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

Some people don’t believe in blazing trails and adopting public reporting standards before you have to. They think you’re sticking your neck out, and will become a guinea pig for SEC comments or fodder for plaintiff’s lawyers or whatever.

A case in point might be First Solar, Inc. First Solar adopted FASB’s new revenue recognition standard early when it filed its first quarter 10-Q on May 5, 2017.  On August 3, 2017, it received a comment letter from the SEC, which included comments on its Form 10-Q and its transition to the new revenue recognition standard.

I’m happy to say First Solar appears to have easily passed the SEC comment process (No, I do not know them or represent them). First Solar responded on August 17, 2017, and on August 24, 2017, the SEC indicated its review was complete.

For those issuers who plan to adopt the new revenue recognition standard in the first quarter of 2018, and who are hoping for an SEC pass because they were recently reviewed, the First Solar fact pattern suggests otherwise. First Solar responded in 2016 to SEC comments on its 2015 Form 10-K, yet they were reviewed again in 2017.  This demonstrates the SEC may not put issuers into a pass category because they were reviewed within the last three years as required by Sarbanes-Oxley.

The SEC comments on the First Solar 10-Q were anything but superficial. The comments requested:

  • We note your disclosure that your solar power system sales include performance guarantees that represent a form of variable consideration and are recognized as adjustments to revenue. Please help us better understand your accounting for these potential bonus payments and/or liquidated damages. In this regard, based on your disclosure, it is unclear to us whether these amounts are included as part of your estimate of your transaction price at the outset of the arrangement and then reassessed at the end of each reporting period. Refer to ASC 606-10-32-5 through 32-10 and ASC 606-10-32-14.
  • Please help us better understand how you reflect consideration in the form of a non-controlling interest as part of your transaction price. In this regard, clarify for us which amounts are included in your estimate of fair value at contract inception and why any profit associated with the non-controlling interest is deferred. Refer to ASC 606-10-32-21 through 32-24.
  • Revise future filings to disclose why for performance obligations that you satisfy over time the method used provides a faithful depiction of the transfer of goods or services. Refer to ASC 606-10-50-18.

For the vast majority of issuers that have not yet transitioned to the new revenue recognition standard, you may wish to consider the following SEC comments when preparing your third quarter Form 10-Q:

  • You state that you are continuing to assess the effect the adoption of ASC 606 will have on your results of operations, financial position and related disclosures. Please revise future filings to provide qualitative financial statement disclosures of the potential impact that this standard will have on your financial statements when adopted. In this regard, include a description of the effects of the accounting policies that you expect to apply, if determined, and a comparison to your current revenue recognition policies. Describe further the status of your process to implement the new standard and the significant implementation matters yet to be addressed. In addition, to the extent that you determine the quantitative impact that adoption of ASC 606 is expected to have on your financial statements, please also disclose such amounts. Please refer to ASC 250-10-S99-6 and SAB Topic 11.M.
  • You disclose that the new revenue standard could change the amount and timing of revenue and costs under certain arrangement types, but you have not completely determined what effect, if any, the new guidance will have on the financial statements and related disclosures. Please revise to provide qualitative financial statement disclosures of the potential impact that this standard will have on your financial statements when adopted. In this regard, include a description of the effects of the accounting policies that you expect to apply, if determined, and a comparison to your current revenue recognition policies. Also, further describe the status of your process to implement the new standard and the significant implementation matters yet to be addressed. In addition, to the extent that you determine the quantitative impact that adoption of Topic 606 is expected to have on your financial statements, please also disclose such amounts. Please refer to ASC 250-10-S99-6 and SAB Topic 11.M.

Two major pieces of guidance emerged from the SEC on September 21, 2017, with respect to the pay ratio rule. First, the Commission issued interpretive guidance on the rule.  Second, the Division of Corporation Finance also issued its own guidance.  The Division also updated previously issued Compliance and Disclosure Interpretations, which are referred to as CDIs.  The emergence of this guidance clearly signals the rule will be effective for the upcoming proxy season and will not be delayed or modified.

