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

Quoting both a nearly 70-year-old decision and a nearly 30-year-old SNL skit, the Delaware Court of Chancery, in Stein v. Blankfein et al, reaffirmed that in most circumstances decisions of directors awarding director compensation are subject to review under the entire fairness standard. The Court also addressed the possibility of stockholder waiver of application of that standard to future director actions, but did not conclude as to whether such a waiver was even possible. The litigation addressed compensation of Goldman Sachs’ directors– primarily the stock incentive plans, or SIPs, approved by Goldman Sachs stockholders in 2013 and 2015. Ruling on a motion to dismiss, the Court rejected director defendants’ arguments that:

  • the stockholder-approved SIPs absolved, in advance, the director’s breaches of duty in self-dealing, absent a demonstration of bad faith. Since the argument was rejected the director decisions were subject to review under the entire fairness standard because the plans provided the directors discretion to determine their own awards; and
  • the plaintiff failed to adequately allege that the self-awarded director compensation was not entirely fair.

The following courses of action remain available to public company boards in approving director compensation:

  • have specific awards or self-executing guidelines approved by stockholders in advance; or
  • knowing that the entire fairness standard will apply, limit discretion with specific and meaningful limits on awards and approve director compensation with a fully developed record, including where appropriate, incorporating the advice of legal counsel and that of compensation consultants.

It may also be possible to obtain a waiver from stockholders of the right to challenge future self-interested awards made under a compensation plan using the entire fairness standard.  To do so, stockholders would have to approve a plan that provides for a standard of review other than entire fairness, such as a good faith standard.  In addition stockholders would have to be clearly informed in the proxy statement that director compensation is contemplated to be a self-interested transaction that is ordinarily subject to entire fairness, and that a vote in favor of the plan amounts to a waiver of the right to challenge such transactions, even if unfair, absent bad faith.  Note that the Court did not conclude, because it was not required to do so, that such a waiver was even possible.

Entire Fairness Applies

Section 141(h) of the of the Delaware General Corporation Law, or DGCL, gives a corporation’s board of directors the power to fix director compensation. Consistent with precedent, the Court noted where a challenge is raised to a director decision on director compensation, Section 141 is the beginning, not the end, of the inquiry. The DGCL provision means that the actions of the directors are not ultra vires, but it says nothing about whether those actions are consistent with the directors’ fiduciary duties.

The Court noted that existing jurisprudence indicates directors’ self-interested decisions on executive compensation are inherently likely to be based on conflicted motives and therefore disloyal.  As a result, directors’ decisions on director compensation are subject to review under the standard of entire fairness, and the burden to demonstrate fair price and process is on the directors, not the plaintiff.

However, in this case the SIPs provided that “no member of the Board . . . shall have any liability to any person . . . for any action taken or omitted to be taken or any determination made in good faith with respect to the [SIPs] or any Award.” Based on stockholders’ approving the SIPs that included this language, the defendants argued that any action taken by the Goldman Sachs board under the SIPs—self-interested or otherwise—was reviewable only under a good faith standard. The defendants argued this was dispositive, since the plaintiff did not plead that the defendants did not act in good faith.

The Court rejected the defendants’ argument.  If the directors wanted to obtain a waiver from stockholders of the right to redress for the directors’ future unfair and self-dealing transactions (assuming such a waiver is even possible), the related proxy statement would have had to have informed stockholders that the SIPs contemplated self-interested transactions subject to entire fairness, and that a vote in favor amounted to a waiver of the right to redress for such transactions, even if unfair, absent bad faith.

Allegations that Compensation was Not Entirely Fair

The Court noted applicable Delaware precedent was set forth in In re Investors Bancorp, Inc. Stockholder Litigation. In that case, a corporation’s stockholders approved an equity incentive plan that allowed the directors to later award themselves compensation, on terms set at the discretion of the directors. Even though the stockholders approved the equity incentive plan, which included specific limits on director awards, because the directors were able to later determine their own compensation under the plan, the Delaware Supreme Court held that entire fairness was the applicable standard.

