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

The House Committee on Financial Services is considering legislation on a number of matters that would affect public companies.  An example of some of the matters under consideration include:

  • A bill that would require public companies to submit quarterly reports to both the SEC and investors detailing the amount, date, and nature of the company’s expenditures for political activities.
  • The ESG Disclosure Simplification Act would require issuers to disclose certain environmental, social and governance (ESG) metrics to shareholders, the connection between those metrics and the issuer’s long term business strategy, and the method by which the issuer determines how ESG metrics impact its long term strategy. The bill would also require the U.S. Securities and Exchange Commission (SEC) to adopt rules requiring issuers to disclose ESG metrics in filings that require audited financial statements.
  • A bill that would require public companies to annually disclose the voluntarily, self-identified gender, race, ethnicity and veteran status of their board directors.

Whether Republicans or Democrats are in charge, many bills considered by this Committee do not progress very far.  Probably the greatest chance of any of this progressing is if it is incorporated in a larger bill.

The SEC Division of Examinations has issued a Risk Alert to highlight observations from recent exams of investment advisers, registered investment companies, and private funds offering ESG products and services.

According to the Risk Alert, during examinations of investment advisers, registered investment companies, and private funds engaged in ESG investing, the staff observed some instances of potentially misleading statements regarding ESG investing processes and representations regarding the adherence to global ESG frameworks. The staff noted, despite claims to have formal processes in place for ESG investing, a lack of policies and procedures related to ESG investing; policies and procedures that did not appear to be reasonably designed to prevent violations of law, or that were not implemented; documentation of ESG-related investment decisions that was weak or unclear; and compliance programs that did not appear to be reasonably designed to guard against inaccurate ESG-related disclosures and marketing materials.

The Risk Alert provides additional thoughts in various areas which include:

  • Portfolio management practices were inconsistent with disclosures about ESG approaches.
  • Controls were inadequate to maintain, monitor, and update clients’ ESG-related investing guidelines, mandates, and restrictions.
  • Proxy voting may have been inconsistent with advisers’ stated approaches.
  • Unsubstantiated or otherwise potentially misleading claims regarding ESG approaches.
  • Inadequate controls to ensure that ESG-related disclosures and marketing are consistent with the firm’s practices.
  • Compliance programs did not adequately address relevant ESG issues.

The SEC has reissued and updated its guidance regarding COVID-19 matters and its effect on some matters related to annual meetings.  The guidance addresses:

  • Changing the Date, Time, or Location of a Shareholder Meeting
  • “Virtual” Shareholder Meetings
  • Presentation of Shareholder Proposals
  • Delays in Printing and Mailing of Full Set of Proxy Materials

John Coates, Acting Director, Division of Corporation Finance, issued a statement questioning the application of the safe harbor for forward looking information in the Private Securities Litigation Reform Act (PSLRA) to a de-SPAC transaction.  A de-PAC transaction occurs when a SPAC, which is already public, acquires a private company which results in the private company being publically owned.

Mr. Coates takes issue with the often repeated claim by some but not all SPAC enthusiasts that an advantage of SPACs over traditional IPOs is lesser securities law liability exposure for targets and the public company itself. This asserted lesser liability is focused on using projections and other valuation materials of a kind that is not commonly found in conventional IPO prospectuses because such materials are thought to benefit from the safe harbor for forwarding looking information provided by the PSLRA.  The PSLRA does not provide such protection for IPOs because of a statutory exclusion but some believe that since a SPAC is already public the safe harbor is available.

Mr. Coates notes that the term “initial public offering” is not defined in the PSLRA. He also asserts that the economic essence of an initial public offering is the introduction of a new company to the public.  According to Mr. Coates, a de-SPAC transaction is also the introduction of a new company to the public.  It therefore follows to Mr. Coates that a de-SPAC transaction is also an initial public offering as contemplated by the PSLRA and therefore the safe harbor for forward looking information may not be available.

Mr. Coates views are his own, not those of the Commission, and may or may not be accepted by a court.

FINCEN has issued an Advance Notice of Proposed Rulemaking, or ANPRM to solicit public comment on a wide range of questions related to the implementation of the beneficial ownership information reporting provisions of the Corporate Transparency Act, or CTA.

