Government Enforcement & Corporate Investigations

A recent SEC consent order against The Dow Chemical Company reminds companies that when evaluating whether or not to disclose a payment or benefit to an executive as a perk in a proxy statement, the fact that the item has a tangential business purpose, or is convenient for the company, is insufficient grounds to exclude the item as a perk.  In order to be excluded as a perk, the item must be "integrally and directly" related to the performance of the executive's duties.  Examples of items that typically should be classified as perks include country club memberships for mixed business and personal use, commuting expenses, and personal guests who join a business flight on the corporate jet. While companies may perceive individual perks as insignificant or as justifiable business expenses, these items can be significant in the aggregate, in hindsight and through a regulatory lens.  The consistent failure to disclose perks over a period of years may result in Commission sanctions and negative publicity, particularly for larger public companies and for companies who for a variety of reasons are the subject of closer Commission scrutiny. As background, on July 2, 2018, the SEC entered into a consent order against Dow, settling claims that from 2011 through 2015, the company did not adequately evaluate and disclose approximately $3 million in executive perks as "other compensation" in its proxy statements.  These authorized but undisclosed perks included personal use of the Dow aircraft and other expenses.  The consent order notes that though Dow applied procedures regarding the evaluation and disclosure of its executives' perks, it did not follow the Commission's standard regarding disclosure of perks, which provides that: • An item is not a perquisite or personal benefit if it is integrally and directly related to the performance of the executive’s duties. • Otherwise an item is a perquisite or personal benefit if it confers a direct or indirect benefit that has a personal aspect without regard to whether it may be provided for some business reason or for the convenience of the company, unless it is generally available on a non-discriminatory basis to all employees. Instead, the consent order finds, Dow incorrectly applied a standard whereby a business purpose related to the executive’s job was sufficient to determine that a benefit would not be a perquisite that required disclosure. Notably, the consent order also sanctions Dow for its disclosure controls.  According to the order, Dow did not adequately train employees in key roles, including those tasked with drafting the CD&A section of the proxy statement and compiling the executive compensation tables, to ensure that the proper standard was applied for perks disclosure.  Dow also had inadequate processes and procedures to ensure proper reporting of perks.  In addition to a $1.75 million penalty, the consent order requires Dow to hire an independent consultant for one year to review and make recommendations on Dow's policies, procedures, controls and training related to the evaluation of whether payments and other expense reimbursements should be disclosed as perks under securities laws.  

The SEC announced that it has voted to amend the definition of "smaller reporting company," or "SRC," expanding the population of companies that qualify for a range of scaled (reduced) disclosure requirements. The rules will become effective 60 days after publication in the Federal Register. Examples of scaled disclosure include that SRCs, in their annual reports on Form 10-K, are not obligated to include risk factors, and selected and supplementary financial data. They may include only two years of income statements (vs three years) and a comparison of two years (vs three years) of financial results. In their proxy statements, SRCs are not required to include a CD&A, CEO pay ratio and certain executive compensation tables. They may include fewer NEOs, and only two years of compensation in the Summary Compensation Table. Under the new definition, companies with a public float of less than $250 million (vs $75 million) will qualify as SRCs. A company with no public float or with a public float of less than $700 million will also qualify as an SRC if it had annual revenues of less than $100 million (vs $50 million) during its most recently completed fiscal year. Commission staff estimates that 966 additional companies will be eligible for SRC status in the first year under the new definition. The SEC released the following summary of the amendments to the definition of an SRC:   Criteria Previous SRC Definition Revised SRC Definition Public Float Public float of less than $75 million Public float of less than $250 million Revenues Less than $50 million of annual revenues and no public float Less than $100 million of annual revenues and no public float, or public float of less than $700 million For purposes of determining whether or not it is an SRC, a reporting issuer (vs. a non-reporting issuer filing its first registration statement) must measure its public float annually, on the last trading day of the second fiscal quarter of the previous fiscal year. Qualifying issuers are then eligible to use scaled disclosure rules for the first quarterly report on Form 10-Q for the fiscal year following the determination. Newly eligible SRCs may "early adopt" those rules for the quarterly report immediately following the determination. Once a company fails to qualify as an SRC, it may continue to report under SRC disclosure requirements through the end of that fiscal year. However, in order to re-qualify as an SRC, the company must meet more stringent qualification thresholds. The subsequent qualification thresholds, set forth in the table below, are set at 80% of the initial qualification thresholds in the table above. Criteria Previous SRC Definition Revised SRC Definition Public Float Public float of less than $50 million Public float of less than $250 million Revenues Less than $40 million of annual revenues and no public float Less than $80 million of annual revenues, if it previously had $100 million or more of annual revenues; and Less than $560 million of public float, if it previously had $700 million or more of public float. It is worth noting that a company may qualify as an SRC, but still be an accelerated filer. The amendments do not change the threshold in the “accelerated filer” definition that requires, among other things, that filers provide the auditor’s attestation of management’s assessment of internal control over financial reporting. However, the SEC staff has begun to formulate recommendations to the Commission for possible additional changes to the “accelerated filer” definition to reduce the number of companies that qualify as accelerated filers. In addition to amendments to the definition of "smaller reporting company," the SEC also adopted amendments to Rule 3-05(b)(2)(iv) of Regulation S-X, in order to increase the net revenue threshold in that rule from $50 million to $100 million. As a result, companies may omit financial statements of businesses acquired or to be acquired for the earliest of the three fiscal years otherwise required by Rule 3-05 if the net revenues of that business are less than $100 million.

