Anna T. Pinedo

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Anna Pinedo is a partner in Mayer Brown’s New York office and a member of the Corporate & Securities practice. She concentrates her practice on securities and derivatives. Anna represents issuers, investment banks/financial intermediaries and investors in financing transactions, including public offerings and private placements of equity and debt securities, as well as structured notes and other hybrid and structured products.

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The Securities and Exchange Commission adopted final rules requiring public companies (other than foreign private issuers and certain fund issuers) to disclose in proxy statements their policies regarding hedging transactions in the company’s securities by directors and employees.  The Commission was required by Section 955 of the Dodd-Frank Act to adopt such rules.

The Commission’s fact sheet notes that new Item 407(i) of Regulation S-K will require a company to describe any practices or policies it has adopted regarding the ability of its employees (including officers) or directors to purchase securities or other financial instruments, or otherwise engage in transactions, that hedge or offset, or are designed to hedge or offset, any decrease in the market value of equity securities granted as compensation, or held directly or indirectly by the employee or director.

The final rule text has not been released yet.

As we previously posted, the Securities and Exchange Commission had announced that at tomorrow’s open meeting the Commission would, among other things, consider a request for comment regarding earnings releases and the frequency of periodic filings.  Well, today, the Commission released the Request for Comment.

This is not the first time that the Commission has considered the frequency of periodic reporting.  In fact, from time to time, Commissioners and representatives of the Commission’s Division of Corporation Finance have questioned whether quarterly or semi-annual reporting is more appropriate for public companies.  However, following comments earlier in the year regarding the burdens placed on reporting companies as a result of the quarterly reporting requirement and the focus on short-termism that may result from quarterly earnings announcements, the Commission had been urged to conduct a study on these matters.  The Request for Comment solicits information regarding the frequency of reporting; suggestions regarding simplifying the process by which investors access quarterly information; an option for companies that issue earnings releases to meet their quarterly report requirements through an enhanced release; and whether quarterly reporting or quarterly guidance fosters a short-term outlook.

A more detailed legal update will follow.

Here is a link to the Commission’s Request:  https://www.sec.gov/rules/other/2018/33-10588.pdf.

The Securities and Exchange Commission announced that it will hold an open meeting on December 19, 2018.  Among other things, the Commission will consider a rule requiring disclosure of hedging arrangements entered into by a reporting company’s directors and employees as required by Dodd-Frank Act Section 955, as well as whether to issue a comment request regarding the content of quarterly reports and earnings releases issued by reporting companies.  The latter has been the subject of significant media coverage since a Presidential tweet suggested that quarterly reporting contributes to short-termism (see our previous blog post).  The proposed package of legislation known as JOBS Act 3.0 contains a bill that would require that a study be conducted by the Commission regarding the requirement for quarterly reporting by smaller reporting companies.  See the meeting notice here: https://www.sec.gov/news/openmeetings/2018/agenda121918.htm.

 

Accounting Standards

Representatives from the Office of Chief Accountant discussed new accounting standards.  The Staff commented on the implementation of the new revenue recognition standard, which requires companies to provide a comprehensive view of revenue arrangements in their financial statements, including their disclosures.  The Staff intends to continue to monitor, and comment on, the implementation of the revenue standard.  The Staff noted that nearly all companies will be affected by the adoption of the new lease accounting standard, which will soon be effective.  To that end, representatives of the Staff have provided guidance on implementation of the standard, which, representatives of the Staff caution require significant time and effort.  Various representatives noted that steps for lease accounting implementation include:  understanding the accounting and disclosure requirements of the new standard; identifying relevant arrangements and leases within those arrangements; determining appropriate accounting policies, including applicable transition elections; applying the guidance to arrangements within the standard’s scope; preparing transition and ongoing disclosures; and establishing adequate and appropriate processes and controls to support implementing and applying the new standard, including preparing required disclosures.  Representatives noted that “it is crucial for each registrant to ensure its implementation plans include sufficient time to identify arrangements that are leases in their entirety or that include embedded leases….[i]t is also critical for companies to identify and resolve transition, application, and other implementation issues arising from the new leases standard.  A lesson learned from the implementation of the new revenue standard is that entities benefit from an early and thorough discussion of implementation issues with their auditors and audit committees.”

