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

Section 925(a) of the Dodd-Frank Act expanded a remedy for certain violations of securities laws form barring association with broker-dealers to a bar that includes municipal advisors, rating organizations and other regulated associations.  In Koch v. SEC, the United States Court of Appeals for the District of Columbia Circuit held that the SEC cannot apply the expanded bar retroactively to conduct that occurred prior to the time the Dodd-Frank Act was enacted.

According to the Court:

  • The Dodd-Frank Act does not expressly authorize retroactive application.
  • Adding additional associations to the bar enhanced the penalties for violations of the securities laws.
  • Application of the enhanced penalties to Koch was impermissibly retroactive because it attached a new disability to conduct that was over and done.

The Dodd-Frank Act also permitted the SEC to bar Koch in one proceeding rather than separate proceedings for each industry.  However the court found that this was merely procedural and did not give rise to retroactivity concerns.

ABOUT STINSON LEONARD STREET

Stinson Leonard Street LLP provides sophisticated transactional and litigation legal services to clients ranging from individuals and privately held enterprises to national and international public companies. As one of the 100 largest firms in the U.S., Stinson Leonard Street has offices in 14 cities, including Minneapolis, Mankato and St. Cloud, Minn.; Kansas City, St. Louis and Jefferson City, Mo.; Phoenix, Ariz.; Denver, Colo.; Washington, D.C.; Decatur, Ill.; Wichita and Overland Park, Kan.; Omaha, Neb.; and Bismarck, N.D.

The views expressed herein are the views of the blogger and not those of Stinson Leonard Street or any client.

Audit committees, CFOs and accountants everywhere are cheering as the FASB has deferred the effective date of its new revenue recognition standard.  As a result, public business entities, certain not-for-profit entities, and certain employee benefit plans will apply the new revenue standard to annual reporting periods beginning after December 15, 2017. All other entities will apply the new revenue standard to annual reporting periods beginning after December 15, 2018.

Public business entities, certain not-for-profit entities, and certain employee benefit plans will apply the new revenue standard to interim reporting periods within annual reporting periods beginning after December 15, 2017 (that is, beginning in the first interim period within the year of adoption). All other entities will apply the new revenue standard to interim reporting periods within annual reporting periods beginning after December 15, 2019 (that is, all other entities will not be required to apply the guidance in the new revenue standard in interim periods within the year of adoption).

Providing an accommodation few, if anyone, will use, the Board affirmed its proposal to permit all entities to apply the new revenue standard early, but not before the original effective date for public business entities, certain not-for-profit entities, and certain employee benefit plans (that is, annual periods beginning after December 15, 2016). Public business entities, certain not-for-profit entities, and certain employee benefit plans choosing this option will apply the new revenue standard to all interim reporting periods within the year of adoption. All other entities will not be required to apply the new revenue standard until interim periods after the first year of adoption.

ABOUT STINSON LEONARD STREET

Stinson Leonard Street LLP provides sophisticated transactional and litigation legal services to clients ranging from individuals and privately held enterprises to national and international public companies. As one of the 100 largest firms in the U.S., Stinson Leonard Street has offices in 14 cities, including Minneapolis, Mankato and St. Cloud, Minn.; Kansas City, St. Louis and Jefferson City, Mo.; Phoenix, Ariz.; Denver, Colo.; Washington, D.C.; Decatur, Ill.; Wichita and Overland Park, Kan.; Omaha, Neb.; and Bismarck, N.D.

The views expressed herein are the views of the blogger and not those of Stinson Leonard Street or any client.

The Third Circuit has issued its decision in the case of Trinity Wall Street v Wal-Mart Stores, Inc.  To try and put it simply, Wal-Mart argued Trinity’s shareholder proposal dressed up a matter related to the ordinary business operations of Wal-Mart, which was the sales of certain products such as assault weapons, as a governance matter.  Wal-Mart disagreed with the end-run and maintained the proposal was excludable because it related to its ordinary business operations.  The Third Circuit agreed with Wal-Mart.

For those of you who scratched your head wondering about the tiny nuances on which the case turned, perhaps the Court’s conclusion is better than the rest of the opinion:

“Although a core business of courts is to interpret statutes and rules, our job is made difficult where agencies, after notice and comment, have hard-to-define exclusions to their rules and exceptions to those exclusions. For those who labor with the ordinary business exclusion and a social-policy exception that requires not only significance but “transcendence,” we empathize. Despite the substantial uptick in proposals attempting to raise social policy issues that bat down the business operations bar, the SEC’s last word on the subject came in the 1990s, and we have no hint that any change from it or Congress is forthcoming . . . We thus suggest that [the SEC] consider revising its regulation of proxy contests and issue fresh interpretive guidance.”

The Court first had to analyze the subject matter of the proposal.  Bowing its head to the notion that “proxy apocalypse” would occur if Trinity’s argument were correct, the Court noted that framing the proposal’s subject matter as “improved corporate governance” would allow drafters to evade Rule 14a- 8(i)(7)’s reach by styling their proposals as requesting board oversight or review.

The Court then found that Wal-Mart’s approach to whether it sells particular products relates to its ordinary business operations.  So long as the subject matter of the proposal relates—that is, bears on—a company’s ordinary business operations, the proposal is excludable unless some other exception to the exclusion applies.

