The Current State of Non-GAAP Disclosures

Though traditionally viewed with skepticism, both investors and regulators currently appear to recognize that non-GAAP financial measurements can often be used to provide informative disclosure. As noted recently by Mike Gould, the U.S. public offerings leader at PricewaterhouseCoopers, “I don’t think there’s any stigma around non-GAAP measures these days. The issues are around how … you describe them and making sure you disclosed how you’ve calculated them and what the weaknesses and risks are.”

The SEC continues to comment on non-GAAP metrics, with a focus on registrants who give non-GAAP measures “undue prominence” or fail to clearly describe non-GAAP measures and adjustments in their filings.  For example, the SEC has commented on titles used for non-GAAP financial measure that are confusingly similar to those of GAAP financial measures. But Gould notes that even the SEC has sometimes encouraged issuers to include valid non-GAAP data in their registration statements. According to Gould “They’ll go on your website, they’ll look at your press release,” he says. “If you have a non-GAAP measure you’ve disclosed and talked about in public, they’ll be asking, ‘Why isn’t that in your documents?’”

It has long been acknowledged that non-GAAP measures are not always problematic and can be effectively utilized to illustrate aspects of a company’s business and ongoing operations not readily apparent based on the use of GAAP alone. Although there has been a fair amount of bad press relating to abuses of non-GAAP data  – often by companies excluding costs that would seem to belong in earnings calculations  – companies should still consider using them as and when appropriate to effectively enhance disclosures.


Final Regulations Addressing Stock Plan Requirements for Performance-Based Exemption to Section162(m)

On March 31, 2015, the IRS published its final regulations under Section 162(m) of the Internal Revenue Code.  Code Section 162(m) limits the ability of public corporations to deduct compensation paid to any covered employee (generally a company’s named executive officers, excluding CFO) to the extent that such compensation exceeds $1,000,000 in any taxable year.  Code Section 162(m)(4)(C) provides an exception from the $1,000,000 deduction limit for “performance-based compensation” that meets the requirements specified in that section.

Individual Award Limitations

The final regulations specify that, in order to satisfy these requirements, a stock-based compensation plan must specify the maximum aggregate number of shares with respect to which equity-based awards may be granted to an employee during a specified period. The final regulations provide that this limitation may apply to all types of equity-based awards under the plan, must be specified on a per employee basis, and must be separately disclosed to shareholders when the plan is approved in order to satisfy the shareholder approval requirements.

IPO Transition Rule

The final regulations also address numerous transition rules that apply to newly public corporations. Treasury Regulation Sections 1.162-27(f)(1-3) provide that, when a corporation first becomes publicly held, the $1,000,000 deduction limitation generally does not apply to compensation received pursuant to the exercise of a stock option or stock appreciation right, the substantial vesting of restricted property, or to compensation otherwise paid pursuant to a compensation plan or agreement that existed prior to the corporation becoming publicly held. Therefore, restricted stock and stock options that are granted before the expiration of the transition period (as defined in the regulations) generally remain “grandfathered” even if compensation is not “paid” until after the transition period.  Although many companies have taken the position that this same rule applies to restricted stock units (RSUs), the IRS has stated that RSUs and phantom stock will not qualify for transition relief unless payment is made before the end of the transition period. This clarification in the final regulations only applies with respect to RSUs and phantom stock grants made after March 31, 2015. Therefore, RSUs and phantom stock granted before March 31, 2015, are presumed permissive even if the RSUs or restricted stock do not settle until after the applicable transition period ends.


Dodd-Frank Whistleblower Protection Rule

On April 1, 2015, the SEC issued its first order addressing the permissible limits of employee confidentiality obligations under the regulations implementing the Dodd-Frank Act’s whistleblower provisions. In re KBR, Inc., Exchange Act Release No. 74,619 (Apr. 1, 2015). The order was based on a confidentiality provision used by KBR with employee-witnesses in connection with certain internal investigations that prohibited KBR employees from discussing any particulars regarding their interview with KBR without the prior authorization of the KBR legal department.  Without admitting or denying the charges, KBR agreed to cease and desist from committing or causing any future violations and paid a fine of $130,000.  KBR voluntarily amended its confidentiality statement to make clear that employees are free to report possible violations to the SEC and other federal agencies without KBR approval or fear of retaliation.

