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

The PCAOB recently noted that during 2019 it will provide an opportunity for audit committee chairs of certain companies whose audits are subject to inspection to “engage in a dialogue with the inspections staff.” While we assume the PCAOB’s motive is in good faith to obtain a better mutual understanding of the PCAOB process on one hand and the audit committee process on the other, the dialogue may be a gateway to enforcement activity.

Accordingly, we believe issuers should approach any such engagement cautiously, if at all. Perhaps the only circumstance for which this may be appropriate is upon assurance by the PCAOB that the inspection of the issuer is complete and final and no potential deficiencies were identified. Even then, issuers should consider whether there is any benefit to the dialogue. It is especially worth consideration because the PCAOB also announced it intends to publish additional updates to audit committees regarding its inspections including observations from these interviews and its inspection findings.

Why? Inspection findings can lead to restatements and potential liability for companies. Even if there are no findings, issuers will not have any control over how the PCAOB reports the results of its interviews to the public. There is a risk that audit committee chairs or issuers could be cast in a negative light.

Additionally, inspections are the root of many PCAOB enforcement actions.  While the PCAOB’s Division of Enforcement and Investigations, or DEI, only has the authority to act against auditors (at present), it is DEI’s practice to share investigative results with government enforcement agencies, including those who have the authority to bring actions against issuers.  Such “engagement” could become the route by which the PCAOB obtains statements from audit committee chairs that are shared with and used by DEI without causing DEI first to obtain an SEC subpoena.

So, what should issuers do if the PCAOB wants to talk to their audit committee chair or if issuers otherwise become aware that their audit has become subject to inspection and deficiencies have been noted?

Issuers should include a requirement in their audit engagement letters that the auditor must (within 14 days) reveal to the company if: (i) the PCAOB selects one of their audits for inspection, (ii) the issuer is the subject of an investigation, or (iii) the issuer otherwise becomes connected to an inquiry from the PCAOB or the SEC. While perhaps more controversial, issuers should also consider including a requirement that the work papers of the auditor will be shared with or available to the issuer if there is a triggering event such as selection of an audit for inspection by the PCAOB. If the conduct of the issuer is questioned as part of the inspection, or if the inspection could result in a restatement, the issuer or perhaps its audit committee should retain counsel to conduct a privileged internal investigation. Counsel should then retain a forensic auditor to assist in the investigation in a privileged manner.

We believe that counsel for the company or the audit committee is the proper person to engage with the PCAOB. If an audit committee member is invited in by the PCAOB’s Director of Registration and Inspections for some “engagement,” she or he may want to bring counsel along, or first send counsel in her or his place to get a preview. Alternatively, to keep the engagement on a narrowly defined track, counsel should request that the PCAOB submit its questions in writing and work with the issuer to provide its response in writing through counsel followed by a subsequent phone call with the PCAOB to resolve any open questions.

Note: Joel Schwartz, a partner with Stinson Leonard Street LLP, is a former assistant director of enforcement at the PCAOB.  Steve Quinlivan, Bryan Pitko and Jaclyn Schroeder practice with Stinson’s Corporate Finance Division and regularly represent public companies.

William Hinman, Director, SEC Division of Corporation Finance, recently gave his views on sustainability disclosures by public companies, among other topics.

According to Mr. Hinman, sustainability disclosures are a complicated topic.  Investors want information, but do not agree on the types of sustainability disclosures that should be made.  It is likely some of the information requested is not material under standards used by the SEC.

Mr. Hinman interprets the currently differing views on sustainability disclosures as the market evaluating what types of disclosure would provide consistently material and useful information.  Allowing this evolution to continue should provide market participants with a continued opportunity to sort out the types of information they find useful. The SEC would have stymied this evolution if it had issued prescriptive regulation the first time an investor asked for it.  Prescriptive regulatory solutions are not preferable to market driven solutions, according to Mr. Hinman.  The SEC is watching carefully as market-led approaches develop in this area, and is actively comparing the information companies voluntarily provide – typically outside of their SEC filings – with the disclosure filed with the SEC.