The CTA requires reporting of beneficial ownership information by “reporting companies.” The CTA defines a reporting company as a corporation, LLC, or other similar entity that is (i) created by the filing of a document with a secretary of state or a similar office under the law of a state or Indian tribe, or (ii) formed under the law of a foreign country and registered to do business in the United States by the filing of a document with a secretary of state or a similar office under the laws of a state or Indian tribe. The CTA exempts certain categories of entities from the reporting requirement.

The CTA defines a beneficial owner of an entity as an individual who, directly or indirectly, through any contract, arrangement, understanding, relationship, or otherwise (i) exercises substantial control over the entity, or (ii) owns or controls not less than 25 percent of the ownership interests of the entity.

Specifically, reporting companies must report, for each identified beneficial owner and applicant, the following information: (i) Full legal name; (ii) date of birth; (iii) current residential or business street address; and (iv) a unique identifying number from an acceptable identification document or the individual’s FinCEN identifier.

The ANPR poses the following questions for public comment amongst many others:

  • How should FinCEN interpret the phrase “other similar entity,” and what factors should FinCEN consider in determining whether an entity qualifies as a similar entity?
  • What types of entities other than corporations and LLCs should be considered similar entities that should be included or excluded from the reporting requirements?
  • To what extent should FinCEN’s regulatory definition of beneficial owner in this context be the same as, or similar to, the customer due diligence rules adopted by FINCEN or the standards used to determine who is a beneficial owner under Rule 13d-3 adopted under the Securities Exchange Act of 1934?
  • Should FinCEN define either or both of the terms “own” and “control” with respect to the ownership interests of an entity? If so, should such a definition be drawn from or based on an existing definition in another area, such as securities law or tax law?
  • Should FinCEN define the term “substantial control”? If so, should FinCEN define “substantial control” to mean that no reporting company can have more than one beneficial owner who is considered to be in substantial control of the company, or should FinCEN define that term to make it possible that a reporting company may have more than one beneficial owner with “substantial control”?

The PCAOB has released a publication captioned “Audit Committee Resource: 2021 Inspections Outlook.”  The purpose of the three-page publication is to assist audit committees in engaging in informed dialogue with their auditors on the PCAOB’s planned focus of their examination of public company audits.

Topics covered in the publication include:

  • Auditor’s risk assessments
  • Firms’ quality control systems
  • How firms comply with auditor independence requirements
  • Fraud procedures
  • Critical audit matters
  • How firms implement new auditing standards
  • Supervision of audits involving other auditors

The NYSE has amended the Listed Company Manual regarding shareholder approval requirements for the issuance of securities and certain related party matters. The SEC approved the amendments on an accelerated basis.

Prior to the amendment, Section 312.03(b) of the Manual required shareholder approval prior to certain issuances of common stock, or securities convertible into or exercisable for common stock, to:

  • a director, officer, or substantial security holder of the company (each a “Related Party” for purposes of Section 312.03(b));
  • a subsidiary, affiliate, or other closely related person of a related party; or
  • any company or entity in which a related party has a substantial direct or indirect interest.

In addition, Section 312.03(b) of the Manual required shareholder approval if the number of shares of common stock to be issued, or if the number of shares of common stock into which the securities may be convertible or exercisable, exceeded either one percent of the number of shares of common stock or one percent of the voting power outstanding before the issuance. A limited exception to these shareholder approval requirements permitted cash sales relating to no more than five percent of the number of shares of common stock or voting power outstanding that met a minimum price test set forth in the rule (“Minimum Price”) if the related party in the transaction has related party status solely because it is a substantial security holder of the company.

Changes to the Manual include:

  • Shareholder approval would not be required for issuances to a Related Parties’ subsidiaries, affiliates or other closely related persons or to any companies or entities in which a Related Party has a substantial interest (except where a Related Party has a five percent or greater interest in the counterparty, as described below).
  • Shareholder approval would be required for cash sales to Related Parties only if the price is less than the Minimum Price.
  • Issuances to a Related Party that meet the Minimum Price would be subject to shareholder approval for any transaction or series of related transactions in which any Related Party has a five percent or greater interest (or such persons collectively have a 10 percent or greater interest), directly or indirectly, in the company or assets to be acquired or in the consideration to be paid in the transaction and the present or potential issuance of common stock, or securities convertible into common stock, could result in an increase in either the number of shares of common stock or voting power outstanding of five percent or more before the issuance.