Audit Committee Oversight

Various Staff members noted the important role of the audit committee in connection with the implementation of new accounting standards.  To that end, the Staff noted that the audit committee should exercise oversight over management’s approach to implementation of new accounting standards, should establish appropriate controls and procedures over the transition; maintain appropriate controls and procedures over ongoing application of the new accounting standard; and should understand how the effects of the new standard are communicated to investors at transition and on an ongoing basis.

Internal Control over Financial Reporting

Various speakers addressed internal control over financial reporting.  In this regard, the speakers again emphasized the important role of audit committees.  Audit committees should have discussions of ICFR in all areas—from risk assessment to design and testing of controls, as well as the appropriate level of documentation.  The Staff noted the importance of identifying and communicating material weaknesses before these manifest in the form of a financial statement restatement.  The Staff noted there has been progress in the evaluation of the severity of internal control deficiencies.  The Staff encouraged audit committee training regarding “the adequacy of and basis for a company’s effectiveness assessment, particularly where there are close calls in the assessment of whether a deficiency is a significant deficiency (and reported to the audit committee) or a material weakness (and reported also to investors).”  Speakers also emphasized that the assessment of ICFR is especially important this year-end as a result of the implementation of new accounting standards, which also affects a company’s internal controls.

Material Weakness Disclosures

Representatives of the Staff noted improvement in the disclosures of a material weakness; however, suggestions were offered that are intended to make the disclosures more useful to investors.  One of the speakers suggested considering the following questions in evaluating the proposed disclosure:

  • Does the disclosure allow an investor to understand what went wrong in the control that resulted in a material weakness?
  • Is it sufficiently clear from the disclosure what the impact of each material weakness is on the company’s financial statements?  For example, is the material weakness pervasive or isolated to specific accounts or disclosures?
  • Are management’s plans to remediate the material weakness sufficiently clear?  For example, does disclosure of the remediation plans provide sufficient detail that an investor would understand what management’s plans are and how the remediation plans would address the identified material weakness?

Implementation Activities for Communicating Critical Audit Matters

The Staff also addressed implementation activities related to the CAM standard.  In order to prepare for the CAM standard implementation, the Staff encourages auditors and registrants to conduct a dry run this year with the auditors and audit committees, share implementation questions and issues with the Staff, and begin to focus on the differing disclosure requirements for MD&A critical accounting estimates and CAMs.

SEC Chair Clayton testified on December 11, 2018 before the U.S. Senate Committee on Banking, Housing and Urban Affairs.  In his testimony, Chair Clayton reviewed the Commission’s Strategic Plan and outlined the agency’s priorities.  Consistent with his remarks delivered at Columbia University, Chair Clayton reviewed some of the principal accomplishments in 2018, including proposed Regulation Best Interest, the amendments to the smaller reporting company definition, the disclosure simplification amendments, and the proposed changes to financial disclosures for guarantors.  He noted that there were other proposals “on the horizon,” including:

  • A proposal to amend the definition of “accelerated filer” (triggering SOX 404(b) attestation);
  • Extension of the test-the-waters accommodation to non-EGCs;
  • Rulemaking to expand Regulation A eligibility to public reporting companies;
  • A release soliciting input on reducing compliance burdens on reporting companies with respect to quarterly reports;
  • A concept release on the exempt offering framework;
  • Changes to Rule 701 to address the comments received on the Commission’s concept release on the exemption;
  • Improvements to the proxy process;
  • Regulation of proxy advisory firms;
  • Revisions of the offering rules for BDCs as required by the Small Business Credit Availability Act; and
  • Revisions of the offering rules for closed-end funds as required by the Economic Growth, Regulatory Relief, and Consumer Protection Act.

On Friday, the Chair of the Securities and Exchange Commission Jay Clayton, the Commission’s Chief Accountant Wes Bricker, and the Chairman of the PCAOB William Duhnke issued a statement reaffirming the significance to the capital markets of high quality and reliable financial statements, which, in turn, depend on the reliability of financial statements, quality audit services and effective regulatory oversight.  The statement notes the particular responsibility of U.S. regulatory agencies in monitoring audit-related information and in overseeing the regulatory framework for financial reporting.  The statement notes that U.S.-listed companies accounted for approximately 40% of the market capitalization of global public companies in 2017.