So Trinity next focused on whether the proposal must be included because it focuses on a significant and transcendent social policy issue: Wal-Mart’s approach to the risk that the sale of a product can cause “harm to [its] customers or its brand and reputation.”

As to whether or not Trinity’s proposal addressed a significant social policy issue, the Court stated the SEC has adopted a “we-know-it-when-we-see-it” approach.  Nevertheless, the Court found it  hard to counter Trinity’s argument that its proposal doesn’t touch the bases of what are significant concerns in our society and corporations in that society. Thus the Court found that the that its proposal raises a matter of sufficiently significant policy.

But to be included, it is not enough that the proposal address a significant policy issue, the proposal’s subject matter must “transcend” the company’s ordinary business.  The Court believed this meant it must refer to a policy issue that is divorced from how a company approaches the nitty-gritty of its core business.  For major retailers of myriad products, a policy issue is rarely transcendent if it treads on the meat of management’s responsibility: crafting a product mix that satisfies consumer demand.   For a policy issue here to transcend Wal-Mart’s business operations, it must target something more than the choosing of one among tens of thousands of products it sells. Trinity’s proposal failed that test and was properly excludable under Rule 14a-8(i)(7).

ABOUT STINSON LEONARD STREET

Stinson Leonard Street LLP provides sophisticated transactional and litigation legal services to clients ranging from individuals and privately held enterprises to national and international public companies. As one of the 100 largest firms in the U.S., Stinson Leonard Street has offices in 14 cities, including Minneapolis, Mankato and St. Cloud, Minn.; Kansas City, St. Louis and Jefferson City, Mo.; Phoenix, Ariz.; Denver, Colo.; Washington, D.C.; Decatur, Ill.; Wichita and Overland Park, Kan.; Omaha, Neb.; and Bismarck, N.D.

The views expressed herein are the views of the blogger and not those of Stinson Leonard Street or any client.

The SEC has issued a concept release to seek public comment regarding audit committee reporting requirements, with a focus on the audit committee’s reporting of its responsibilities with respect to its oversight of the independent auditor. The SEC has categorized the specific audit committee disclosures about which the Commission is interested in receiving comment into three groups:

  • The audit committee’s oversight of the auditor.
  • The audit committee’s process for selecting the auditor.
  • The audit committee’s consideration of the qualifications of the audit firm and certain members of the engagement team when selecting the audit firm.

The Audit Committee’s Oversight of the Auditor

Currently the audit committee report discloses whether certain communications have occurred. The SEC believes potential additional disclosures about the communications might provide additional information about the actions the audit committee has taken during the most recently completed fiscal year to oversee the auditor and the audit.   The Commission is considering whether to require additional qualitative disclosures about the nature and timing of the required communications between the audit committee and the auditor. The concept release suggests:

  • The disclosure rules could require the audit committee to discuss not just whether and when all of the required communications occurred, but also the audit committee’s consideration of the matters discussed.
  • Requiring additional disclosure about the specific meetings with the auditor may provide additional insight into the audit committee’s oversight of the auditor.
  • There could be disclosure required about the nature of any discussions held with the auditor about the results of the firm’s internal quality review and most recent PCAOB inspection.
  • There could be disclosure about whether, and if so how, as part of its oversight of the auditor, the audit committee assesses, promotes, or reinforces the auditor’s objectivity and professional skepticism.

Audit Committee’s Process for Appointing or Retaining the Auditor

Potential topics for additional disclosure include:

  • The process the audit committee undertook and the criteria used to assess the auditor and the audit committee’s rationale for selecting or retaining the auditor.
  • When a new auditor is selected, the process the audit committee undertook, including the number of auditors that were asked to make proposals, information on how those auditors were selected, and the information that the audit committee used in its decision.
  • The board of directors’ policy, if any, for an annual shareholder vote on the selection of the auditor, and the audit committee’s consideration of the voting results in evaluating and selecting the audit firm, including situations where the audit firm fails to achieve majority support.

Qualifications of the Audit Firm and Certain Members of the Engagement Team Selected By the Audit Committee

Potential topics for additional disclosure include:

  • The name of the engagement partner, alone or with the name(s) of other key members of the audit engagement team (e.g., the engagement quality reviewer), the length of time such individual(s) have served in that role and any relevant experience.
  • The involvement of the audit committee in the selection of the engagement partner, and any input the audit committee had in the decision.
  • Information on the number of years the audit firm has been retained and how auditor tenure was considered by the audit committee in retaining the auditor.

ABOUT STINSON LEONARD STREET

Stinson Leonard Street LLP provides sophisticated transactional and litigation legal services to clients ranging from individuals and privately held enterprises to national and international public companies. As one of the 100 largest firms in the U.S., Stinson Leonard Street has offices in 14 cities, including Minneapolis, Mankato and St. Cloud, Minn.; Kansas City, St. Louis and Jefferson City, Mo.; Phoenix, Ariz.; Denver, Colo.; Washington, D.C.; Decatur, Ill.; Wichita and Overland Park, Kan.; Omaha, Neb.; and Bismarck, N.D.