The order underscores the SEC’s emphasis on ensuring employees are free to contact the Commission about possible securities law violations. SEC Rule 21F-17(a) provides that “[n]o person may take any action to impede an individual from communicating directly with the Commission staff about a possible securities law violation, including enforcing, or threatening to enforce, a confidentiality agreement…with respect to such communications.”  In order to ensure compliance with SEC Rule 21F-17(a), companies should review any policies, procedures, practices, forms, agreements, plans, or other company documents that subject employees to confidentiality obligations including: codes of conduct, confidentiality policies, employment agreements, termination or severance agreements, releases, severance plans, or other compensation or benefits arrangements.


Conflict Minerals Reporting – Selected Suggestions for 2015

With the filing deadline for the second year of Form SDs and Conflicts Mineral Reports fast-approaching, set forth below are several suggestions for improving this year’s disclosures:

  • Compare your company’s filing against those of competitors and peers, but keep in mind that the pack is going to move, and staying in the pack this year is probably more important than in was last year.
    • If you decided that you weren't subject to the conflict mineral rules last year, look at what Form SDs were filed and see if other companies in similar situations have filed a Form SD (to see if you potentially are an outlier).
  • If your company concludes that it need only file a Form SD (no CMR required) based on your RCOI, explain how your company reached the conclusion that the RCOI was good.
  • Focus on readability and comprehensibility – if your company’s filing is difficult to follow, you are less likely to receive credit for all the hard work you have done.
    • Ask yourself – what does the reader really need to know, and how much detail should I provide?  Then, present it.
    • Organize your filing with subsections for, among other things, program design, due diligence steps undertaken, in-scope products, smelter and refine disclosure, and future action items.  This will be advantageous if you have to have an IPSA in the future.
    • Follow the OECD five-step framework in the discussion of both the design of the framework and in the due diligence measures undertaken.
    • Use Plain English (as you would with your other SEC reports).
  • Build sufficient time into your process to prepare and validate data regarding smelter and refiner information.
  • Keep in mind that if your company indicates in its CMR that it has products that are DRC conflict free, it has to get an audit of the relevant sections of its CMR.  Absent further changes by the SEC, this will be the last year companies will have the option of saying their products are DRC conflict undeterminable.
  • Consider audit readiness and, in particular, whether your OECD framework is completely built out and whether you have documentation to support the assertion that the program was designed in accordance with the OECD framework. 
  • If your company is considering a mock audit, think carefully about whether using the same entity to conduct both a mock audit for management purposes and the formal audit for reporting compliance would create an impairment to auditor independence.
  • While additional context, such as an introduction or a supply chain overview, may be helpful, keep those discussions out of the due diligence section (unless the company identifies those activities as due diligence) and remember that the entire CMR is not subject to the audit. Since the audit is solely focused on due diligence, anything that's not due diligence should be kept outside of that specific section.  If your company is already preparing a public CSR, environmental, or other similar report, these may be the appropriate places for lengthier discussions.
  • Consider a more comprehensive approach to conflict mineral reporting, supply chain, and CSR compliance in order to enhance efficiency, reduce risk, and convey a more consistent compliance message.  

Proposed Amendments to Regulation D (including Form D filing requirements)

When the SEC adopted new Rule 506(c) permitting the general solicitation of investors in connection with certain private placements, it also proposed to amend certain private placement rules to, among other things: (a) require issuers that intend to engage in general solicitation as part of a Rule 506 offering to file the Form D at least 15 calendar days before engaging in general solicitation for the offering; (b) require issuers, within 30 days of completing any Rule 506 offering (whether or not general solicitation was used), to update the information contained in the Form D and indicate that the offering has ended; (c) disqualify issuers from using Rule 506 for one year if they failed to comply, within the past five years, with the Form D filing requirements for a Rule 506 offering; (d) require issuers to include legends and disclosures in written general solicitation materials; and (e) require issuers to submit written general solicitation materials to the SEC no later than the date of first use.

