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

The Financial Accounting Standards Board issued a proposed Accounting Standards Update on the recognition and measurement of deferred revenue in business combinations.

The proposed ASU clarifies when acquiring organizations should recognize a contract liability in a business combination. In the proposal, an organization should recognize deferred revenue from acquiring another organization if there is an unsatisfied performance obligation for which the acquired organization has been paid by the customer.

The proposal was issued because diversity exists on whether and how to record deferred revenue in a business combination.

 

SEC Commissioner Hester M. Peirce was awarded the nick name “Crypto Mom” by digital asset aficionados in a previous speech encouraging forward thinking by the SEC in the regulation of tokens and initial coin offerings.

Crypto Mom has now given her view on the application of the Howey test to public token transactions.  According to Ms. Pierce, the Howey test is the central tenant of the SEC’s regulatory approach, but blind adherence may not make sense:

While the application of the Howey test seems generally to make sense in this space, we need to tread carefully. Token offerings do not always map perfectly onto traditional securities offerings. . . Functions traditionally completed by people designated as “issuers” or “promoters” under securities laws—which, importantly, bestow those roles with certain responsibilities and potential liabilities—may be performed by a number of unaffiliated people, or by no one at all.

Additionally, I am worried that the application of the test will be overly broad. The Supreme Court in Howey embraced a “flexible rather than static principle, one that is capable of adaptation,” an unwelcome phrase for people craving clarity. The subsequent application of the Supreme Court’s decision has further added to the ambiguity by diluting factors, such as the prong that asks whether the investors were anticipating “profits to come solely from the efforts of others.”[ “Solely” has gotten dropped in the application of this prong. In the years since Howey, many courts have instead focused on whether profits are derived in effect principally from the efforts of others. This approach has been formulated by one appellate court as a question of whether “the efforts made by those other than the investor are the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise.” More to the point, the Commission itself determined in 2017 that tokens issued by the DAO, a decentralized organization based on a distributed ledger, were securities despite the fact that token-holders had certain roles within the organization necessary to its operation.

Given the role that individuals play in some token environments, either through mining, providing development services, or other tasks, the SEC must take care not to cast the Howey net so wide that it swallows the “efforts of others” prong entirely. In the realm of securities regulation, we often talk of the need for disclosure as a means of addressing information asymmetries between the issuers and the investors. The “efforts of others” prong of Howey aims at the heart of this problem. If the investors are not in control of the enterprise, that is, if they lack material information about the operation of the organization, they will need to obtain that information from those who are in control in order to make an informed investment decision.

In a novel sequence of events, SEC Chair Jay Clayton issued a statement on February 11, 2019 expressing the Commission’s non-view on mandatory shareholder arbitration provisions implemented by publicly-listed companies. The statement was released in conjunction with a no-action letter from Corp Fin staff issued on the same day concurring with the exclusion of a proposal seeking adoption of mandatory arbitration of shareholder claims arising under the federal securities laws.

In the Rule 14a-8 no-action letter request, the company argued that the proposal, if implemented, would result in a violation of both federal and state law in a manner that would permit exclusion of the proposal under Rule 14a-8(i)(2). The staff’s response was carefully drafted to note that the staff granted relief solely on the issuer’s argument that the proposal would violate New Jersey  state law and expressed no view on the propriety of mandatory arbitration clauses under federal law. The Chairman’s corresponding statement also highlighted that the basis for the staff’s response was state law-specific and repeatedly indicated that the Commission’s policy on mandatory shareholder arbitration would need to be carefully considered by the Commission (not SEC staff) and that the staff’s no-action letter response is not binding on the Commission or other parties.

Both the staff’s response and Chairman’s statement also emphasized that the staff was strongly persuaded by the inclusion of the opinion of the Attorney General of State of New Jersey that the proposal, if adopted, would cause the company to violate state law.  This, in and of itself, is a unique occurrence under Rule 14a-8, where requests for relief on the (i)(2) “improper under the law” basis often include inconclusive (and sometimes dueling) legal opinions. The authoritative nature of an opinion from the “the state’s chief legal officer” appears to have been a decisive factor in the staff’s determination.