The views expressed herein are the views of the blogger and not those of Stinson Leonard Street or any client.

The SEC has proposed new rules to implement Section 954 of the Dodd-Frank Act, which added Section 10D to the Securities Exchange Act of 1934. Section 10D requires the Commission to adopt rules directing the national securities exchanges and national securities associations to prohibit the listing of any security of an issuer that is not in compliance with Section 10D’s requirements for disclosure of the issuer’s policy on incentive-based compensation and recovery of incentive-based compensation that is received in excess of what would have been received under an accounting restatement.

The proposed rules direct the exchanges to establish listing standards that require listed issuers to:

  • adopt and comply with written policies for recovery of incentive-based compensation based on financial information required to be reported under the securities laws, applicable to the listed issuers’ executive officers, over a period of three years; and
  • disclose those recovery policies in accordance with Commission rules.

To assure that issuers listed on different exchanges are subject to the same disclosure requirements regarding compensation recovery policies, the SEC is proposing amendments to the disclosure rules that would require all issuers listed on any exchange to file their written recovery policy as an exhibit to their annual reports and, if they have taken actions pursuant to that policy, to disclose those actions.

Issuers and Securities Subject to the Rule

The proposal would require exchanges to apply the disclosure and recovery policy requirements to all listed issuers, with only limited exceptions. The limited exceptions apply only to security futures products, standardized options, and the securities of certain registered investment companies. The SEC does not propose to exempt categories of listed issuers, such as emerging growth companies, smaller reporting companies, foreign private issuers, and controlled companies, because the SEC believes the objective of recovering excess incentive-based compensation is as relevant for these categories of listed issuers as for any other listed issuer.

Restatements

Restatements Triggering Application of a Recovery Policy

Proposed Rule 10D-1 provides that issuers adopt and comply with a written policy providing that in the event the issuer is required to prepare a restatement to correct an error that is material to previously issued financial statements, the obligation to prepare the restatement would trigger application of the recovery policy. In connection with this, the proposed rule defines an accounting restatement as the result of the process of revising previously issued financial statements to reflect the correction of one or more errors that are material to those financial statements. The SEC believes an issuer should consider whether a series of immaterial error corrections, whether or not they resulted in filing amendments to previously filed financial statements, could be considered a material error when viewed in the aggregate.

The SEC recognizes the following types of changes to an issuer’s financial statements do not represent error corrections, and therefore would not trigger application of the issuer’s recovery policy under the proposed listing standards:

  • retrospective application of a change in accounting principle;
  • retrospective revision to reportable segment information due to a change in the structure of an issuer’s internal organization;
  • retrospective reclassification due to a discontinued operation;
  • retrospective application of a change in reporting entity, such as from a reorganization of entities under common control;
  • retrospective adjustment to provisional amounts in connection with a prior business combination; and
  • retrospective revision for stock splits.

Date the Issuer Is Required to Prepare an Accounting Restatement

The proposed rule states that the date on which an issuer is required to prepare an accounting restatement is the earlier to occur of:

  • The date the issuer’s board of directors, a committee of the board of directors, or the officer or officers of the issuer authorized to take such action if board action is not required, concludes, or reasonably should have concluded, that the issuer’s previously issued financial statements contain a material error; or
  • The date a court, regulator or other legally authorized body directs the issuer to restate its previously issued financial statements to correct a material error.

A note to the proposed rule indicates that the first proposed date generally is expected to coincide with the occurrence of the event described in Item 4.02(a) of Exchange Act Form 8-K, although neither proposed date is predicated on a Form 8-K having been filed. For the first proposed date to occur, the issuer merely needs to have concluded that previously issued financial statements contain a material error, which the SEC expects may occur before the precise amount of the error has been determined.

Application of Recovery Policy

Executive Officers Subject to Recovery Policy

Section 10D of the Exchange Act does not define “executive officer” for purposes of the recovery policy. The proposed listing standards would include a definition of “executive officer” in Rule 10D-1 that is modeled on the definition of “officer” in Rule 16a-1(f) of the Exchange Act. For purposes of Section 10D, an “executive officer” would be the issuer’s president, principal financial officer, principal accounting officer (or if there is no such accounting officer, the controller), any vice-president of the issuer in charge of a principal business unit, division or function (such as sales administration or finance), any other officer who performs a policy-making function, or any other person who performs similar policy-making functions for the issuer. Executive officers of the issuer’s parents or subsidiaries would be deemed executive officers of the issuer if they perform such policy making functions for the issuer.

Section 10D(b)(2) calls for the recovery policy to apply to “any current or former executive officer of the issuer who received incentive-based compensation during the three-year look-back period.” Accordingly, the proposed rules require recovery of excess incentive-based compensation received by an individual who served as an executive officer of the listed issuer at any time during the performance period for that incentive-based compensation. This would include incentive-based compensation derived from an award authorized before the individual becomes an executive officer, and inducement awards granted in new hire situations, as long as the individual served as an executive officer of the listed issuer at any time during the award’s performance period.

Incentive-Based Compensation Subject to Recovery Policy

The SEC proposes to define “incentive-based compensation” in a principles-based manner. As proposed, “incentive-based compensation” would be defined as “any compensation that is granted, earned or vested based wholly or in part upon the attainment of any financial reporting measure.”