The SEC held a very busy open meeting yesterday, voting on the following final and proposed rules: Adoption of amendments to modernize the definition of “smaller reporting company,” which was established in 2008.  See our previous discussion of the amendments.   Adoption of amendments to require the use of the Inline XBRL format in certain filings, which were proposed in 2017 and have been under study for many years. The amendments require the use of the Inline eXtensible Business Reporting Language (“XBRL”) format for the submission of operating company financial statement information and fund risk/return summary information and make related changes.  Inline XBRL involves embedding XBRL data directly into the filing so that the disclosure document is both human-readable and machine-readable. Phase-in for operating companies: Large accelerated filers that use U.S. GAAP will be required to comply beginning with fiscal periods ending on or after June 15, 2019. Accelerated filers that use U.S. GAAP will be required to comply beginning with fiscal periods ending on or after June 15, 2020. All other filers will be required to comply beginning with fiscal periods ending on or after June 15, 2021. Filers will be required to comply beginning with their first Form 10-Q filed for a fiscal period ending on or after the applicable compliance date. The requirement for operating companies and funds to post XBRL data on their websites will be eliminated upon the effective date of the amendments. A proposal that would permit certain exchange-traded funds to operate without first obtaining a fund-specific exemptive order from the Commission, which is a process that has not changed since the first ETF was approved in 1992.    Adoption of amendments related to disclosures of liquidity risk management for open-end funds, which were proposed earlier this year.    A proposal to amend rules that govern the Commission’s whistleblower program.  It has been seven years since these rules were adopted. The Commission is seeking public comment and data on a broad range of issues relating to the whistleblower program, and will then consider further action on the proposal, which includes provisions: Allowing awards based on deferred prosecution agreements and non-prosecution agreements entered into by the DOJ or a state AG in a criminal case, or a settlement agreement entered into by the Commission. Providing the Commission with flexibility to increase awards on smaller actions, while decreasing larger awards.  In the Wall Street Journal, Stephen Kohn, executive director of the National Whistleblower Center, criticized the proposal, saying that scaling back payouts is tantamount to "killing the goose that lays the golden egg."  The Commission would have discretion to increase awards that could yield a payout of less than $2 million , and establish awards for enforcement actions that do not currently qualify as covered actions because they do not meet the more than $1 million threshold requirement.  Meanwhile, the Commission would have discretion to reduce larger awards, though in no event would awards be adjusted below $30 million, and awards would still be subject to the 10% statutory minimum. The SEC's related Fact Sheet notes that 40% of funds paid out by the Commission to whistleblowers have been paid out in only three awards. Eliminating potential double recoveries under the current definition of "related action." Modifying Rule 21F-2 to comport with the Supreme Court's holding in Digital Realty Trust, Inc. v. Somers, where the Court held that whistleblower provisions of the Exchange Act require that a person report a possible securities law violation to the Commission in order to qualify for protection against employment retaliation under that Rule. Increasing the efficiency of the claims review process. Clarifying and enhancing certain policies and procedures and issuing interpretive guidance to help clarify the meaning of "independent analysis" as that term is defined in Exchange Act Rule 21F-4 and utilized in award applications. An archived webcast of the meeting will be available on sec.gov

Earlier this week, Dorsey hosted a webinar panel presentation on the SEC’s recent guidance on cybersecurity disclosures and policies. The webinar provided a detailed walk-through of the SEC’s guidance, including issues related to enhanced disclosure, insider trading, and Reg FD policies. The panel also discussed the impact of the SEC’s guidance within the changing landscape of cybersecurity and current developments in shareholder litigation, SEC enforcement actions, and other regulatory and legislative initiatives such as the GDPR. The Equifax data breach is used as a case study to illustrate how the SEC’s guidance might play out in this broader context. The webinar recording and presentation materials are available on our website at www.dorsey.com/newsresources/events/videos/2018/06/seminar-playback-sec-guidance-on-cybersecurity.

Scienter has been a critical element of a claim based on Exchange Act Section 10(b) in an SEC enforcement action since the Supreme Court’s decision in Aaron v. SEC, 446 U.S. 680 (1980). It has also been a key element in private damage actions based on the cause of action implied under Section 10(b) and Rule 10b-5 since Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976). Both decisions were based largely on the text and language of Section 10(b). Section 14(e), added to the Exchange Act by the Williams Act in 1968, has also been held to require proof of scienter by the Circuit Courts – the Supreme Court has not considered the questions. Now, however, the decisions by the five Circuit Courts regarding Section 14(e) are being called into question by the Ninth Circuit. That Circuit recently examined the statutory language of Section 14(e), as well as its purpose and history, all of which lead the Court to conclude that the clause prohibiting a misrepresentation/omission only requires proof of negligence. Read more in our recent eUpdate here: www.dorsey.com/newsresources/publications/client-alerts/2018/05/ninth-circuit-rejects-decisions-of-five-other.

Last month, over 35% of General Electric Co.’s shareholders voted against ratification of KPMG LLC as GE’s auditor. This high level of opposition (for some context, last year’s votes against KPMG were at a mere 5.7%) comes in the wake of GE’s recent accounting issues and criticism from proxy-advisory firms. More specifically, the SEC is currently investigating some of GE’s accounting practices, including its need for increased reserves in its insurance operations and its revenue recognition accounting for long-term service agreements. KPMG, which has been GE’s auditor for 109 years, didn’t catch any of these issues. While GE’s 109-year relationship with KPMG may seem unusual, in the context of large U.S. companies, a relationship spanning 50 years or more is relatively common and, as many will argue, beneficial. Long tenures mean that the auditors have deep institutional knowledge of the company and are potentially more cost-effective, since auditor changes consume significant resources as the new auditor is getting up to speed. Auditor tenure has been the subject of rulemaking by regulatory bodies here and abroad: In June 2017, the Public Company Accounting Oversight Board (PCAOB) finalized a new standard requiring that auditor’s reports disclose the length of the relationship between the company and its auditor. This new standard, which is applicable to audits conducted after December 15, 2017, was adopted amidst concerns that lengthy auditor tenures could mean greater tolerance of “creative” accounting and susceptibility to turning a blind eye to management issues. Proponents of the new standard claimed that disclosing tenure length was an important data point for investor consideration. Back in 2011, the PCAOB issued a concept release that broached the topic of mandatory audit firm rotation due to independence concerns, but after significant pushback from both auditors and companies, the topic was tabled. In the European Union, a mandatory audit firm rotation requirement has been in place since 2014: public companies must rotate auditing firms every 10 years, with the potential for an additional 10 years provided a competitive bidding process is conducted. Last Wednesday, the Securities and Exchange Commission issued a proposing release to “refocus the analysis [of] whether an auditor is independent when the auditor has a lending relationship with certain shareholders of an audit client.” The release shows that the SEC is once again thinking about auditor independence, and its call for comments on whether the SEC should “make other changes to our auditor independence rules” could lead to some interesting discussion in the coming months.

