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In this Issue:
Reminder: Form 8-K Reporting on “Say-on-Pay Frequency”
Many public companies have held, or will hold, their second “say-on-pay frequency” vote at their 2017 annual shareholders’ meeting. Companies generally must disclose the voting results of matters submitted to shareholders within four business days following the annual meeting of shareholders in a current report on Form 8-K under Item 5.07(b). Voting results may also be reported in a Form 10-Q or Form 10-K that is filed on or before the date that the Form 8-K is due.
Because the say-on-pay frequency vote is an advisory vote and nonbinding, companies must take action to determine the frequency of the vote (every one, two or three years) going forward. Item 5.07(d) of Form 8-K requires disclosure of “the company’s decision in light of [the shareholder] vote as to how frequently the company will include a shareholder vote on the compensation of executives in its proxy materials …” This disclosure is required even if the company included its recommendation for say-on-pay frequency in the proxy statement and shareholders supported the company’s recommendation. Many companies make this disclosure in the post-meeting Form 8-K reporting voting results; however, Item 5.07(d) of Form 8-K allows companies up to 150 calendar days after the annual meeting to disclose their say-on-pay frequency determination, so long as the disclosure is made no later than 60 calendar days prior to the deadline for shareholder proposals for the next year’s annual meeting of shareholders. If the voting results were disclosed in a Form 8-K without a say-on-pay frequency determination, the frequency determination must be later disclosed by amending that Form 8-K (by filing a Form 8-K/A), rather than by filing a new Form 8-K. If a company reported voting results on Form 10-Q or Form 10-K, the Item 5.07(d) disclosure can be made in a new Form 8-K under Item 5.07, rather than in an amendment to the Form 10-Q or Form 10-K. (See SEC Division of Corporation Finance, Compliance and Disclosure Interpretations, Exchange Act Form 8-K-Question 121A.04.)
In 2011, when the say-on-pay frequency disclosure rules were relatively new, hundreds of companies failed to timely make the Item 5.07(d) disclosure on the company’s determination as to the frequency of their “say-on-pay” vote. Failure to timely make the Form 8-K disclosures required under Item 5.07 can be problematic for companies planning on raising capital, because the disclosure failure can result in Form S-3 eligibility for 12 months unless a waiver is granted by the SEC. While the SEC generally granted waivers on a case-by-case basis for failure to make the required disclosures in 2011, such waivers will likely be more difficult to come by going forward. Speaking at a conference in 2012, Meredith Cross, then director of the SEC’s Division of Corporate Finance, commented that the failure of many companies to amend their Form 8-Ks following the first say-on-pay frequency vote “shouldn’t be a recurring problem.” In addition, companies should bear in mind the staff is generally reluctant to grant eligibility waivers and will do so “only under very limited circumstances.” (See SEC Division of Corporation Finance, Compliance and Disclosure Interpretations, Securities Act Forms ‒ Question and Answer 101.01.) Companies should make sure that the required disclosure has been made or take action to file an amendment to the post-meeting Form 8-K, if necessary.
There are some companies that do not need to address say-on-pay frequency this year. In particular, smaller reporting companies were exempt from holding a say-on-pay or say-on-pay frequency vote until their 2013 annual meeting, so they will not be required to hold a say-on-pay frequency vote until 2019. In addition, emerging growth companies (EGCs) are exempt until after they cease to be classified as EGCs. Unlike with respect to the say-on-pay vote, however, the statute does not provide an explicit transition period for the first say-on-pay frequency vote, so it appears that the say-on-pay frequency vote would be required at the first annual meeting taking place after the company ceases to be an EGC. Other companies that will not need to hold a say-on-pay frequency vote in 2017 include those that held a say-on-pay frequency vote after 2011, such as those that became public or assumed reporting obligations after 2011. For these companies, the say-on-pay frequency vote will not be on the ballot again until the sixth anniversary of the previous vote.
PCAOB Adopts Changes to the Auditor’s Report to Require Disclosure of Critical Audit Matters
On June 1, 2017, the Public Company Accounting Oversight Board (PCAOB) adopted a new auditor reporting standard, The Auditor’s Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion (AS 3101) that requires the auditor to provide new information about the audit and make the auditor’s report more informative and relevant to investors. The new standard retains the pass/fail opinion of the existing auditor’s report but makes significant changes to the existing auditor’s report, including the following:
- Communication of critical audit matters (CAMs) – Matters communicated or required to be communicated to the audit committee and that (1) relate to accounts or disclosures that are material to the financial statements and (2) involved especially challenging, subjective or complex auditor judgment
- Disclosure of auditor tenure – Disclosure of the year in which the auditor began serving consecutively as the company’s auditor
- Clarify auditor’s role and responsibilities – Clarifies standard language about the nature and scope of the auditor’s existing responsibilities, including:
- Disclosure of auditor independence – Disclosure that the auditor is required to be independent
- New error or fraud language – The addition of the phrase “whether caused by error or fraud,” to be used in the description of the auditor’s responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatements; the existing standard does not require the auditor’s report to contain the phrase “whether due to error or fraud”
- Addressed to shareholders and the board – The audit report will be addressed to the company’s shareholders and board of directors, with additional addressees permitted
- Financial statement notes – Identification of the financial statements, including the related notes and, if applicable, schedules, as part of the financial statements that were audited; under the existing standard, the notes to the financial statements and the related schedules are not identified as part of the financial statements
- Nature of the audit – The description of the nature of the audit reflected the auditor’s responsibilities in a risk-based audit and aligned the description with the language in the PCAOB’s risk assessment standards, including:
- Performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks
- Examining, on a test basis, appropriate evidence regarding the amounts and disclosures in the financial statements
- Evaluating the accounting principles used and significant estimates made by management
- Evaluating the overall presentation of the financial statements
- More helpful and standardized format – The audit opinion will appear in the first section of the auditor’s report, and section titles have been added to guide the reader
Critical Audit Matters
Communicated or required to be communicated to the audit committee
Under the new standard, a CAM is defined as any matter arising from the audit of the financial statements that was required to be communicated to the audit committee (even if not actually communicated) and matters actually communicated (even if not required) that are related to accounts or disclosures that are material to the financial statements and involved especially challenging, subjective or complex auditor judgment. It will include auditor communication requirements under AS 1301, Communications with Audit Committees, other PCAOB rules and standards, and applicable law, as well as communications made to the audit committee that were not required.
