We are deep into this year’s proxy season, so my next three blogs will be on recurring issues.
Whenever I prattle on about the recent spike in litigation over executive compensation, clients usually (eventually) ask me, "Mike, what is the most important thing we need to look out for this year?"
Readers will recall that in September 2014, the SEC announced a major enforcement action against 34 individuals and corporations for violations of the beneficial ownership reporting requirements of Sections 16(a) and 13(d) and (g) of the Securities Exchange Act of 1934 and corporations’ violations of the Item 405 disclosure requirement of Reg. S-K (the proxy statement). (We described the enforcement action and provided an overview of Section 16(a) and other ownership reporting requirements in our September 2014 blogs.) Since these enforcement actions, we expect that most readers have review and, where necessary, improved their Section 16(a) reporting procedures.
This blog post is a reminder to readers to carefully review their proxy statement Item 405 disclosures this proxy season. In addition to targeting individual insiders, last year’s sweep brought enforcement actions against six companies for failing to disclose Section 16 reporting violations as required under Item 405. The six companies settled with the SEC, agreeing to monetary penalties of $75,000 to $150,000 each.
Item 405 requires a corporation to review the Forms 3, 4 and 5 filed by its insiders (directors, officers, and 10% owners) for the preceding fiscal year and disclose in its proxy statement all known instances where a corporate insider failed to make a Section 16(a) filing or filed one late. It appears that some of the companies subject to the enforcement action had not reviewed or revised their Item 405 disclosures for several years. A number of the violations seem to be attributable to an over-reliance on boilerplate.
For example, two of the companies in the enforcement action had included boilerplate Item 405 disclosure to the effect that all reports were timely filed. However, it was clear even from EDGAR filings that dozens of their required Form 4s were filed late. Another corporation had filed numerous late reports and all it said under Item 405 was that certain directors or executives filed late, which isn’t enough. Another corporation indicated that its compliance with Section 16 reporting requirements was based on written certifications from insiders when in fact it had not obtained any such certifications.
Four of the corporations cited for Item 405 violations were also charged with causing their insiders to violate Section 16(a) by undertaking to file the Section 16 reports for the insiders – which is the common practice among corporations – by filing them late. This is notable because it is the first time, to our knowledge, that the SEC has brought enforcement actions like this against a corporation since the adoption of Section 16. For corporations that file Section 16 reports on behalf of their officers and directors, this could mean that Section 16(a) compliance is now part of the corporation’s legal compliance risk. We don’t expect companies to push this responsibility back onto officers and directors, but boards of directors now have more of a stake in making sure the compliance process is adequate. In addition to the insiders, corporations are now possible enforcement targets when the corporation’s processes and systems fail.
Now that these failures have come to light, we expect the SEC to pay closer attention to the accuracy of the Item 405 disclosures. One of our concerns is that the SEC will bring additional Section 16 enforcement actions in the future. It has not done so yet, but it might after all of the calendar-year companies filing their proxies this spring make their Item 405 disclosures.
Our second concern is that, based on these widely publicized enforcement actions, the plaintiffs’ lawyers will scrutinize corporations’ Item 405 proxy disclosure more carefully than in the past – or for the first time – and be on the lookout for inaccurate Item 405 disclosures.
We strongly urge corporations to take an extra moment to review their insiders’ Form 4 filings for 2014 to verify that all reportable transactions were, in fact, reported and that all reports were filed on time. A delinquency of even one day still must be disclosed under Item 405. We also strongly urge corporations to review their Item 405 disclosure this year’s proxy statement carefully and not make the mistake of simply copying last year’s disclosure without verifying that it is still accurate.