The proposed definition would further provide that “financial reporting measures” are measures that are determined and presented in accordance with the accounting principles used in preparing the issuer’s financial statements, any measures derived wholly or in part from such financial information, and stock price and total shareholder return. Such measures would be encompassed by the definition of financial reporting measures whether or not included in a filing with the Commission, and may be presented outside the financial statements, such as in Management’s Discussion and Analysis of Financial Conditions and Results of Operations or the performance graph.

In addition to measures that are derived from the financial statements, the proposed definition of financial reporting measures would include performance measures based on stock price or total shareholder return. Although the phrase “financial information required to be reported under the securities laws” might be interpreted as applying only to accounting-based metrics, the SEC believes that it also includes performance measures such as stock price and total shareholder return that are affected by accounting-related information and that are subject to our disclosure requirements.

Time Period Covered by Recovery Policy

Under proposed Rule 10D-1, the three-year look-back period for the recovery policy required by the listing standards would be the three completed fiscal years immediately preceding the date the issuer is required to prepare an accounting restatement. The SEC believes that basing the look-back period on fiscal years, rather than a preceding 36-month period, is consistent with issuers’ general practice of making compensation decisions and awards on a fiscal year basis. Using the proposed recovery period trigger, if a calendar year issuer concludes in November 2018 that a restatement of previously issued financial statements is required and files the restated financial statements in January 2019, the recovery policy would apply to compensation received in 2015, 2016 and 2017.

When Incentive-Based Compensation Is “Received”

Section 10D does not specify when an executive officer is deemed to have received incentive-based compensation to which the recovery policy must apply. As proposed, incentive-based compensation would be deemed received for purposes of triggering the recovery policy under Section 10D in the fiscal period during which the financial reporting measure specified in the incentive-based compensation award is attained, even if the payment or grant occurs after the end of that period. Under this standard, the date of receipt would depend upon the terms of the award. If the grant of an award is based, either wholly or in part, on satisfaction of a financial reporting measure, the award would be deemed received in the fiscal period when that measure was satisfied. If an equity award vests upon satisfaction of a financial reporting measure, the award would be deemed received in the fiscal period when it vests.

 

A particular award may be subject to multiple conditions. The SEC is not proposing that an executive officer must have satisfied all conditions to an award for the incentive-based compensation to be deemed received for purposes of triggering the recovery policy. For example, an issuer could grant an executive officer an RSU award in which the number of RSUs earned is determined at the end of the three-year incentive-based performance period (2015- 2017), but the award is subject to service-based vesting for two more years (2018-2019). Although the executive officer does not have a non-forfeitable interest in the RSUs before expiration of the subsequent two-year service-based vesting period, the number of shares in which the RSUs ultimately will be paid will be established at the end of the three-year performance period. In this circumstance the executive officer “receives” the compensation for purposes of triggering the recovery policy when the relevant financial reporting measure performance goal is attained, even if the executive officer has established only a contingent right to payment at that time.

Determination of Excess Compensation

Section 10D(2)(b) requires exchanges and associations to adopt listing standards that require issuers to adopt and comply with recovery policies that apply to the amount of incentive based compensation received “in excess of what would have been paid to the executive officer under the accounting restatement.” The SEC proposes to define the recoverable amount as “the amount of incentive-based compensation received by the executive officer or former executive officer that exceeds the amount of incentive-based compensation that otherwise would have been received had it been determined based on the accounting restatement.” Applying this definition, after an accounting restatement, the issuer would first recalculate the applicable financial reporting measure and the amount of incentive-based compensation based thereon. The issuer would then determine whether, based on that financial reporting measure as calculated relying on the original financial statements and taking into account any discretion that the compensation committee had applied to reduce the amount originally received, the executive officer received a greater amount of incentive-based compensation than would have been received applying the recalculated financial reporting measure.

For incentive-based compensation that is based on stock price or total shareholder return, where the amount of erroneously awarded compensation is not subject to mathematical recalculation directly from the information in an accounting restatement, the recoverable amount may be determined based on a reasonable estimate of the effect of the accounting restatement on the applicable measure. To reasonably estimate the effect on the stock price, there are a number of possible methods with different levels of complexity of the estimations and related costs. For these measures, the issuer would be required to maintain documentation of the determination of that reasonable estimate and provide such documentation to the relevant exchange or association.

The recoverable amount would be calculated on a pre-tax basis to ensure that the company recovers the full amount of incentive-based compensation that was erroneously awarded, consistent with the policy underlying Section 10D.

Board Discretion Regarding Whether to Seek Recovery

The Dodd-Frank Act provides that “the issuer will recover” incentive-based compensation, and does not address whether there are circumstances in which an issuer’s board of directors may exercise discretion not to recover. Proposed Rule 10D-1 provides that an issuer must recover erroneously awarded compensation in compliance with its recovery policy except to the extent that pursuit of recovery would be impracticable because it would impose undue costs on the issuer or its shareholders or would violate home country law and certain conditions are met.

The SEC believes the unqualified “no-fault” recovery mandate of Section 10D intends that the issuer should pursue recovery in most instances.