The Securities and Exchange Commission (the "SEC") announced Tuesday that Altaba, the entity formerly known as Yahoo! Inc., has agreed to pay a $35 million penalty to settle charges that it misled investors by failing to disclose one of the world’s largest data breaches in which hackers stole personal data relating to hundreds of millions of user accounts. According to the SEC’s order, within days of the December 2014 intrusion, Yahoo’s information security team learned that Russian hackers had stolen what the security team referred to internally as the company’s “crown jewels”: usernames, email addresses, phone numbers, birthdates, encrypted passwords, and security questions and answers for hundreds of millions of user accounts.  Although information relating to the breach was reported to members of Yahoo’s senior management and legal department, Yahoo failed to properly investigate the circumstances of the breach and to adequately consider whether the breach needed to be disclosed to investors.  The fact of the breach was not disclosed to the investing public until more than two years later, when in 2016 Yahoo was in the process of closing the acquisition of its operating business by Verizon Communications, Inc. In the order, the SEC finds that Yahoo's post-breach disclosure in quarterly and annual reports was too general, stating that the company faced only the risk of, and negative effects that might flow from, data breaches.  The company failed to disclose the actual breach or its potential business impact and legal implications. In addition to deficiencies in Yahoo's disclosure to investors, the SEC’s order found that Yahoo did not share information regarding the breach with its auditors or outside counsel in order to assess the company’s disclosure obligations in its public filings. Finally, the SEC’s order found that Yahoo failed to maintain disclosure controls and procedures designed to ensure that reports from Yahoo’s information security team concerning cyber breaches, or the risk of such breaches, were properly and timely assessed for potential disclosure. In its Statement and Guidance on Public Company Cybersecurity Disclosures, released earlier this year, the SEC reiterates that public companies are required to disclose material risks and incidents, including those related to cybersecurity, in their current and periodic reports.  The SEC encourages companies to continue to use current reports to disclose material cybersecurity-related information promptly as this practice reduces the risk of selective disclosure.  Furthermore, beyond requirements explicitly found in SEC regulations, companies are also required to disclose material information and revisit previous disclosure, especially during a cybersecurity investigation, as may be necessary to ensure the company’s filings are not misleading.  Notably, perhaps in recognition of how rapidly the scope of a breach may evolve, the SEC provides that companies “have a duty to correct prior disclosures that the company determines were untrue at the time it was made, or a duty to update a disclosure that becomes materially inaccurate after it is made.”  See our earlier memo for a summary of the SEC's guidance. In evaluating the range of potential disclosure for quarterly and annual reports, companies should consider that cybersecurity breaches or the risk of such breaches may trigger disclosure in the Management's Discussion and Analysis, if the breach presents a material event, trend or uncertainty that has had or is reasonably likely to have a material effect on results of operations, liquidity or financial condition.  Furthermore, financial statements may need to reflect costs incurred, insurance proceeds and contingent liabilities resulting from claims.  A cybersecurity breach may also need to be addressed in the description of business, discussion of legal proceedings and effectiveness of internal controls and disclosure controls and procedures. Even before the next quarterly or annual report, companies should consider whether the information available on the cybersecurity breach is material and should be communicated to investors in a current report in order to reduce the risk of selective disclosure in violation of Regulation FD.  If material information on a cybersecurity breach is not publicly disclosed in a current report, companies should consider whether it is appropriate to impose an event-specific blackout on trading in the company's stock, in accordance with applicable insider trading policies.  Determining the population of employees and other individuals who know, or in hindsight should have known, about the breach, and who should be subject to the event-specific blackout, deserves careful consideration, as demonstrated by the Equifax experience, where high-ranking executives traded in the company's stock after a cybersecurity breach was discovered but before it was announced.      

As companies prepare their Form 10-K and proxy statement disclosures, they will be challenged with disclosing the impact of the Tax Cuts and Jobs Act on performance results for the purposes of financial reporting as well as for compensation measurement. Here is a short list of issues to be aware of. Form 10-K Disclosure Implications of Tax Reform: Sections in the MD&A likely to be affected by tax reform include the discussion of operating results and financial condition and discussion of critical accounting estimates. Companies also are adding or modifying their risk factors to acknowledge the impact of the Tax Cuts and Jobs Act. In the MD&A, companies are required to describe any “known trends or uncertainties that have had or that the company reasonably expects will have a material favorable or unfavorable impact on net sales or revenues or income from continuing operations.” There are comparable requirements for known trends or uncertainties impacting liquidity and capital resources. Companies should be prepared to assess the potential impact of tax reforms including: Reduction of top corporate tax rate from 35% to 21% beginning in 2018 Capital expenditure deductions: Expensing of new and qualified property placed in service after September 27, 2017, through 2022 Limit on net interest deductions to 30% of EBITDA Net operating loss (NOL) deduction limited to 80% of taxable income with indefinite carryforward; carrybacks generally eliminated R&D expenditures paid or incurred after 2021 must be capitalized and amortized over a five-year period Adoption of a territorial tax regime: foreign source portion of a qualified dividend received by a 10% U.S. corporate shareholder is exempt from U.S. tax Deemed repatriation: 15.5% tax on post-1986 foreign earnings held in cash and an 8% rate on all other post-1986 earnings To the extent that companies use reasonable estimates of the tax reform impact in their disclosure in accordance with SAB 118, they may want to caution readers that they are in the process of determining the actual impact, and that their reasonable estimates are based on provisional amounts that may be adjusted upon obtaining, preparing, or analyzing additional information. Proxy Disclosure Implications of Tax Reform: Changes to Internal Revenue Code Section 162(m) will eliminate deductibility of compensation for “covered employees” (including now the CFO) over $1 million, even for qualified, performance-based compensation. However, arrangements in place before November 3, 2017, and that are not materially modified will be grandfathered; IRS guidance is forthcoming. Disclosure and governance considerations include: CD&A Disclosure: 162(m) deductibility will still be a relevant discussion for past awards and grandfathered awards and for distinguishing what’s deductible vs not deductible. CD&A Disclosure: Discuss tax reform impact on performance results, and whether those results are adjusted to exclude the impact of tax reform for compensation purposes (e.g., revaluation of deferred tax asset or deferred tax liability based on new corporate tax rate may result in a big non-cash gain or loss in Q4 of 2017). CD&A Disclosure: Elimination of 162(m) deductibility is a significant change for compensation programs going forward and may impact compensation design. D&O questionnaires: Continue to confirm that compensation committee members qualify as “outside” directors for purposes of certifying grandfathered awards and for certifying vesting of grandfathered performance awards. Covered employees: A “covered employee” will now be anyone who has ever been the CEO, CFO, or one of the three most highest compensated officers in any fiscal year beginning after December 31, 2016. Thus, the new rule is essentially “once a covered employee, always a covered employee.” If possible, employers should not structure one-off payments that would cause an individual to become one of the three highest compensated officers in a particular year, when he or she typically would not be one in other years. In addition, employers should track “covered employees” and their compensation arrangements.