Commission Interpretive Guidance

Use of Reasonable Estimates, Assumptions, and Methodologies and Statistical Sampling

The Commission noted the pay ratio rule affords significant flexibility to registrants in determining appropriate methodologies to identify the median employee and calculating the median employee’s annual total compensation. Required disclosure may be based on a registrant’s reasonable belief; use of reasonable estimates, assumptions, and methodologies; and reasonable efforts to prepare the disclosures.

In light of the use of estimates, assumptions, adjustments, and statistical sampling permitted by the rule, the Commission noted the pay ratio disclosures may involve a degree of imprecision. This has led some commenters to express concerns about compliance uncertainty and potential liability. In the Commissions view, if a registrant uses reasonable estimates, assumptions or methodologies, the pay ratio and related disclosure that results from such use would not provide the basis for Commission enforcement action unless the disclosure was made or reaffirmed without a reasonable basis or was provided other than in good faith.

As always, a no-action position of the Commission is not binding on any court.

Use of Internal Records

Non-US Employees

The pay ratio rule permits registrants to exempt non-U.S. employees where these employees account for 5% or less of the registrant’s total U.S. and non-U.S. employees, with certain limitations. In the interpretive guidance the Commission clarifies that a registrant may use appropriate existing internal records, such as tax or payroll records, in determining whether the 5% de minimis exemption is available.

Median Employee

In the interpretive guidance the Commission clarifies that a registrant may use internal records that reasonably reflect annual compensation to identify the median employee, even if those records do not include every element of compensation, such as equity awards widely distributed to employees.

When calculating total compensation for the identified median employee that the registrant identified using a consistently applied compensation measure based on internal records, the registrant may determine that there are anomalous characteristics of the identified median employee’s compensation that have a significant higher or lower impact on the pay ratio. The Commission observed the registrant need not conclude its methodology was unsuitable to identify its median employee. Instead, the registrant may substitute another employee with substantially similar compensation to the originally identified median employee based on the compensation measure it used to select the median employee.

Independent Contractors

In determining who is an “employee” for purposes of the rule, registrants may apply a widely recognized test under another area of law that the registrant otherwise uses to determine whether its workers are employees. The Commission appears to agree with commentators that such a test might, for example, be drawn from guidance published by the Internal Revenue Service with respect to independent contractors.

Division of Corporation Finance Guidance

The Division’s guidance is meant to assist registrants in determining how to use statistical sampling methodologies and other reasonable methodologies. The Division’s guidance:

  • Notes registrants may combine the use of reasonable estimates with the use of statistical sampling or other reasonable methodologies. For instance, a registrant with multinational operations or multiple business lines is permitted to use sampling for some geographic/business units and a combination of other methodologies and reasonable estimates for other geographic/business units.
  • Notes registrants are permitted to use a combination of sampling methods and examples are provided.
  • Provides examples of situations where registrants may use reasonable estimates such as identifying the median employee and using the mid-point of a compensation range to estimate compensation.
  • Notes that registrants may use a combination of reasonable methodologies and provides examples, including using reasonable methods of addressing extreme observations, such as outliers.
  • Provides hypothetical examples of the use of reasonable estimates, statistical sampling and other reasonable methods. The hypotheticals involve three companies with complex international operations and work forces.

Updated CDIs

New CDI 128C.06 provides that the pay ratio may be referred to as an “estimate.” CDI 128C.01 was revised to refer to the Commissions interpretive guidance.  CDI 128C.05 was withdrawn, which provided  a registrant should include a worker as an “employee” for the purposes of Item 402(u) if the worker compensation is determined by the registrant or one of its consolidated subsidiaries. According to the withdrawn CDI, this was true regardless of whether such worker would be considered an “employee” for tax or employment law purposes.