The Commission and Division of Corporation Finance have historically been hesitant to express an official opinion on whether mandatory arbitration clauses would be improper under federal law. The staff’s response and the Chairman’s statement do not provide any additional insight on this point. As such, the staff’s no-action letter, as further clarified by the Chairman’s statement, should be viewed with a narrow lens. The Commission’s views on mandatory arbitration remain an open question that will no doubt continue to be tested in the context of requests for no-action relief under Rule 14a-8 and filing reviews notwithstanding any future “measured and deliberative” action from the body of the Commission.

In two new Compliance and Disclosure Interpretations (Questions 116.11 and 133.13), the SEC staff provided guidance on disclosure of self-identified specific diversity characteristics of board members and board nominees. The full text the C&DI’s (which are identical) are set forth below.

Question: In connection with preparing Item 401 disclosure relating to director qualifications, certain board members or nominees have provided for inclusion in the company’s disclosure certain self-identified specific diversity characteristics, such as their race, gender, ethnicity, religion, nationality, disability, sexual orientation, or cultural background. What disclosure of self-identified diversity characteristics is required under Item 401 or, with respect to nominees, under Item 407?

Answer: Item 401(e) requires a brief discussion of the specific experience, qualifications, attributes, or skills that led to the conclusion that a person should serve as a director. Item 407(c)(2)(vi) requires a description of how a board implements any policies it follows with regard to the consideration of diversity in identifying director nominees. To the extent a board or nominating committee in determining the specific experience, qualifications, attributes, or skills of an individual for board membership has considered the self-identified diversity characteristics referred to above (e.g., race, gender, ethnicity, religion, nationality, disability, sexual orientation, or cultural background) of an individual who has consented to the company’s disclosure of those characteristics, we would expect that the company’s discussion required by Item 401 would include, but not necessarily be limited to, identifying those characteristics and how they were considered. Similarly, in these circumstances, we would expect any description of diversity policies followed by the company under Item 407 would include a discussion of how the company considers the self-identified diversity attributes of nominees as well as any other qualifications its diversity policy takes into account, such as diverse work experiences, military service, or socio-economic or demographic characteristics.

The SEC is conducting market research to determine the availability and technical capability of large and small businesses to provide blockchain data to support the SEC’s efforts to monitor risk, improve compliance, and inform Commission policy with respect to digital assets. The SEC is seeking information for potential sources to support the goal of acquiring data for the most widely used blockchain ledgers, including the universe of available information and transaction details.

More specifically, the SEC is seeking sources for a data source (subscription), which extracts blockchain data and parses this data to make it easily reviewable. The SEC would like to know not only the vendor’s ability to provide the requested data but also an overview of the processes used to extract the data, convert the data into a reviewable format, and the verification steps to ensure there is no loss in data completeness and accuracy due to the data transformation tools and processes applied. The requirements for the data provision include:

  • Provide data extracts on a recurring basis for the most widely used blockchain ledgers, based on transaction volume.
  • Cleanse and normalize data to enable review and exploration.
  • Provide capability to derive insights from the available data, including attribution data (i.e. to whom a particular address belongs).
  • Provide a means to demonstrate data provided is accurate and complete.

 

The SEC announced settled charges against four public companies for failing to maintain internal control over financial reporting, or ICFR, for seven to 10 consecutive annual reporting periods. Two of the charged companies also failed to complete the required evaluation of the effectiveness of ICFR for two consecutive annual reporting periods.

According to the SEC’s orders, year after year, the four companies disclosed material weaknesses in ICFR involving certain high-risk areas of their financial statement presentation. As discussed in the SEC orders, each of the four companies took months, or years, to remediate their material weaknesses after being contacted by the SEC staff. One of the companies is still in the process of remediating its material weaknesses.

According to an SEC official “Companies cannot hide behind disclosures as a way to meet their ICFR obligations. Disclosure of material weaknesses is not enough without meaningful remediation. We are committed to holding corporations accountable for failing to timely remediate material weaknesses.”

