to the potential theft or compromise of their technology, data or intellectual property in connection with their international operations, as well as how the realization of these risks may impact their business, including their financial condition and results of operations, and any effects on their reputation, stock price and long-term value. Where these risks are material to investment and voting decisions, the SEC states they should be disclosed, and the SEC encourages companies to provide disclosure that allows investors to evaluate these risks through the eyes of management.

SEC Chairman Jay Clayton, Sagar Teotia, Chief Accountant and William Hinman, Director, Division of Corporation Finance issued a Statement on Role of Audit Committees in Financial Reporting and Key Reminders Regarding Oversight Responsibilities.

The statement does not include any new information.

In the statement:

The SEC notes ss the 2019 calendar year-end financial reporting season approaches, the SEC is providing observations and reminders on a number of potential areas of focus for audit committees. Issuers and independent auditors also should be mindful of these considerations with an eye toward ensuring that audit committees have the resources and support they need to fulfill their obligations.

  • Tone at the Top – Because audit committees of public companies have financial reporting and independent auditor oversight authority and responsibility, they are instrumental in setting the tone for the company’s financial reporting and the relationship with the independent auditor.
  • Auditor Independence – Compliance with auditor independence rules is a shared responsibility of the audit firm, the issuer and its audit committee.
  • Generally Accepted Accounting Principles (GAAP) – While the process of implementing new GAAP standards is a collaborative effort among different stakeholders, the importance of the audit committee in promoting an environment for management’s successful implementation of new standards cannot be overstated.
  • ICFR – Audit committees are responsible for overseeing ICFR, including in connection with their consideration of management’s assessment of ICFR effectiveness and, when applicable, the auditor’s attestation.
  • Communications to the Audit Committee from the Independent Auditor – The SEC reminds audit committees of the year-end financial reporting process under PCAOB AS 1301, Communications with Audit Committees, which requires the auditor to communicate with the audit committee regarding certain matters related to the conduct of the audit and to obtain certain information from the audit committee relevant to the audit.
  • Non-GAAP Measures –It is important that audit committees understand whether—and how and why—management uses non-GAAP measures and performance metrics, and how those measures are used in addition to GAAP financial statements in the company’s financial reporting and in connection with internal decision making.
  • Reference Rate Reform (LIBOR) –The SEC encourages audit committees to understand management’s plan to identify and address the risks associated with reference rate reform, and specifically, the impact on accounting and financial reporting and any related issues associated with financial products and contracts that reference LIBOR.
  • Critical Audit Matters – The SEC encourages audit committees to engage in a substantive dialogue with the auditor regarding the audit and expected CAMs to understand the nature of each CAM, the auditor’s basis for the determination of each CAM and how each CAM is expected to be described in the auditor’s report.

The SEC is proposing Rule 13q-1 and an amendment to Form SD to implement Section 1504 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “DoddFrank Act”) relating to disclosure of payments by resource extraction issuers. Section 1504 of the Dodd-Frank Act added Section 13(q) to the Securities Exchange Act of 1934. Section 13(q) directs the SEC to issue rules requiring resource extraction issuers to include in an annual report information relating to payments made to a foreign government or the Federal Government for the purpose of the commercial development of oil, natural gas, or minerals. Section 13(q) requires these issuers to provide information about the type and total amount of payments made for each of their projects related to the commercial development of oil, natural gas, or minerals, and the type and total amount of payments made to each government. In addition, Section 13(q) requires a resource extraction issuer to provide information about those payments in an interactive data format.

The SEC initially adopted Rule 13q-1 and amendments to Form SD on August 22, 2012. Those rules were vacated by the U.S. District Court for the District of Columbia on July 2, 2013. On June 27, 2016, the Commission adopted a revised version of Rule 13q-1 and amendments to Form SD which are referred to as the 2016 Rules. On February 14, 2017, the revised rules were disapproved by a joint resolution of Congress pursuant to the Congressional Review Act, or CRA. Although the joint resolution vacated the 2016 Rules, the statutory mandate under Section 13(q) of the Exchange Act remains in effect.