These proposed amendments received a good deal of criticism as being unnecessary, draconian in nature and potentially setting issuers up to inadvertently violate Rule 506.  As of the end of the first quarter of fiscal year 2015, the SEC has not taken action on the proposed rules, and we believe it is unlikely that the SEC plans to act on these proposals in the near future.


Rule 506(c) and General Solicitation Offerings

As noted above, in late 2013 the SEC adopted new rule 506(c) to remove the ban on general solicitation and general advertising in certain private securities offerings.

Despite the excitement about the adoption of this new rule, one source has reported that fewer than 10% of the Form Ds subsequently filed with the SEC checked the box to indicate that they were being filed for a Rule 506(c) general solicitation offering.  The explanations for this low utilization of general solicitation vary, but the general consensus is that the due diligence required to confirm that investors are accredited is cumbersome and the risk of violating the requirements of the rule often outweigh the benefits of being able to generally solicit and advertise an offering of securities. In addition, issuers have to consider whether potential investors will refuse to invest if they are asked to provide the type of personal financial detail required to verify accredited investor status in a Rule 506(c) general solicitation offering.

The JOBS Act also required the SEC to adopt rules to disqualify securities offerings in which certain "bad actors" are participants from reliance on Rule 506 of Regulation D.  The SEC rules disqualify securities offerings from reliance on Rule 506 (including Rule 506 offerings that do not utilize general solicitation) if the issuer or any other participant (as determined under the rule) in the offering is a "bad actor."  In the SEC's adopting release, the final rule takes four pages to define who is and is not a "bad actor" and to establish certain related disclosure requirements.  As an example of certain potential practical consequences of these additional provisions, we have worked with one large investment bank which took the position (rightly or wrongly) that, due to their employment of thousands of broker-dealers, and the many ways that a person can be disqualified as a "bad actor," the investment bank could not effectively assure that it did not have "bad actors." As a result, the investment bank did not want a private placement to a small number of its existing institutional investor clients, for which offering the investment bank was acting as the placement agent, to be characterized as a Rule 506 offering. 

It appears that, as a result of the requirements associated with Rule 506(c) general solicitation offerings, combined with the added "bad actor" complexity and potential disqualification, the JOBS Act's required changes to Rule 506 have, at least thus far, on balance not facilitated any material increase in Rule 506 capital raising transactions. 


Broken Windows

Roughly one year has passed since SEC Chairman Mary Jo White publicly declared that the agency would pursue “all types of violations of our federal securities laws, big and small,” comparing the new approach to the “no broken windows” policy used by New York City authorities to set a tone of legal compliance by combating even small crimes.  Some of the SEC’s recent enforcement activity appears to reflect the SEC’s adoption of that approach.

On March 14, 2015, the SEC charged eight officers, directors or major shareholders for failing to update their Schedule 13D beneficial ownership reports to reflect material changes in connection with going private transactions. According to the SEC, each person charged "took steps to advance undisclosed plans to effect going private transactions" without timely amending the required ownership reports.

Generally, a Schedule 13D must be filed when a person or group directly or indirectly acquires more than 5% of a reporting company’s voting securities. Schedule 13D requires disclosure of, among other things, the purpose of the acquisition, including any plans to cause an extraordinary corporate transaction such as a merger, reorganization or going private transaction. Material changes to the Schedule 13D disclosures, including the shareholder’s plans to cause an extraordinary corporate transaction, must be reported promptly through an amendment to the Schedule 13D.

