Highlights of the 2017 PLI Securities Regulation Institute

Print

Summarized below are some of the highlights of the 2017 PLI Securities Regulation Institute panel discussions with the SEC staff (Michele Anderson, Wesley Bricker, Karen Garnett, William Hinman, Mark Kronforst, Shelley Parratt, Ted Yu), as well as a number of  former staffers and other commentators. Topics included the Congressional and SEC agendas, fresh insights into the shareholder proposal guidance, as well as expectations regarding cybersecurity, conflict minerals, pay ratio disclosure, waivers and many other topics.

But to start the proceedings, SEC Chair Jay Clayton addressed the gathering on ”Governance and Transparency at the Commission and in Our Markets.” In particular, Clayton reiterated that, with respect to transparency at the SEC, he planned to make the SEC’s near-term agenda, which will be published as part of the federal government’s Unified Agenda, shorter than in the past in an effort to identify only those rulemakings that the SEC actually planned to pursue in the following twelve months. Although he did not discuss which rulemakings would make the cut for the near-term agenda, based on prior addresses (see, e.g., this PubCo post), presumably some will relate to his efforts to facilitate capital formation, such as the recent release regarding FAST Act Modernization and Simplification of Regulation S-K (see this PubCo post).

With regard to the SEC’s longer term agenda, Clayton noted the remaining Dodd-Frank rulemakings were “top of mind.”  (These likely include hedging disclosure, pay-for-performance disclosure and clawbacks.) On one panel, former Corp Fin Director Meredith Cross speculated that, given the new administration and the time that had elapsed since those proposals first saw the light of day, she expected to see reproposals for these topics.) Other longer term agenda items included shareholder engagement and the proxy process, including how shareholders participate—or in the case of retail shareholders, don’t participate—in the proxy process and corporate governance at public companies. Clayton noted that

“the SEC staff estimates that over 66% of the Russell 1000 companies are owned by Main Street investors, either directly or indirectly through mutual funds, pension or other employer-sponsored funds, or accounts with investment advisers….In situations where the voting power is held by or passed through to Main Street investors, it is noteworthy that non-participation rates in the proxy process are high. In the 2017 proxy season, retail shareholders beneficially-owned 30% of the shares in U.S. public companies; however, only 29% of those shares voted. This may be a signal that our proxy process is too cumbersome for retail investors and needs updating…”

Expect to see the “proxy plumbing” concept  release reopened. Main street shareholders were again the subjects of interest with regard to the shareholder proposal rules. Do the current rules serve the long-term interests of these retail investors?  Clayton recognized that shareholder proposals have certainly led over time to improvements in corporate governance; however, they can also involve substantial cost and management time. How should these conflicting interests be reconciled?  Expect to see the eligibility ownership thresholds and  resubmission thresholds for shareholder proposals be revisited.

Panel highlights:

(Based on my notes, so standard caveats apply.)