On December 22, 2017, the Securities and Exchange Commission announced publication of staff guidance for issuers, auditors, and others to ensure timely public disclosures of the accounting impacts of the Tax Cuts and Jobs Act (the “TCJA”), which was enacted on December 22, 2017. Specifically, the staff of the Office of the Chief Accountant and the Division of Corporation Finance issued the following interpretations: Staff Accounting Bulletin (SAB) No. 118 expresses views of the staff regarding application of U.S. GAAP when preparing an initial accounting of the income tax effects of the TCJA. Compliance and Disclosure Interpretation 110.02 expresses views of the staff regarding the applicability of Item 2.06 of Form 8-K with respect to reporting the impact of a change in tax rate or tax laws pursuant to the TCJA. SAB 118 The staff issued SAB 118 to address certain fact patterns where the accounting for changes in tax laws or tax rates under ASC Topic 740 is incomplete upon issuance of an issuer’s financial statements for the reporting period in which the TCJA is enacted. As detailed in SAB 118, in the financial reporting period during which the TCJA is enacted, companies must first reflect the income tax effects of the TCJA in which the accounting under ASC Topic 740 is complete. These completed amounts would not be provisional amounts. The income tax effects of the TCJA for which the accounting under ASC Topic 740 is incomplete, but for which a reasonable estimate is determinable, would be reported as provisional amounts, which would be subject to adjustment during a "measurement period" until the accounting under ASC 740 is complete. For any specific income tax effects of the Act for which a reasonable estimate cannot be determined, provisional amounts would not be reported, and companies would continue to apply ASC Topic 740 based on the provisions of the tax laws that were in effect immediately prior to the TCJA being enacted. For those income tax effects for which companies were not able to determine a reasonable estimate (such that no related provisional amount was reported for the reporting period in which the Act was enacted), companies would report provisional amounts in the first reporting period in which a reasonable estimate can be determined. The measurement period begins in the reporting period that includes the TCJA’s enactment date and ends when an issuer has obtained, prepared, and analyzed the information that was needed in order to complete the accounting requirements under ASC 740. During the measurement period, the staff expects that issuers will be acting in good faith to complete the accounting under ASC 740. The staff notes that in no circumstances should the measurement period extend beyond one year from the enactment date. During the measurement period, an issuer may need to reflect adjustments to its provisional amounts or report additional tax effects upon obtaining, preparing, or analyzing additional information about facts and circumstances that existed as of the enactment date. Any income tax effects of events unrelated to the TCJA should not be reported as measurement period adjustments. SAB 118 also describes supplemental disclosures that should accompany the provisional amounts, including the reasons for the incomplete accounting, the additional information or analysis that is needed, and other information relevant to why the issuer was not able to complete the accounting required under ASC 740 in a timely manner. C&DI 110.02 In C&DI 110.02 the staff clarifies that the re-measurement of a deferred tax asset (“DTA”) to incorporate the effects of newly enacted tax rates or other provisions of the TCJA does not trigger an obligation to file under Item 2.06 of Form 8-K. The re-measurement of a DTA to reflect the impact of a change in tax rate or tax laws is not an impairment under ASC 740. Issuers employing the “measurement period” approach as contemplated by SAB 118 that conclude that an impairment has occurred due to changes resulting from the enactment of the TCJA may rely on the Instruction to Item 2.06 of Form 8-K and disclose the impairment, or a provisional amount with respect to that possible impairment, in its next periodic report.

Human nature being what it is, the law, in its wisdom, does not presume that directors will be competent judges of the fair treatment of their company where fairness must be at their own personal expense.[1] According to the Delaware Supreme Court in In re Investors Bancorp, Inc. Stockholder Litigation, when equity awards are granted to directors under a stockholder-approved equity incentive plan that gives directors discretion to determine the size of the awards, the awards are subject to the “entire fairness” standard of review. This decision may expand stockholder litigation in the area of director compensation. When reading the recent opinion issued by the Delaware Supreme Court in In re Investors Bancorp, Inc. Stockholder Litigation, it is tempting to regard the dispute as a perfect example of “pigs get fat, hogs get slaughtered” and minimize the issues raised by the case. After all, on the heels of stockholder approval of an equity compensation plan, the 12-person Bancorp Board awarded themselves over $51 million in equity grants from plan; the non-employee directors each received grants valued at approximately $2 million (as compared to average awards of approximately $176,000 for non-employee directors at peer companies). Your company’s board, you tell yourself confidently, would never act in such a manner. However, even the most prudent of Boards needs to consider the implications from the In re Investors Bancorp decision. But first, let’s step back and look at a bit of background in the case: In June 2015, stockholders approved Bancorp’s Equity Incentive Plan (the “EIP”), which reserved 30,881,296 common shares for various types of equity grants for the Company’s 1,800 officers, employees, non-employee directors, and service providers, of which up to 30% were available to be granted to non-employee directors. Two weeks following stockholder approval of the EIP, the Board approved the grants noted above. Disclosure of the equity grants resulted in three stockholder complaints being filed in the Court of Chancery alleging breach of fiduciary duties by the directors for awarding themselves excessive compensation. The Court of Chancery dismissed the complaint because the EIP contained “meaningful, specific limits on awards to all director beneficiaries.” In other words, because stockholders approved the EIP, which the Court of Chancery noted contained meaningful limits, the ratification defense came into play, which allowed the Board’s actions to be reviewed under the business judgement standard. In December, the Delaware Supreme Court reversed the Court of Chancery’s decision and determined that the “entire fairness” standard applied. The Delaware Supreme Court noted that because director compensation determinations are inherently self-interested, those decisions will be reviewed under the business judgment rule only where fully-informed stockholders approve (i) specific compensation decisions or (ii) self-executing plans (plans with fixed criteria). However, if a stockholder-approved equity incentive plan gives directors discretion within general parameters when compensating themselves, then the “entire fairness” standard is appropriate. As the Supreme Court noted: We think, however, when it comes to the discretion directors exercise following stockholder approval of an equity incentive plan, ratification cannot be used to foreclose the Court of Chancery from reviewing those further discretionary actions when a breach of fiduciary duty claim has been properly alleged. As the Court of Chancery emphasized in Sample, using an expression coined many years ago, director action is “twice-tested,” first for legal authorization, and second by equity. When stockholders approve the general parameters of an equity compensation plan and allow directors to exercise their “broad legal authority” under the plan, they do so “precisely because they know that that authority must be exercised consistently with equitable principles of fiduciary duty.” The stockholders have granted the directors the legal authority to make awards. But, the directors’ exercise of that authority must be done consistent with their fiduciary duties. Given that the actual awards are self-interested decisions not approved by the stockholders, if the directors acted inequitably when making the awards, their “inequitable action does not become permissible simply because it is legally possible” under the general authority granted by the stockholders. So, what does this mean for Boards and Compensation Committees? If designing a new equity incentive plan, or amending an existing plan, consider whether self-executing awards to non-employee directors are appropriate or desired. If self-executing awards are not desired, determine if the plan contains significant and meaningful limitations on awards, as this might assist with the defense against a claim that the Board violated its fiduciary duties. If equity awards to directors are unusual in size compared to prior awards, consider making the awards subject to stockholder ratification at the next stockholders’ meeting. Have the Board and Compensation Committee pay close attention to compensation at peer companies and its own historical pay practices. Significant deviations from either may be more likely to trigger stockholder litigation under the new standards.   [1] Footnote 2 to Investors Bancorp opinion, citing Gottlieb v. Heyden Chem. Corp., 90 A.2d 660, 663 (1952)