Required communications to the audit committee generally include the areas in which investors have expressed particular interest in obtaining information in the auditor’s report, such as significant management estimates and judgments made in preparing the financial statements, areas of high financial statement and audit risk, significant unusual transactions, and other significant changes in the financial statements. The new standard does not limit the source of CAMs to critical accounting policies and estimates, nor does it exclude from the source of CAMs certain required audit committee communications that relate to sensitive areas (e.g., corrected and uncorrected misstatements, qualitative aspects of significant accounting policies and practices, alternative treatments within GAAP, independence considerations, disagreements with management, overall planned audit strategy, delays encountered in the audit, and competency issues of management) and that could result in the auditor communicating information not disclosed by management. To the extent that any such communication qualifies as a CAM (including that it (1) relates to accounts or disclosures that are material to the financial statements and (2) involved especially challenging, subjective or complex auditor judgment), it will be an appropriate subject for an auditor to communicate.
Relates to Accounts or Disclosures That Are Material to the Financial Statements
The new standard provides that each CAM relates to accounts or disclosures that are material to the financial statements, which means that the CAM could be a component of a material account or disclosure and does not necessarily need to correspond to the entire account or disclosure in the financial statements. For example, the auditor’s evaluation of the company’s goodwill impairment assessment could be a CAM if goodwill was material to the financial statements, even if there was no impairment. The CAM would relate to goodwill recorded on the balance sheet and the disclosure in the notes to the financial statements about the company’s impairment policy and goodwill. In addition, a CAM may not necessarily relate to a single account or disclosure but could have a pervasive effect on the financial statements if it relates to many accounts or disclosures. For example, the auditor’s evaluation of the company’s ability to continue as a going concern could also qualify as a CAM depending on the circumstances of a particular audit.
On the other hand, a matter that does not relate to accounts or disclosures that are material to the financial statements cannot be a CAM. For example, a potential loss contingency that was communicated to the audit committee, but that was determined to be remote and was not recorded in the financial statements or otherwise disclosed under the applicable financial reporting framework, would not meet the definition of a CAM. The same rationale would apply to a potential illegal act if an appropriate determination was made that disclosure was not required in the financial statements.
Similarly, the determination that there is a significant deficiency in internal control over financial reporting does not qualify as a CAM because it does not relate to an account or disclosure that is material to the financial statements. However, a significant deficiency could be among the principal considerations that led the auditor to determine that a matter is a CAM.
Involved Especially Challenging, Subjective or Complex Auditor Judgment
The determination of whether a matter qualifies as a CAM is principles-based. The new standard does not specify any items that would always constitute CAMs. For example, not all matters determined to be “significant risks” under PCAOB standards would qualify as CAMs because not every significant risk would involve especially challenging, subjective or complex auditor judgment. For example, improper revenue recognition is a presumed fraud risk, and all fraud risks are significant risks; however, if a matter related to revenue recognition does not involve especially challenging, subjective or complex auditor judgment, it will not be considered a CAM. In accordance with the new standard, material related-party transactions or matters involving the application of significant judgment or estimation by management do not qualify as CAMs, unless the auditor determines, in the context of the specific audit, that the matter involved especially challenging, subjective or complex auditor judgment. The PCAOB believes that focusing on the auditor’s judgment should limit the extent to which expanded auditor reporting could become duplicative of management’s reporting. The PCAOB also believes that CAMs reflecting differences in auditors’ experience and competence will also be informative.
In determining whether a matter involved especially challenging, subjective or complex auditor judgment, the auditor should take into account, alone or in combination, certain nonexclusive factors, including:
- The auditor’s assessment of the risks of material misstatement, including significant risks
- The degree of auditor judgment related to areas in the financial statements that involved the application of significant judgment or estimation by management, including estimates with significant measurement uncertainty
- The nature and timing of significant unusual transactions and the extent of audit effort and judgment related to these transactions
- The degree of auditor subjectivity in applying audit procedures to address the matter or in evaluating the results of those procedures
- The nature and extent of audit effort required to address the matter, including the extent of specialized skill or knowledge needed or the nature of consultations outside the engagement team regarding the matter
- The nature of audit evidence obtained regarding the matter
The new standard requires the auditor to communicate in the auditor’s report any CAMs arising from the current period’s audit of the financial statements or state that the auditor determined that there are no CAMs. Once an auditor decides that a CAM needs to be included in the report, the auditor would (1) identify the CAM, (2) describe the principal considerations that led the auditor to determine that the matter is a CAM, (3) describe how the CAM is addressed in the audit and (4) refer to the relevant financial statement accounts or disclosures.
Some investors believe that CAMs will highlight areas that they may wish to emphasize in their engagement with the company and provide important information that they can use in making proxy voting decisions, including ratification of the appointment of auditors.
Excluded Companies from CAM Disclosures
The new standard will generally apply to audits conducted under PCAOB standards. Communication of CAMs is not required for audits of brokers and dealers, investment companies other than business development companies, benefit plans, and emerging growth companies; however, auditors of these entities may choose to include CAMs in the auditor’s report voluntarily. The other requirements of the new standard will apply to these audits.
Subject to approval by the Securities and Exchange Commission (SEC), the new standard will take effect as follows:
- All provisions other than those related to CAMs will take effect for audits of fiscal years ending on or after December 15, 2017.
- Large accelerated filers – Provisions related to CAMs will take effect for audits of fiscal years ending on or after June 30, 2019
- All other companies not excluded – Provisions related to CAMs will take effect for audits of fiscal years ending on or after December 15, 2020
This proposed timeline should provide accounting firms, companies and audit committees time to prepare for implementation of the CAM requirements, which are expected to require more effort to implement than are the additional improvements to the auditor’s report. Auditors may elect to comply before the effective date, at any point after SEC approval of the new standard.
Expectations of the New Standard
We expect the new standard to present meaningful challenges for public companies and their audit committees with respect to their disclosures and the dynamics of their interactions with the auditors. The new standard recognizes that the audit report may disclose a company’s nonpublic information as part of the CAM communications if that information is needed to describe the principal considerations that led to the CAM determination or how the CAM was addressed in the audit. In addition, the auditor’s insistence that certain CAM-related disclosures be included in the auditor’s report may impact a public company’s disclosure in other areas. For example, public companies already provide substantial disclosures regarding their accounting practices, policies and processes, particularly in the risk factors and MD&A section, and often have to contend with the auditor’s desire or suggestion to include additional (viewed as either clarifying or unnecessary, depending on your perspective) disclosures.