In addition, the NYSE amended to Section 312.03(c) of the Manual, which prior to the amendment required shareholder approval of any transaction relating to 20 percent or more of the company’s outstanding common stock or 20 percent of the voting power outstanding before such issuance, but provides the following exceptions: (1) any public offering for cash; and (2) any bona fide private financing involving a cash sale of the company’s securities that comply with the Minimum Price requirement. A “bona fide private financing” was defined as a sale in which either: (1) a registered broker-dealer purchases the securities from the issuer with a view to the private sale of such securities to one or more purchasers; or (2) the issuer sells the securities to multiple purchasers, and no one such purchaser, or group of related purchasers, acquires, or has the right to acquire upon exercise or conversion of the securities, more than five percent of the shares of the issuer’s common stock or more than five percent of the issuer’s voting power before the sale.

The amendment replaces the reference to “bona fide private financing” in Section 312.03(c) with “other financing (that is not a public offering for cash) in which the company is selling securities for cash.” This change eliminates the requirement that, for the exception, the issuer sell the securities to multiple purchasers, and that no one such purchaser, or group of related purchasers, acquires more than five percent of the issuer’s common stock or voting power. In addition, because any sale to a broker-dealer under the current bona fide private financing exception would also qualify for an exception to shareholder approval under the proposed amended exception, there is no need to retain a separate provision for sales made to broker-dealers.

The NYSE also amended Section 312.03(c) to provide that, if the securities in a financing (that is not a public offering for cash) in which the company is selling securities for cash are issued in connection with an acquisition of the stock or assets of another company, shareholder approval will be required if the issuance of the securities alone or when combined with any other present or potential issuance of common stock in connection with such acquisition, is equal to or exceeds either 20 percent of the number of shares of common stock or 20 percent of the voting power outstanding before the issuance.

Finally, the NYSE amended Section 314.00 of the Manual, which prior to the amendment provided that related party transactions normally include transactions between officers, directors, and principal shareholders and the company and that each related party transaction is to be reviewed and evaluated by an appropriate group within the listed company involved. Prior to the amendment the rule also stated that, while the NYSE does not specify who should review related party transactions, the NYSE believes that the audit committee or another comparable body might be considered as an appropriate forum for this task.

The NYSE amended the first paragraph of Section 314.00 by stating that, for purposes of Section 314.00, the term “related party transaction” refers to transactions required to be disclosed pursuant to Item 404 of Regulation S-K under the Exchange Act (but without applying the transaction value threshold under that provision), and, in the case of foreign private issuers, the term “related party transaction” refers to transactions required to be disclosed pursuant to Form 20-F, Item 7.B (but without regard to the materiality threshold of that provision).

The amendments to Section 314.00 also provide that the company’s audit committee or another independent body of the board of directors shall conduct a reasonable prior review and oversight of all related party transactions for potential conflicts of interest and will prohibit such a transaction if it determines it to be inconsistent with the interests of the company and its shareholders.

The SEC issued two pieces of guidance on special purpose acquisition companies, or SPACs.  One piece, styled as a statement by Paul Munter, Acting Chief Accountant, speaks to financial reporting and auditing considerations of companies merging with SPACs.  The other statement, issued by the Division of Corporation Finance, is labeled “Staff Statement on Select Issues Pertaining to Special Purpose Acquisition Companies.”

As to financial reporting and auditing matters the SEC notes, among other things:

  • Companies acquired by SPACs need to be prepared to transition from being a private company to a public company very quickly. Do not underestimate the challenges.
  • The combined public company should have finance and accounting professionals with sufficient knowledge of the relevant reporting requirements, including the applicable accounting requirements, and the appropriate staffing to meet deadlines for required current and periodic reports. In particular, there are matters that require significant judgement in accounting for the merger with the SPAC.
  • It is important for target companies to understand internal control over financial reporting and disclosure controls and procedures and have a plan in place for the combined public company to comply with those requirements on a timely basis.
  • Clear and candid communications between the audit committee, auditor, and management are important for setting expectations and proactively engaging as reporting, control, or audit issues arise during and after the merger process.
  • It is also important for the auditor to consider whether the appropriate acceptance and continuance procedures have taken place when a formerly private audit client prepares to go public through a SPAC merger. While this process also occurs in a traditional IPO, the compressed timing and complexity in a de-SPAC transaction may require thoughtful consideration and analysis pertaining to the client continuance assessment and may require the audit firm to quickly make adjustments to its engagement team to ensure the team has the appropriate level of expertise and experience with SEC and PCAOB requirements.