Similar to the prior rules, the proposed rules, would require resource extraction issuers to submit on an annual basis a Form SD that includes information about payments related to the commercial development of oil, natural gas, or minerals that are made to governments. Given the requirements of Section 13(q), certain elements of the proposed rules are also in the 2016 Rules. Nevertheless, the SEC believes that the proposed rules, considered as a whole, are not in substantially the same form as the 2016 Rules and therefore in compliance with the CRA’s restriction on subsequent rulemaking.

In this regard, the proposed new rules include several significant changes to the core provisions of the 2016 Rules. Specifically, the proposed rules would:

  • revise the definition of the term “project” to require disclosure at the national and major subnational political jurisdiction, as opposed to the contract, level;
  • revise the definition of “not de minimis” to include both a project threshold and an individual payment threshold;
  • add two new conditional exemptions for situations in which a foreign law or a pre-existing contract prohibits the required disclosure;
  • add an exemption for smaller reporting companies and emerging growth companies;
  • revise the definition of “control” to exclude entities or operations in which an issuer has a proportionate interest;
  • limit the liability for the required disclosure by deeming the payment information to be furnished to, but not filed with, the SEC;
  • add an instruction in Form SD that would permit an issuer to aggregate payments by payment type made at a level below the major subnational government level;
  • add relief for issuers that have recently completed their U.S. initial public offerings; and
  • extend the deadline for furnishing the payment disclosures.

Section 13(q) defines a resource extraction issuer in part as an issuer that is “required to file an annual report with the Commission.” The SEC believes this language could reasonably be read to include or to exclude issuers that file annual reports on forms other than Forms 10-K, 20-F, or 40-F. The SEC is therefore using its discretion and proposing to cover only issuers filing annual reports on Forms 10-K, 20-F, or 40-F. Specifically, the proposed rules would define the term “resource extraction issuer” to mean an issuer that is required to file with the Commission an annual report on one of those forms pursuant to Section 13 or 15(d) of the Exchange Act and that engages in the commercial development of oil, natural gas, or minerals.

As with the 2016 Rules, the SEC believes that covering issuers that provide disclosure outside of the Exchange Act reporting framework would do little to further the transparency objectives of Section 13(q) but would add costs and burdens to the existing disclosure regime governing those categories of issuers. The proposed definition would therefore exclude issuers subject to Tier 2 reporting obligations under Regulation A and issuers filing annual reports pursuant to Regulation Crowdfunding. In addition, investment companies registered under the Investment Company Act of 1940 (“Investment Company Act”) would not be subject to the proposed rules.

The SEC has proposed amendments to the definition of “accredited investor” to add new categories of qualifying natural persons and entities and to make certain other modifications to the existing definition. Specifically, the proposed amendments:

  • would add new categories of natural persons that may qualify as accredited investors based on certain professional certifications or designations or other credentials or their status as a private fund’s “knowledgeable employee;”
  • expand the list of entities that may qualify as accredited investors and allow entities meeting an investments test to qualify;
  • add family offices with at least $5 million in assets under management and their family clients; and
  • add the term “spousal equivalent” to the definition.

Professional Certifications and Designations and Other Credentials

The SEC is proposing to amend the rule to include natural persons holding one or more professional certifications, designations or other credentials issued by an accredited educational institution that the SEC designates from time to time as meeting specified criteria. An investor would need to maintain these certifications, designations, or credentials in good standing in order to qualify for accredited investor status.

The SEC’s designation of certifications, designations, or credentials would be based upon its consideration of all the facts pertaining to a particular certification, designation, or credential. The proposed amendment would provide a non-exclusive list of attributes that the SEC would consider in determining which professional certifications, designations or other credentials qualify for accredited investor status.

The SEC preliminarily expects that the following certifications or designations would be included in an initial SEC order accompanying the final rule, if adopted:

  • Licensed General Securities Representative (Series 7);
  • Licensed Investment Adviser Representative (Series 65); and
  • Licensed Private Securities Offerings Representative (Series 82).

Knowledgeable Employees of Private Funds

Pursuant to Rule 3c-5 of the Investment Company Act, “knowledgeable employees” of a private fund (such as hedge funds, private equity funds and venture capital funds) may acquire securities issued by the fund without being counted for purposes of investor limits.  This provision permits individuals who participate in a fund’s management to invest in the fund as a benefit of employment.