 

The SEC announced a settled action against Beverly Hills-based investment adviser, Platinum Equity Advisors, LLC, for charging three of its private equity fund clients with about $1.8 million more than it should have in broken deal expenses.

According to the SEC’s order, from 2004 to 2015, the three private equity funds invested in 85 companies, in which co-investors connected with Platinum also invested. During this time, Platinum incurred expenses related to potential fund investments that were not ultimately made, known as “broken deal expenses.” While the co-investors participated in Platinum’s successful transactions and benefited from Platinum’s sourcing of private equity transactions, Platinum did not allocate any of the broken deal expenses to the co-investors. Instead, it allocated all broken deal expenses to the private equity funds even though the agreements governing the funds did not disclose that the funds would be responsible for anything other than their own expenses. The Commission found that from Q2 2012 to 2015 (the applicable limitations period for disgorgement in this matter), the private equity funds were allocated $1,811,501 more in broken deal expenses than they should have been. In addition, Platinum did not adopt and implement a written compliance policy or procedure governing its broken deal expense allocation practices.

The SEC’s order finds that Platinum violated Sections 206(2) and 206(4) of the Investment Advisers Act, and Rule 206(4)-7 thereunder. Without admitting or denying the findings in the SEC’s order, Platinum consented to the entry of a cease-and-desist order and agreed to pay a total of $1,902,132 in disgorgement and prejudgment interest and a $1.5 million civil penalty.

 

The CFTC filed a federal civil enforcement action in the U.S. District Court for the Southern District of New York against Defendants Nicholas Gelfman, of Brooklyn, New York, and Gelfman Blueprint, Inc. (GBI), a New York corporation. The CFTC is charging them with fraud, misappropriation, and issuing false account statements in connection with solicited investments in Bitcoin.

The CFTC complaint alleges that from approximately January 2014 through approximately January 2016, GBI and Gelfman, the Chief Executive Officer and Head Trader of GBI, operated a Bitcoin Ponzi scheme. They allegedly fraudulently solicited more than $600,000 from approximately 80 persons, supposedly for placement in a pooled commodity fund that purportedly employed a high-frequency, algorithmic trading strategy, using a computer trading program called “Jigsaw.” According to the CFTC the strategy was fake and the purported performance reports were false.  The CFTC claims payouts of supposed profits to GBI customers in actuality consisted of other customers’ misappropriated funds.

The CFTC complaint also alleges that the Defendants attempted to conceal trading losses and misappropriation by providing false performance reports to pool participants, including statements that created the appearance of positive Bitcoin trading gains. According to the CFTC, the Defendants’ Jigsaw trading account records reveal only infrequent and unprofitable trading.

According to the CFTC Gelfman attempted to conceal the scheme by staging a fake computer “hack” that supposedly caused the loss of nearly all GBI Customer funds. The CFTC complaint states “This was a lie.”

The above is based on the CFTC’s allegations in the Complaint. No judicial finding has been made that the Defendants violated the law.

SEC Chairman Jay Clayton today issued an unusual statement highlighting the importance of cybersecurity to the agency and market participants, and detailing the agency’s approach to cybersecurity as an organization and as a regulatory body.

The statement is part of an ongoing assessment of the SEC’s cybersecurity risk profile that Chairman Clayton initiated upon taking office in May. Components of this initiative have included the creation of a senior-level cybersecurity working group to coordinate information sharing, risk monitoring, and incident response efforts throughout the agency.   The statement provides an overview of the Commission’s collection and use of data and discusses key cyber risks faced by the agency.

Perhaps the first-ever news that EDGAR was hacked will be the most widely reported facet of the statement. According to Chairman Clayton:

“Notwithstanding our efforts to protect our systems and manage cybersecurity risk, in certain cases cyber threat actors have managed to access or misuse our systems. In August 2017, the Commission learned that an incident previously detected in 2016 may have provided the basis for illicit gain through trading.  Specifically, a software vulnerability in the test filing component of our EDGAR system, which was patched promptly after discovery, was exploited and resulted in access to nonpublic information.  We believe the intrusion did not result in unauthorized access to personally identifiable information, jeopardize the operations of the Commission, or result in systemic risk.  Our investigation of this matter is ongoing, however, and we are coordinating with appropriate authorities.”