• Setting the agenda. One question that framed much of the early discussion was “who is setting the agenda?” Is it Congress, the SEC or investors? What about the new administration?
  • Congress. The argument for Congress is that it controls the purse strings and, under the Congressional Review Act, can effectively rescind agency rulemakings, as it did last year with the resource extraction disclosure rules adopted by the SEC. (See this PubCo post.) The panel noted that the Financial CHOICE Act of 2017, which would repeal significant parts of Dodd-Frank, has passed in the House, but seems unlikely to pass in Senate. (See this PubCo post.) However, if it did pass in the Senate, it could reverse the “Chevron doctrine,” which is a well-worn two-step test for determining whether deference should be accorded to federal administrative agency actions interpreting a statute.  It would also impose all sorts of limitations and mandates on agency rulemaking, including the right of Congress to disapprove certain rules  and treatment of SEC guidance like rulemaking from a procedural perspective. And speaking of guidance, one panelist observed that the Congressional Review Act allows Congress to overturn agency guidance that rises to the level of rulemaking.
    • More likely headed for passage in the Senate are House bills that peel off various topics covered by the CHOICE Act. For example, a number of bills intended to encourage IPOs have passed in the House, such as the fortuitously named Encouraging Public Offerings Act of 2017, which would expand permission to “test the waters” from only emerging growth companies to all issuers and codify the staff’s recent expansion of the use of confidential submissions of registration statements beyond EGCs to all IPOs and registration statements filed within one year post-IPO. One caveat, however, is that the bill’s provisions for follow-ons may be difficult to implement in practice in some contexts: while the staff guidance requires the issuer to confirm that it will publicly file its registration statement and nonpublic draft submission at least 48 hours prior to any requested effective time (see this PubCo post), the bill would require public filing not later than 15 days before the road show or, if none, at least 15 days prior to the requested effective date.
    • Another House bill mentioned is the Fair Investment Opportunities for Professional Experts Act, which would modify the definition of “accredited investor.”
    • Two bills entitled the Encouraging Employee Ownership Act have passed the House and the Senate and are now awaiting a presidential signature to become law. Both bills would require the SEC, within 60 days after enactment, to raise the  Rule 701(e) cap (for information delivery) from $5 million to $10 million, and to index it for inflation every five years to reflect changes in the CPI. (See this PubCo post.)
    • Another bill, just introduced in the House but expected to receive bipartisan support, is the Corporate Governance Reform and Transparency Act of 2017, which would mandate registration of proxy advisory firms. A former Hill staffer on one panel commented that the concept of registration of proxy advisors had drawn favorable comments from over 100 companies.  In light of the data that there are about 4,400 public companies 75% of which have calendar-year fiscal years, former Corp Fin Director Keith Higgins raised an issue about the practicality of the bill’s provisions requiring proxy advisory firms to provide companies with the opportunity to present detailed comments on the firm’s recommendations to the person responsible for developing the recommendation in person or telephonically. It was also noted that the recent Treasury Report recommendations (see this PubCo post) regarding proxy advisory firms were substantially more muted and did not call for legislation, but instead recommended “further study,” which could include “regulatory responses to promote free market principles if appropriate.”
  • Executive. The Treasury Department, acting under an Executive Order (see this PubCo post), recently issued a new report, A Financial System That Creates Economic Opportunities—Capital Markets, noted above, that, in its recommendations, not surprisingly, echoed in many respects the House’s Financial CHOICE Act of 2017. The recommendations in the Treasury report addressed approaches to improving the attractiveness of the public markets, focusing in particular on ways to increase the number of public companies by limiting the regulatory burden. Panelists noted that, with a more vocal administration, it’s become more difficult to read the tea leaves.
  • SEC. Key SEC priorities identified were disclosure simplification and effectiveness, the needs of retail investors, cybersecurity and, in particular, facilitating capital formation. In that regard, the SEC has released its proposal for FAST Act Modernization and Simplification of Regulation S-K, which proposes amendments to rules and forms based primarily on the staff’s recommendations in its Report to Congress on Modernization and Simplification of Regulation S-K (required by the FAST Act).The proposal is expected to be considered for adoption in the winter. (See this PubCo post and this PubCo post.) The SEC may also take another look at the 2016 concept release, part of its Disclosure Effectiveness Initiative, which sought comment on modernizing certain business and financial disclosure requirements in Reg S-K (see this PubCo post), as well as the “Disclosure Update and Simplification Proposing Release,” which identified a number of requirements that mandate substantially the same disclosures as U.S. GAAP, IFRS or other SEC disclosure requirements and proposed to eliminate the redundant SEC disclosure requirements. (See this PubCo post.)  Another possible topic for SEC action is this 2015 concept release regarding possible revisions to audit committee disclosures.  (See this PubCo post.) Former Chief Counsel Thomas Kim questioned rhetorically whether better rules will really result in better disclosure: you may have more navigability but will you have better quality? According to Corp Fin Director William Hinman, the staff is trying to make it easier to be a public company, and is attempting to do what it can through policy measures, which are more expedited than rulemaking. Hinman also remarked that the staff is taking a more collaborative approach, encouraging contact with companies as issues arise.