Mr. Hinman also warned that imposing specific bright-line requirements can increase the costs associated with being a public company but not deliver the relevant and material information that market participants are seeking. Adding costly disclosure requirements that do not deliver commensurate benefits decreases the attractiveness of public markets, which in turn can reduce the number of public investment options available to all investors.

In a published document, the PCAOB noted its new strategic plan anticipated enhanced external engagement and more proactive communication with its stakeholders, including audit committees, to inform them about its core activities—including its inspections—and to maintain an ongoing dialogue with them.

The PCAOB noted that during 2019 it will provide an opportunity for audit committee chairs of certain companies whose audits are subject to inspection to engage in a dialogue with the inspections staff. The purpose of the audit committee dialogue is to provide further insight into the PCAOB process and obtain audit committee views. The PCAOB expects to publish additional updates to audit committees regarding its inspections to provide observations from these interviews and its inspection findings.

I guess that means if your audit is selected for inspection the PCAOB may contact you.  It may be advisable to set up a protocol for responding to any such contact such as who should be informed and who will participate in the “dialogue” with the inspections staff and any necessary preparation for the dialogue.

Following that introduction, the PCAOB summarized its previously announced 2019 inspection priorities.  The PCAOB then noted that in addition to required communications from their auditors, audit committees may—at their discretion—choose to further engage with their auditors on current issues of inspection focus as they work to positively affect audit quality in those areas. The PCAOB provided the following sample questions that are designed to provide audit committees ideas of the types of questions they may consider asking their auditors, if relevant, throughout the year.

  • Auditor Response to Identified Risks
    • How have the current economic factors influenced the auditor’s risk assessment for the current year’s audit?
    • How has the auditor considered the relevant economic factors that could affect the company’s ability to continue as a going concern?
    • How has the auditor assessed potential risks of material misstatement related to the company’s technology systems, including cyber security, and how has it addressed those potential risks?
  • Changes in Auditor’s Report
    • What are the most substantive issues or learnings identified pursuant to the firm’s pilot testing and dry runs related to communicating CAMs in the auditor’s report?
    • What items, if any, were considered “close calls” but ultimately not identified as a CAM by the auditor? Why were these items not determined to be CAMs?
  • Implementation of New Accounting Standards
    • What are the auditor’s observations regarding the company’s implementation of the new revenue recognition standard?
    • What is the auditor’s view of the company’s readiness to adopt new accounting standards pertaining to lease accounting and valuation of financial instruments, including credit losses (if relevant)?
  • Quality Controls
    • How does the firm’s quality control system promote audit quality?
    • What are recent actions taken by the firm to strengthen its quality control system?
    • Did the audit include the use of software audit tools? If so, how were these tools used and how did the use of these tools affect the risk assessment and the quality of audit evidence?
  • Auditor Independence
    • How does the firm monitor compliance with the independence requirements of the PCAOB and SEC, including compliancewith obtaining pre-approvals for non-audit services?
    • How can the audit committee and management assist the auditor in complying with independence requirements?
  • PCAOB Inspection Results and Corrective Actions
    • If the firm has been inspected by the PCAOB, were there inspection findings? If so, what were those findings and what corrective actions has the firm taken?
    • How has the firm’s inspection findings changed over time?
  • Possible Indicators to Audit Quality
    • Has the firm developed a definition of audit quality? If so, how is audit quality defined?
    • Based on the firm’s definition, what are the key drivers of audit quality for the firm overall and for this audit engagement specifically?
    • How does the firm identify, set targets for, and monitor those key drivers generally, and specifically with respect to this audit engagement?

The SEC’s Division of Investment Management is seeking comment on the application of the Custody Rule to digital assets. The Custody Rule provides that it is a fraudulent, deceptive or manipulative act, practice or course of business for an investment adviser that is registered or required to be registered under the Investment Advisers Act to have “custody” of client funds or securities unless they are maintained in accordance with the requirements of the Custody Rule.