In the above actions, the SEC determined that the charged persons engaged in a number of activities in anticipation of a going private transaction, including obtaining waivers from preferred shareholders, determining the form of the going private transaction, assisting with shareholder vote projections, informing company management of the intention to privatize the company and forming a consortium of shareholders to participate in the transaction.  Despite these actions, the shareholders did not amend their Schedule 13D filings to report the changes in their plans until months later.

Some of the charged persons were also found to have violated Section 16(a) of the Securities Exchange Act of 1934 by failing to disclose transactions on Form 4 within the two-day window. In one case, transactions went unreported until years later. Each of the charged persons consented to the entry of a Cease-and-Desist Order and agreed to pay a fine to the SEC.

These recent orders underscore the importance of careful planning in connection with the consideration of any going private transaction with close attention to when disclosure is required. These cases also highlight the fact that commonly-used generic disclosures in a Schedule 13D about future plans that reserve the right to engage in future transactions will often not suffice when the Schedule 13D filer changes its plans.


Activist shareholders: Will a surprise be on the agenda at a future shareholders meeting?

According to a report released by Moody’s Investors Service on April 7, 2015, shareholder activism continues to rise through the first quarter of 2015 as activists targeted 26% more North American companies during the first quarter of 2015 than in the same period in 2014. 

To protect against the possibly detrimental effects of shareholder activism, companies should address three areas:  advance notice requirements, shareholder-called special meetings, and shareholder actions by written consent.  Companies should consider reviewing their bylaws and articles of incorporation to determine whether they have in place (i) proper advance notice requirements and (ii) provisions addressing shareholders’ ability to call a special meeting or act by written consent.  If they are not in place, then (i) a company at some point may find itself with a very short timeframe to address and respond to a shareholder proposal or special meeting demand (or no time to respond to a written consent); and (ii) the interests of an activist shareholder (who may have no fiduciary duties to the company or its shareholders) in the subject matter may not be fully disclosed to the board or to the company’s shareholders. 

Control of a company can ultimately be affected by how these matters are managed.  Preparation can be critical. 

Advance Notice Provisions

Activist shareholders sometimes seek to nominate directors or propose matters to be voted upon at a shareholders meeting.  Advance notice requirements, which are typically in a company’s bylaws, are generally intended to:

  • provide the company’s board of directors with adequate time in advance of the meeting to consider a proposed shareholder nomination or matter to be voted upon;
  • provide an opportunity for all shareholders to be fully informed regarding such matters; and
  • enable the board to make informed recommendations or present alternatives to shareholders regarding such matters.

Advance notice bylaw provisions can establish, among other things, certain timing, procedural and informational requirements for shareholders to properly bring director nominations or other proposals before a shareholders meeting.  The time period for the required shareholder notice varies from company to company.  The required notice typically must include information about the shareholder submitting the notice, along with specific information about director nominees or the other item of business proposed to be voted upon at the shareholders meeting.  If a shareholder fails to provide the notice within the timeframe and in accordance with the informational requirements prescribed under the bylaws, the company can typically exclude the proposal at the shareholders meeting.

Without robust advance notice bylaw provisions, a board may be forced to respond quickly to a last-minute proposal without adequate time to develop a response strategy.

Advance notice provisions should also address the fact that certain qualifying shareholders can seek to include certain types of proposals in a public company’s proxy statement under Rule 14a-8 adopted under Section 14(a) of the Securities Exchange Act of 1934, and thereby effectively have the company solicit proxies with respect to such a proposal.  If a Rule 14a-8 proposal is submitted for a regularly scheduled annual meeting, the proposal generally must be received at the company’s principal executive offices not less than 120 calendar days before the date of the company’s proxy statement released to shareholders in connection with the previous year’s annual meeting (or a reasonable time before the company begins to print and send its proxy materials if the company did not hold an annual meeting the previous year or if the date of the annual meeting has been changed by more than 30 days from the date of the previous year’s meeting).  Rule 14a-8 allows a company to exclude proposals regarding certain subjects that are submitted under such rule from the company’s proxy statement.