On Tuesday, December 12, Dorsey will present our annual review of developments and disclosure requirements for the upcoming proxy season, including practical advice on how to prepare your proxy statement and annual report in 2018. Click here for more information or to register to attend in-person or via webinar: https://sites-dorsey.vuture.net/76/665/november-2017/12-12-preparing-for-the-2018-proxy-season(2).asp.

Tax reform efforts by Congress are ongoing, and the substance of the tax bills remains fluid. However, for foreign corporations with U.S. operations, there are some specific potential risks to consider, such as additional limitations on the deductibility of interest, the migration from a “worldwide” system of taxation to a territorial system, and the use of certain border adjustments. Foreign corporations with U.S. operations may want to consider including a risk factor in their periodic reports or offering documents regarding the potential impact of U.S. tax reform. A sample risk factor (based on the current iteration of the tax bills) is below. As the tax bills are amended during the legislative process, the language of the risk factor may need to be edited prior to use. Possible U.S. federal income tax reform could adversely affect us. The new U.S. administration and certain members of the U.S. House of Representatives have stated that one of their top legislative priorities is significant reform of the Internal Revenue Code. Proposals by members of Congress have included, among other things, changes to U.S. federal tax rates, imposing significant additional limitations on the deductibility of interest, allowing for the expensing of capital expenditures, the migration from a “worldwide” system of taxation to a territorial system, and the use of certain border adjustments. There is substantial uncertainty regarding both the timing and the details of any such tax reform. The impact of any potential tax reform on our business and on holders of our common shares is uncertain and could be adverse. [Prospective investors should consult their own tax advisors regarding potential changes in U.S. tax laws.]

There are a couple of recent developments that we would like to remind issuers to keep in mind for their upcoming annual reports. Foreign private issuers who prepare their financial statements in accordance with the International Financial Reporting Standards (“IFRS”) will be required to file their annual audited financial statements in XBRL format in respect of any period ending after December 15, 2017 (i.e., for a December 31 company, beginning with any Form 20-F or Form 40-F for the fiscal year ending December 31, 2017). The following is a link to a Dorsey blog posting about this topic from earlier this year: https://www.governancecomplianceinsider.com/compliance-with-xbrl-for-foreign-private-issuers-that-prepare-their-financial-statements-in-accordance-with-ifrs-required-beginning-with-annual-reports-for-fiscal-periods-ending-on-or-after-december-1/. Foreign private issuers who file their financial statements in accordance with IFRS should reach out to their EDGAR agents now to start the process as it takes a significant amount of time to prepare the template for an issuer’s first XBRL filing. While there is a 30-day grace period for first time filers that would permit an issuer to file the XBRL exhibit by amendment, issuers that wait until the last minute to start the process may miss the grace period deadline. In addition, foreign private issuers who file their Annual Reports on Form 20-F should also remember that they are required to include hyperlinks in the exhibit index to the underlying document. The links may be included in the exhibit list prior to the signature page. In those circumstances, issuers are no longer required to include an exhibit index after the signature page. The following is a link to a Dorsey article prepared on this topic from earlier this year: www.dorsey.com/newsresources/publications/client-alerts/2017/03/sec-adopts-use-of-exhibit-hyperlinks-in-filings.

At last Friday's ABA annual meeting, Bill Hinman (with the standard disclaimer that he is speaking for himself and not on behalf of the SEC) confirmed that the SEC will not be delaying implementation of the CEO pay ratio rule, which will require most public companies to report the pay ratio in their 2018 proxy statements, for the first fiscal year beginning on or after Jan. 1, 2017.  (Foreign private issuers, MJDS filers, emerging growth companies and smaller reporting companies are exempt from the rule.)  Bill Hinman is the Director of the SEC's Division of Corporation Finance. Director Hinman also mentioned that the Division will be issuing additional guidance on the CEO pay ratio rule in the near future.  This earlier blog entry includes a summary of the SEC's previous guidance on implementing the CEO pay ratio rule. In a recent Compensation Standards survey, Liz Dunshee reported on trending practices in pay ratio preparation.

Insider trading allegations have surfaced at Equifax, a credit rating agency that last week announced a data breach that could potentially affect 143 million consumers in the United States, nearly half of the country’s population. SEC filings show that three Equifax executives sold nearly $2 million in shares of the company’s common stock days after the cyberattack was discovered but before the news was publicly announced. It was unclear whether their share sales had anything to do with the breach. None of the SEC filings list the sales as being conducted as part of pre-established 10b5-1 trading plans. Equifax said in a statement that the three executives sold a “small percentage” of their shares on August 1 and August 2, adding they “had no knowledge that an intrusion had occurred at the time they sold their shares.” Following the company’s announcement of the data breach on September 9, Equifax shares traded down by almost 14 percent. The SEC has not commented on the share sales. The developing circumstances at Equifax serve as a reminder for public companies to consider several important provisions when implementing or revising an insider trading policy. Read more in our eUpdate here: www.dorsey.com/newsresources/publications/client-alerts/2017/09/equifax-data-breach.