  • Investors. But if action isn’t taken on the legislative or regulatory front—or perhaps if deregulatory action is taken—that’s not necessarily the end of the issue.  Whether through private ordering, voting to oust directors or through the influence of shareholder engagement, investors are more and more holding sway. This past proxy season, the panel noted, three climate-related proposals won majority votes (see this PubCo post), and other proposals in the environmental or social categories either won or came close. (See this PubCo post.) Much of this success was attributed to the impact of large asset managers, such as BlackRock and State Street. Although shareholder proposals are typically only precatory, boards usually pay attention if a proposal passes. (See, e.g., this PubCo post, this PubCo post and this PubCo post.) The question is how will investors continue to use their muscle? (See this PubCo post.) In some cases, investors are approaching social issues through a corporate governance lens. A panelist from the Council of Institutional Investors predicted that the hot topics this year would be board gender diversity (particularly in light of current events), with investors rejecting the notion of “one and done,” the gender pay gap, more muscular clawbacks (especially where there has been a failure of oversight) and the opioid crisis, with requests for reports on risk.  During a later panel, board gender diversity was predicted to be a huge issue this coming year, especially in view of the new campaign by the NYC Comptroller to leverage the success of its proxy access campaign to “demand change” focused on corporate board diversity, independence and climate expertise. (See this PubCo post.)
• Pay ratio. Several panelists took note of the SEC’s recent  interpretive guidance regarding pay ratio disclosure, which provided a more expansive reading of three topics: company reliance on reasonable estimates, the use of existing internal records to determine the median employee and non-U.S. employees, and the use of other recognized tests and criteria (such as published IRS guidance) to determine employee/independent contractor status..  (See this PubCo post.) Interestingly, the guidance with regard to the use of reasonable estimates, assumptions and methodologies was characterized as a “safe harbor”  by Corp Fin Deputy Director Shelley Parratt. According to Corp Fin Associate Director Michele Anderson, the theme of this new guidance is “reasonableness.” What is a bad number?  That will be sector-specific, but one possible answer is to look at the AFL-CIO ratio as a marker. (As discussed in this PubCo post,  the AFL-CIO reported that, for 2015, the average S&P 500 CEO made 335 times the pay of the average worker, based on U.S. government reports. Not all investors have expressed interest in the ratio, but employees, hearing for the first time of the median wage, may be concerned and require further communications..
• Shareholder proposals. Anderson also discussed Corp Fin’s new guidance regarding shareholder proposals, particularly the exclusions for “ordinary business” and “economic relevance.” (See this PubCo post.) Although the guidance expressly states that Corp Fin “would expect a company’s no-action request to include a discussion that reflects the board’s analysis of the particular policy issue raised and its significance,” in her “soft” guidance, Anderson made clear that not all requests under those exclusions must include board discussions. (Emphasis added.) Rather, she indicated that it would “helpful” to include board analyses, but a company can demonstrate the propriety of the exclusion without a board analysis, for example, in circumstances where companies have historically been permitted to exclude the proposal.  Hinman observed that part of the board analysis might be the board’s (or nominating and corporate governance committee’s) process, its prior engagement with proponents or other  shareholders on the topic and its understanding of the interest in the issue of its particular shareholder base.  He also reiterated that there is no expectation of a new full board analysis where there already is a well-worn path to exclusion under the circumstances. (For additional insight on this topic from Corp Fin, see this PubCo post.)
• Proxy access.  Five 14Ns were filed last year to submit board candidates using proxy access.  Three were filed under the requirements of foreign law, one was an error and one was withdrawn. (See this PubCo post.)  In contrast to the overturned SEC rule,  with private ordering for proxy access, there are no exemptions for soliciting, and groups using proxy access are probably prohibited from relying on Schedule 13G. In addition, Anderson discussed the staff’s recent position in connection with proxy access fix-it proposals.  Under 14a-8(i)(10), the question is whether the essential objective of the proposal has been met.  In fix-it proposals, the objective is the specific revision sought.  The staff has found in the past that a fix-it proposal to raise the aggregation limit from 20 persons to 40 persons was still substantially implemented by the original bylaw, but a fix-it proposal to remove the cap entirely—which would make proxy access available to any shareholder—was not substantially implemented by the existing 20-person limit.  (See this PubCo post.)