While the SEC may be investigating the matter, they apparently did not tell Commissioner Piwowar. Commissioner Piwowar issued a separate statement which said “I was recently informed for the first time that an intrusion occurred in 2016 in the SEC’s Electronic Data Gathering, Analysis, and Retrieval (“EDGAR”) system.”

FASB’s new revenue recognition standard is expected to have wide ranging effects on M&A transactions. The new revenue recognition standard under GAAP (Accounting Standards Update 2014-09; Topic 606) will be applicable to public companies for annual reporting periods beginning after December 15, 2017.  Thus the impact of the new standard should begin to be assessed for public company transactions that are negotiated in the fall of 2017.  For private companies, the new standard will be effective a year later, for annual reporting periods beginning after December 15, 2018.  This post provides a summary of the new accounting standard, describes several ways the new standard will impact M&A transactions, and offers sample representations for use in M&A transactions before and after the adoption of the new standard.

Background

To understand the effect on M&A transactions it is helpful to consider some background with respect to the new standard.

The new standard sets forth a five-step process to recognize revenue arising from contracts with customers:

  • Identify the contract(s)
  • Identify the performance obligations
  • Determine the transaction price
  • Allocate the transaction price to the performance obligations in the contract
  • Recognize revenue when (or as) the entity satisfies a performance obligation

The new standard permits two methods of transition. For purposes of comparing the two transition methods, consider a calendar year-end public company that must begin recording revenue using the new standard on January 1, 2018:

  • Retrospectively to each prior period presented, subject to the election of certain practical expedients (“full retrospective method”). In its 2018 annual report, the company would revise its 2016 and 2017 financial statements to reflect recognition of revenue from customer contracts according to the new standard and record the cumulative effect of the change recognized in opening retained earnings as of January 1, 2016.
  • Retrospectively with the cumulative effect of initially applying the new revenue standard recognized at the date of adoption (“modified retrospective method”). In its 2018 annual report, the company would not revise its 2016 or 2017 financial statements, but it would record the cumulative effect of the change recognized in opening retained earnings as of January 1, 2018.

While required footnote disclosures for the two transition methods are similar, there are subtle differences regarding disclosure about the effects of adopting the new standard:

  • Full Retrospective Method: Required disclosures are to include the effect of the change on income from continuing operations, net income (or other appropriate captions of changes in the applicable net assets or performance indicator), any other affected financial statement line item, and any affected per-share amounts. The foregoing disclosures are required for each reporting period that has been retrospectively adjusted but not for the current reporting period in which the new standard is adopted.
  • Modified Retrospective Method: Required disclosures are to include the amount by which each financial statement line item is affected in the current reporting period by the application of the new standard as compared with the guidance that was in effect before the change and an explanation of the reasons for any significant changes.

We do not mean to suggest that the new standard will result in material differences in financial results for all companies. Many public companies have disclosed they do not believe the new standard will have a material impact, and a significant number are still in the process of evaluating the standard.  Even if the impact on revenue or the bottom line is not material, extensive new disclosures must still be prepared. Whatever the resulting impact may be, the new standard represents a significant shift in methodology that should be considered in evaluating a proposed target.

Business Valuations and Valuation Metrics

A new accounting standard should not affect the valuation of an enterprise except in unusual situations. However, to the extent the new standard accelerates or delays revenues, it will impact EBITDA multiples and like metrics used to price transactions.  Where revenue is accelerated, logically one would expect EBITDA multiples to decrease.  While the valuation remains constant, a decreased EBITDA multiple could have a negative psychological impact on sellers who naturally seek to equal or improve on the multiples associated with the most recently reported transactions.