On September 5, 2017, the U.S. House of Representatives overwhelmingly passed (by a vote of 403-3) the Improving Access to Capital Act. The Act directs the SEC to amend Regulation A+ to allow SEC reporting issuers to use Regulation A+ when raising capital, and to deem their SEC periodic reports to satisfy the periodic and current reporting requirements of Tier 2 of Regulation A+. The Act is now being considered by the Senate. If the Act becomes law, it will increase the alternatives available to SEC reporting companies in seeking additional capital. Smaller public companies that are not listed on Nasdaq or the NYSE, and are therefore subject to state securities regulation in respect of their capital raising activities, may find Regulation A+ especially attractive, because an offering under Tier 2 of Regulation A+ is preempted from state securities regulation other than the potential requirement to make a notice filing, consent to service of process, and pay a filing fee.

Following the 2016 election, corporate governance circles have focused intently on what will happen in the nation’s capital with regard to a potential roll back of the current regulatory regime. While attention given to Congress and the SEC for the possible direction of corporate governance is not misplaced, future changes in this arena will most likely come from investors, and they have their own agenda which is very different from that of the Trump administration. Regardless of, or perhaps in response to, any changes in the U.S. governance regulatory framework, investors and groups of investors are likely to continue to push for actions and disclosures beyond what is mandated and will use the their voting power to effect change. Public companies should also anticipate increased demand for the use of metrics and related disclosures that facilitate comparison, including in non-traditional performance areas such as certain environmental, social and governance matters where investors see a strong tie to long-term value creation. Read the full article here, as posted on the Harvard Law School Forum on Corporate Governance and Financial Regulation.

On August 14, 2017, the SEC approved an NYSE rule change that requires listed companies to give notice to the NYSE at least 10 minutes before any public announcement of dividends or stock distributions, even if such announcements occur outside the hours of the Exchange’s current immediate release policy. The rule change was effective immediately. The Exchange’s immediate release policy (Sections 202.05 and 202.06 of the NYSE Listed Company Manual (the “Manual”)) already requires listed companies to provide notification to the Exchange at least 10 minutes prior to the public release of a dividend or stock distribution announcement during the hours between 7:00 a.m. Eastern Time and market close (usually 4:00 p.m. Eastern Time). During those hours, listed companies are required to call the Exchange’s Market Watch department at least 10 minutes before any material news announcement, including stock distributions and dividends. Additionally, Section 204.12 of the Manual already requires listed companies to give notice to the NYSE of any action related to dividends or stock distributions in relation to a listed stock. Such notice must be at least 10 days in advance of the record date for such events. Section 204.21 also requires 10 days advance notice of the fixing of a date for the taking of a record of shareholders for any purpose. The effect of the rule change is to amend Sections 204.12 and 204.21 of the Manual to specify that listed companies are to provide 10 minutes advance notice to the Exchange about any dividend or stock distribution announcement made at any time, not just those announcements made in the hours during which the Exchange’s immediate release policy is in effect.

As previously reported on this blog, Vanguard received a shareholder proposal requesting additional disclosure on its climate change voting record, and the proposal was scheduled to appear on the agenda for Vanguard's 2017 annual meeting.   Today, Vanguard announced that it had negotiated the proposal's withdrawal. Glenn Booraem, the Vanguard Funds’ Investment Stewardship Officer, commented: “Climate change represents an evolving set of risks and opportunities for companies in many sectors. Vanguard has prioritized climate risk on our engagement agenda, and we have discussed the topic with more companies over the past year than ever before. Our discussions have centered on advocating for disclosure of material risks to companies’ long-term business prospects and the value of their assets under a range of forward-looking scenarios. It is crucial to our fund investors that market participants have access to consistently comparable information to incorporate these risks and opportunities into market prices.

Companies who engage with their large institutional shareholders on environmental and social issues during the 2018 proxy season should keep in mind that these investors are facing pressure from other investors on their voting policies. Large institutional investors are receiving shareholder proposals from a coalition of smaller investors, urging them to take a more engaged approach to environmental and social proposals.  During the 2017 proxy season, investors  including Vanguard, BlackRock, Bank of New York Mellon, T.Rowe Price, JP Morgan Chase & Co. and Fidelity Investments received shareholder proposals from investors including Walden Asset Management, requesting that management issue reports on their proxy voting policies and practices related to climate change. Some of these proposals were withdrawn, based on vote changes, updated voting policies and greater disclosure, as reported by BNA Bloomberg.  However, Vanguard's November 15th annual meeting agenda will include Walden's proposal.  This is Vanguard's first shareholder meeting since 2009 (Vanguard is not required to hold a meeting unless there is a proposal for a shareholder vote).  In its preliminary proxy filing, Vanguard opposes Walden's proposal, for reasons including that the report requested is duplicative of information that's already publicly available, and that direct, ongoing engagement with companies is often more effective than votes for shareholder proposals. Vanguard and many other institutional investors have historically voted against climate change shareholder proposals, given the challenges of demonstrating a material business impact over a definitive time horizon.  However, their positions have evolved over recent proxy seasons.1  Earlier this year, Vanguard voted for shareholder proposals at Exxon Mobil and Occidental Petroleum Corp. requiring that the companies report on climate change.  Vanguard had voted against a similar proposal at Exxon Mobil in 2016.  These climate change proposals, and another one at PPL Corp., subsequently passed.  More broadly, during the 2017 proxy season, shareholders submitted 144 environmental proposals.  Of the 55 proposals voted on, support averaged 28.9% of votes cast, compared to 71 proposals that received 25.1% of votes cast in 2016. 1Vanguard's updated proxy voting guidelines state that Vanguard will consider environmental and social proposals on their merits, and that it may support those proposals where there is a link to long-term shareholder value.  According to Vanguard's proxy voting guidelines, some of the factors considered when evaluating these proposals include the materiality of the issue, the quality of current disclosures/business practices, and any progress by the company toward the adoption of best practices and/or industry norms. (See Liz Dunshee's blog for additional articulation of Vanguard's approach).  