Areas in which the SEC is seeking comments include:

  • What challenges do investment advisers face in complying with the Custody Rule with respect to digital assets? What considerations specific to the custody of digital assets should the staff evaluate when considering any amendments to the Custody Rule? For example, are there disclosures or records other than account statements that would similarly address the investor protection concerns underlying the Custody Rule’s requirement to deliver account statements?
  • To what extent are investment advisers construing digital assets as “funds”, “securities”, or neither, for purposes of the Custody Rule? What considerations are advisers applying to reach this conclusion?
  • To what extent are investment advisers including digital assets in calculating regulatory assets under management for purposes of meeting the thresholds for registering with the Commission? What considerations are included within this analysis?
  • To what extent do investment advisers use state chartered trust companies or foreign financial institutions to custody digital assets? Have these investment advisers experienced similarities/differences in custodial practices of such trust companies as compared to those of banks/broker-dealers?

Elon Musk, in a court filing, offered the following three reasons why he should not be held in contempt of court for violating a court Order in a recent tweet:

  • There is no clear and convincing evidence that an unambiguous court order was violated. According to Musk, Tesla has confirmed Musk has complied with its policies, which permits Musk to exercise his reasonable discretion in the first instance to determine whether his communications contain information requiring pre-approval.
  • There is no evidence that Musk did not diligently attempt to comply with the order.
  • The Order as the SEC interprets it would raise serious First Amendment issues and implicate other constitutional rights. The SEC seeks to rewrite the Order to eliminate Musk’s discretion, effectively requiring Musk to seek pre-approval of any tweet that relates to Tesla, regardless of its significance, prior dissemination, or nature.

 

The CFTC announced an Enforcement Advisory on self-reporting and cooperation for violations of the Commodity Exchange Act, or CEA, involving foreign corrupt practices.  Because the Enforcement Advisory is limited to the CEA, it does not suggest that the CFTC will bring actions regarding violations of the Foreign Corrupt Practices Act.

The new Enforcement Advisory provides further clarity surrounding the benefits of self-reporting misconduct, full cooperation, and remediation in this context, according to the CFTC.  According to a CFTC official, “Together with the Department’s Corporate Enforcement Policy, CFTC’s Advisory on self-reporting and cooperation will make clear to companies the significant benefits of voluntarily self-disclosing misconduct, fully cooperating with the government’s investigation, and remediating the misconduct.”

A CFTC official also noted companies and individuals engaging in foreign corrupt practices should recognize that foreign corrupt practices might constitute fraud, manipulation, false reporting, or a number of other types of violations under the CEA, and thus be subject to enforcement actions brought by the CFTC.  “Bribes might be employed, for example, to secure business in connection with regulated activities like trading, advising, or dealing in swaps or derivatives.  Corrupt practices might be used to manipulate benchmarks that serve as the basis for related derivatives contracts.  Prices that are the product of corruption might be falsely reported to benchmarks.  Or corrupt practices in any number of forms might alter the prices in commodity markets that drive U.S. derivatives prices.  We currently have open investigations involving similar conduct.  But regardless of the specific factual scenario, we are committed at the CFTC to enforcing the CEA provisions that encompass foreign corrupt practices.”

The new Enforcement Advisory only apples to non-CFTC registrants.  CFTC registrants have existing obligations to disclose to the Commission CEA violations, including those involving foreign corrupt practices; registrants are thus not eligible for the presumptive recommendation of no penalty set out in this Advisory.  Nevertheless, the CFTC stated CFTC registrants who self-report, cooperate, and remediate still would be eligible to receive the recommended substantial reduction in penalty generally applicable under existing Enforcement Advisories.

We have been unable to find extensive SEC comments on last year’s first round of pay ratio disclosures.  Searches for comment letter responses referring to for “402(u)” or “pay ratio” do not seem to turn up anything of general applicability.

Maybe the SEC staff determined that commenting on pay ratio disclosures would not materially benefit investor protection. Or maybe filings selected for review by the staff had materially complete disclosures. Who knows.

In any event, issuers can proceed towards proxy season knowing there are not any staff positions out there that are not clearly reflected in the rules.

Set forth below are examples of pay ratio disclosures from recently filed proxies where registrants chose to rely on the median employee identified in the prior year.