In the SEC’ s view, inconsistencies between the proposed rules and existing compensation contracts is not a basis for finding recovery to be impracticable, because the SEC believes issuers can amend those contracts to accommodate recovery. Further, the SEC indicated the only criteria that should be considered are whether the direct costs of enforcing recovery would exceed the recoverable amounts or whether recovery would violate home country law. Before concluding that it would be impracticable to recover any amount of excess incentive-based compensation based on enforcement costs, the issuer would first need to make a reasonable attempt to recover that incentive-based compensation. The issuer would be required to document its attempts to recover, and provide that documentation to the exchange. As discussed below, the issuer also would be required to disclose why it determined not to pursue recovery.

Board Discretion Regarding Manner of Recovery

Section 10D does not address whether an issuer’s board of directors may exercise discretion in the manner in which it recovers excess compensation to comply with the listing standards. As proposed, Rule 10D-1 would not limit the amount of compensation the board could seek to recover on any legal basis. However, under the proposed rule, issuers’ boards of directors would not be permitted to pursue differential recovery among executive officers, including in “pool plans,” where the board may have exercised discretion as to individual grants in allocating the bonus pool.

The proposal does not permit issuers to settle for less than the full recovery amount unless it is impracticable from a cost standpoint. In that circumstance, the same conditions discussed above would apply as for a determination to forgo recovery.

Means of Recovery

The SEC recognizes that the appropriate means of recovery may vary by issuer and by type of compensation arrangement. Consequently, the SEC believes issuers should be able to exercise discretion in how to accomplish recovery. Nevertheless, in exercising this discretion, the SEC believes that issuers should act in a manner that effectuates the purpose of the statute – to prevent executive officers from retaining compensation that they received and to which they were not entitled under the issuer’s restated results. Regardless of the means of recovery utilized, the SEC believes that issuers should recover excess incentive-based compensation reasonably promptly, as undue delay would constitute non-compliance with an issuer’s policy.

Compliance with Required Policy

Under the proposed rules, an issuer would be subject to delisting if it does not adopt and comply with its compensation recovery policy. The proposed rules do not specify the time by which the issuer must complete the recovery of excess incentive-based compensation. Rather, under proposed Rule 10D-1, an exchange would determine whether the steps an issuer is taking constitute compliance with its recovery policy. In making this assessment, an exchange would need to determine, among other things, whether the issuer was making a good faith effort to promptly pursue recovery.

Disclosure of Issuer Policy on Incentive-Based Compensation

Required Disclosures

The proposal would amend Item 601(b) of Regulation S-K to require that a listed issuer file its recovery policy as an exhibit to its annual report on Form 10-K. To further implement the Dodd-Frank Act, the SEC is using its discretionary authority to propose to amend Item 402 of Regulation S-K to require listed issuers to disclose how they have applied their recovery policies. Proposed Item 402(w) of Regulation S-K would apply if at any time during its last completed fiscal year either a restatement that required recovery of excess incentive-based compensation pursuant to the listed issuer’s compensation recovery policy was completed or there was an outstanding balance of excess incentive-based compensation from the application of that policy to a prior restatement. In this circumstance, the listed issuer would be required to provide the following information in its Item 402 disclosure:

  • for each restatement, the date on which the listed issuer was required to prepare an accounting restatement, the aggregate dollar amount of excess incentive-based compensation attributable to such accounting restatement and the aggregate dollar amount of excess incentive-based compensation that remains outstanding at the end of its last completed fiscal year;
  • the estimates used to determine the excess incentive-based compensation attributable to such accounting restatement, if the financial reporting measure related to a stock price or total shareholder return metric;
  • the name of each person subject to recovery of excess incentive-based compensation attributable to an accounting restatement, if any, from whom the listed issuer decided during the last completed fiscal year not to pursue recovery, the amount forgone for each such person, and a brief description of the reason the listed issuer decided in each case not to pursue recovery; and
  • the name of, and amount due from, each person from whom, at the end of its last completed fiscal year, excess incentive-based compensation had been outstanding for 180 days or longer since the date the issuer determined the amount the person owed.

Changes to Summary Compensation Table

The SEC is also proposing amendments to the Summary Compensation Table disclosure requirements. A new instruction to the Summary Compensation Table requires that any amounts recovered pursuant to a listed issuer’s erroneously awarded compensation recovery policy reduce the amount reported in the applicable column for the fiscal year in which the amount recovered initially was reported, and be identified by footnote.

XBRL Tagging

The proposed rules require that the disclosure required by proposed Item 402(w) be provided in interactive data format using XBRL using block-text tagging. The interactive data would have to be provided as an exhibit to the definitive proxy or information statement filed with the Commission and as an exhibit to the annual report on Form 10-K.   Issuers would be required to prepare their interactive data using the list of tags the Commission specifies and submit them with any supporting files the EDGAR Filer Manual prescribes. This requirement generally would apply to all listed issuers.

Indemnification and Insurance

Rule 10D-1, as proposed, prohibits a listed issuer from indemnifying any executive officer or former executive officer against the loss of erroneously awarded compensation.   Further, while an executive officer may be able to purchase a third party insurance policy to fund potential recovery obligations, the indemnification prohibition would prohibit an issuer from paying or reimbursing the executive for premiums for such an insurance policy. In addition, the SEC believes that the anti-waiver provision in Section 29(a) of the Exchange Act would render any indemnification agreement unenforceable to the extent that the agreement purported to relieve the issuer of its obligation under Section 10(D).