On Tuesday, July 25, as many practitioners probably expected, the SEC issued a warning that offers and sales of digital assets (virtual coins or tokens) by organizations using blockchain or distributed ledger technology (often referred to, among other things, as Initial Coin Offerings (“ICOs”) or Token Sales) are subject to the requirements of the federal securities laws. Depending on the offering, investors may use an established currency (e.g., U.S. dollars) or virtual currency (e.g., Bitcoin or Ether) to buy the virtual coins or tokens being offered. After they are issued, the virtual coins or tokens may be resold to others in a secondary market on virtual currency exchanges or other platforms. A blockchain or distributed ledger is an electronic ledger, or list of entries, maintained by participants in a computer network who use cryptography to process and verify transactions on the ledger, providing comfort to users and potential users that entries are secure. Examples of blockchains are Bitcoin and Ethereum, which are used to create and track transactions in the tokens known as Bitcoin and Ether, respectively. ICOs have captured significant attention recently as several enterprises, often start-up or development stage businesses, have attracted substantial investments through internet-based offerings, in some cases generating proceeds in the tens and hundreds of millions of dollars. Promoters of ICOs may tell investors that their investments will fund development of a digital platform, software, or similar projects and that the virtual tokens or coins offered may be used to access the platform, use the software, or otherwise participate in the project. Additionally, promoters and issuers may lead potential investors to expect a return on their investment or to participate in a share of the profits expected from the project. The SEC warned that, depending on the facts and circumstances of each individual ICO, the virtual coins or tokens that are offered or sold may be securities under U.S. law. If so, the offer and sale of these virtual coins or tokens in an ICO are subject to U.S. federal securities laws. Furthermore, promoters and issuers participating in unregistered ICOs may be liable for securities law violations, and any exchange providing for trading in these virtual coins or tokens may need to register as a securities exchange with the SEC. The SEC's warning was made in a Report of Investigation stemming from an Enforcement Division inquiry into whether an organization known as “The DAO” violated federal securities laws with unregistered offers and sales of “DAO Tokens” in exchange for the Ether virtual currency. By the time the offering by The DAO closed, The DAO had raised Ether valued at approximately US$150 million. The DAO has been described as a “crowdfunding contract,” but it would not have met the requirements of the Regulation Crowdfunding exemption because, among other things, it was not a broker-dealer or a funding portal registered with the SEC and FINRA. In its report, the SEC concluded that the tokens offered and sold by The DAO were securities offered and sold in the United States and therefore subject to the U.S. federal securities laws. Under the circumstances, however, the SEC decided not to bring charges or make findings of violations, but rather to caution industry and market participants to be cognizant that U.S. federal securities laws apply to anyone who offers and sells securities in the United States, whether the issuer is a traditional company or a decentralized autonomous organization and regardless of whether purchases are made using U.S. dollars or virtual currencies. Moreover, the report confirms that the use of distributed ledger technology does not affect the determination whether virtual coins or tokens are securities. The SEC's Office of Investor Education and Advocacy also issued an investor bulletin to provide information to investors about ICOs. The bulletin explains that new technologies may be used to perpetrate investment schemes that don’t comply with federal securities laws and highlights several red flags of investment fraud.

In Henry v. Phixios Holdings, Inc., C.A. No. 12504-VCMR,the Delaware Court of Chancery held that pursuant to Section 202 of the General Corporation Law, in order for a stockholder to be bound by stock transfer restrictions that are not “noted conspicuously on the certificate or certificates representing the security,” he must have actual knowledge of the restrictions before he acquires the stock. If the stockholder does not have actual knowledge of the stock transfer restrictions at the time he acquires the stock, he can become bound by the stock transfer restrictions after the acquisition of the stock only if he affirmatively assents to the restrictions, either by voting to approve the restrictions or by agreeing to the restrictions. The Chancery Court concluded that the plaintiff did not have actual knowledge of the restrictions, though the restrictions were contained in the company's bylaws provided to the plaintiff prior to his purchase of the company's stock, and that as a result, the company could not rescind his shares pursuant to the restrictions contained in the bylaws. Since it can be challenging to prove "actual knowledge,"  issuers are reminded to place appropriate legends on their restricted securities prior to sale.  With regard to book-entry shares, versus certificated shares, issuers should provide notice of such restrictions pursuant to Section 151(f) of the General Corporation Law.  Issuers may also obtain an agreement, a vote or other evidence that purchasing securityholders accepted the applicable restrictions on transferability prior to sale. Under the Securities Act, issuers are required to take steps to prevent distribution to the public of securities that are neither registered nor exempt from registration.  Restrictions on transfer may also be required under an issuer's charter documents or in an agreement with a stockholder. Common types of legends include: a "'33 Act" legend that indicates that securities have not been registered under the Securities Act and may not be resold unless they are either registered or exempt from registration, an "affiliate" legend for control shares held by directors, executives or large stockholders, and a "lockup" legend that indicates that a contract prohibits the stockholder from selling the shares for a period of time.  

The SEC's semi-annual update of its rulemaking docket was released on July 20. Overall, the SEC has cut its rulemaking agenda by about half under the Trump administration. A number of long-anticipated Dodd-Frank rulemakings on executive compensation disclosure are missing from the docket: Pay Versus Performance Listing Standards for Recovery of Erroneously Awarded Compensation (Clawbacks) Disclosure of Hedging by Employees, Officers and Directors Incentive Compensation at Financial Institutions. Likewise, the Universal Proxy rulemaking was missing. Still on the docket of proposed rulemakings: Amendments to the XBRL Program Business and Financial Disclosures required by Regulation S-K Guide 3 Bank Holding Company Disclosure Reporting of Proxy Votes on Executive Compensation and Other Matters Concept Release on Possible Revisions to Audit Committee Disclosures Rulemaking to Simplify Regulation S-K Provisions Governing Non-Financial Disclosures

For U.S. and Canadian companies with annual meetings to be held between September 16, 2017, and January 31, 2018, the window for alerting Institutional Shareholder Services (ISS) about changes to self-selected peer groups used for executive compensation benchmarking closes this Friday, July 21st, at 8:00 pm EDT. Information on self-selected peer groups may influence ISS as it constructs the peer groups that it uses in its pay for performance analysis in its voting reports. According to the ISS press release, companies that have made no changes to their previous proxy-disclosed executive compensation benchmarking peers, or companies that do not wish to provide this information in advance, do not need to participate. For companies that do not submit changes, the proxy-disclosed peers from the company’s last proxy filing will automatically be factored into ISS’ peer group construction process. More information on ISS’ peer group selection process, including a link to the form for submitting peer group changes, is available here.