Sabre Corporation

In accordance with Item 402(u), we are using the same “median employee” identified in 2017 in our 2018 pay ratio calculation, as we believe that there has been no change in our employee population or employee compensation arrangements that we believe would result in a significant change to our pay ratio disclosure for 2018. See our 2017 proxy statement for information regarding the process we utilized to identify our “median employee.” We then identified and calculated the elements of this employee’s total compensation for 2018 in accordance with the requirements of Item 402(c)(2)(x) of Regulation S-K, resulting in annual total compensation of $88,297. This annual total compensation includes the estimated value of the employee’s health care benefits (estimated for the employee and the employee’s eligible dependents to be $1,890) and other statutory benefits. With respect to the annual total compensation of our CEO, we used the amount reported in the “Total” column of our 2018 Summary Compensation Table, adjusted as follows. To maintain consistency between the annual total compensation of our CEO and the “median employee,” we added the estimated value of our CEO’s health care benefits (estimated for our CEO and our CEO’s eligible dependents at $24,905) to the amount reported in the 2018 Summary Compensation Table. This resulted in annual total compensation for purposes of determining the ratio in the amount of $10,797,250, which exceeds the amount reported for him in the Summary Compensation Table by this amount.

Seaboard Corporation

Seaboard has elected to identify its median employee every three years unless a significant change in employee population or employee compensation arrangements has occurred. In 2018, the prior year’s median employee terminated employment. Therefore, as allowed by the SEC, Seaboard identified an alternate median employee with comparable pay as the median employee for 2018.

Superior Industries International, Inc.

In accordance with Instruction 2 to Item 402(u) of Regulation S-K, because there has been no change in our employee population or employee compensation arrangements in the past fiscal year that we reasonably believe would result in a significant change to our pay ratio disclosure, we elected to utilize the same median employee that we had identified in 2017 to calculate our 2018 CEO pay ratio. The process that we used to determine our median employee in 2017 is summarized below:

The Goodyear Tire & Rubber Company

For 2018, we used the same median employee that was identified in 2017 since there has been no change in our employee population or employee compensation arrangements that we believe would significantly impact our pay ratio disclosure.

The SEC has proposed new rules that would permit all issuers to solicit investor views about potential offerings to be taken into account at an earlier stage in the process than is the case today. The new rule and related amendments would expand the “test-the-waters” accommodation—currently available to emerging growth companies or “EGCs”—to all issuers, including investment company issuers. The ability for EGCs to engage in test-the-waters-communications was provided for under the JOBS Act.

The proposed rule eases regulatory burdens because Section 5(c) of the Securities Act prohibits any written or oral offers prior to the filing of a formal registration statement with the SEC. Once an issuer has filed a registration statement, Section 5(b)(1) limits written offers to a formal prospectus that conforms to the requirements of the Securities Act. As such, without the proposed rule change, most communications by issuers seeking to gauge investor interest would violate the Securities Act and constitute what is popularly referred to as “gun jumping.” According to the SEC, the ability of EGCs to engage in test-the-waters communications under the JOBS Act has not impaired investor protection.

The proposed rule will allow all issuers to engage in test-the-waters communications with potential investors that are, or that the issuer reasonably believes to be, qualified institutional buyers (“QIBs) or institutional accredited investors (“IAIs”), either prior to or following the date of filing of a registration statement related to such offering. Generally a QIB is a specified institution that, acting for its own account or the accounts of other QIBs, in the aggregate, owns and invests on a discretionary basis at least $100 million in securities of unaffiliated issuers. IAIs are institutional investors that are also accredited investors, that meet the criteria of SEC Rule 501(a)(1), (a)(2), (a)(3), (a)(7), or (a)(8), and includes organizations with assets in excess of $5,000,000 not formed for the purpose of acquiring the securities offered. The SEC believes these types of entities do not need the protections of the Securities Act’s registration process.

The SEC noted its belief that allowing more issuers to engage with certain sophisticated institutional investors while in the process of preparing for a contemplated registered securities offering could help issuers to better assess the demand for and valuation of their securities and to discern which terms and structural components of the offering may be most important to investors before incurring costs associated with launching an offering. This, in turn, could enhance the ability of issuers to conduct successful offerings and lower their cost of capital.

Test-the-waters communications that comply with the proposed rule would not need to be filed with the SEC, nor would they be required to include any specified legends. The SEC does not believe it is necessary to impose such requirements because communications under the proposed rule would be limited to investors that are, or are reasonably believed to be, QIBs and IAIs. These types of investors are generally considered to have the ability to assess investment opportunities, thereby reducing the need for the additional safeguards provided by a filing or legending requirement.