There is also likely to be additional pressure between management and the auditors to understand how the auditor intends to approach CAM disclosure with respect to the company, which existing accounting policies and practices would be likely to receive a CAM designation, and extensive discussions about what CAM disclosure would look like for those matters. As these discussions evolve, it will be interesting to see whether companies provide additional details of the communications with their auditors in the proxy statement in areas such as the audit committee report (which is furnished rather than filed), ratification of the independent auditor proposal (which is not required but is a matter of good corporate practice), a summary of the audit committee’s responsibilities or discussion related to the board of directors’ role in risk oversight. In that regard, we are mindful that only a handful of companies have volunteered additional disclosures, whether in the audit committee report or elsewhere in the proxy statement, in light of the SEC’s encouragement to do so in its 2015 concept release regarding possible revisions to its audit committee disclosures. We certainly encourage companies to engage in these discussions sooner rather than later to minimize these issues and to allow senior management and the board of directors time to consider these issues well in advance of finalizing their financial statements and substantive disclosures. This is not a discussion a public company wants to wrap up the week its public filing is due.
There is also likely to be additional pressure between management and the auditors to understand how the auditor intends to approach CAM disclosure with respect to the company, which existing accounting policies and practices would be likely to receive a CAM designation, and extensive discussions about what CAM disclosure would look like for those matters. As these discussions evolve, it will be interesting to see whether companies provide additional details of the communications with their auditors in the proxy statement in areas such as the audit committee report (which is furnished rather than filed), ratification of the independent auditor proposal (which is not required, but is a matter of good corporate practice), a summary of the audit committee’s responsibilities or as part of the discussion related to the board of directors’ role in risk oversight. In that regard, we are mindful that only a handful of companies have volunteered additional disclosures, whether in the audit committee report or elsewhere in the proxy statement, in light of the SEC’s encouragement to do so in its 2015 concept release regarding possible revisions to its audit committee disclosures. We certainly encourage companies to engage in these discussions sooner rather than later to minimize these issues and to allow senior management and the board of directors time to consider these issues well in advance of finalizing their financial statements and substantive disclosures. This is not a discussion a public company wants to wrap up the week their public filing is due.
 The PCAOB release contains a helpful chart that summarizes the critical audit matter analysis.  See Appendix B of AS 1301, which identifies other PCAOB rules and standards that require audit committee communication.  See, e.g., Section 10A(k) of the Exchange Act;, Rule 2-07 of Regulation S-X;, and Exchange Act Rule 10A-3.  See Possible Revisions to Audit Committee Disclosures, SEC Rel. No. 33-9862 (July 1, 2015) (e.g., Section VI.A.1.).
Why the Future of Dodd-Frank May Depend on CHOICE Act 2.0
Repealing or substantially modifying the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) remains a top priority of Republican lawmakers. The latest attempt to do so is in the form of a comprehensive regulatory reform bill labeled the Financial CHOICE Act of 2017 (CHOICE Act 2.0), which was introduced by the bill’s sponsor, Jeb Hensarling, R-Texas, chairman of the House Financial Services Committee, in April 2017. CHOICE Act 2.0 is a modified version of the original bill, the Financial CHOICE Act of 2016, which was introduced by Chairman Hensarling in June 2016 to the House Financial Services Committee but failed to advance to the U.S. House of Representatives. CHOICE Act 2.0 passed the House Financial Services Committee on May 4, 2017, and passed the U.S. House of Representatives on June 7, 2017, in a party-line vote (233 to 186). All but one Republican voted for CHOICE Act 2.0, and all Democrats opposed it. Although the bill now must be approved by the U.S. Senate, it is not expected to receive the required 60 votes to pass, unless it undergoes substantial revisions to garner Democratic support. However, it is possible that portions of the proposed legislation may be passed by the Senate.
Despite the uncertainty, it is clear that Republican lawmakers will continue to seek regulatory reforms, whether through CHOICE Act 2.0 or some other legislation. It seems equally clear that any proposed reform passed by the House of Representatives will likely be subject to significant negotiations and extensive modification during the legislative process, at least in the Senate. Regardless, CHOICE Act 2.0 provides valuable insight as to the areas on which Republican lawmakers are focused and the provisions that may be targeted for repeal or modification. We urge companies to continue to monitor the status of these proposals and, in cases where rules promulgated as a result of Dodd-Frank are set to take effect, to continue to prepare for implementation.
Below is a summary of the key provisions of Dodd-Frank that may be affected by CHOICE Act 2.0. We have also included other notable provisions of CHOICE Act 2.0 that, if approved, would impact capital formation.
Pay ratio ‒ Item 402(u) of Regulation S-K, which was promulgated as a result of the requirements of Dodd-Frank, requires public reporting companies to disclose their median employee’s total annual compensation as a ratio to the total annual compensation of their chief executive officer (Pay Ratio Rule). The Pay Ratio Rule is effective beginning on a company’s first fiscal year beginning on or after January 1, 2017. Thus, most reporting companies will be required to include pay ratio disclosure in their proxies during the 2018 proxy season. If passed, CHOICE Act 2.0 would repeal the Dodd-Frank requirement for adoption of the Pay Ratio Rule.
In February 2017, then-acting chairman of the Securities and Exchange Commission (SEC), Michael S. Piwowar, issued a public statement questioning the Pay Ratio Rule, directed the SEC to reexamine the rule, and asked the public to submit comments on any unexpected challenges experienced and whether relief is needed. During the 45-day comment period, the SEC received approximately 180 comment letters, of which approximately 85 percent were in favor of the Pay Ratio Rule, as well as approximately 14,000 form letters in favor of pay ratio disclosures.
We recommend that public reporting companies continue to prepare for implementation of the Pay Ratio Rule, as any relief or delay in the implementation is uncertain and, as more time passes, looks less and less likely. This is particularly important because CHOICE Act 2.0 would only eliminate the Dodd-Frank provision requiring the adoption of the Pay Ratio Rule. It would not result in a repeal of Item 402(u) of Regulation S-K, which would require additional regulatory action to accomplish.