Shareholder-Called Special Meetings and Action by Written Consent

In certain circumstances, depending on the applicable state law as well as a company’s articles of incorporation and bylaws, a shareholder may have the right to call a special meeting of shareholders.  This right can play a significant role in a takeover attempt.  As a matter of takeover preparedness, many companies have eliminated the ability of shareholders to call a special meeting.  However, an amendment to the company’s articles of incorporation or bylaws by a board of directors, without a shareholder vote, that eliminates the ability of shareholders to call a special meeting could attract negative attention and criticism from proxy advisory services such as Institutional Shareholder Services (ISS).

Where a company’s shareholders have the ability to call a special meeting, a company should review its governing documents and consider revising them to, among other things, ensure that (i) the company can determine whether the shareholders seeking to call a special meeting are entitled to do so and have disclosed their relevant interests and (ii) the board of directors has time to gather information and give due consideration to a shareholder demand for a special meeting and to respond appropriately in the best interests of the company and its shareholders. 

As in the case where provisions allow one or more of a company’s shareholders to call a special meeting, the provision for action by less than unanimous written shareholder consent without a meeting can create opportunities for activist shareholders.  If a company has such provisions for shareholder action by written consent without a meeting, this shareholder capability could potentially enable a would-be hostile acquirer or other activist investor to act quickly before a board has had time to respond appropriately in the best interests of the company and all its shareholders.  A company evaluating its preparedness for activist investors should review the ability of its shareholders to act by written consent and consider revising its governing documents, if necessary and appropriate.


U.S. Supreme Court Rules on Liability Standard for Statements of Opinion

Seller Beware

In addition to information directly stated in a registration statement, information disclosed in a Form 10-Q, 10-K or 8-K or proxy statement is often incorporated by reference into a registration statement. On March 24, 2015, in Omnicare Inc. v. Laborers District Council Construction Industry Pension Fund, the U.S. Supreme Court has given issuers reason to pause as they prepare their next registration statement or other SEC filing that will be incorporated by reference into a registration statement.

Based on the Omnicare decision, issuers should be more cautious about expressing opinions directly in a registration statement or in documents that will be incorporated by reference into a registration statement. Issuers should now give increased consideration to, among other things:

  • whether to disclose an opinion;
  • the adequacy of the basis for that opinion; and
  • whether the basis for that opinion should be disclosed or whether additional “hedges, disclaimers, and apparently conflicting information” should be disclosed (and, if so, where) to avoid an arguable implication that the issuer has done more than it has actually done in forming the opinion. 

Of course, while Omnicare leaves an open door for issuer liability for statements of opinion, characterizing a position as an opinion (where the opinion asserted is reasonable and genuinely held), as opposed to a statement of fact, remains a generally safer approach to disclosure when an issuer decides to include disclosure with respect to a matter that is not entirely certain.

Case Overview

On March 24, 2015, the U.S. Supreme Court held, in Omnicare Inc. v. Laborers District Council Construction Industry Pension Fund, that liability under Section 11 of the Securities Act of 1933 does not attach to a statement of opinion in a registration statement simply because the opinion is objectively incorrect.

The case arose out of the following statements made in Omnicare’s registration statement for a public offering in December 2005:

  • “We believe our contract arrangements with other healthcare providers, our pharmaceutical suppliers and our pharmacy practices are in compliance with federal and state laws.”
  • “We believe that our contracts with pharmaceutical manufacturers are legally and economically valid arrangements that bring value to the healthcare system and the patients that we serve.”

These statements of opinion were accompanied by some caveats, including mentions of state-initiated enforcement actions regarding manufacturer payments for pharmacies that dispense their products and the possibility that laws relating to the practice might in the future be interpreted in a manner inconsistent with Omnicare’s interpretation and application. Apparently, Omnicare’s belief was misguided, as Omnicare later paid nearly $200 million in settlements with government agencies following a whistleblower action regarding kickback payments.