The four companies did not admit or deny the SEC’s findings.

 

The International Organization of Securities Commissions, or IOSCO, published a statement setting out the importance for issuers of considering the inclusion of environmental, social and governance, or ESG, matters when disclosing information material to investors’ decisions.

According to IOSCO, issuers are encouraged to consider the materiality of ESG matters to their business and to assess risks and opportunities in light of their business strategy and risk assessment methodology. When ESG matters are considered to be material, issuers should disclose the impact or potential impact on their financial performance and value creation.

IOSCO believes that information disclosed outside of securities filings following a voluntary disclosure framework may also be required to be disclosed under security filings if it is material. Although some information is disclosed following a voluntary disclosure framework, that disclosure should not substitute for disclosure in regulatory filings, if material, according to the published statement.

IOSCO is an international body that brings together the world’s securities regulators. The United Stated Securities and Exchange Commission did not vote on publication of the statement.

The Section 162(m) deduction limit for performance-based compensation was repealed by the Tax Cut and Jobs Act, effective for taxable years beginning after December 31, 2017, subject to transition relief. Public companies should consider revising disclosures in their upcoming proxy statements. Recently filed proxy statements may provide some ideas, a sample of which is noted below.

The disclosures seem to range from “compensation in excess of $1,000,000 will no longer be tax deductible, get used to it” to “it may not be deductible, but we still intend to tie pay to performance.”

TD Ameritrade Holding Corporation

Certain compensation previously paid to executive officers under the MIP, and certain equity awards that previously vested, were and are intended to be fully deductible under the “performance-based” compensation exception (discussed below) previously provided by Section 162(m) of the Code. As a result of the Tax Cuts and Jobs Act of 2017 (the “Act”), for tax years beginning after December 31, 2017, Section 162(m) of the Code limits to $1 million the federal income tax deduction we can receive for annual individual compensation paid to certain current and former executive officers, subject to a transition rule for written binding contracts in effect on November 2, 2017, and not materially modified after that date. Prior to the Act, Section 162(m)’s deduction limit included an exception for “performance-based” compensation that permitted qualifying compensation to be deductible even if it exceeded the $1 million limit. Significant aspects of the Company’s compensation programs were designed to permit (but not require) compensation to qualify for this performance-based exception. To accomplish this, the Company previously asked shareholders to approve equity and incentive compensation plans that included limitations and provisions required to be included under Section 162(m). Now that the performance-based compensation exception is no longer available, the Company will no longer include specific Section 162(m)-related limitations or provisions or request shareholder approval for this purpose, and generally will not attempt to meet the requirements previously included in our plans related to the now eliminated performance-based exception as there is no tax benefit from doing so. The Company will continue to seek shareholder approval of certain compensation plans as may be required by applicable law or regulation.

Aramark

Section 162(m) of the Internal Revenue Code (“Section 162(m)”) generally disallows a tax deduction to a public corporation for compensation over $1,000,000 paid in any fiscal year to a company’s chief executive officer or other named executive officers (excluding the company’s principal financial officer, in the case of tax years commencing before 2018). However, in the case of tax years commencing before 2018, the statute exempted qualifying performance-based compensation from the deduction limit if certain requirements were met. Section 162(m) was amended in December 2017 by the Tax Cuts and Jobs Act to eliminate the exemption for performance-based compensation (other than with respect to payments made pursuant to certain “grandfathered” arrangements entered into prior to November 2, 2017) and to expand the group of current and former executive officers who may be covered by the deduction limit under Section 162(m). While Aramark’s shareholder approved incentive plans were previously structured to provide that certain awards could be made in a manner intended to qualify for the performance-based compensation exemption, that exemption will no longer be available for future tax years (other than with respect to certain “grandfathered” arrangements as noted above). The Compensation Committee expects in the future to authorize compensation in excess of $1,000,000 to named executive officers that will not be deductible under Section 162(m) when it believes doing so is in the best interests of Aramark and its shareholders.