The Goldman Sachs SIPs set no specific limit on non-employee director compensation, and permitted directors to use their discretion to set that compensation. In other words, the stockholders were not informed about the specifics of the compensation package itself; that is to say, as in Investors Bancorp, the stockholders did not “know precisely what they [were] approving,” triggering application of the entire fairness standard.

Given the result in Investors Bancorp, the defendants argued, and the Court agreed, that plaintiff’s complaint must meet a pleading burden: plaintiff must assert facts that, if true, make it reasonably conceivable that the transaction is not entirely fair to the corporation.  Such a burden in the self-compensation area cannot be simply conclusory, in light of the power the DGCL confers on directors to self-compensate.

The plaintiff alleged that the directors were paid nearly twice as much as their counterparts at companies identified as peers by Goldman Sachs, and attended fewer board meetings than the directors of the peer companies—that is, the Goldman Sachs directors awarded themselves more pay for the same or less work. The plaintiff did not allege that the process used to determine compensation was unfair.

Although the Court noted the allegations of excessive compensation were not particularly strong, it found that the plaintiff met the low pleading burden regarding director compensation: to point to “some facts” implying lack of entire fairness. The Court observed the foregoing allegations were more than conclusory.

In a review of a PCAOB disciplinary proceeding the SEC took the rare step of cancelling the PCAOB’s finding that an audit partner of a Big Four firm engaged in repeated instances of negligent conduct during the audit of a mortgage REIT’s financial statements.

The facts were extreme.  The audit firm issued an unqualified audit opinion on February 27, 2008, and the company filed its 2007 Form 10-K, including the audit opinion, on February 28, 2008. The same day it filed its Form 10-K, the company received more than $150 million in margin calls. Although the company had represented that it had $150 million in available liquidity two days earlier, the company was able to meet only $31.6 million in calls on February 28. The SEC stated that it was not clear from the record why this was the case but, regardless, this led to a notice of default and additional cross-defaults. The company received an additional $125 million in margin calls on February 29—the next day— and was able to meet only $15.7 million of them.

The audit partner learned of these post-audit margin calls and defaults on Sunday, March 2, 2008. After consulting with others at the audit firm, interviewing management, and reviewing emails and other documents, the audit partner and her team concluded that the company’s financial statements contained material misstatements related to whether losses to the company’s ARM Assets were other than temporary (OTTI) and therefore needed to be recognized in the company’s income statement.

The audit partner sent the company’s audit committee a letter on March 4, 2008, notifying the committee that the audit firm’s audit opinion of February 27 should no longer be relied upon, that the company’s financial statements contained material misstatements, and that the audit report “should have contained an explanatory paragraph indicating that substantial doubt exists relative to the [c]ompany’s ability to continue as a going concern for a reasonable period of time.”

On March 5, the company’s board of directors concluded that the company needed to restate its financial statements and, on March 11, the company filed an amended Form 10-K in which it restated portions of its 2007 financial statements. Unlike in its original Form 10-K, the company concluded that a more than $400 million decline in its Purchased ARM Assets was an OTTI because the company may not be able to hold those securities for the foreseeable future and may need to sell them to satisfy margin calls from lenders or to otherwise manage its liquidity position. This caused the company to include in its net loss for 2007 roughly $427.8 million in previously unrealized losses in its Purchased ARM Assets, which, along with certain other charges not at issue, increased the company’s losses by more than 75%—from $875 million to $1.546 billion.

The company’s amended Form 10-K also included the audit firm’s revised audit report. The report explained that the company did not have the financial resources as of March 6, 2008 to satisfy approximately $610 million in margin calls associated with its reverse repurchase agreements and other financial instruments and that failure to satisfy those margin calls was an event of default under the reverse repurchase agreements. These events, the report explained, provided lenders the discretion to declare the entire unpaid amounts due and payable on demand and to force liquidation of the company’s assets to satisfy those obligations. The report concluded that these matters raised substantial doubt about the company’s ability to continue as a going concern.