The statement by the Division of Corporation Finance focuses on accounting, financial reporting and governance issues that should be carefully considered before a private operating company undertakes a business combination with a SPAC. Among other things:

  • Financial statements for the acquired business must be filed within four business days of the completion of the business combination pursuant to Item 9.01(c) of Form 8-K. The registrant is not entitled to the 71-day extension of that Item;
  • The combined company will not be eligible to incorporate Exchange Act reports, or proxy or information statements filed pursuant to Section 14 of the Exchange Act, by reference on Form S-1 until three years after the completion of the business combination;
  • The combined company will not be eligible to use Form S-8 for the registration of compensatory securities offerings until at least 60 calendar days after the combined company has filed current Form 10 information;
  • The combined company will be an “ineligible issuer” under Securities Act Rule 405 for three years following the completion of the business combination;
  • If the combined company is NYSE or Nasdaq listed, the company also must meet qualitative standards regarding corporate governance, such as requirements regarding a majority independent board of directors, an independent audit committee consisting of directors with specialized experience, independent director oversight of executive compensation and the director nomination process, and a code of conduct applicable to all directors, officers, and employees. There is a risk that a private operating company that has not prepared for an initial public offering and is quickly acquired by a SPAC may not have these elements in place in order to meet the listing standards at the time required.  Advance planning may be necessary to identify, elect, and on-board a newly-constituted independent board and audit committee, and for them to adequately oversee the preparation and audit of the company’s financial statements, books and records, and internal controls.

Deluxe Entertainment Services Inc. v. DLX Acquisition Corporation involved a stock purchase agreement where Plaintiff Deluxe Entertainment sold all of its stock (the “Transaction”) in its wholly owned subsidiary, Deluxe Media Inc. (“Target”), to defendant DLX Acquisition Corporation (“Buyer,” and together with Target, “Defendants”), an affiliate of the private equity firm Platinum Equity. All of Target’s assets, except for those excluded by the parties’ purchase agreement (the “Purchase Agreement”), were transferred in the Transaction.

At closing, several million dollars in cash remained in Target’s bank accounts (the “Disputed Cash”). Seller alleges it failed to sweep those funds from Target before closing “for various practical and technical reasons,” and Buyer did not dispute Seller had the right to sweep those funds before closing.

Buyer refused to return the Disputed Cash upon request from the Seller, indicating the Purchase Agreement did not require it to do so.  Seller then commenced an action in the Court of Chancery alleging three causes of action for return of the Disputed Cash:

  • Buyer’s failure to return the Disputed Cash amounted to a breach of the Purchase Agreement.
  • Failure to return the cash was a breach of the implied covenant of good faith and fair dealing.
  • A request to reform the Purchase Agreement to address the issue.

Seller argued the parties never intended to transfer the Disputed Cash to Buyer as evidenced by:

  • The Purchase Agreement’s definition of net working capital for purposes of calculating the purchase price, and
  • Extrinsic evidence about the parties’ negotiations leading up to the Purchase Agreement, which Seller contends reflects the parties’ otherwise undocumented agreement that the Transaction would be “cash-free, debt-free.”

Breach of Purchase Agreement

The Court noted it is a general principle of corporate law that all assets and liabilities are transferred in the sale of a company effected by a sale of stock.  When Seller agreed to sell Buyer all the Target Shares, it agreed to sell all the Target’s assets.

As a result, the parties did not enumerate the assets transferred but instead listed certain excluded assets on a schedule.  The schedule did not address the Disputed Cash.

Seller argued the Purchase Agreement did not transfer Target’s cash to Buyer based on the Purchase Agreement’s calculation of the purchase price, which directs a calculation of net working capital that excluded cash.  Seller further argued that the Purchase Agreement’s exclusion of cash from Net Working Capital, and thus from the Closing Date Purchase Price, indicated the parties’ clear intent that the Transaction would be “cash-free, debt-free.”  The Court rejected these arguments, noting that the purchase price adjustments are just that: adjustments to how much Buyer was to pay, not to what assets the Buyer purchased. Nothing in the purchase price provisions indicated the parties’ intention to exclude cash according to the Court.