Transition and Timing

The proposal requires that:

  • each exchange file its proposed listing rules no later than 90 days following publication of the final adopted version of Rule 10D-1 in the Federal Register, and that its rules be effective no later than one year following that publication date;
  • each listed issuer must adopt the recovery policy required by the proposed rules no later than 60 days following the date on which the applicable exchange’s rules become effective;
  • each listed issuer must recover all erroneously awarded incentive-based compensation received by executive officers and former executive officers as a result of attainment of a financial reporting measure based on or derived from financial information for any fiscal period ending on or after the effective date of Rule 10D-1 and that is granted, earned or vested on or after the effective date of Rule 10D-1 pursuant to the issuer’s recovery policy; and
  • listed issuers must file the required disclosures in applicable SEC filings required on or after the date on which the exchanges’ rules become effective.

The rule proposal is silent about how issuers should deal with retroactive application of the recovery policy to existing compensation arrangements. However, the SEC is crystal clear in its mandate that issuer compliance is required whether the incentive-based compensation is received pursuant to a pre-existing contract or arrangement, or one that is entered into after the effective date of the exchange’s listing standard.

Stinson Leonard Street LLP provides sophisticated transactional and litigation legal services to clients ranging from individuals and privately held enterprises to national and international public companies. As one of the 100 largest firms in the U.S., Stinson Leonard Street has offices in 14 cities, including Minneapolis, Mankato and St. Cloud, Minn.; Kansas City, St. Louis and Jefferson City, Mo.; Phoenix, Ariz.; Denver, Colo.; Washington, D.C.; Decatur, Ill.; Wichita and Overland Park, Kan.; Omaha, Neb.; and Bismarck, N.D.

The views expressed herein are the views of the blogger and not those of Stinson Leonard Street or any client.

Members of the Dolan family hold 73% of the voting power of Cablevision Systems Corporation’s stock.  A shareholder commenced a derivative action regarding the executive compensation paid to Dolan family members serving as Executive Chairman and Chief Executive Officer and the Delaware Court of Chancery dismissed the claims.

In setting the compensation for the two family members that serve as Executive Chairman and Chief Executive Officer of Cablevision, the compensation committee used a peer group of 14 publicly traded companies.  The court, in analyzing the case, also looked to additional companies in Cablevision’s ISS peer group, for a total peer group of 26 companies.  18 members of the peer group had market capitalizations of over $10 billion and the average total revenue was $30.87 billion.  By comparison, Cablevision had a market capitalization of $4.39 billion and $19.58 billion in revenue.

Of the 17 peer companies with less than $30 billion in market capitalization, only two paid their CEO more than Cablevision paid its CEO.  The Executive Chairman earned more than 14 (of 17) CEOs at peer companies with a market capitalization below $30 billion.

The plaintiff claimed that the entire fairness standard should apply to review of the executive compensation rather than the business judgment rule.  The rational that was advanced was that transactions between controllers and a controlled company are reviewed under the entire fairness standard regardless of whether the transaction is approved by a committee or whether challenged in a merger or non-merger.

The Court agreed with the defendants’ analysis about the need to distinguish an independent committee’s compensation decisions from other matters warranting default entire fairness review. For example, major concerns in applying entire fairness review are informational advantages and coercion.  The Court noted the complaint does not support its allegations of leveraging control over the compensation committee with a factual basis to make that inference, and the Court did not believe the Executive Chairman and the CEO had a material informational advantage over the compensation committee about the value of their services. Additionally, the Court would not endorse the principle that every controlled company, regardless of use of an independent committee, must demonstrate the entire fairness of its executive compensation in court whenever questioned by a shareholder. Finally, the Court stated it was especially undesirable to make such a pronouncement here, where annual compensation is not a “transformative” or major decision.

The Court found the compensation committee was independent and rejected the plaintiff’s allegations of non-independence based on long-term board service, service at other Dolan controlled entities, age, retirement status, a sibling’s employment, and continued self-nomination with board approval.  The Court stated it was not reasonable to infer that age and retirement defeated independence — the plaintiff did not make fact-based allegations suggesting that the compensation committee defendants had infirmities or were dependent on their compensation. In addition, there were no allegations of how a compensation committee member’s decision were tied to his brother’s general employment by a Dolan entity that would lead the Court to deem the director’s decisions were discretion sterilized.  According to the Court, the totality of the complaint did not make a reasonably conceivable case that the directors wanted to remain on the board so much that they sacrificed their professional integrity.

ABOUT STINSON LEONARD STREET

Stinson Leonard Street LLP provides sophisticated transactional and litigation legal services to clients ranging from individuals and privately held enterprises to national and international public companies. As one of the 100 largest firms in the U.S., Stinson Leonard Street has offices in 14 cities, including Minneapolis, Mankato and St. Cloud, Minn.; Kansas City, St. Louis and Jefferson City, Mo.; Phoenix, Ariz.; Denver, Colo.; Washington, D.C.; Decatur, Ill.; Wichita and Overland Park, Kan.; Omaha, Neb.; and Bismarck, N.D.