Hedging ‒ Dodd-Frank mandated that the SEC adopt rules requiring companies to disclose whether they allow their directors and employees to engage in hedging transactions related to company securities. The SEC has not yet adopted final rules. Under CHOICE Act 2.0, the SEC would no longer be required to adopt final rules. Many companies have already begun to adopt policies related to hedging transactions; thus, regardless of CHOICE Act 2.0 or other legislation, these policies may become “best practices” for public reporting companies.
Say-on-pay and say-on-pay frequency ‒ Section 14(a) of the Securities Exchange Act of 1934, as amended (Exchange Act), requires public reporting companies to submit to stockholders an advisory vote to approve the executive compensation paid to named executive officers (say-on-pay), and also an advisory vote to determine how often the say-on-pay vote must occur (say-on-pay frequency). CHOICE Act 2.0 would amend Section 14(a) of the Exchange Act to solely require a say-on-pay vote when there is a material change to the executive compensation program; thus, eliminating the say-on-pay frequency vote requirement. Regardless of whether CHOICE Act 2.0 becomes law, we expect that companies will continue to face pressure from stockholders or institutional shareholder organizations, such as ISS, to allow stockholders to provide feedback on a company’s executive compensation policies through similar advisory votes or other mechanisms.
Executive compensation clawbacks ‒ Section 10D of the Exchange Act requires national securities exchanges to have listing standards requiring listed companies to “clawback” incentive-based compensation from any current or former executive officer in the event of a financial restatement. CHOICE Act 2.0 would amend Section 10D of the Exchange Act to limit the clawback to those current or former executive officers who had control or authority over the company’s financial reporting that resulted in the financial restatement.
Accredited investor status ‒ Dodd-Frank mandated the SEC to increase the dollar thresholds for accredited investor status every four years. CHOICE Act 2.0 would amend Section 2(a)(15) of the Securities Act of 1933, as amended (Securities Act), to create a new statutory definition of “accredited investor” that would fix the income test at $200,000 (or $300,000, including income attributable to a spouse), but would adjust the net worth test, which is currently set at $1 million, for inflation every five years.
Separately, the U.S. House of Representatives passed legislation in February 2017 that would include in the definition of “accredited investor” anyone who is licensed or registered with the SEC as a broker or investment advisor or “whose demonstrable education or job experience qualifies as professional knowledge of a subject related to a particular investment, and whose education or job experience is verified by FINRA or an equivalent self-regulatory organization.” Also in February 2017, then-acting Chairman Piwowar called for the SEC to increase investor access to private and risky investment strategies that are usually reserved for wealthy individuals, which could come in the form of a change to the current definition of “accredited investor.” The effect of the February 2017 proposed legislation as well as then-acting Chairman Piwowar’s statements indicate the desire on the part of some lawmakers to expand the definition of “accredited investor” to allow more individuals to qualify and participate in riskier investments. Conversely, the amendment proposed by CHOICE Act 2.0 signals the desire to continue to limit those individuals who qualify as an “accredited investor.”
Conflict minerals ‒ In August 2012, the SEC adopted Rule 13p-1 of the Exchange Act as required by Section 1502 of Dodd-Frank. Rule 13p-1 of the Exchange Act requires public reporting companies that manufacture products containing certain minerals to disclose whether the minerals originated from the Democratic Republic of the Congo (DRC) or any country that shares a border with the DRC. CHOICE Act 2.0 would repeal Section 1502 of Dodd-Frank, as well as Sections 1503 and 1504 of Dodd-Frank requiring disclosure of resource extraction and mine safety.
Prior to the House Financial Services Committee approving CHOICE Act 2.0, in April 2017 the SEC’s Division of Corporation Finance issued a public statement that it will not recommend enforcement of the conflicts source and chain of custody due diligence, independent audit, and Conflict Minerals Report requirements set forth in Item 1.01(c) of Form SD, as a result of the April 2, 2017, decision of the U.S. Court of Appeals for the District of Columbia Circuit reaffirming its prior holding regarding the constitutionality of Section 1502 of Dodd-Frank. For more information, please see our prior alert “Conflict Minerals Disclosure – New SEC Guidance.” Except as modified by the SEC’s April 2017 statement, companies were still required to file Form SDs for the 2016 calendar year. It is unclear, however, whether companies will be required to file Form SDs going forward.
Proxy access rules ‒ Dodd-Frank granted the SEC authority to adopt mandatory proxy access rules. Pursuant to such authority, the SEC adopted Rule 14a-11 under the Exchange Act to give stockholders meeting certain criteria the ability to include director nominees in a company’s proxy statement. Litigation regarding the validity of the rule ensued, with the U.S. Court of Appeals for the District of Columbia Circuit ultimately vacating Rule 14a-11.
After the court’s decision, the SEC implemented changes to Rule 14a-8, requiring companies to include in their proxy materials stockholder proposals addressing the director nomination process. Under Rule 14a-8, a stockholder who holds 1 percent or $2,000 of the company’s voting securities for at least one year and submits a proposal at least 120 days before the anniversary of the previous year’s proxy mailing may submit a 500-word proposal for inclusion in the company’s proxy statement. Effectively, Rule 14a-8 empowers stockholders to make the decision on proxy access, and the applicable standards, on a company-by-company basis instead of through universally applicable procedures.
CHOICE Act 2.0 would repeal the SEC’s authority to issue mandatory proxy access rules. However, this is not expected to impact many companies because they have already adopted proxy access provisions in their bylaws in response to stockholder pressure or as “best practices.” We expect companies to continue to adopt these measures regardless of whether the SEC’s authority to adopt proxy access rules is repealed.
In addition, CHOICE Act 2.0 would direct the SEC (1) to amend Rule 14a-8 to require a stockholder to hold 1 percent ownership of a company’s voting securities for three years (instead of the current $2,000 worth of voting securities for one year) to be eligible to submit a proposal, (2) to increase the required voting success thresholds for resubmission of a stockholder proposal, and (3) to prohibit a company from including in its proxy materials a stockholder proposal submitted by a person in such person’s capacity as a proxy, representative or agent. Finally, CHOICE Act 2.0 would amend Section 14 of the Exchange Act to prohibit the SEC from adopting a “universal proxy” ballot in contested director elections.