On appeal from the PCAOB’s final decision the issue presented to the SEC was the PCAOB’s finding that the audit partner engaged in “repeated instances of negligent conduct, each resulting in a violation of the applicable statutory, regulatory, or professional standard.”  The PCAOB expressly declined to find that the audit partner engaged in “reckless conduct.”

The SEC noted it had not previously specified what constitutes “repeated instances” of negligent conduct under Sarbanes-Oxley, but that it had analyzed a similar provision in the SEC’s analogous Rule of Practice 102(e).  Rule of Practice 102(e) uses largely the same language as in Sarbanes-Oxley Section 105(c)(5) in allowing the Commission to suspend an accountant from appearing before it if that accountant is found to have engaged in “[r]epeated instances of unreasonable conduct, each resulting in a violation of applicable professional standards . . . .” When the SEC adopted Rule 102(e) it explained that “repeated” can “encompass as few as two separate instances of unreasonable conduct occurring within one audit, or separate instances of unreasonable conduct within different audits.” When adopting the rule the SEC added that “a single error that results in an issuer’s financial statements being misstated in more than one place would not, by itself, constitute [repeated instances of unreasonable conduct].”

The SEC also noted negligence is the failure to exercise reasonable care or competence, which the SEC has described as an objective standard “measured by the degree of the departure from professional standards rather than the intent of the accountant.” In this case, the PCAOB erroneously found that the audit partner engaged in repeated instances of negligent conduct under Sarbanes-Oxley Section 105(c)(5) on two, alternate bases: first, because of the audit partner’s alleged auditing failures encompassed two audit areas—going concern and OTTI/ability to hold—and not just one financial statement account; and, alternatively, because “even if these two audit areas were treated as one,” the audit partner allegedly failed to take four auditing steps within her going-concern and OTTI inquiries and that each of these failures constituted an independent instance of negligence.

The SEC found that the PCAOB has not established either basis for determining that the audit partner engaged in more than one instance of negligent conduct. The PCAOB did not establish how the audit partner’s alleged audit deficiencies constituted repeated instances of negligent conduct for purposes of Sarbanes-Oxley solely because they affected the two audit areas of going-concern and OTTI. Moreover, the preponderance of the evidence did not support the conclusion that the audit partner’s decisions to take, or not take, four audit steps each constituted an instance of negligence. The record did not support the conclusion that the audit partner engaged in the conduct that the PCAOB found her to have engaged in regarding two of those audit steps. Regarding the two other steps, the record does not support the conclusion that the audit partner’s conduct constituted repeated instances of negligent conduct in the context of her audit. Accordingly, there was not a sufficient basis to support the PCAOB’s findings that the audit partner engaged in repeated instances of negligent conduct and the SEC concluded it could not sustain the PCAOB’s imposition of sanctions.

The SEC did not remand for further proceedings.

Given the extreme facts, the SEC sent a clear message to the PCAOB that its enforcement proceedings and related Board actions need to make sense and, assuming they make sense, be documented much better.  Restatements alone do not violate Sarbanes-Oxley.

In Shareholder Representative Services LLC v. RSI Holdco, LLC et al, the Delaware Court of Chancery considered when a buyer can use the acquired company’s privileged pre-merger attorney-client communications in post-closing litigation against the sellers.  The question arises because at closing all computer systems and email servers are acquired by buyers.  Those systems and servers contain pre-merger communications between the target company’s owners and representatives (i.e., the sellers) and the target company’s counsel. Thus, in a post-closing dispute between the sellers and buyer, the buyer possesses the target company’s privileged pre-merger attorney-client communications, including those concerning merger negotiations.

The Court of Chancery previously addressed this issue in Great Hill Equity Partners IV, LP v. SIG Growth Equity Fund I, LLLP.  The Court held that by operation of Section 259 of the Delaware General Corporation Law, all assets of a target company, including privileges over attorney-client communications, transfer to the surviving company unless the sellers take affirmative action to prevent transfer of those privileges.  In Great Hill, the sellers did not retain their ability to assert privilege over the pre-merger attorney-client communications because they neither negotiated for language in the merger agreement preserving the right to assert privilege over the communications nor prevented the surviving company from taking actual possession of the communications. Thus, the Court held that the sellers waived their ability to assert privilege.  The Court further advised that in the future sellers should “use their contractual freedom” to avoid waiver.