The views expressed herein are the views of the blogger and not those of Stinson Leonard Street or any client.

The CrowdCheck Blog has an interesting post on “The case of the vanishing Form 1-A filings.”  Most everything that was filed to date has disappeared, probably because of defects like lack of financial statements.

The initial filings seemed to be of low quality.  I feel for the SEC staff, because it appears they will have their hands full as people lob in poorly conceived filings.  It appears they will have to do more babysitting than assisting in capital formation transactions on simplified terms.

The high quality bona fide filings will come in time.  I suspect that most of those have been filed confidentially and we’ll just have to wait to see those.

[Update:  Some of the filings CrowdCheck said had vanished have reappearred.  But I still think the SEC staff is going to have its hands full dealing with a lot of these filings.]

ABOUT STINSON LEONARD STREET

Stinson Leonard Street LLP provides sophisticated transactional and litigation legal services to clients ranging from individuals and privately held enterprises to national and international public companies. As one of the 100 largest firms in the U.S., Stinson Leonard Street has offices in 14 cities, including Minneapolis, Mankato and St. Cloud, Minn.; Kansas City, St. Louis and Jefferson City, Mo.; Phoenix, Ariz.; Denver, Colo.; Washington, D.C.; Decatur, Ill.; Wichita and Overland Park, Kan.; Omaha, Neb.; and Bismarck, N.D.

The views expressed herein are the views of the blogger and not those of Stinson Leonard Street or any client.

Everyone knew the SEC would pursue a marquee-name private equity sponsor for misallocating expenses.  It finally happened, with KKR settling charges for misallocating “broken deal” expenses.  Charges against others are likely to follow over time.

According to the SEC an investigation found that during a six-year period ending in 2011, KKR incurred $338 million in broken deal or diligence expenses related to unsuccessful buyout opportunities and similar expenses.  Broken deal expenses include research costs, travel costs and professional fees, and other expenses incurred in deal sourcing activities related to specific “dead deals” that never materialize. Broken deal expenses also include expenses incurred by KKR to evaluate particular industries or geographic regions for buyout opportunities as opposed to specific potential investments, as well as other similar types of expenses.

The SEC maintains that even though KKR’s co-investors, including KKR executives, participated in the firm’s private equity transactions and benefited from the firm’s deal sourcing efforts, KKR did not allocate any portion of these broken deal expenses to any of them for years. The SEC also maintains KKR did not expressly disclose in its fund limited partnership agreements or related offering materials that it did not allocate broken deal expenses to the co-investors.

The SEC found KKR violated Section 206(2) of the Investment Advisers Act, which prohibits an investment adviser, directly or indirectly, from engaging “in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client.” The SEC order states a violation of Section 206(2) may rest on a finding of simple negligence.

In October 2011, KKR engaged a third-party consultant to review the firm’s fund expense allocation practices. At the time, there was public awareness of heightened regulatory scrutiny on the private equity industry.  KKR revised its expense allocation policy as a result of the review, and the new policy was not the subject of the SEC order.

The SEC’s order instituting a settled administrative proceeding also finds that KKR failed to implement a written compliance policy governing its fund expense allocation practices until the end of the six-year period in 2011.

KKR agreed to pay more than $14 million in disgorgement (in addition to $3.26 million that was previously refunded to clients) as well as more than $4.5 million in prejudgment interest and a $10 million penalty.  KKR neither admitted nor denied the SEC’s findings.

ABOUT STINSON LEONARD STREET

Stinson Leonard Street LLP provides sophisticated transactional and litigation legal services to clients ranging from individuals and privately held enterprises to national and international public companies. As one of the 100 largest firms in the U.S., Stinson Leonard Street has offices in 14 cities, including Minneapolis, Mankato and St. Cloud, Minn.; Kansas City, St. Louis and Jefferson City, Mo.; Phoenix, Ariz.; Denver, Colo.; Washington, D.C.; Decatur, Ill.; Wichita and Overland Park, Kan.; Omaha, Neb.; and Bismarck, N.D.

The views expressed herein are the views of the blogger and not those of Stinson Leonard Street or any client.

The CFPB has gone live with an enhanced customer complaint data base. It now includes over 7,700 consumer descriptions of alleged problems they are facing with financial companies concerning mortgages, bank accounts, credit cards, debt collection, and more.

In March 2015, the Bureau finalized a policy to allow consumers to publicly share their stories when they submit complaints to the Bureau. Since the Bureau launched this feature, more than half of consumers submitting complaints to the CFPB website have “opted in” to share their accounts of what happened. Consumer narratives that have been scrubbed of personal information will be added to the complaint database on a daily basis.

ABOUT STINSON LEONARD STREET

Stinson Leonard Street LLP provides sophisticated transactional and litigation legal services to clients ranging from individuals and privately held enterprises to national and international public companies. As one of the 100 largest firms in the U.S., Stinson Leonard Street has offices in 14 cities, including Minneapolis, Mankato and St. Cloud, Minn.; Kansas City, St. Louis and Jefferson City, Mo.; Phoenix, Ariz.; Denver, Colo.; Washington, D.C.; Decatur, Ill.; Wichita and Overland Park, Kan.; Omaha, Neb.; and Bismarck, N.D.

