The Center for Audit Quality (CAQ) recently published “Non-GAAP Measures: A Roadmap for Audit Committees” (CAQ Roadmap), which examines themes that emerged from a series of 2017 roundtables hosted by CAQ with various stakeholders.  The CAQ publication notes that audit committees have an important responsibility to oversee the financial reporting process and external audit.

The CAQ report notes that the audit committee can act as a bridge between management and investors, assess management’s reasons for presenting non-GAAP measures and evaluate the sufficiency of related disclosures.  It adds that the audit committee can determine whether the measures present a fair and balanced view of company performance.  CAQ lays out a three-fold roadmap for audit committee members: (1) identify key discussion topics with management, counsel and external auditors, (2) understand the external auditor’s role regarding non-GAAP measures and (3) adopt leading practices to support the presentation of high-quality non-GAAP measures.  With respect to item (1), CAQ suggests that audit committee members consider topics for dialogue including: asking management whether it has internal guidelines for determining how non-GAAP measures are generated, calculated and presented; seeking the perspective of counsel on non-GAAP measures; asking the company to benchmark such measures to those of its peers; and finding out what disclosure controls and procedures are in place.  With respect to item (2), while external auditors do not audit non-GAAP measures as part of their financial statement or ICFR audits, audit committees and management may consider external auditors as a resource when evaluating such measures and may ask them to perform certain procedures, such as testing controls related to the preparation and use of such measures in light of management’s polices, and to report such results to them.  Last, the audit committee and management should consider adopting best practices, such as subjecting non-GAAP measures to robust disclosure controls, and adopting guidelines to follow when preparing and presenting non-GAAP measures to stakeholders.

On April 4, 2018, the staff of the SEC’s Division of Corporation Finance (Staff) updated its Compliance & Disclosure Interpretations on the use of non-GAAP financial measures (C&DIs), by issuing two new C&DIs (C&DI 101.02 and C&DI 101.03).  These new C&DIs provide that, under certain conditions, financial measures included in forecasts used in business combination transactions are excluded from the definition of non-GAAP financial measures.

To recall, in October 2017, the Staff clarified in C&DI 101.01 that financial measures provided to a financial advisor would be excluded from the definition of non-GAAP financial measures, and therefore not subject to Item 10(e) of Regulation S-K and Regulation G, if and to the extent: (1) the financial measures are included in forecasts provided to the financial advisor for the purpose of rendering an opinion that is materially related to the business combination transaction; and (2) the forecasts are being disclosed in order to comply with Item 1015 of Regulation M-A or requirements under state or foreign law, including case law, regarding disclosure of the financial advisor’s analyses or substantive work.

New C&DI 101.02 now provides that a registrant can rely on the exemption provided by C&DI 101.01 if the same forecasts provided to its financial advisor are also provided to its board of directors or a board committee.  In addition, new C&DI 101.03 clarifies that financial measures in forecasts provided by a registrant to bidders in business combinations would also be excluded from the definition of non-GAAP financial measures, if a registrant determines that such forecasts are material and that disclosure of such forecasts is required to comply with the anti-fraud and other liability provisions of the federal securities laws.

A copy of the updated C&DIs is available here.

Recent years have seen significant growth in Securities Act of 1933 (“1933 Act”) class actions filed in California state courts, based on conflicting readings of the jurisdictional provisions of the Securities Litigation Uniform Standards Act (“SLUSA”).  SLUSA was designed, among other things, to prevent certain state private securities class action lawsuits alleging fraud from being used to frustrate the objectives of the Private Securities Litigation Reform Act of 1995 (“PSLRA”). However, the jurisdictional provisions of SLUSA proved to be vague and unclear, resulting in a circuit split.  Some courts had found that SLUSA covered class actions filed in state court alleging only 1933 Act claims must be heard in federal courts.  In Cyan, Inc. v. Beaver County Employees Retirement Fundthe Supreme Court unanimously held that state courts have jurisdiction over class actions that allege federal violations under the 1933 Act and defendants are not permitted to remove such actions from state court to federal court for lack of subject matter jurisdiction.  In Cyan, the Court was charged with interpreting the jurisdictional provisions of the SLUSA to determine the jurisdictions of such claims. Justice Kagan concluded: “SLUSA’s text, read most straightforwardly, leaves in place state courts’ jurisdiction over 1933 Act claims, including when brought in class actions.” Thus, the Court determined SLUSA did not strip state courts of jurisdiction over class actions alleging violations under the 1933 Act. Furthermore, the court concluded that SLUSA did not empower defendants to remove such actions from state to federal court. State courts will continue to exercise concurrent jurisdiction over class actions that allege federal violations under the 1933 Act.  The Supreme Court cured a circuit split and the decision may lead to more securities class actions alleging 1933 Act violations to be brought in state courts.