If revenue is shifted to later years under the new standard, it has the opposite effect – to increase EBITDA multiples. The wary buyer may think she is overpaying for the business.

What are the unusual situations where the new revenue recognition standard might actually affect the value of business? It is difficult to be specific, but it would probably be those situations where the new standard and related disclosures provide additional transparency into the economics of the business that provide new insights into valuations.

Changes in valuation multiples may not happen immediately. Transactions priced off of trailing twelve months results may reflect some mixture of a change in multiple for a period of time, especially in the earlier months.

The inability to make direct apples to apples comparisons with transactions before and after the adoption of the new standard is expected to persist from some time, especially in industries where comparable transactions do not occur regularly.

Forecasts and Projections

Confidential information memorandums associated with auctions often include forecasts or projections of future results.  Caution is urged on the publication of forecasts where the impact of the new revenue recognition standard has not been evaluated.  Alternatively, disclosure is urged if the forecasts do not consider the impact of the new standard.

Working Capital Adjustments

A change in revenue recognition patterns will affect the calculation of a target’s working capital. The change will be most difficult to deal with when the working capital target is determined before adoption of the new standard with a true up occurring after the new standard has been adopted. Solutions will include calculating working capital using existing standards for the true up (or using the new standard for the determination of the target) but the level of effort will need to be assessed as it will vary amongst companies and the alternative calculations may not be feasible for some.

Working capital targets are often calculated using an average of working capital for the twelve preceding months. Thus for transactions documented after the new standard becomes effective, a method may need to be developed to account for differing accounting principles during the look back period.

Earn Outs

Much like working capital, the transition to the new standard may greatly impact the documentation and calculation of earn out payments in purchase agreements entered into before the new standard is effective. The obvious solutions present significant drawbacks.  Parties could agree that earn out thresholds will be determined and measured using the new standard, but without visibility into the future impact of the new standard it will be difficult to determine applicable thresholds for earn out payments. Parties could alternatively require that earn out thresholds and company performance will be determined under the current standard for the duration of the earn out period, but requiring the target to keep two sets of books in order to calculate earn out payments using the current standard far into the future may be exceptionally burdensome.  Transaction parties that are determined to use financial statement metrics for an earn out should search for bench marks that are not affected or least affected by the new standard, such as net cash provided from operating activities as set forth in the statement of cash flows.  It is possible non-financial statement based milestones may become more prevalent for a period of time.

Due Diligence

The new standard will affect more than top line revenue, and deal teams will need to assess the total impact of the transition. The new standard can affect how costs associated with revenue are recognized, and shifts the analysis from a matching principle to a balance sheet inquiry.  Accruals for income tax are important as well.  It is possible that adopting the new standard to recognize revenue for financial statement purposes means the target is no longer using a method permitted by the IRS for tax purposes. If not, the target may need to comply with IRS procedures to employ a new method of revenue recognition for tax purposes. Other areas need to be considered as well, such as the impact of the new standard on incentive compensation based on financial statement metrics and sales commissions.

SEC Registration Statements

Public companies that need to file a registration statement on Form S-3 to sell securities to finance an acquisition must also consider impacts resulting from the interaction of the new standard with the S-3 rules. Public companies that adopt the new revenue recognition standard using the full retrospective method may encounter difficulties if a Form S-3 is filed after the first quarter of 2018. Item 11(b)(ii) of Form S-3 requires restated financial statements to be filed if there has been a change in accounting principles that requires a material retroactive restatement of financial statements.  This would require filing of restated financial statements for 2015, 2016 and 2017 significantly in advance of the 2018 Form 10-K (likely filed in the first quarter of 2019), and restated 2015 financial statements would not otherwise be required.  This can be avoided if the Form S-3 is filed during the first quarter of 2018 because during this time period no public filings have yet been made that reflect a material retroactive restatement of financial statements.

SEC Form S-4 is often used to register securities issued in M&A transactions such as stock-for-stock mergers. Items 10, 12 and 15 of Form S-4 include similar requirements to Form S-3.