In the RSI Holdco case before the Court, the merger agreement, which involved the acquisition of Radixx, included the following provision:

“Any privilege attaching as a result of [Seyfarth] representing [Radixx] . . . in connection with the transactions contemplated by this Agreement [1] shall survive the [merger’s] Closing and shall remain in effect; provided, that such privilege from and after the Closing [2] shall be assigned to and controlled by [Representative]. [3] In furtherance of the foregoing, each of the parties hereto agrees to take the steps necessary to ensure that any privilege attaching as a result of [Seyfarth] representing [Radixx] . . . in connection with the transactions contemplated by this Agreement shall survive the Closing, remain in effect and be assigned to and controlled by [Representative]. [4] As to any privileged attorney client communications between [Seyfarth] and [Radixx] . . . prior to the Closing Date (collectively, the “Privileged Communications”), [Holdco], the Merger Subsidiary and [Radixx] (including, after the Closing, the Surviving Corporation), together with any of their respective Affiliates, successors or assigns, agree that no such party may use or rely on any of the Privileged Communications in any action or claim against or involving any of the parties hereto after the Closing.”

The Court noted, as reflected by the bracketed numbers that the provision (1) preserves any privilege attaching to pre-merger communications as a result of Seyfarth’s representation of Radixx in connection with the merger; (2) assigns to Representative control over those privileges; (3) requires the sellers and buyer to take steps necessary to ensure that the privileges remain in effect; and (4) prevents Holdco and affiliates from using or relying on any privileged communications in post-closing litigation against the sellers.

Buyer (Holdco) sought to use Emails discovered on servers in litigation against sellers and filed an action seeking “full, unfettered access” to the Emails.  The Court held that by its plain and broad language, the merger agreement provision preserved privilege over the Emails and assigned control over the privilege to Representative. The Court also noted the provision does more than preserve the privilege. Its “no-use” clause provides that “none of the parties ‘may use or rely on any of the Privileged Communications in any action or claim against or involving any of the parties [to the Merger Agreement] after the Closing.’” Thus, the provision prevented Holdco from doing exactly what Holdco wanted to do—use the Emails in litigation with the sellers.

The Court rejected Holdco’s argument that the sellers waived privilege based on post-closing conduct because of the express language of the merger agreement provision spoke as of privileged communications prior to closing. Holdco also asserted a waiver occurred because sellers failed to take “steps to segregate” or “excise” the communications from the computer systems pre-merger and had “done nothing” post-closing to “get these computer records back.” This argument was rejected because it would undermine the guidance of Great Hill—which cautioned parties to negotiate for contractual protections.

Holdco’s arguments in support of waiver also suffer another problem. The merger agreement provision required all parties to the merger agreement to “take the steps necessary to ensure that any privilege attaching as a result of [Seyfarth] representing [Radixx] . . . in connection with the transactions contemplated by this Agreement shall survive the Closing, remain in effect and be assigned to and controlled by the [Representative].” According to the Court, for privilege to be waived, it would necessarily be due in part to Holdco’s own failure to “take the steps necessary” to preserve it. As a result the Court stated Holdco cannot argue that its own failure to preserve privilege should now inure to its benefit.

In AG Oncon, LLC et al v. Ligand Pharmaceuticals Inc., the Delaware Court of Chancery upheld an issuer’s right to conform an Indenture to the related description of notes contained in the offering memorandum used to privately place the convertible notes.

The Indenture authorized Ligand to conform its terms to the description of the notes in the offering memorandum. Three-and-a-half years after issuing the notes, Ligand invoked this right to replace a defined term in the conversion formula in the Indenture.

The offering memorandum explained that the conversion value of the notes would depend on the “daily VWAP,” defined as the value-weighted average price of Ligand’s stock on each day of a fifty-trading-day observation period. The offering memorandum stated that for each trading day, the conversion value would be divided by the daily VWAP, generating a value-equivalent number of shares for that day.