One of the more utilized provisions of the Jumpstart Our Business Startups Act (JOBS Act) has been the confidential submission of IPO registration statements by Emerging Growth Companies (EGCs) to the Securities and Exchange Commission. The nonpublic nature of the SEC review process has allowed EGCs to submit IPO registration statements and respond to SEC comments outside the public eye and without having to alert the market of their intention to go public. As of July 10, 2017, all issuers will now have the ability to submit draft registration statements to the SEC on a confidential basis. Read more in our recent eUpdate here: www.dorsey.com/newsresources/publications/client-alerts/2017/07/all-issuers-eligible-to-submit-draft-ipo.

This week, during his opening remarks at the 2017 National Conference of the Society for Corporate Governance, SEC Commissioner Michael Piwowar remarked on prospects for repealing or delaying the CEO pay ratio rule. Under the rule, most public companies must disclose the median of the annual total compensation of all employees (including non-U.S., part-time, temporary and seasonal workers), except for the CEO; the annual total compensation of the CEO; and the ratio of the two amounts, as calculated under proxy rules. The disclosure must be prepared for fiscal years beginning on or after January 1, 2017, which would be disclosed in 2018 proxy statements. Emerging growth companies, smaller reporting companies and foreign issuers are not subject to the rule. Commissioner Piwowar expressed his support for repealing the rule, which would require Congressional action. In terms of delaying effectiveness of the rule, he stated that public commentary would determine whether that alternative is feasible in light of the associated costs and benefits of implementing the rule. Though the latest comment period on the rule has ended, he urged interested parties to continue to submit comment letters describing specific reasons why the rule is burdensome, as well as proposed fixes. During the latest comment period, the SEC received approximately 180 unique comments, with 150 of those comments in favor of the rule. Given the approaching 2018 proxy season, we advise companies not to count on a repeal or delay of the rule. Companies should continue preparing for the CEO pay ratio disclosure, and keep in mind that there is significant latitude for how the ratio may be calculated, in accordance with Item 402(u) of Regulation S-K and related guidance in C&DIs 128C.01-128C.05. In particular: The median employee, which must be identified once every three years absent a significant change, may be identified from a survey of the entire employee population, a statistical sample or other reasonable method. A de minimis exemption allows companies to exclude non-U.S. employees who account for 5% or less of their employees, including employees whose inclusion would result in a violation of foreign privacy data laws. If certain employees are excluded, then all employees from that jurisdiction must be excluded. Companies may use a consistently applied compensation measure (“CACM”) other than annual total compensation to identify the median employee, as long as the CACM reasonably reflects the annual compensation of employees. For example, total cash compensation could be a CACM unless the company also distributed annual equity awards widely among its employees. Companies may select a determination date within three months prior to the end of their fiscal year, in order to determine employee population from which to identify the median. In applying the CACM to identify the median employee, companies are not required to use a compensation period that includes the determination date. Nor are they required to use a full annual period. As an example, the SEC states that a company may use annual total compensation from its prior fiscal year so long as there has not been a change in the registrant’s employee population or employee compensation arrangements that would result in a significant change of its pay distribution to its workforce. Workers whose compensation is determined by an unaffiliated third party may be excluded from the pay ratio calculation. This population may include leased workers, independent contractors who determine their own compensation, and even workers whose minimum level of compensation is set by the company. Companies should consider testing alternative methodologies in order to assess the quality and consistency of results. While there is considerable latitude to design a pay ratio methodology, companies should let reason be their guide and be prepared to explain the decisions that they make. Companies are required to describe in their proxy statements the methodology used, as well as any material assumptions, adjustments and estimates. Not surprisingly, CEO pay ratios have varied significantly depending on the companies surveyed and the methodology. The AFL-CIO’s annual report on CEO pay calculated a CEO-to-worker-pay ratio of 347-to-1 for 2016, based on the average total compensation package for 400 of the S&P 500 CEOs of $13.1 million last year, and the average annual cash income only (excluding fringe benefits) for America’s 100,525,000 rank-and-file workers of $37,632. In contrast, a 2016 Mercer study found the ratio among respondents to be less than 200-to-1.

As the 2017 proxy season winds down, one clear take-away is that shareholder proposals attempting to modify the terms of previously adopted mainstream proxy access bylaws did not fare well. Many of these proposals focused solely on the aggregation limit, seeking to increase the number of shareholders (usually 20) that are required to meet the minimum ownership threshold (usually 3% of outstanding shares) in order to nominate a director using the company’s proxy statement. Other proposals tried to amend multiple terms of the proxy access bylaw in order to make the provisions more shareholder-friendly. To date, none of these so-called “fix-it” amendments to mainstream proxy access provisions has received majority support, and the average support for all such proposals has been less than 30%. In addition, some companies were able to exclude proposals to amend the aggregation limits from their proxy statements by making a case under the SEC no-action process that the proposal had been “substantially implemented” where the company could provide specific information to support the view that it already had a meaningful proxy access right in place. Other companies facing fix-it amendments to multiple provisions were successful in excluding the proposal as “substantially implemented” where the company acted to adopt one or more of the amendments. See our prior memo here: Recent Developments in Proxy Access. Meanwhile, the trend of adopting mainstream proxy access provisions continues apace. Approximately 175 additional companies have adopted proxy access provisions since the end of the 2016 proxy season, and virtually all shareholder proposals seeking the adoption of proxy access bylaws have received majority support this year. More than 60% of companies in the S&P 500 now have some form of proxy access provision. The mainstream model adopted by a broad range of these companies allows shareholders owning 3% of shares outstanding for at least 3 years to nominate up to 20% of the board (or at least two members) with an aggregation limit of 20 shareholders to reach the ownership threshold. The ability of the mainstream model to withstand fix-it shareholder proposals this proxy season bodes well for this approach and may discourage fix-it proposals in future years.