Disclosure of board leadership structure ‒ Dodd-Frank requires disclosure in annual proxy statements as to why a company chose its current board leadership model. Prior to the enactment of Dodd-Frank, Item 407(h) of Regulation S-K substantially required this disclosure. CHOICE Act 2.0 would repeal the Dodd-Frank provision requiring this disclosure; however, it would not repeal Item 407(h) of Regulation S-K, which would require additional regulatory action to accomplish.
Other notable capital formation provisions contained in CHOICE Act 2.0 are discussed below:
Definition of “general solicitation” ‒ CHOICE Act 2.0 would direct the SEC to revise the definition of “general solicitation” in Regulation D under the Securities Act so that it does not cover advertisements for meetings with issuers sponsored by angel investor groups, venture forums, venture capital associations and certain other entities (as long as the advertisement does not reference a specific securities offering), or apply to the meetings themselves, as long as only specified information about the issuers’ securities offerings is presented at the meetings.
Expansion of Form S-3 eligibility ‒ CHOICE Act 2.0 would expand Form S-3 eligibility to include any registrant with listed equity securities, even those registrants that do not meet the $75 million minimum public float requirement.
Extension of state blue-sky preemption ‒ CHOICE Act 2.0 would extend state blue-sky preemption to any security that is listed on a national securities exchange, or tier or segment thereof, as compared with granting blue-sky preemption only to securities listed on the NYSE, NYSE Amex and NASDAQ, and any other national securities exchange whose listing standards are deemed by the SEC to be substantially similar to NYSE, NYSE Amex and NASDAQ.
Registration under Section 12(g) of the Exchange Act ‒ CHOICE Act 2.0 would change the threshold requirement to register under Section 12(g) of the Exchange Act from 500 non-accredited holders to 2,000 and permit companies to deregister once they have fewer than 1,200 holders (as compared with 300).
Nasdaq’s Blueprint to Revitalize U.S. Capital Markets
In what has proven to be a busy spring for various groups to assess the vitality of the financial markets, Nasdaq decided to join the fray as well. In early May, Nasdaq released its blueprint for revitalizing the U.S. capital markets by addressing several critically needed reforms with the hope that it sparks a dialogue – and action – among investors, public and private companies, industry groups, and policymakers.
Nasdaq’s vision is rooted in the belief that robust public markets are the fuel that ignites America’s economic engine and wealth creation. According to Nasdaq, companies list on U.S. stock exchanges to access a steady, dependable stream of capital to grow and create jobs, and investors choose our markets because they are the world’s most trusted venues for long-term wealth creation. Unfortunately, however, Nasdaq believes that many companies are questioning whether the benefits of being a public company are worth the burdens after the U.S. has continued to add layer after layer of obligation. Nasdaq reports that, in recent years, a growing number of companies have chosen to remain private, and some public companies are deciding to stay private.
Nasdaq recognizes, however, that the market dynamics driving opposition to the public markets are complex. These include concerns about (1) shareholder activists, (2) frivolous shareholder litigation, (3) pressure to prioritize short-term returns over long-term strategic growth, and (4) burdensome costs and frustrations with the proxy process as well as onerous disclosure requirements, to name a few. Once public, companies – particularly smaller ones – sometimes find that the cost of accessing equity capital to fund growth can be expensive, given the distributed nature of trading across markets and trading venues today. Therefore, they seek private sources of capital, which, in today’s environment, is abundantly available for many dynamic companies.
According to Nasdaq, the case for strong public markets is overwhelming. Since 1970, 92 percent of job creation has occurred after an IPO. Nasdaq notes that the vast majority of Americans are invested in and count on public markets, either directly through stock ownership or through pension funds, mutual funds and individual retirement accounts. Additionally, with more investors choosing index strategies to meet their investment needs, funds and exchange-traded product providers are relying upon a deep and healthy selection of public companies across industries and at various stages of maturity and growth to provide investors a wide range of index strategies with strong return profiles. Investor access to vibrant and growing public capital markets is a critical driver of wealth creation and financial security for the American people.
Today, pension funds are slowly shrinking and being replaced with defined contribution retirement plans (typically 401(k) plans) as the core savings vehicles for average American workers. Additionally, pension plans allocate only a small percentage of their overall portfolios to private alternative funds because the underlying investments are very illiquid and difficult to value. Defined contribution plans are even more limited in their ability to invest in private securities and private equity funds due to the lack of liquidity and valuation transparency. Therefore, for the foreseeable future, pension funds and most mutual funds serving average investors will continue to rely heavily on the public markets to supply investment opportunities that will help the funds reach their return thresholds. It will get harder and harder to achieve such return thresholds if there are fewer growth-oriented companies entering the public markets.
To address these concerns, Nasdaq provided concrete solutions across three topic areas in its blueprint:
Reconstructing the Regulatory Framework
Over time, an inconsistent regulatory patchwork has clearly developed that under-regulates some areas and over-regulates others. Public companies – and those contemplating an entrance into public markets – are increasingly hamstrung by the complexity and cost of navigating this regulatory maze, and investors are harmed by both the impact of these costs on companies that do go public and the shrinking investment options as more companies avoid going public.
A. Reform the Proxy Proposal Process
While proxy voting can be an important tool to raise legitimate concerns, Nasdaq believes it is far too often used for unhelpful purposes that cause a nuisance and significant financial strain on companies, particularly smaller ones. As a result, Nasdaq proposes a number of simple, commonsense reforms to protect the shareholder voice while filtering out needless and costly annoyances.
1. Raise the minimum ownership amount and holding period to ensure proposals have meaningful shareholder backing
Nasdaq suggests deleting the meaningless dollar threshold (currently $2,000) and instead require a proposing shareholder to hold at least 1 percent of the company’s securities entitled to vote, and increase the holding period to three years. This would ensure that shareholder proposals representing the views of a meaningful percentage of a company’s long-term owners are considered at shareholder meetings.
2. Update the SEC process for removing repetitive, unsuccessful proposals from proxies
Nasdaq believes Congress should significantly increase the shareholder support that a proxy proposal must receive before the same proposal can be reintroduced at future meetings. This concept was recently introduced in the Financial CHOICE Act of 2017. In addition, Nasdaq recommends that the SEC study the categories of topics suitable for shareholder proxies and modify its rules accordingly to ensure that proposals considered at annual meetings are properly placed before shareholders, are meaningful to the business of the company and are not related to ordinary business matters.
3. Create transparency and fairness in the proxy advisory industry
Nasdaq suggests that the SEC require proxy advisory firms to explain their criteria or provide companies a means to question analysis or even correct factual errors. In addition, these firms should be required to disclose whether they have a financial relationship or ownership stake in the companies on which they report.