Loan Covenants

When acquisitions are financed with debt that includes financial covenants, the impact of the new revenue recognition standard will have to be considered when negotiating the financial covenants. Lenders may also be interested in the same due diligence maters as acquirors.

Representations and Warranties before Adoption of the New Standard

It is likely that transition to the new standard will result in new representations being included in acquisition agreements. For public companies, any such specific representations may begin to appear later in 2017 and the first quarter of 2018, before a company actually issues any financial statements reflecting the new revenue recognition standard.  Many acquirors will simply want contractual protections to the effect that the target is prepared to adopt the new standard and its prior disclosures on this matter have been accurate.  The representations for public companies could take the following form, although perhaps with more qualifiers if the issuance of financial statements is not imminent and work to adopt the standard is ongoing:

The Company has developed disclosure controls and procedures required by Rule 13a-15 or 15d-15 under the Exchange Act which the Company anticipates will be effective to ensure that information required to be disclosed by the Company pursuant to Topic 606 [FN 1] and Subtopic 340-40 [FN 2] of the FASB Accounting Standards Codification (the “Revenue Recognition Standard”) is recorded and reported on a timely basis to the individuals responsible for the preparation of the Company’s filings with the SEC and other public disclosure documents. The Company has developed internal controls over financial reporting (as defined in Rule 13a-15 or 15d-15, as applicable, under the Exchange Act) which the Company anticipates are sufficiently designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with the Revenue Recognition Standard. The Company’s disclosure of the impact of the adoption of the Revenue Recognition Standard set forth in [describe SEC filing] is true and correct in all material respects and is in accordance with Staff Accounting Bulletin No. 74 promulgated by the SEC.

FN 1: Topic 606 is the heart of the new standard.

FN 2: Subtopic 340-40 is a corollary to the new standard and is captioned “Other Assets and Deferred Costs—Contracts with Customers.”

Representations and Warranties after Adoption of the New Standard

Once financial statements have been issued which reflect the adoption of the new standard, the representations could take the following form if an issuer has used the modified retrospective method to adopt the new standard, but as usual subject to negotiation:

The Financial Statements [describe financial statements] have been prepared reflecting the adoption of Topic 606 and Subtopic 340-40 of the FASB Accounting Standards Codification (the “Revenue Recognition Standard”). The Company elected to utilize the modified retrospective method of transition beginning [January 1, 2018].  Footnote [insert reference] to the Financial Statements accurately states in all material respects (i) the amount by which each Financial Statement line item is affected [describe reporting period] by the application of the Revenue Recognition Standard as compared to GAAP that was in effect before the change and (ii) the reasons for each significant change identified. [FN 3]  Footnote [insert reference] to the Financial Statements accurately states in all material respects the judgments, and changes in judgments, made in applying the Revenue Recognition Standard that significantly affect the determination of the amount and timing of revenue from contracts with customers. [FN 4]

The Company has implemented disclosure controls and procedures required by Rule 13a-15 or 15d-15 under the Exchange Act which are effective to ensure that information required to be disclosed by the Company pursuant to the Revenue Recognition Standard is recorded and reported on a timely basis to the individuals responsible for the preparation of the Company’s filings with the SEC and other public disclosure documents. The Company has implemented internal controls over financial reporting (as defined in Rule 13a-15 or 15d-15, as applicable, under the Exchange Act) which are designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with the Revenue Recognition Standard.

FN 3: See ASC 606-10-65-1i.

FN 4: See ASC 606-10-50-1.