Unfortunately, the Indenture used a different term in the denominator of the conversion formula. Instead of referring to the daily VWAP, the Indenture referred to the “Daily Principal Portion.” That term was defined as one-fiftieth of the principal due on the note. It was a fixed dollar amount ($20 per $1,000 of issuance) that had nothing to do with the trading price of Ligand’s stock, and its use made no sense in light of what the formula attempted to calculate. Exercising its right to conform the terms of the Indenture to the offering memorandum, Ligand replaced the reference to the Daily Principal Portion with a reference to the daily VWAP, which the Court referred to as the Conversion Formula Amendment.

The plaintiffs were sophisticated bond traders who purchased the notes in the secondary market. In this lawsuit, they sought to invalidate the amendment and enforce the conversion formula as it originally appeared in the Indenture. The notes Ligand issued had a face value of $245 million. Four years after issuance, the plaintiffs claimed they are entitled to conversion consideration amounting to $4 billion.

The Delaware Court of Chancery granted Ligand’s motion to dismiss for failure to state a claim. Section 9.01(b) of the Indenture stated that Ligand “may amend . . . this Indenture or the Notes without the consent of any Holder to: . . . conform the terms of this Indenture or the Notes to the ‘Description of the Notes’ section of the Offering Memorandum,” which the Court referred to as the Conforming Amendment Provision.  The Court rejected plaintiff’s claim that the Indenture constituted the complete and final agreement governing the notes such that Ligand could not rely on the Offering Memorandum when effectuating the Conversion Formula Amendment. The Court rejected this argument because the Indenture itself contained the Conforming Amendment Provision, which allowed Ligand to conform the Indenture to the Offering Memorandum. The right was not dependent on any language or document outside of the Indenture.

The plaintiffs also claimed that the Conversion Formula Amendment materially and adversely amended the noteholders’ rights without their consent in violation of two other provisions of the Indenture. The plaintiffs asserted that Ligand could not rely on the Conforming Amendment Provision, because that provision must be read in conjunction with the other provisions of the Indenture.  Ligand argued that the Conforming Amendment Provision means what it says and permits any amendment necessary to conform the Indenture to the Offering Memorandum.

This Court agreed with Ligand. In this case, reading the Indenture as a whole established that Ligand could rely on the Conforming Amendment Provision to effectuate the Conversion Formula Amendment. The Indenture’s terms recognize that the Description of the Notes section in the Offering Memorandum established the baseline terms for the notes. In the Conforming Amendment Provision, the Indenture authorized any amendments necessary to conform the Indenture to those baseline terms. Other provisions in the Indenture restricted amendments that would depart from the baseline terms. Those other provisions limit midstream amendments. The other provisions did not apply to amendments necessary to conform the Indenture to the baseline terms set forth in the Offering Memorandum.

Finally, plaintiffs argued that the Conversion Formulae Amendment violated Section 316(b) of the Trust Indenture Act. That argument failed for several reasons.  First, the notes were privately offered and thus the indenture was not required to be qualified under the Trust Indenture Act. The Court found that while some provisions of the Trust Indenture Act were incorporated into the Indenture, Section 316(b) was not. Finally, Section 316(b) by its terms protects “the right of any holder of any indenture security to receive payment of the principal of and interest on such indenture security, on or after the respective due dates expressed in such indenture security . . . .” According to the Court the protections of Section 316(b) do not extend to consideration received under a conversion right.

The SEC awarded more than $4.5 million to a whistleblower whose tip triggered the company to review the allegations as part of an internal investigation and subsequently report the whistleblower’s allegations to the SEC and another agency. According to the SEC this is the first time a claimant is being awarded under this provision of the whistleblower rules, which was designed to incentivize internal reporting by whistleblowers who also report to the SEC within 120 days.