• Cybersecurity.  On reviewing the 2011 guidance initially, Hinman believed that the guidance, which is principles-based, still worked effectively. But with cybersecurity now so omnipresent in the media, he expects new guidance probably at the SEC level.  New guidance will likely address disclosure controls and escalation procedures for cyber events.  Because it may be hard to determine the significance of attacks initially, the controls should require the IT and business folks to promptly consider the impact of the event together, with an eye toward the implications for the business. Companies should also consider the impact of potential cyber events on insider trading policies, including a prophylactic policy for officers and directors once it is known that an event has occurred that could be material.
• Conflict minerals. Hinman remarked that the staff is still considering how to proceed on conflict minerals.  In light of the substantial history of litigation surrounding this rule, in which part of the rule was struck down on First Amendment grounds, the staff may be reluctant to go too far.  (See this PubCo post.) Currently, the staff is sorting out whether the First Amendment problem derives from the statute (which would require action by Congress) or from the rule only, which the SEC could amend.  The staff is also considering other ways to improve the rule beyond the First Amendment issue, for example, ways to make it easier for companies to remain at Step 2 and file only a Form SD (without having to undertake the expensive and time-consuming due diligence process) as well as ways to make the due diligence process more efficient.  For now, the current guidance remains in place.  He noted that, notwithstanding Corp Fin’s  Updated Statement on the Effect of the Court of Appeals Decision on the Conflict Minerals Rule, which offered relief from potential Enforcement action if companies filed limited disclosure only on a Form SD without a conflict minerals report, 80% of companies still filed full conflict minerals reports. (See this PubCo post.)
• Resource extraction. As noted above, Congress used the Congressional Review Act to rescind the resource extraction disclosure rules adopted by the SEC (see this PubCo post) , and the SEC then had a year to come up with new rules. Although one panelist thought the SEC would “take a knee” on this rulemaking, according to Hinman, they are working on having a new rule by the February 14 deadline.
• Smaller reporting company threshold/SOX 404(b) auditor attestation. The SEC is  again looking at the June 2016 proposal to change the definition of a “smaller reporting company” to raise the financial cap from “less than $75 million” in public float to “less than $250 million,” allowing more companies to take advantage of the scaled disclosures permitted for companies that meet the definition. (See this PubCo post.) Although it was not part of that proposal, the staff is also looking at whether market cap should be the only basis for determining whether an auditor internal control attestation is required under SOX 404(b). For example, does it make sense to require life sciences companies with few revenues to undergo the attestation process? (See this PubCo post.)
• New revenue recognition standard. After a couple of years of prep, it’s now exam time for the new revenue recognition standard, according to SEC Chief Accountant Wesley Bricker. The new standard takes account of how management manages its business, starting with evaluations of customer contracts and their performance obligations over time. The standard requires more disclosure, more estimates and more judgment.  It will also require cross-functional implementation with attention to contract review, internal controls and changing metrics in covenants and employee plans. In anticipation of adoption next year, companies should be providing enhanced transition disclosure this year. It is expected that the disclosure in the footnotes will “bleed back” into the MD&A.  According to Bricker, about 55% of companies have elected to transition using the modified retrospective method, where the cumulative effect of the change is reflected in retained earnings, as opposed to the full retrospective approach, where all three years are restated. Several panelists cautioned that companies should consider the potential registration statement impact for the full retrospective method—if a shelf is filed before the 2018 10-K has been filed, an S-3 that requires incorporation of three years of financials could require that 2015 be restated also. In reviewing and commenting on implementation of the new standard, the staff will probably be looking for red flags, but is not expected to regulate revenue recognition through the comment process on a case-by-case basis. Companies will be expected to learn over time.