Seller contended that “at worst,” the Purchase Agreement is ambiguous in its treatment of cash, so the Court may reach its proffered extrinsic evidence and conclude the parties intended the Transaction to exclude cash. But the Court noted the Purchase Agreement was not ambiguous on this point, so it did not reach Seller’s arguments about the parties’ negotiation history. According to the Court a party cannot use negotiation history itself to create ambiguity, as extrinsic, parol evidence cannot be used to manufacture an ambiguity in a contract that facially has only one reasonable meaning.

Good Faith and Fair Dealing

Seller argued that the implied covenant of good faith and fair dealing required Buyer to return the Disputed Cash. Since Seller failed to identify a gap in transaction terms in which the implied covenant could operate, the Seller’s claim failed.

Other provisions of the Purchase Agreement contemplated the possibility that an asset could be inadvertently transferred at closing, but those provisions did not address the Disputed Cash. Here an unintended asset transfer was not an “unanticipated development,” but rather was “expressly covered by the contract.”  The Court stated to use the implied covenant to add the Disputed Cash to the list of excluded assets would be “to create a free-floating duty unattached to the underlying legal documents.”

Reformation

Seller contended that if the Purchase Agreement’s plain language does not evidence the parties’ agreement that the Disputed Cash was to be excluded from the Transaction, then the absence of such language was the result of a scrivener’s error. Seller therefore urged the Court to reform the Purchase Agreement.

The Court declined to reform the Purchase Agreement.  The Court noted Seller’s allegations about the parties’ negotiation history failed to plead the terms of a definite agreement that was materially different from the Purchase Agreement the terms of which the parties intended to incorporate into the Purchase Agreement. The alleged mistake that led to the perhaps unintended transfer of the Disputed Cash is not the sort of mistake that supports reformation; it is not a mistake in the expression of the Purchase Agreement, but rather an operational mistake by Seller in preparing to perform.

More fundamentally, Seller offered no evidence of a scrivener’s error in the Purchase Agreement. Seller did not identify what error was made when reducing the Purchase Agreement to writing nor any mistake as to the contents or effect of a writing that expresses the agreement. Nor did Seller identify an erroneous belief relating to the facts as they existed at the time of the making of the contract.

The Court stated the “mistake” at issue was Seller’s failure to sweep the Disputed Cash from Target’s bank account, separate and apart from the terms of the Purchase Agreement. Seller’s failure to sweep Target’s cash was an operations or accounting mistake, which is crucially distinguishable from a scrivener’s error in the underlying agreement itself that can be remedied by reformation.  The Court held it will not change the terms of the parties’ bargain to accommodate Seller’s error in preparing to perform under the agreement that reflects that bargain.

In September 2020 the SEC adopted final rules altering the shareholder proposal framework for the first time in 20 years. Following another split-vote of the Commissioners, the SEC approved modifications to the current shareholder ownership threshold for initial submissions as well as the shareholder support levels required for resubmissions of proposals and adopted several other notable changes.

Now, following the change in administrations, a resolution has been introduced to invalidate the revised rules under the Congressional Review Act.  The CRA empowers Congress to review, by means of an expedited legislative process, new federal regulations issued by government agencies and, by passage of a joint resolution, to overrule a regulation. Once a rule is thus repealed, the CRA also prohibits the reissuing of the rule in substantially the same form or the issuing of a new rule that is substantially the same “unless the reissued or new rule is specifically authorized by a law enacted after the date of the joint resolution disapproving the original rule.”

The resolution that has been introduced is very simple:

Resolved by the Senate and House of Representatives of the United States of America in Congress assembled, That Congress disapproves the rule submitted by the Securities and Exchange Commission relating to “Procedural Requirements and Resubmission Thresholds Under Exchange Act Rule 14a–8’’ (85 Fed. Reg. 70240 (November 4, 2020)), and such rule shall have no force or effect.

Additional background information can be found in Liz Dunshee’s blog at TheCorporateCounsel.net.