The whistleblower sent an anonymous tip to the company alleging significant wrongdoing and submitted the same information to the SEC within 120 days of reporting it to the company. This information prompted the company to review the whistleblower’s allegations of misconduct and led the company to report the allegations to the SEC and the other agency. As a result of the self-report by the company, the SEC opened its own investigation into the alleged misconduct. Ultimately, when the company completed its internal investigation, the results were reported to the SEC and the other agency.

 

The New York Stock Exchange proposes to amend Section 303A.08 of the Manual to clarify the circumstances under which certain sales of a listed company’s securities will not be deemed to be equity compensation for purposes of that rule. The rule proposal states as follows:

Section 303A.08 provides that an “equity-compensation plan” is a plan or other arrangement that provides for the delivery of equity securities (either newly issued or treasury shares) of the listed company to any employee, director or other service provider as compensation for services. The adoption of an equity compensation plan under the rule — or any material revision to a plan — is subject to shareholder approval. However, Section 303A.08 provides for certain exclusions from its definition of equity compensation plan, including for:

Plans that merely allow employees, directors or other service providers to elect to buy shares on the open market or from the listed company for their current fair market value, regardless of whether the:

– shares are delivered immediately or on a deferred basis; or

– payments for the shares are made directly or by giving up compensation that is otherwise due (for example, through payroll deductions).

The Exchange has always interpreted the above provision with respect to the purchase of shares for fair market value as applying only when the securities are acquired directly from the company, either in the form of treasury shares or newly-issued shares. Plans that merely allow their participants to elect to buy shares on the open market do not give rise to any concern about diluting the economic interests of the company’s shareholders.

For purposes of the above exclusion from the definition of equity compensation plan, the Exchange has always interpreted “current fair market value” as requiring that the price used be the most recent official closing price on the Exchange. For the avoidance of doubt, the Exchange now proposes to include in Section 303A.08 text specifying how the fair market value of the issuer’s common stock should be calculated for this purpose. “Fair market value” will be defined as the most recent official closing price on the Exchange, as reported to the Consolidated Tape, at the time of the issuance of the securities. For example, if the securities are issued after the close of the regular session at 4:00 pm Eastern Standard Time on a Tuesday, then Tuesday’s official closing price will be used. If the securities are issued at any time between the close of the regular session on Monday and the close of the regular session on Tuesday, then Monday’s official closing price will be used.

The proposed definition of fair market value under Section 303A.08 is modeled on the definition of “Official Closing Price” set forth in Section 312.04(j), as such definition is proposed to be amended by this filing (as discussed below). However, the definitions differ in one material respect. The Official Closing Price as defined in Section 312.04(j) (as proposed to be amended) when used in calculating whether a transaction qualifies for an applicable exemption from the shareholder approval requirements of Sections 312.03(b) and (c) is defined as the most recent official closing price on the Exchange, as reported to the Consolidated Tape, at the time of the signing of a binding agreement to issue the securities. By comparison, “fair market value” for purposes of Section 303A.08 will be the most recent official closing price on the Exchange, as reported to the Consolidated Tape, at the time of the issuance of the securities themselves, rather than most recently reported at the time of the signing of the binding agreement.

In particular, issuers may issue shares in lieu of cash at the election of participants in a deferred compensation arrangement because the exclusion from the definition of equity compensation plan applies to plans that allow employees, directors and service providers to elect to buy shares from the listed company for their current fair market value regardless of whether the shares are issued immediately or on a deferred basis. Arrangements of this type are common and they are appropriate as they are primarily designed to ensure that the issuances under the deferred compensation arrangement are not economically dilutive to the other shareholders at the time of such issuance. For example, a director compensation plan may require its participants to defer receipt of a portion of their director fees until the director retires from the board. Such arrangements may provide that an individual director can elect to receive shares in lieu of the deferred cash compensation, with the number of shares to which such director is entitled representing the number of shares whose fair market value at the time of issuance equals the amount of the deferred compensation. Because any economic dilution to the issuer’s shareholders would be incurred at the time of the deferred issuance, requiring that the shares are issued for fair market value measured at the time of issuance of the shares rather than at the time the company incurs the obligation ensures that the issuance is not economically dilutive.