Information provided in a test-the-waters communication under the proposed rule must not conflict with material information in a related registration statement. As is currently the practice of the SEC staff when reviewing offerings conducted by EGCs, the SEC or its staff could request that an issuer furnish the staff any test-the-waters communication used in connection with an offering.

The SEC cautioned public companies to consider whether any information in a test-the-waters communication would trigger any obligations under Regulation FD. Regulation FD requires public companies to make public disclosure of any material nonpublic information that has been selectively disclosed to certain securities market professionals or shareholders. To avoid the application of Regulation FD, a public company could consider obtaining a confidentiality agreements from any potential investor engaged under the proposed rule prior to providing the test-the-waters material.

In addition, the Commission noted that although the new rule would exempt test-the-waters communications from the gun-jumping provisions of Section 5, they would still be considered “offers” as defined under the Securities Act such that Section 12(a)(2) liability and the anti-fraud provisions of the federal securities laws would continue to be applicable.

Under the proposed rule, any potential investor solicited must meet, or issuers must reasonably believe that the potential investor meets, the requirements of the rule. The SEC stated that this standard would avoid imposing an undue burden on issuers compared to requiring issuers to verify investor status. For example, under the proposed rule, an issuer could reasonably believe that a potential investor is a QIB or IAI even though the investor may have provided false information or documentation to the issuer. The SEC does not believe that an issuer should be subject to a violation of Section 5 in such circumstances, so long as the issuer established a reasonable belief with respect to the potential investor’s status based on the particular facts and circumstances.

The SEC did not propose specific steps that an issuer could or must take to establish a reasonable belief that the intended recipients of test-the-waters communications are QIBs or IAIs. Identifying specific steps or providing additional guidance that could be used by an issuer to establish a reasonable belief regarding an investor’s status could create a risk that such steps or guidance would become a de facto minimum standard. The SEC believes issuers should continue to rely on the methods they currently use to establish a reasonable belief regarding an investor’s status in analogous circumstances. By not specifying the steps an issuer could or must take to establish a reasonable belief as to investor status, this approach is intended to provide issuers with the flexibility to use methods that are cost-effective but appropriate in light of the facts and circumstances of each contemplated offering and each potential investor.

Nasdaq has filed an immediately effective rule proposal that clarifies and amends Nasdaq rules that permit a direct listing without an IPO.  A December 22,2017,  Wall Street Journal article states that Nasdaq had completed about a half dozen direct listings at that time. The NYSE has previously adopted a rule change to permit a direct listing.

Highlights of the Nasdaq proposal include:

  • Direct listings are subject to all initial listing requirements applicable to equity securities and, subject to applicable exemptions, the corporate governance requirements set forth in the Rule 5600 Series. To provide transparency to the initial listing process, the Exchange proposes to adopt Listing Rule IM-5315-1, which will state how the Exchange calculates the initial listing requirements based on the price of a security, including the bid price, market capitalization and market value of publicly held shares for a direct listing on the Nasdaq Global Select Market.
  • Nasdaq also proposes to require that a company that lists on the Nasdaq Global Select Market through a direct listing do so at the time of effectiveness of a registration statement filed under the Securities Act of 1933 solely for the purpose of allowing existing shareholders to sell their shares.
  • Under IM-5315-1, Nasdaq would require that a company listing on the Nasdaq Global Select Market through a Direct Listing provide Nasdaq an independent third-party valuation. Nasdaq will determine that the company has met the market value of publicly held shares requirement for listing on the Nasdaq Global Select Market if the company provides a valuation evidencing a market value of publicly held shares of at least $250,000,000.

The rule filing only relates to the Nasdaq Global Select Market.  Nasdaq intends to subsequently file a proposed rule change under Section 19(b) of the Exchange Act to adopt requirements for the Nasdaq Capital and Global Markets applicable to companies which have not been listed on a national securities exchange or traded in the over-the-counter market pursuant to FINRA Form 211 immediately prior to the initial pricing and wish to list their securities to allow existing shareholders to sell their shares.