In a wide-ranging speech today, SEC Chief Accountant Wesley Bricker addressed recent changes and forthcoming changes to accounting standards, including the new revenue recognition standard.  He noted the need to continue to focus on the implementation of the lease accounting standard next year and the credit losses standard.  Bricker also commented on accounting for equity investments in other companies.  Bricker touched briefly on non-GAAP financial measures, reminding the audience that reporting companies must have disclosure controls and procedures that address the use of non-GAAP measures.  In this regard, he noted that audit committees have an important role to play in reviewing the presentation of non-GAAP measures, understanding the purpose and integrity of the non-GAAP measures, evaluating whether the measures are consistently prepared and presented period to period, and understanding how corrections of errors in such measures will be presented.  Bricker also noted the importance of the audit committee’s role with respect to the disclosure of market risks.  Bricker mentioned the Commission’s recently proposed rulemaking addressing the auditor independence rules.  He concluded his remarks with observations regarding the importance of independent minded audit committees as one element of a strong corporate governance structure.  The full text of his remarks may be found here.

 

A number of industry groups, including SIFMA, have joined to put forward recommendations to promote capital formation and assist more companies in going public or remaining public.  Many of the measures suggested in the report have been presented previously, whether in the U.S. Treasury Report on capital markets or in bills introduced in, or passed by, the House Financial Services Committee.  For example, the group suggests:

  • That for issuers that meet the EGC definition, extending the on-ramp provisions of Title I of the JOBS Act from five to ten years;
  • Amending Section 5 of the Securities Act in order to extend the ability to test-the-waters to non-EGC issuers;
  • Extending the Sarbanes-Oxley Section 404(b) exemption from five to ten years for lower revenue EGCs;  and
  • Simplifying or eliminating the “phase out” provisions relating to EGC status.

The report also addresses research related issues and suggests:

  • Amending the Securities Act Rule 139 safe harbor to eliminate the Form S-3 eligibility prong;
  • Allowing research and banking colleagues to attend pitch meetings and reviewing the Global Research Analyst Settlement; and
  • Studying the factors impacting the decision of most firms not to publish pre-IPO research.

Finally, the report addresses other measures, such as regulation of proxy advisory firms, short-selling, the baby shelf restrictions for smaller issuers, and financial reporting and market structure matters, not as closely tied to the IPO market.

In a recent speech, Commissioner Jackson focuses on the traditional IPO 7% spread, which he refers to as a “tax.”  From time to time, such as in the correspondence between Congressman Issa and then Securities and Exchange Chair Schapiro and in academic literature, questions have been raised regarding the IPO book building process and “IPO underpricing”; however, I don’t think an SEC Commissioner has previously taken on this topic.  The speech cites to Professor Jay Ritter’s work and notes that the Commissioner’s staff undertook an effort to look at more recent data, which included data from more than 700 middle market IPOs over a 15-year period beginning in 2001.  There is a link to the supplemental research (you may access here).  The following chart illustrates the study findings from 2001 to 2016:

Larger companies are able to use their bargaining power to negotiate lower spreads, Commissioner Jackson observes.  While this is true, it’s also important to consider that the market dynamics for larger companies going public are quite different.  Their securities tend to be purchased more broadly by institutional investors and there is more liquidity in their stocks.  Commissioner Jackson suggests that the “middle market tax” may be another deterrent for smaller and middle market companies to defer or avoid undertaking IPOs.  The Commissioner also draws a connection to the availability of private capital.  However, in practice, private capital is more readily available for the largest tech companies and not as readily available for smaller and middle market companies.  For example, more mezzanine or late-stage private placements are completed for tech companies and for larger cap companies generally (across industries) than are completed for smaller and midcap biotech and life sciences companies.  The smaller and midcap life science companies, to the extent that they can complete private placements, rely on dedicated sector investors and insiders and almost “must” go public in order to raise substantial amounts of capital.  Larger companies have many more financing choices.  Going public, I would argue, is more important to smaller and midcap companies.  While, of course, it is important to consider all of the many factors that may be at play that affect the IPO market, the underwriting spread may have the least effect on a company’s decision.  Additional disclosure regarding “underpricing” is unlikely to have an effect on the IPO dynamics.  Studying research coverage and the lack of institutional investor participation in smaller IPOs may be more directly impactful for smaller and midcap companies.