B. Reduce the Burden of Corporate Disclosure
Nasdaq believes it is time to move away from a one-size-fits-all approach to corporate disclosure. Transparency is critical to healthy markets, but technology and markets have evolved to a point where a reasonable degree of flexibility can allow for disclosure requirements that are shareholder-friendly while reducing the burden on companies.
1. Offer flexibility on quarterly reporting
Nasdaq promotes amending the quarterly reporting process to provide for more flexibility. For example, Nasdaq believes that companies looking to encourage long-termism and reduce costs would benefit from the flexibility to provide full reports semiannually, as has been done in the United Kingdom. Under this approach, companies would be able to update key metrics for any material changes between mandated reports using existing disclosure methods.
2. Streamline quarterly reporting obligations for small- and medium-growth companies
As a practical matter, Nasdaq believes most investors view an earnings press release as a company’s actual quarterly report on Form 10-Q. Yet, despite this view, companies are still required to file a more robust Form 10-Q with the SEC, which is complex, time-consuming, and provides little additional information that cannot be found in the earnings press release. By establishing simple guidelines, the earnings release can replace the Form 10-Q entirely for companies that prefer to report information quarterly, aligning regulatory and shareholder interests.
3. Expand classifications for disclosure relief
Current SEC rules permit certain types of companies, including emerging growth companies, smaller reporting companies and non-accelerated filers, to submit disclosure reports that are robust and transparent but far less burdensome than those required for more mature companies. However, few companies benefit from the spirit of these carve-outs because the definitions to qualify as an “emerging growth company,” “smaller reporting company” or “non-accelerated filer” are narrow and, in some cases, limited in duration. Nasdaq believes the carve-outs should be expanded and simplified by:
- Expanding the JOBS Act’s “test the waters” provisions, allowing emerging growth companies to communicate with certain potential investors and file their registration statement confidentially, to all companies and all capital-raising transactions
- Raising the revenue cap to qualify as an emerging growth company from the current $1 billion (subject to inflation adjustment every five years) to $1.5 billion
- Deleting the current phaseout of emerging growth company status five years after such company’s IPO
- Harmonizing the definitions for “smaller reporting company” and “non-accelerated filer” with that of “emerging growth company” to avoid a patchwork of inconsistent and illogical exemptions
These suggestions dovetail with the SEC’s Disclosure Effectiveness Initiative to simplify disclosure by stripping out unnecessary and duplicative requirements, thereby creating less onerous disclosure requirements for companies and more meaningful disclosure for investors. Similarly, Nasdaq believes that the SEC should consider ways to streamline the offering process by giving all public companies the opportunity to raise capital using simplified and faster “shelf registrations” and reducing the requirements for supplemental forms and other bureaucracy associated with capital raising that serve no meaningful purpose.
4. Roll back politically motivated disclosure requirements
Nasdaq believes there should be a clear distinction between disclosure of material information that investors require to evaluate a company’s financial performance and economic prospects and those that are motivated by social and political causes or otherwise are not relevant to a company’s bottom line. As such, Nasdaq supports the elimination of the currently required reporting of conflicts minerals and executive pay ratio, along with a comprehensive review of all disclosure requirements and the elimination of those that do not have a clear connection with a company’s financial performance, practices and outlook.
C. Litigation Reform
The burden of having to defend meritless class action lawsuits is repeatedly cited by private companies as a major reason why they have not become public reporting companies. Given the trend of third-party investors financing these cases, Nasdaq expects that the number of cases filed will only increase, along with the burden placed on public companies, unless litigation reform is prioritized. The following sets forth the areas Nasdaq believes are necessary to reduce the burden of meritless class actions on public reporting companies.
1. Support legislation currently before Congress that addresses litigation reform
Nasdaq supports legislation reform that would, among other things, (1) ease the standard for imposing sanctions on lawyers bringing frivolous lawsuits, (2) tighten the requirements for granting class certification, (3) facilitate interlocutory appeal of decisions to grant class certification, (4) require disclosure of third-party financing of litigation and (5) limit plaintiff legal fees.
2. Expand the scope of provisions under congressional consideration
Nasdaq also encourages Congress to consider additional provisions that would (1) allow interlocutory appeals from the denial of a motion to dismiss; (2) allow a plaintiff to amend its complaint only once; (3) further codify the standards for pleading with respect to scienter and loss causation, and clarify the exclusive nature of federal jurisdiction over securities claims; (4) require proof of actual knowledge of material misstatements or omissions (as opposed to mere recklessness); and (5) make SEC findings in enforcement consent decrees inadmissible in private litigation.
3. Study longer-term comprehensive reform
Given the significant costs of the current litigation system and questions about whom the system actually benefits, Nasdaq advocates for more comprehensive changes.
D. Tax Reform
Finally, Nasdaq advocates for reform of U.S. tax policies that will promote, rather than discourage, saving and investment in the U.S. economy. Among other items, Nasdaq suggests expanding the tax exemption on the sale of small-business stock to the secondary market by revising Internal Revenue Code Section 1202 to include all qualified domestic corporations. Nasdaq also recommends shortening the ownership tenure requirement from five years to three years, and increasing the maximum asset threshold from $50 million to $100 million. Nasdaq believes this shareholder-friendly move would enable smaller companies to access the public markets. In addition, Nasdaq supports complete elimination of the double taxation of corporate profits through a 100 percent dividends received deduction for holders of qualified domestic corporate stock.
Modernizing Financial Market Structure
Nasdaq believes that the fundamental structure that underpins our financial markets has not evolved to benefit all market segments equally. Accordingly, while efficient markets benefit both issuers and investors, inefficient markets can choke the flow of capital, become a drain on growth and block companies – particularly small- and medium-growth companies – from reaching their fullest potential. As such, Nasdaq proposes new and improved frameworks that account for the different needs among market participants and the fluid nature of our markets.
A. Strengthen Markets for Smaller Companies
Nasdaq believes concentrating disaggregated liquidity onto a single stock exchange, with limited exceptions, will allow investors to better source liquidity, increase price transparency, and result in less dramatic price swings for small- and medium-growth companies and their investors.