• Rule 3-13 waivers. Corp Fin Chief Accountant Mark Kronforst discussed the recent effort by Chair Clayton and others encouraging the use of the Reg S-X Rule 3-13 waiver process. In the event that mandated disclosures are burdensome to generate, but may not be material to the total mix of information available to investors, companies can seek waivers under Rule 3-13 of Reg S-X to modify their financial reporting requirements. (See this PubCo post  and this PubCo post.)  Apparently, the process is not often used, but relief is almost always granted, he said.  However, that may be because companies have been guided in their submissions by the experience of audit firms as to what will fly.  Kronforst noted that the companies can also streamline their request letters to focus on key issues.  There’s no harm in asking, and companies should first speak with the experts identified in the Corp Fin Financial Reporting Manual to get a feel for what will work.  Expedited turnaround time is around five days.
• Audit report. This coming year, the audit report will include auditor tenure, which includes predecessor firms. With regard to the future requirement to report critical audit matters, panelists suggested that companies may want to do a trial run in advance and be sure to keep the audit committee advised so that there are no surprises. There may be overlap with disclosure in the 10-K under “critical  estimates,” which might give companies a chance to “front run” some of the content of the disclosure. (See this PubCo post.)
• Duty to update. Panelists advised that companies be sure to include, in their forward-looking statements legends, a disclaimer of any duty to update forward-looking statements.
• Dual class/governance. The debate over dual-class share structures was characterized by panelists as a debate over short-termism versus accountability. According to one panelist, in many cases, companies would not go public at all without the protection of dual-class structures, and he contended, some large investors are starting to understand that. Panelists also advised that companies not “get ahead of their skis” on shareholder protection matters.  Why de-stagger the board in the absence of an investor request?  Shooting for the highest marks from ISS right away, the panelist contended, comes with a cost—in evaluating which companies to attack, hedge fund activists often look at how easy it would be to get a foothold/voice at the target.
• Shareholder engagement. Panelists noted that index funds have now become “stewards” of the companies in which they own shares. Tactically, it’s best to be targeted with investors. Director participation in the engagement process has increased; among companies in the S&P 500, 30% have directors participating in shareholder engagement.  With regard to executive comp issues, investors are looking at whether performance  metrics are effectively softballs, as well as whether the “total quantum” of CEO pay is excessive.
• Sustainability. One panelist discussed the increasing prevalence of separate sustainability reports, in part in response to the demands of a changing and younger investment community.  It was noted that, although these reports could be subject to 10b-5 liability, they are often not reviewed by counsel.  In addition, companies should consider issues such as how to vet the data that is used, which frameworks (e.g., SASB, GRI) to employ, and which internal controls should be applied. (See this News Brief.) Currently, SEC disclosure requirements are primarily triggered off of materiality concepts; however, climate change topped the list of issues in comments on the SEC’s Reg S-K concept release. (See this PubCo post.) Nevertheless, it seemed unlikely that sustainability reporting would be mandated in the current deregulatory environment.
• Proxy contests/universal proxy. According to Anderson, there has been a 30% decline in the number of proxy contests.  Approximately 1/3 go to a vote, 1/3 are settled and 1/3 withdrawn.  A proposal providing for mandatory universal proxy in contested elections is not on the SEC’s short-term agenda, but the staff is still considering it.  (See this PubCo post.)
• Non-GAAP measures. Although the pendulum has swung and there is less focus and comment now on non-GAAP financial measures, the staff continues to look at consistency and the quality of disclosure if changes are made. Panelists advised to have internal controls and policies behind non-GAAP measures. To the extent there are changes to a non-GAAP policy, audit committees should play a role.
• Accredited investor. Another possible change under consideration is to the definition of “accredited investor.” The potential change would make the definition less binary and instead take into account other measures of sophistication.
• Confidential submission.  Parratt observed that the process that has been extended through guidance to non-EGCs is slightly different regarding confidentiality than for EGCs. (See this Pubco post and this PubCo post.)  She emphasized that the staff will try to accommodate accelerated schedules, and companies that need accelerated review should notify the staff.  Chief of the Office of M&A, Ted Yu, noted that confidential review can also be available for registration statements used in M&A transactions (although not for other M&A filings).  He advised that the staff be consulted first to be sure that the process would be available.
• Confidential treatment. Parratt discussed the new confidential treatment process proposed in the FAST Act Modernization and Simplification of Regulation S-K release, under which companies would be permitted to redact from material contract exhibits confidential information that is not material and would cause competitive harm—the (b)(4) basis of confidentiality—if publicly disclosed, without having to submit an unredacted copy and  formal confidential treatment request in advance to the staff, as is currently required. Assuming the new process is implemented, the staff will need to determine how to monitor compliance to become comfortable that companies are rigorous in redacting narrowly and have the right steps in place to satisfy (b)(4). (See this PubCo post.)