In the opinion authored by Justice Elena Kagan, the Court established the liability standard for statements of opinion under Section 11 of the Securities Act. The Securities Act provides for strict liability if a registration statement (a) contains an untrue statement of a material fact or (b) omits a material fact that renders a statement made in the registration statement misleading. Unlike Section 10(b) of the Securities Exchange Act of 1934, liability attaches regardless of whether the issuer knew that the statements were false.

The Court held that a statement of opinion can only be an untrue statement of a material fact if it is subjectively untrue – i.e., the speaker did not in fact hold that belief. A sincere statement of pure opinion is not an untrue statement of material fact regardless of whether an investor can ultimately prove the belief wrong. The holding at this point is consistent with the Court’s prior holding inVirginia Bankshares v. Sandberg, which addressed liability for statements of opinion in the Section 10(b) context. Accordingly, Omnicare’s statement that it believed that it was in compliance with law, although incorrect, could give rise to liability only by establishing that Omnicare did not in fact hold this belief.

The Court also noted that if an opinion contains an imbedded statement of fact that is incorrect, there would be an untrue statement of fact. “Accordingly, liability under Section 11’s false-statement provision would follow (once again, assuming materiality) not only if the speaker did not hold the belief she professed but also if the supporting fact she supplied were untrue,” the Court stated.  As an illustration of an opinion that contains an imbedded statement of fact, the court used the hypothetical statement, “I believe our TVs have the highest resolution available because we use a patented technology to which our competitors do not have access.”

Omission-Based Claims Related to Opinions

The Court next considered whether the omission of a fact can make a statement of opinion, even if literally genuinely held, misleading to an ordinary investor. The Court noted that reasonable investors may “understand an opinion statement to convey facts about how the speaker has formed the opinion.”

The Court concluded that an investor can reasonably expect:

not just that the issuer believes the opinion (however irrationally), but that it fairly aligns with the information in the issuer’s possession at the time. Thus, if the registration statement omits material facts about the issuer’s inquiry into or knowledge concerning a statement of opinion, and if those facts conflict with what a reasonable investor would take from the statement itself, then §11’s omissions clause creates liability.

The Court noted that SEC-filed registration statements are formal documents and that:

Investors do not, and are right not to, expect opinions contained in those statements to reflect baseless, off the-cuff judgments, of the kind that an individual might communicate in daily life. At the same time, an investor reads each statement within such a document, whether of fact or of opinion, in light of all its surrounding text, including hedges, disclaimers, and apparently conflicting information.

The Court also stated, “All else equal, a reasonable person would think that a more detailed investigation lay behind the former statement.”

For example, the Court said that the statement “we believe our conduct is lawful” could potentially be misleading if the issuer has not in fact consulted a lawyer. Accordingly, the Court held that when a registration statement omits material facts about the issuer’s inquiry into or knowledge concerning a statement of opinion, and if those facts conflict with what a reasonable investor would take from the statement itself, the statement of opinion may be actionable under Section 11.

Consequences of Omnicare

Registration statements customarily include numerous statements of opinion about the issuer’s business and financial condition. The Omnicare decision opens the door for issuer liability for statements of opinion, but the Court has attempted to set a high bar for pleading such a case. The investor must identify particular (and material) “facts about the inquiry the issuer did or did not conduct or the knowledge it did or did not have” whose omission makes the statement misleading to a reasonable person. The Omnicare case underscores the importance of proper diligence to assure that all statements of opinion in a registration statement are genuinely held and disclosed in the proper context.

The Court ultimately remanded the case for further proceedings on plaintiffs’ omission claim.  How the lower court applies the standard articulated by the Court to the plaintiffs’ allegations and whether it permits plaintiffs to replead could provide an initial indication regarding the viability of Section 11 opinion omission-based claims. The practical effect of the Omnicare decision on Section 11 litigation will be determined over time as claims are made and settled and courts apply the standards articulated by the Court to cases before them.  The waters may remain muddy for some time with respect to omission-based Section 11 claims related to opinions.  Until the water clears, issuers should use increased caution in deciding whether and how to disclose opinions in registration statements, including SEC filings incorporated into them.