B. Give Companies a Choice to Consolidate Liquidity and Improve Trading Quality
By creating a market for smaller companies that is voluntary for companies to join and that is largely exempt from the unlisted trading privileges (UTP) obligations, subject to key exclusions, Nasdaq can concentrate liquidity to reduce volatility and improve the trading experience. Eliminating UTP for small- and medium-growth companies would reduce the number of exchanges authorized to trade them, and, more important, it would allow for liquidity to develop and for supply and demand to find one another.
In addition, Nasdaq proposes the following changes: (1) deploy intelligent tick sizes for small- and medium-growth companies, (2) cultivate innovative market-level solutions that improve the trading of small- and medium-growth companies, (3) implement an intelligent rebate/fee structure that promotes liquidity and avoids market distortions, and (4) ensure fair and reasonable pricing for participants in the context of limiting exchange competition.
Promoting Long-Term Views of Value Creation
Nasdaq believes that in recent years, a variety of market dynamics have started to disfavor long-term investors and long-term corporate strategies. Market participants and the investing community have become less patient with corporate management and boards of directors, as well as their overarching strategies to deliver shareholder returns.
This results in private companies being forced to weigh the capital-raising benefits of public markets with the risks that they will be unable to pursue productive long-term strategies. The trend away from long-term thinking is also harmful to investors with long-term outlooks and to the broader American economy because sustained job creation and economic output depend on a company’s ability to measure performance not in quarters or fiscal years but in decades.
In particular, Nasdaq advocates for reforms that help public companies plan and execute for long-term growth, job creation and innovation, and ensure that long-term investors have an equal opportunity to participate in wealth creation with those investors who focus on speed and market timing.
A. Industry Dialogue to Address Concerns Regarding Activist Investors
There are many dimensions to the issue of activist investing, and Nasdaq is a strong believer in the capital markets ecosystem, exchanges, issuers and investors coming together to develop a comprehensive solution to this concern. For instance, Nasdaq strongly supports, and has built into its listing standards, the need for greater transparency around arrangements by which activist investors tie director compensation to a company’s stock price, which creates the potential for conflicts between the activist’s and the company’s best interest. Nasdaq is a firm believer that this dialogue should focus on several key issues that promote transparency so that investors and activists are on a level playing field when engaging with a company.
B. Equalize Short Interest Transparency
U.S. securities laws require certain investors to disclose their long positions 45 days after the end of each quarter and require institutions to make disclosure within 10 days after their position reaches or exceeds 5 percent of a company’s outstanding shares. As has been hotly debated among practitioners, there are no corresponding disclosure requirements applicable to short positions. Nasdaq believes that legitimate short selling contributes to efficient price formation, enhances liquidity and facilitates risk management. Short sellers may benefit the market and investors in other important ways, including by identifying and uncovering instances of fraud and other misconduct at public companies.
To provide transparency to other investors and the affected companies, Nasdaq supports extending existing disclosure requirements for long investors, such as on Form 13F, Schedule 13D and Schedule 13G, to persons with short positions, including any agreements and understandings that allow an investor to profit from a loss in value of the subject security.
C. Continue to Support Dual Class Structures
Nasdaq supports dual class structures in appropriate situations. The U.S. is a hotbed for entrepreneurship and innovation, and in order to maintain this strength, we must offer entrepreneurs multiple paths to participate in public markets. Nasdaq believes that by permitting dual class structures investors can invest side by side with innovators and high-growth companies and enjoy the financial benefits of these companies’ success. Consistent with its one-size-does-not-fit-all approach, Nasdaq believes each publicly traded company should have the flexibility to determine its class structure, so long as the company is transparent and initially discloses such structure to investors.
D. Encourage Rather Than Mandate Environmental, Social and Governance (ESG) Disclosure
As stated in its blueprint, most of Nasdaq’s listed companies make some ESG disclosures not only because they believe in responsible business practices but also because they understand that investors are increasingly expecting to analyze ESG metrics in their decision-making process. In keeping with its one-size-does-not-fit-all approach, Nasdaq generally supports the principle that ESG reporting should not be mandated but instead encouraged, so that companies can determine on a case-by-case basis how best to address ESG disclosures and so that the disclosures remain valuable to investors.
While Nasdaq’s blueprint does provide some interesting ideas and is meant to foster dialogue between industry participants, it does acknowledge that comprehensive market reform is extraordinarily complex. Indeed, most recognize that a variety of factors have likely contributed to making it more difficult or less attractive for smaller companies to go public.
There is certainly no shortage of suggested causes or possibilities, including the availability of alternative sources of capital, including private equity, hedge funds and even mutual funds; the emergence of trading venues that provide liquidity for privately held shares; new offering methods, such as crowdfunding, and Regulation A; consolidation in investment banking and brokerage services, which left fewer underwriters for small IPOs; changes in the economic environment due to globalization; industry trends forcing companies to get bigger faster to improve profitability, and therefore prefer being acquired by a large company instead of growing organically; macroeconomic factors, such as cheaper debt financing and increased mergers and acquisitions activity; high costs disproportionately imposed on smaller companies by regulatory changes from Sarbanes-Oxley; decimalization and Regulation NMS changed the economics of market making for small company stocks and left fewer market makers willing to organize a market for small stocks post-IPO; an increase in the shareholder threshold introduced by the JOBS Act in 2012, also make it more likely that companies will stay private for a longer period of time; and a significant shift away from retail investing toward institutional investing ‒ who have little interest in investing in small-cap public companies because of concerns regarding trade liquidity and regulatory barriers. Although much of the focus has been placed on reinvigorating the IPO market, there are certainly other areas of the securities laws that are ripe for change as well, which would also have a positive impact on the financial markets. Regardless, we need to bring a balanced approach to study both demand-side and supply-side reforms in order to attract more companies to the public markets.
 See Committee on Capital Markets Regulation, “U.S. Public Equity Markets Are Stagnating,” April 2017; Committee on Capital Markets Regulation, “Roadmap for Regulatory Reform,” May 2017; SEC Commissioner Piwowar’s Opening Remarks in May 2017 at the SEC-NYU Dialogue on Securities Market Regulation: Reviving the U.S. IPO Market; Ernst & Young’s “Looking Behind the Declining Numbers of Public Companies – An Analysis of Trends in U.S. Capital Markets,” May 2017; and SEC Investor Advocate Rick Fleming, “Enhancing the Demand for IPOs,” May 2017, NASAA 2017 Public Policy Conference.