Costco Wholesale Corporation

Our RSU grants impose performance conditions for the CEO and executive vice presidents. These conditions for fiscal 2018 and prior years were intended to qualify the awards as tax-deductible under section 162(m) of the Internal Revenue Code. As a result of changes in December 2017 to federal tax laws, we expect that equity awards granted or other compensation provided under arrangements entered into or materially modified after November 2, 2017 generally will not be deductible to the extent they result in compensation to certain executive officers that exceeds $1 million in any one year for any such officer. Due to uncertainties as to the application and interpretation of Section 162(m), including the scope of the transition relief under the legislation repealing the exemption the Section 162(m) deduction limit, no assurance can be given that compensation intended to satisfy the requirements for exemption in fact will do so.

Because of the importance of linking pay and performance, RSU grants made for fiscal 2019 continued to impose performance conditions on grants to the CEO and executive officers.

Becton, Dickinson and Company

Section 162(m) of the Internal Revenue Code precludes BD from taking a federal income tax deduction for compensation paid in excess of $1 million to our “covered employees” (which includes the CEO and our three other most highly-compensated executive officers, other than the Chief Financial Officer, for years prior to 2018). Prior to 2018 (and including tax years that began prior to January 1, 2018), this limitation did not apply to “performance-based” compensation. While the Compensation Committee has generally attempted to maximize the tax deductibility of executive compensation, the Compensation Committee believes that the primary purpose of our compensation program is to support BD’s business strategy and the long-term interests of our shareholders. Therefore, the Compensation Committee has maintained the flexibility to award compensation that may not be tax-deductible if doing so furthers the objectives of our executive compensation program.

Under the recent U.S. tax reform, the exception to Section 162(m) for performance-based compensation has been repealed for tax years beginning after December 31, 2017, subject to certain transition and grandfathering rules. In addition, the Chief Financial Officer will be included as a covered employee.   Despite these new limits on the deductibility of performance-based compensation, the Compensation Committee continues to believe that a significant portion of our named executive officers’ compensation should be tied to BD’s performance. Therefore, it is not anticipated that the changes to Section 162(m) will significantly impact the design of our compensation program going forward.

Finally, if you are going to amend a compensation plan, perhaps the disclosures become far more complex. For instance, CBS Corporation amended a plan to extend the term, and included the following disclosure:

Prior to the enactment of the Act, Section 162(m) generally limited to $1 million the federal tax deductibility of some forms of compensation paid in one year to the chief executive officer and the three other most highly compensated executive officers employed by the Company at the end of the year (other than the Company’s chief financial officer) and provided that performance-based compensation may qualify for an exception to the limit on deductibility, if, among other requirements, the plan under which such compensation is paid met certain requirements, including stockholder approval. The Current Plan was originally designed to permit awards that would comply with this Section 162(m) Exception. As a result of the Act enacted in December 2017, significant changes were made to Section 162(m), including expanding the number of individuals covered by Section 162(m) and the elimination of the Section 162(m) Exception, effective for taxable years beginning after December 31, 2017. However, the Act also includes Transition Relief, pursuant to which these changes to Section 162(m) will not apply to compensation payable under a written binding agreement that was in effect on November 2, 2017 that is not subsequently materially modified, and which compensation otherwise would have been deductible under Section 162(m) prior to the effective time of the Act.

The Company believes it is important to preserve the ability to continue to use the Section 162(m) Exception, to the extent such exception remains available under the Act. Because of the uncertainties in the interpretation of Section 162(m) as amended by the Act, including in the interpretation of the scope of the Transition Relief, the Amended Plan continues to include provisions relating to Section 162(m), including with respect to the Section 162(m) Exception. Such provisions in the Amended Plan will only apply to the extent required to comply with the Section 162(m) Exception to the extent such exception remains available under the Act by means of guidance relating to the Transition Relief or otherwise. Because of the uncertainties in the interpretation of Section 162(m) as amended by the Act, no assurance can be given that awards under the Amended Plan that had been intended to qualify for the Section 162(m) Exception will be deductible under these transition relief rules. To the extent that the transition relief rules do not apply to an award under the Amended Plan, such awards may not be deductible under the Section 162(m) Exception.