The views expressed herein are the views of the blogger and not those of Stinson Leonard Street or any client.

On May 20, 2015, the Securities and Exchange Commission (SEC) released several proposals, “Amendments to Form ADV and Investment Advisers Act Rules,” that would require investment advisers to provide additional information on Form ADV. Form ADV is the uniform form used by investment advisers to register with both the Securities and Exchange Commission (SEC) and state securities authorities.

Specifically, the SEC proposals would impose additional reporting requirements for Separately Managed Accounts (SMAs), require new disclosures for investment advisers and their businesses, clarify the use of “umbrella” registration for private fund and certain other advisers, and expand the books and records required to be kept by the adviser. The purpose of the proposals is to improve the quality of information that investors and the SEC receive, as well as to fill gaps identified by the SEC and facilitate risk-monitoring initiatives.

SEPARATELY MANAGED ACCOUNTS

Under Form ADV, SMAs are advisory accounts other than pooled investment vehicles. Form ADV currently requires considerably more disclosure for pooled investment vehicles than for SMAs. The SEC’s proposals would increase the disclosure requirements for SMAs to more closely match the level of disclosure for pooled investment vehicles. Any investment adviser that has SMA regulatory assets under management (RAUM) will be required to make disclosures related to: (a) the types of assets held, (b) the adviser’s use of derivatives and borrowings, and (c) the role of custodians.

TYPE OF ASSETS HELD

Each adviser of a SMA would be required to provide the approximate percentage of its SMA RAUM in ten broad asset categories specified under the proposal. Financial advisers would need to make annual disclosures of SMA RAUM percentages. However, the level of detail required to be provided annually will vary depending on the size of the adviser. For example, advisers with at least $10 billion in SMA RAUM will be required to provide its SMA RAUM percentages as of two specified dates each year when making their annual filings.

DERIVATIVES AND BORROWINGS

The SEC proposals also would require advisers to report on their use of borrowing and derivatives in their SMAs. The level of disclosure again depends on the amount of SMA RAUM. Advisors with at least $150 million but less than $10 billion in RAUM attributable to SMAs will be required to:

(1) categorize their SMAs annually based on the net asset value and gross notional exposurepercentage of each account; and

(2) calculate and report the weighted average amount of borrowing within each category.

In addition to the obligations listed in the previous sentence, advisers with at least $10 billion in SMA

RAUM would also need to:

(1) report average derivatives exposures within six different types of derivatives for each category of SMA; and

(2) annually report borrowing and derivatives information for two dates per year: mid-year and end-of-year.

CUSTODIANS

Advisors would be required to identify any custodian that accounts for at least 10% of the adviser’s SMA RAUM, with certain exceptions, and the amount held by such custodian.

ADDITIONAL INVESTMENT ADVISER INFORMATION

The SEC’s proposed changes to Form ADV include requirements for additional information regarding a financial adviser including, but not limited to, the following:

  • Item 1.F would be expanded to request the total number of offices in which the adviser conducts business as well as information about the adviser’s twenty-five (instead of five) largest offices as calculated by the number of personnel in each office.
  • Item 1.I would be expanded to request all of the adviser’s websites and any social media platform on which the adviser has a presence, which the SEC staff may use to determine the consistency of information provided via the various social media platforms.
  • Item 1.J would be expanded to disclose whether the adviser’s chief compliance officer is employed by someone other than the adviser or a related person. The SEC designed this disclosure to allow them to better monitor risks of advisers outsourcing chief compliance officers.

UMBRELLA REGISTRATION

The SEC proposals also clarify the process for umbrella registrations, that was outlined by the SEC in 2012 in a no-action letter. Such umbrella registrations can be useful to private equity fund adviser groups.

Umbrella registration allows one adviser called the “filing adviser” to file a single Form ADV on behalf of itself and certain other advisers known as “relying advisers”. Based in part on that earlier guidance, the SEC proposals include certain conditions that must be met in order to qualify for umbrella registration, including: (1) the relying adviser being controlled by or under common control with the filing adviser; (2) each relying adviser remaining subject to the filing adviser’s supervision and control; (3) all advisers under the umbrella registration advise only private funds and clients in SMAs that are “qualified clients”; (4) the requirement for the filing adviser’s principal place of business to be located within the United States and (5) all advisers operating under a single code of ethics and compliance program that is administered by the same chief compliance officer.

BOOKS AND RECORDS

Registered advisers have certain obligations to maintain books and records under Rule 2042 of the Advisers Act. The Rule currently requires advisers to maintain documentation supporting performance claims in communications distributed to ten or more persons. The proposals would require advisers to maintain records supporting performance claims in any communication that the adviser circulates or distributes, regardless of the number of recipients. Additionally, while the current Rule requires advisers to maintain copies of written communications sent or received by the advisers, the SEC proposals creates a new category of documents relating to the performance or rate of return of any or all managed accounts or securities recommendations that would need to be maintained in the adviser’s books and records.

COMMENT PERIOD

The SEC will be accepting public comment on its proposals to amend Form ADV until August 11, 2015.