For issuers that have used the full retrospective method of accounting, the first paragraph of the foregoing representations could be replaced with the following paragraph, subject to negotiation (with changes from the modified retrospective method representation noted as well):

The Financial Statements [describe financial statements] have been prepared reflecting the adoption of Topic 606 and Subtopic 340-40 of the FASB Accounting Standards Codification (the “Revenue Recognition Standard”). The Company elected to utilize the modified full retrospective method of transition beginning [January 1, 2018].  Footnote [insert reference] to the Financial Statements accurately states in all material respects (i) the amount by which each Financial Statement line item is affected [describe reporting period] by the application of the Revenue Recognition Standard as compared to GAAP that was in effect before the change and (ii) the reasons for each significant change identified the effect of the change on income from continuing operations, net income [or describe other appropriate captions of changes in the applicable net assets or performance indicator], any other affected financial statement line item other than the effect on financial statement totals and subtotals, and any affected per-share amounts for [list prior periods that have been retrospectively adjusted]. [FN 5]  Footnote [insert reference] to the Financial Statements accurately states in all material respects the judgments, and changes in judgments, made in applying the Revenue Recognition Standard that significantly affect the determination of the amount and timing of revenue from contracts with customers.

FN 5: See ASC 606-10-65-1e.

 

The Office of the Inspector General has issued an evaluation of the Division of Corporation Finance’s disclosure review and comment process. The report begins with a description of the Division’s comment process. Perhaps the most interesting part is the report notes that the Division is developing a new system to improve and streamline certain aspects of the disclosure review process. The new system is called the System for Workflow Activity Tracking, which is referred to as SWAT. SWAT will automate certain aspects of the review process such as providing notifications of filing review status to other review team members. In addition, according to Division officials, SWAT will generate a draft comment letter based on comments input into and approved within the system. The reviewer or another designated member of the relevant Assistant Director’s staff will review and revise the draft letter to ensure that it meets the Division’s policies for format, tone, and content. Once the draft letter is approved, a final comment letter will be generated within SWAT.

According to the report, the IG found that:

  • examiners and reviewers did not always properly document comments before issuing comment letters to companies;
  • some case files were incomplete as of the date the Division issued a comment letter to a company; and
  • examiners and reviewers inconsistently documented oral comments to companies.

As a result, the IG issued three recommendations with which the Director of the Division of Corporation Finance concurred. The IG therefore noted that the recommendations were resolved and the recommendations will be closed upon verification of the action to be taken.

The SEC’s Office of Compliance Inspections and Examinations has provided a list of compliance issues relating to Rule 206(4)-1, which is referred to as the Advertising Rule, under the Investment Advisers Act of 1940. In general, the Advertising Rule prohibits an adviser, directly or indirectly, from publishing, circulating, or distributing any advertisement that contains any untrue statement of material fact, or that is otherwise false or misleading.

OCIE’s objective in providing this guidance was to encourage advisers to assess the full scope of their advertisements and consider whether those advertisements are consistent with the Advertising Rule, related the prohibitions and their fiduciary duties, and review the adequacy and effectiveness of their compliance programs.

Some of the compliance issues noted were:

  • Use of misleading performance results
  • Misleading use of one-on-one presentations
  • Misleading claims of compliance with voluntary performance standards
  • Use of cherry-picked profitable stock selections
  • Use of misleading selections of recommendations
  • Failure to have compliance policies and procedures reasonably designed to prevent deficient advertising practices
  • Misleading use of third party rankings or awards
  • Misleading use of professional designations
  • Published statements of clients attesting to services or otherwise endorsing the adviser that may be prohibited testimonials

Regulation FD prohibits public companies from disclosing material nonpublic information to designated classes of persons such as securities professionals and holders of the issuer’s securities without, in most cases, simultaneous public disclosure. For many good reasons, public companies generally prohibit disclosure of material non-public information to anyone not subject to a confidentiality obligation.

But Regulation FD does not apply to issuers of municipal securities because municipal issuers are exempt from regulation by the SEC with limited exceptions. To help plug that gap, the Municipal Securities Rulemaking Board, or the MSRB , has warned municipal issuers, underwriters and municipal advisors about the consequences of selective disclosure of material nonpublic information. The MSRB cannot impose a Regulation FD like rule on municipal issuers because it does not have authority to write rules governing the activities of issuers.