The Chairs of the Commission and the PCAOB and the Chief Accountant noted the formal cooperative arrangements that are in place between the Commission and foreign regulators and enforcement agencies, as well as the cooperative agreements in place between the PCAOB and foreign regulators allowing for the PCAOB to conduct joint inspections with such regulators or providing for the sharing of information.  Perhaps because of the increase in the number of China-based IPOs, the remarks focus on difficulties associated with obtaining access to information that would allow the PCAOB to do its work.  The remarks note that the laws of various countries include blocking statutes and data protection, privacy, confidentiality, bank secrecy, state secrecy, and national security laws that may create obstacles to cross-border flows of information between regulators and foreign-domiciled registrants.  In addition, the statement notes that the positions taken by some foreign authorities currently prevent or impair the PCAOB’s ability to inspect non-U.S. audit firms in certain countries.  The remarks then go on to address the issues affecting China-based companies:

“The Commission and the PCAOB currently face significant challenges in overseeing the financial reporting for U.S.-listed companies whose operations are based in China.  The business books and records related to transactions and events occurring within China are required by Chinese law to be kept and maintained there.  China also restricts the auditor’s documentation of work performed in the country from being transferred out of China.  China’s state security laws are invoked at times to limit U.S. regulators’ ability to oversee the financial reporting of U.S.-listed, China-based companies.  In particular, Chinese laws governing the protection of state secrets and national security have been invoked to limit foreign access to China-based business books and records and audit work papers.  As a result, for certain China-based companies listed on U.S. stock exchanges, the SEC and PCAOB have not had access to the books and records and audit work papers to an extent consistent with other jurisdictions both in scope and timing.”

The statement also alerts market participants that the PCAOB publishes on its website a list of companies whose auditors are located in jurisdictions where there are obstacles to PCAOB inspections, which currently includes 224 issuers of which 213 have auditors based in China or Hong Kong.  The statement concludes with an expression of frustration regarding the inability to have made more progress in reaching agreements with China that would provide the Commission and the PCAOB access to the information needed for information sharing, inspections, and oversight.  Finally, the Chairs and the Chief Accountant note that the failure to enter into such arrangements results in investor protection issues.  In order to address these investor protection issues, the Commission may be required to adopt measures mandating additional disclosures or even to restrict new issuances.

FINRA today published its Report on FINRA Examination Findings and highlights private placement related concerns.  In its examinations of the practices of many broker-dealers, the report notes FINRA found instances where the diligence review undertaken in connection with private placements was not sufficient in scope or depth to be considered a “reasonable investigation of the issuer and the securities.”  In its Regulatory Notice 10-22 issued several years ago, FINRA noted that FINRA member firms have a suitability obligation under FINRA Rule 2111, including in connection with recommending an investment in a private placement.  The notice describes the type of investigation that broker-dealers ought to conduct with respect to a private placement.

In its examinations, FINRA noted that member firms that had performed reasonable diligence “conducted meaningful, independent research on material aspects of the offering; identified any red flags with the offering or the issuer; and addressed and resolved concerns that would be relevant to a potential investor.  Depending on their size, firms’ diligence processes included creating a due diligence committee (at larger firms) or otherwise formally designating one or more qualified persons (at smaller firms), and charging them with investigating and determining whether to approve the offering for sale to investors. As part of their process, firms independently verified information that was key to the performance of the offering, and some received support from due diligence firms, experts and third-party vendors.  Further, in offerings involving issuers that were affiliates of the firm or whose control persons were also employed by the firm, firms used the reasonable diligence process to mitigate conflicts of interest, ensured that the offerings were suitable for investors in spite of such conflicts of interest, and developed comprehensive disclosures. Firms also used insights from the diligence analysis to establish post-approval processes and investment limits based on the complexity or risk level of the offering. After the offering, firms conducted ongoing diligence to ascertain whether offering proceeds were used in a manner consistent with the offering memorandum, particularly when the firms engaged in ongoing sales of an offering after initial closing.”

The report cites examples of other problematic practices, including reliance on the firm’s prior experience with the same issuer without refreshing their diligence, reviewing the offering memorandum without more in-depth diligence, failing to verify independently material aspects of the offerings, and failing to investigate red flags identified during the reasonable diligence process, placing undue reliance on due diligence consultants, experts or other third-party vendors.