The Exchange also proposes to clarify the definition of “Official Closing Price” used in Section 312.04(j) of the Manual. That provision currently reads in relevant part as follows:

“Official Closing Price” of the issuer’s common stock means the official closing price on the Exchange as reported to the Consolidated Tape immediately preceding the signing of a binding agreement to issue the securities.

As amended, the provision will read as follows:

“Official Closing Price” of the issuer’s common stock means the most recent official closing price on the Exchange, as reported to the Consolidated Tape, at the time of the signing of a binding agreement to issue the securities.

The purpose of this amendment is simply to clarify the meaning of the provision and it is not intended to have any substantive effect.

 

 

 

The PCAOB posted to its website a staff guidance document, A Deeper Dive on the Communication of CAMs, developed to support implementation of the new critical audit matter requirements. This document was informed by discussions with auditors regarding their experiences conducting dry runs of CAMs with their audit clients, the staff’s review of methodologies submitted by 10 U.S. audit firms that collectively audit approximately 85% of large accelerated filers, and other outreach efforts.

The guidance addresses the following topics, with key portions of the related response noted:

  • How should auditors describe the principal considerations that led them to determine a matter is a CAM?

The description of the principal considerations is meant to provide a clear, concise, and understandable discussion of why the matter is a CAM, including the especially challenging, subjective, or complex auditor judgments made in the context of the particular audit. The “why” is intended to provide information appropriately tailored to the audit and the matter that helps financial statement users understand the aspects of the audit that stood out from the auditor’s perspective.

  • If describing audit procedures as part of communicating how a CAM was addressed in the audit, what considerations apply?

If the auditor chooses to describe audit procedures as part of communicating how a CAM was addressed in the audit, it is expected that the procedures described would be specific to the CAM and to the audit. General statements about procedures that would likely be performed in most audits or in relation to most significant areas of the audit, such as “testing the operating effectiveness of the company’s controls” in the case of an integrated audit, typically do not, by themselves, provide useful information to a reader about how the auditor addressed the particular CAM.

  • If describing the outcome of audit procedures or key observations with respect to a matter, what considerations apply?

In describing how the CAM was addressed in the audit, the auditor may choose to include findings as an indication of the outcome of audit procedures or as key observations about a matter. However, the language used to describe how the CAM was addressed in the audit should not imply that the auditor is providing a separate opinion on the CAM or on the accounts or disclosures to which it relates. For example, a CAM should not indicate that the auditor concluded that the financial statement accounts and/or disclosures related to the CAM are fairly presented in accordance with the applicable financial reporting framework.

  • How do CAM communications relate to company disclosures and other information the company has made publicly available?

While CAMs, by definition, relate to the company’s financial statement accounts and disclosures, a CAM communication also includes the principal considerations that led the auditor to determine a matter was a CAM and how the CAM was addressed in the audit (i.e., the “why” and “how” of the CAM). Accordingly, CAM communications will not simply duplicate disclosures made by the company. When communicating CAMs, the auditor is not expected to provide information about the company that has not been made publicly available by the company, unless such information is necessary to describe the “why” and “how” of the CAM. In that context, information a company has made publicly available includes all means of public communication, whether within or outside the financial statements, including SEC filings, press releases, and other public statements.

  • If a CAM is recurring, how should auditors apply the CAM communication requirements?

The auditor determines and communicates CAMs every year in connection with the current period audit. It is possible that a CAM identified in one or more prior periods may also continue to be a CAM in the current period. A CAM may be determined based on the same or different considerations, and the way a CAM is addressed in the audit may be similar or may vary. Regardless of whether a matter was previously determined to be a CAM, the auditor would consider the specific facts and circumstances that existed during the audit of the current period’s financial statements, and tailor the communication of the CAM as necessary.

  • Is there a specific order in which CAMs should appear in the CAM section of the auditor’s report?

AS 3101 does not specify any particular order of presentation for matters included within the CAM section of the auditor’s report. The auditor may consider ordering the presentation of CAMs based on the auditor’s judgment of relative importance, an order that corresponds to the presentation of the company’s financial statements, or any other order.