The MSRB notes municipal issuers are subject to the antifraud provisions of the Securities Act and the Exchange Act, which generally prohibit fraud in the offering, purchase or sale of securities. Accordingly, there are multiple ways in which selective disclosure could lead to potential violations of these provisions. For example, to the extent the selective disclosure is of nonpublic material information and that information was known to the issuer at the time of, but was not included in, a preliminary official statement, official statement or other required disclosure, the relevant documents likely would suffer from a material omission or misstatement.

The MSRB also notes that should an individual make a selective disclosure in breach of a duty to the issuer, and the recipient of the nonpublic material information purchases or sells the issuer’s securities on the basis of that information, it could constitute insider trading.

The MSRB’s warning discusses the role underwriters and municipal advisors may play in selective disclosure. According to the MSRB, dealers and municipal advisors often plan and participate in road shows and investor conferences. Given this direct connection to the selective disclosure, these intermediaries may also incur liability under the antifraud provisions for their part. This liability could include aiding and abetting, or causing, the issuer’s violations, or their own direct violations. In addition, any selective disclosure that creates potential liability under the Securities Act and the Exchange Act could similarly trigger potential violations by dealers or municipal advisors of MSRB Rule G-17, which requires that dealers and municipal advisors deal fairly with all persons and shall not engage in any deceptive, dishonest or unfair practice. The rule contains an antifraud prohibition similar to the standard set forth in the Exchange Act; however, it also establishes a general duty to deal fairly, even in the absence of fraud.

The MSRB encourages issuers and their financial professionals to implement practices to ensure that all investors and stakeholders have equal access to the same information in a timely manner. The MSRB recommends that:

  • Presale documents, such as rating agency presentations, be publicly filed with preliminary official statements on EMMA.
  • Issuers disseminate non-transaction-based material information to the marketplace on EMMA by posting a voluntary continuing disclosure and associating such disclosure with all of the issuer’s bonds.

SEC Chief Accountant Wesley R. Bricker recently gave remarks at the AICPA National Conference on Banks & Savings Institutions. Mr. Bricker spoke to the adoption of FASB’s new credit loss standard and related implementation matters. He also addressed new PCAOB standards and stated that the SEC was reviewing comments on the new auditor reporting standard and that “the Commission must take action by October 26.”

Mr. Bricker also gave his thoughts on financial reporting requirements for registered initial coin offerings, which are sometimes referred to as ICOs or token sales. I assume he did so not solely because he finds the topic intellectually interesting, but that the SEC is fielding questions on how actually to go about registering an ICO in the wake of the SEC’s investigative report on The DAO.

According to Mr. Bricker:

“An organization should consider applicable accounting and reporting guidance, for example in U.S. GAAP, when preparing financial statements.

The guidance addresses relevant considerations, including, for example, those regarding presentation and disclosure of financial statements, consolidation, translation, assets, liabilities, revenue, expenses, and ownership. In this regard, issuers and holders should consider, for example, the application of the guidance in addressing questions such as:

Issuers

  • What are the necessary financial statement filing requirements?
  • Are there liabilities requiring recognition or disclosure?
  • Are there previously recognized assets that require de-recognition?
  • Are there revenues or expenses requiring recognition or deferral?
  • Is there a transaction with owners, resulting in debt or equity classification and possibly compensation expense?
  • Are there implications for the provision for income taxes?

Holders

  • Does specialized accounting guidance (such as for investment companies) apply to the holder’s financial statement presentation?
  • What are the characteristics of the coin or token in considering whether, how, and at what value the transaction should affect the holder’s financial statements?
  • What is the nature of the holder’s involvement in considering whether the issuer’s activities should be consolidated or accounted for under the equity method?

Again, these are intended only to be illustrative questions. An entity involved in initial coin or token offering activities will need to consider the necessary accounting, disclosure and reporting guidance based on the nature of its involvement.”