The proposed new category of accredited investor would be the same in scope as the definition of “knowledgeable employee” in Rule 3c-5(a)(4).  It would include, among other persons, trustees and advisory board members, or persons serving in a similar capacity, of specified funds or an affiliated person of the fund that oversees the fund’s investments, as well as employees of the private fund or the affiliated person of the fund (other than employees performing solely clerical, secretarial, or administrative functions) who, in connection with the employees’ regular functions or duties, have participated in the investment activities of such private fund for at least 12 months.

Proposed Note to Rule 501(a)(5)

The SEC is proposing to add a note to Rule 501 to clarify that the calculation of “joint net worth” for purposes of Rule 501(a)(5) can be the aggregate net worth of an investor and his or her spouse (or spousal equivalent if “spousal equivalent” is included in Rule 501(a)(5), as proposed), and that the securities being purchased by an investor relying on the joint net worth test of Rule 501(a)(5) need not be purchased jointly.

Registered Investment Advisers

The SEC proposes to include investment advisers registered under Section 203 of the Investment Advisers Act and investment advisers registered under the laws of any state in the definition of accredited investor.

Limited Liability Companies

Given the widespread adoption of the limited liability company as a corporate form, the SEC proposes to include limited liability companies in Rule 501(a)(3). The proposed amendment would codify a longstanding staff position that limited liability companies that satisfy the other requirements of the definition are eligible to qualify as accredited investors under Rule 501(a)(3).

The SEC also notes the term “executive officer” is defined in Rule 501(f) as “the president, any vice president in charge of a principal business unit, division or function, as well as any other officer who performs a policy making function, or any other person who performs similar policy making functions for the issuer.” The SEC believes that a manager of a limited liability company performs a policy making function for the issuer equivalent to that of an executive officer of a corporation under Rule 501(f), and therefore the SEC does not believe it is necessary to amend Rule 501(a)(4) or Rule 501(f) to specifically include managers of limited liability companies.

Other Entities

The SEC is proposing to add a new category in the accredited investor definition for any entity owning investments in excess of $5 million that is not formed for the specific purpose of acquiring the securities being offered. As shown by the emergence of limited liability companies, it is possible that an entirely new corporate form could gain acceptance but not come within the scope of Rule 501(a). Proposed Rule 501(a)(9) is intended to capture all existing entity forms not already included within Rule 501(a), such as Indian tribes and governmental bodies, as well as those entity types that may be created in the future.

To assist both issuers and investors, the SEC proposes to incorporate the definition of investments from Rule 2a51-1(b) under the Investment Company Act, which includes, among other things: securities; real estate, commodity interests, physical commodities, and non-security financial contracts held for investment purposes; and cash and cash equivalents. By using an existing definition, the SEC hopes to alleviate confusion and facilitate compliance.

Proposed Note to Rule 501(a)(8)

Under Rule 501(a)(8), an entity qualifies as an accredited investor if all of the equity owners of that entity are accredited investors. Because in some instances, an equity owner of an entity is another entity, not a natural person, the SEC is proposing to add a note to Rule 501(a)(8) that would clarify that, in determining accredited investor status under Rule 501(a)(8), one may look through various forms of equity ownership to natural persons.

Certain Family Offices and Family Clients

The SEC proposes to amend the definition of accredited investor to include any “family office” with at least $5 million in assets under management and its “family clients,” each as defined in the family office rule set forth in Investment Advisers Act Rule 202(a)(11)(G)-1.  The SEC believes requiring the family office to have a minimum amount of assets under management would ensure the family office has sufficient assets to sustain the risk of loss. In addition, the proposed definition would apply only to a family office whose purchases are directed by a person who has such knowledge and experience in financial and business matters that such family office is capable of evaluating the merits and risks of the prospective investment. In order to avoid improper reliance on the amended rule, the SEC also proposes that the family office not be formed for the specific purpose of acquiring the securities offered and that a family client must be a family client of a family office that meets these requirements. The SEC expects that all or most current family offices would be accredited investors under the proposed amendments to the definition.

Permit Spousal Equivalents to Pool Finances for the Purposes of Qualifying as Accredited Investors

The SEC proposes to allow natural persons to include joint income from spousal equivalents when calculating joint income under Rule 501(a)(6), and to include spousal equivalents when determining net worth under Rule 501(a)(5).  The proposed amendments would define spousal equivalent as a cohabitant occupying a relationship generally equivalent to that of a spouse.