In a speech yesterday, Securities and Exchange Commission Chair Jay Clayton provided an overview of the Commission’s significant accomplishments in 2018.

Chair Clayton noted his approach to the Reg Flex agenda and the setting of more realistic rulemaking priorities.  In the last year, he noted that the Commission advanced 23 of the 26 rules on the Commission’s near-term agenda.  Among the key accomplishments in 2018, Chair Clayton cited the Commission’s work with regard to proposed Regulation Best Interest.  With respect to capital formation, Chair Clayton noted the Commission’s amendments to the smaller reporting company definition and the disclosure effectiveness related updates.

In terms of priorities for 2019, Chair Clayton again cited completion of the Commission’s work on proposed Regulation Best Interest as one of the most important projects.

Chair Clayton also pointed to proxy plumbing as another key objective for 2019.  Addressing regulation of proxy advisory firms, Chair Clayton noted that “there should be greater clarity regarding the division of labor, responsibility and authority between proxy advisors and the investment advisers they serve. We also need clarity regarding the analytical and decision-making processes advisers employ, including the extent to which those analytics are company- or industry-specific. On this last point, it is clear to me that some matters put to a shareholder vote can only be analyzed effectively on a company-specific basis, as opposed to applying a more general market or industry-wide policy.”

Chair Clayton cited changes in the capital markets and reaffirmed the commitment to review initiatives “to facilitate access to capital for issuers and to make sure Main Street investors have the best possible mix of investment opportunities.”  Based on prior comments, this would appear to allude to opportunities to invest in private companies, including unicorns.  The Commission also is considering expanding test the waters communications to non-emerging growth companies, evaluating quarterly reporting requirements, and streamlining or harmonizing securities offering exemptions.  He noted that the staff is working on a concept release to solicit input about key topics, including whether the accredited investor definition is appropriately tailored to address both investment opportunity and investor protection concerns.

Chair Clayton noted that the Commission is monitoring three risks:  (1) the impact to reporting companies of the United Kingdom’s exit from the European Union, or “Brexit”; (2) the transition away from LIBOR as a reference rate for financial contracts; and (3) cybersecurity.  Among other things, the Commission staff will focus on disclosures related to Brexit risks.  Chair Clayton noted that he “would like to see companies providing more robust disclosure about how management is considering Brexit and the impact it may have on the company and its operations.”  Chair Clayton also noted that the transition away from LIBOR is a significant risk for many market participants—whether public companies who have floating rate obligations tied to LIBOR, or broker-dealers, investment companies or investment advisers that have exposure to LIBOR.  Finally, he commented on cybersecurity.  The full text of yesterday’s remarks can be found: https://www.sec.gov/news/speech/speech-clayton-120618.

On November 30, 2018, the Securities and Exchange Commission (the “Commission”) adopted a new rule establishing a non-exclusive research report safe harbor (“Rule 139b”) for unaffiliated brokers or dealers that publish or distribute research reports regarding qualifying investment funds.  The Commission took this action in furtherance of the mandate of the Fair Access to Investment Research Act of 2017 (the “FAIR Act”).  The FAIR Act required that the Commission expand the Rule 139 safe harbor for research reports in order to cover research reports on investment funds.

Continue reading our Legal Update.

In September, California mandated women directors on corporate boards.  In a new paper titled “Mandating Women on Boards: Evidence from the United States,” authors Sunwoo Hwang, Anil Shivdasani, and Elena Simintzi review the effects of mandating the inclusion of women on boards.

The California law requires that public companies headquartered in the state of California have at least one female director by end of 2019.  By year-end 2021, companies with six or more directors must have three female directors, boards with five members must have two female directors, and boards with four or fewer directors, must have at least one female director.  Noncompliance would result in potential fines. There are approximately 450 public companies in the Russell 3000 index headquartered in California with a market cap of nearly $5 trillion.

The authors present evidence that mandating gender diversity through legislation is expensive for shareholders.  This results from heightened costs for female directors, because there is a small supply and public companies will be pressed to comply at the same time resulting in competition.  In addition, the authors find costs will increase as a result of the possibility that companies will expand their boards in part to comply with the requirements.   Although the paper concludes that there is a lack of a consensus on the impact of regulations mandating gender diversity, it raises concerns.

Separate from the paper, commentators have raised concerns regarding the constitutionality of the California law.