Regulation Crowdfunding (Regulation CF) took effect on May 16, 2016. In line with the second anniversary of the implementation of the Regulation CF, the Heritage Foundation organized a discussion regarding the market. The host noted that approximately $112 million has been raised through crowdfunding since the effective date of Regulation CF. The panel considered possible amendments to, and improvements to, the crowdfunding framework. For example, the panelists recommended, among other things, (i) increasing to $3 million for the maximum amount that eligible companies may raise through crowdfunding, (ii) allowing financial review (instead of a full-blown audit) until a company raises $5 million, and (iii) streamlining the number of mandatory disclosures. The full discussion may be viewed here.

Today, Bill Hinman, Director of the Commission’s Division of Corporation Finance testified to the House Financial Services Subcommmittee.  Mr. Hinman provided an overview of the Division’s ongoing projects and its priorities.  He noted that the Commission remains focused on capital formation related initiatives designed to promote interest in having more companies undertake IPOs.   In this regard, for the first time, he mentioned that the Division is considering rules extending the ability to test-the-waters to non-emerging growth companies.  Extending the test-the-waters provisions to non-EGCs has been a measure that has been included in various proposed bills that have garnered strong bipartisan support on the House side.

Mr. Hinman also reported on measures affecting smaller companies. Mr. Hinman provided market updates on Regulation A offerings (since the amendments in 2015, 78 issuers have raised approximately $670 million in 185 offerings) and Rule 506(c) (noting $147 billion has been raised in reliance on generally solicited offerings under Rule 506).  Mr. Hinman indicated that the Staff would be conducting retrospective reviews of these new exemptions.  Mr. Hinman noted that the Division is considering recommendations that would expand the accredited investor definition.  This is interesting given that amendments to the definition had not appeared as a high priority in the Commission’s regulatory agenda.  He also signaled that the Division is considering harmonizing or rationalizing the exempt offering rules, which had been suggested by practitioners for some time now.

Addressing upcoming priorities, Mr. Hinman again mentioned the proposed changes to the smaller reporting company definition, the disclosure effectiveness initiative, the resource extraction payments rule, and possible revisions to the conflict minerals rule.  The written testimony is available here.

Chair Clayton focused his testimony on the Commission’s plans with respect to the fiscal year 2019 budget requests, and provided some commentary regarding the best interests rule proposal.  The written testimony is available here.

Nasdaq Inc. plans to propose a rule to the Securities and Exchange Commission (SEC) that, if adopted, would allow stock exchanges (such as Nasdaq Inc. and the New York Stock Exchange) to provide smaller public companies with the option of limiting the trading of their listed securities to a single stock exchange.  Presently, numerous secondary stock exchanges facilitate trading in public company securities even though the securities are separately listed on the company’s primary stock exchange.  The proposed rule would likely increase total trading volume on the smaller public company’s primary stock exchange and, as a result, has the potential to increase the smaller public company’s liquidity and access to capital.  Securities trading on private venues is not expected to be impacted by the proposed rule.  Allowing more trading options for smaller public companies appears consistent with SEC Chairman Jay Clayton’s stated goal of making the U.S. stock market more desirable and attractive for smaller public companies.  The SEC is requesting public comment on the proposal.

Recently, SIFMA held its Equity Market Structure conference, which addressed a broad range of issues.  Of course, conference participants addressed market structure concerns that may affect a company’s decision to undertake an IPO or to remain public and pointed to recent statistics, reprinted below.  The Securities and Exchange Commission has also undertaken discussions regarding equity market structure issues.  Representatives from the Commission recently spoke at a University of Chicago-sponsored symposium commenting on the Treasury Department report recommendations to review market structure issues.  The Commission has had the tick pilot in operation for some time providing for wider tick increments for smaller companies as a means of improving liquidity.  While the pilot is set to expire early in the fall, it is clear that tick size increments alone are not a solution to achieve greater liquidity in the trading of stocks of smaller companies.  For many companies considering an initial public offering, while listing rules, tick sizes and liquidity may factor into their considerations, these usually do not figure prominently in their decision making.  It is interesting that the Treasury Department report recommendations regarding equity research rules have not received more attention by the Commission or by other market participants given that research coverage (and not market structure) concerns are top of mind for management of emerging growth companies.