As described above, awards under the Amended Plan may continue to qualify for the Section 162(m) Exception. To continue to qualify, the material terms of the performance goals under which compensation may be paid must be disclosed to and approved by the stockholders. For purposes of Section 162(m), the material terms include (i) the individuals eligible to receive compensation, (ii) a description of the business criteria on which the performance goal is based, and (iii) the maximum amount of compensation that can be paid to an individual under the performance goal. Each of these aspects is discussed above, and stockholder approval of the Amended Plan will be deemed to constitute approval of each of these aspects of the Amended Plan for purposes of the stockholder approval requirements of Section 162(m).

As required by the Economic Growth, Regulatory Relied and Consumer Protection Act, the SEC has adopted final rules which will permit public companies to rely on the exemption from registration to offer securities in amounts of up to $50 million afforded by Regulation A. The new rules will be effective upon publication in the Federal Register. That has not yet occurred, presumably as a result of the government shutdown.

In addition to deleting the prohibition in the rules which prevents public companies from using Regulation A, the final rules specify that the duty to file periodic reports under Regulation A is met if:

  • the issuer is subject to the reporting requirements of Section 13 or 15(d) of the Exchange Act, and
  • as of the due date of Regulation A required periodic reports, the issuer has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the 12 months (or such shorter period that the registrant was required to file such reports) preceding such due date.

The SEC brought a settled enforcement action against ADT Inc. because it did not afford equal or greater prominence to comparable GAAP financial measures in two of its earnings releases containing non-GAAP financial measures – ADT’s Q4 2017 and Fiscal Year 2017 Earnings Release dated and furnished to the Commission on March 15, 2018 (the “FY 2017 Earnings Release”) and ADT’s Q1 2018 Earning Release dated and furnished to the Commission on May 9, 2018 (the “Q1 2018 Earnings Release”).

As alleged by the SEC, ADT did not comply with the rules. But it raises the troubling inference that the SEC is going to ratchet up compliance issues with the non-GAAP rules to enforcement level activity.  ADT has a relatively short history as a public reporting company, and it is somewhat surprising, without knowing more, that an enforcement action resulted without a warning in a comment letter.  There is no way to draw a line between what happened to ADT and perhaps other more technical foot faults on the non-GAAP rules, so issuers should procced with caution and in full compliance with the rules. ADT agreed to pay a civil monetary penalty of $100,000.

Turning back to the details, in the headline of the FY 2017 Earnings Release, ADT presented its adjusted EBITDA for fiscal year 2017 and stated that adjusted EBITDA was up 8% year-over-year, without mentioning ADT’s net income or loss (the comparable GAAP financial measure) in the headline.

Amongst other things, In the headline of the Q1 2018 Earnings Release, ADT presented its adjusted EBITDA (a non-GAAP financial measure) for the first quarter of 2018 and stated that adjusted EBITDA was up 7% year-over-year, without mentioning ADT’s net income or loss (the comparable GAAP financial measure) in the headline.

As many know, Item 10(e)(1)(i)(A) of Regulation S-K provides that an issuer, when including a non-GAAP financial measure in a filing with the Commission, must include a presentation, with equal or greater prominence, of the most directly comparable financial measure or measures calculated and presented in accordance with GAAP. Instruction 1 of Item 2.02 of Form 8-K states that the “requirements of this Item 2.02 are triggered by the disclosure of material non-public information regarding a completed fiscal year or quarter. Release of additional or updated material non-public information regarding a completed fiscal year or quarter would trigger an additional Item 2.02 requirement.” Instruction 2 of Item 2.02 of Form 8-K states that the “requirements of paragraph (e)(1)(i) of Item 10 of Regulation S-K (17 CFR 229.10(e)(1)(i)) shall apply to disclosures under this Item 2.02.”

ADT did not admit nor deny the findings in the SEC order.