  • How do the CAM requirements apply to a dual-dated auditor’s report?

If the auditor’s report is dual-dated, the new information for which the auditor’s report is dual-dated may give rise to one or more additional CAMs or may necessitate modifications to previously communicated CAMs. For example, if an auditor’s report is dual-dated because of a subsequent event, the report would include, as applicable, any new CAMs or any modifications to previously issued CAMs arising from the impact of the subsequent event on the audit.

Research by Lucian A. Bebchuk, Harvard Law School, and Scott Hirst, Boston University School of Law, indicates three key index fund advisors could cast 34% of votes in the next decade at S&P 500 companies, and about 41% of votes at S&P 500 companies in two decades. The key index fund managers are BlackRock, Vanguard, and State Street Global Advisors.

Extrapolations of the make-up of the public securities markets 20 years into the future are often notoriously unreliable.  Nevertheless, the magnitude of the statistic is eye-opening and perhaps someday it will be viewed as akin to an early warning of global warming.

There are at least two possible outcomes of this voting concentration should it occur.  Research by Professor John Coates theorizes investment managers will excessively use the power that comes from their large ownership stakes.  On the other hand, Professors Bebchuk and Hirst theorize the index fund managers will be excessively deferential to corporate managers. Their concern is that the substantial proportion of equity ownership with incentives towards deference will depress shareholder intervention overall, and will result in insufficient checks on corporate managers.

ISS ESG, an arm of ISS, released ESG Review 2019, an annual analysis of the state of adherence by companies across the globe to environmental, social, and governance (ESG) criteria. This year’s report finds the share of companies covered by ISS’ Corporate Rating and assessed as “good” or “excellent” (both assessments lead to Prime status) now stands at 20.4 percent, up from just over 17 percent in the previous year.

This year’s report also shows that the group rated with medium or excellent performance (on a four-category scale of poor, medium, good or excellent) now includes more than 67.5 percent of covered companies in developed markets. This represents an all-time high over the 11-year history of the report. Similar patterns can be observed among companies in emerging markets, the report finds, albeit at a considerably lower level. Broken down by sector, Household & Personal Products has the highest share of Prime-rated (i.e., good to excellent performance) companies, followed by Semiconductors and Electronic Devices & Appliances. Sectors with the lowest share of Prime-rated companies are Food & Beverages, Oil, Gas & Consumable Fuels, and Retail.

Meanwhile, ISS states Norm-Based Research, which identifies significant allegations against companies linked to the breach of established standards for responsible business conduct, saw a more than 40 percent rise in the number of reported controversies across all ESG topics. ISS says this exemplifies a growing misalignment of corporate practices with stakeholder expectations that are grounded in  UN Global Compact and the OECD Guidelines for Multinational Enterprises.

ISS stated at the close of 2018, failures to respect human rights and labor rights together accounted for the majority (56 percent) of significant controversies assessed under ISS’s Norm-Based Research. Industries that are most exposed to controversies in the environmental area are Materials, Energy, and Utilities. On social matters, Materials is also leading, similarly followed by Energy and Capital Goods. The governance area sees most controversies within Banks, Capital Goods, and Pharmaceuticals & Biotechnology.

 

Nasdaq has released its new global environmental, social and governance (ESG) reporting guide which it believes will support public and private companies. The 2019 ESG Reporting Guide includes third-party reporting methodologies adopted by the industry and Nasdaq intends it to help companies navigate the evolving standards on ESG data disclosure.

The global version of the ESG Reporting Guide is based on three developments:

  • Reporting frameworks developed by the Task Force on Climate-related Financial Disclosures and the UN’s Sustainable Development Goals and others;
  • Guidance and best practices provide by the World Federation of Exchanges; and
  • The results of Nasdaq’s year-long ESG reporting pilot program

The Guide is not intended to compete with, supersede, or supplement any existing ESG reporting framework.  Nasdaq intends for the guide to act as an informal reference guide for companies looking to leverage ESG reporting as a way to improve operations, enhance strategy, broaden risk oversight, or engage with new investors.