NYSE Intends to Request Advance Notice of All Dividend and Stock Distribution Announcements
In mid-April, the NYSE proposed a change that would require NYSE listed companies to provide notice to the NYSE at least 10 minutes before making a public announcement regarding a dividend or stock distribution (e.g., stock split) in all cases, including outside the hours in which the NYSE’s immediate release policy is in operation. The NYSE subsequently withdrew its proposal after the SEC rejected the proposal for technical reasons. We expect the NYSE to resubmit the proposal to the SEC within the next few months.
The NYSE’s immediate release policy (Sections 202.05 and 202.06 of the NYSE Listed Company Manual) requires companies releasing material news (including dividend-related announcements) between 7:00 a.m. ET and the close of trading on the NYSE (generally 4:00 p.m. ET) to call and email the NYSE’s Market Watch team at least 10 minutes before issuing the public announcement to discuss its content.
A related rule (Section 204.12 of the NYSE Listed Company Manual) requires companies to give prompt notice to the NYSE regarding any dividend- or stock distribution-related action, including the omission or postponement of a dividend-related action. This notice must be given at least 10 days before the record date and is in addition to the disclose requirements under the immediate release policy. Notice must be given as soon as possible after a dividend is declared but no later than simultaneously with release to the media. In addition, Section 204.21 of the NYSE Listed Company Manual requires companies to give prompt notice to the NYSE of fixing a record date for any purpose.
The NYSE proposed to amend each of Sections 204.12 and 204.21 of the NYSE Listed Company Manual to specify that notice of any dividend or stock distribution must be provided to the NYSE at least 10 minutes before any public announcement. In short, this rule change would require companies to provide 10 minutes’ advance notice to the NYSE with respect to a dividend announcement made at any time rather than just during the hours of operation, as required by the immediate release policy.
The NYSE also proposed to amend Section 202.06(B) of the NYSE Listed Company Manual to emphasize the NYSE’s consistent interpretation of that rule as requiring listed companies to comply with the immediate release policy with respect to all announcements relating to a dividend or stock distribution.
The NYSE’s goal is to ensure it has access to dividend information prior to its public availability to hopefully avoid confusion in the marketplace if there is contradictory information available from multiple sources or uncertainty as to whether news reports of dividends are accurate.
NYSE to Expand Opportunity for Private Companies to List on NYSE Without IPO
As private growth companies continue to change the dynamics and the landscape of the financial markets, the NYSE has responded by proposing a change to its listing requirements to allow companies to list their shares immediately upon effectiveness of an Exchange Act registration statement without a concurrent public offering of its shares. The NYSE also proposed a change to allow a company to list its shares on the NYSE if the company provides an independent valuation (without reliance on its trading price on a private market) indicating at least $250 million in market value of publicly held shares (i.e., shares not held by directors, officers, their immediate families and 10 percent holders).
Generally, a company is listed on the NYSE either through the typical underwritten IPO process, upon transfer from another market such as Nasdaq or the OTC market, or in connection with a spin-off. Though less common, a company may also seek to list its shares on the NYSE when a registration statement filed solely for the purpose of allowing existing shareholders to sell their shares becomes effective. In each case, a company is required to meet certain distribution standards (either $40 million or $100 million) imposed by the NYSE to ensure a liquid trading market for their shares.
If a company seeks to list its shares upon effectiveness of a resale registration statement, the NYSE has discretion to list the shares if it determines the company has at least $100 million in market value of publicly held shares. The NYSE bases this determination on a combination of (1) an independent valuation of the company, and (2) the most recent trading price of the company’s shares on a private market for unregistered securities, such Nasdaq Private Market and SharesPost. The NYSE then attributes a market value of publicly held shares to the company equal to the lesser of the valuation and the trading price. The rule further provides that the NYSE will rely upon a trading price only if the trading price shows a sustained history over several months that supports a market value in excess of $100 million.
The NYSE recognizes that reliance on a trading price in addition to a valuation may cause difficulties for certain companies that are otherwise qualified for listing. Specifically, the NYSE notes that some companies are clearly large enough to be suitable for listing on the NYSE, but their shares are not traded at all before going public. In other cases, the private market trading is too limited to provide a reasonable basis for reaching conclusions about a company’s qualification. Consequently, the NYSE is seeking to amend Footnote (E) to Section 102.01B of the NYSE Listed Company Manual to (1) explicitly state that the rule applies to companies listing upon effectiveness of an Exchange Act registration statement without a concurrent Securities Act registration, as well as to companies listing upon effectiveness of a resale registration statement, and (2) provide an exception to the private market trading requirement if a company provides a recent valuation from an independent firm indicating at least $250 million in market value of publicly held shares. Similar to the current rule, any valuation used for this purpose must be provided by an independent firm that has “significant experience and demonstrable competence in the provision of such valuations.” The proposed rule provides that the valuation firm will not be deemed to be independent if:
- At the time it provides the valuation, the valuation firm or any affiliated person beneficially owns in the aggregate more than 5 percent of the class of securities to be listed, including any right to receive such securities exercisable within 60 days
- The valuation firm or any affiliated person has provided any investment banking services to the listing company within the 12 months preceding the date of the valuation, which includes acting as an underwriter; acting as a financial adviser in a merger or acquisition; providing venture capital, equity lines of credit, PIPEs or similar investments; serving as placement agent; or acting as a member of a selling group in a securities underwriting
- The valuation firm or any affiliated person has been engaged to provide investment banking services to the listing company in connection with the proposed listing or any related financings or other related transactions
The rule proposal also addresses a few technical trading rules related to the proposed changes to Footnote (E) to Section 102.01B. In particular, the NYSE proposes to further amend its rules governing the opening of trading on the day of initial listing of a company that lists under the amended provisions of Footnote (E) to Section 102.01B and that did not have any recent trading in a private placement market before listing to specify that the opening price will be determined by the NYSE (through the designated market maker) in consultation with a financial advisor to the listing company, which the listing company must retain within 90 days of the date of listing to provide these specified functions. Finally, the rule proposal specifies that the NYSE may declare a regulatory halt in a security that is the subject of an IPO or initial listing on the NYSE.
We expect these proposed changes to be especially attractive to companies seeking to list on the NYSE that (1) have VC and PE investors who would like liquidity or flexibility over the shares they acquired in various private placements, including shares acquired by conversion of various convertible equity or debt instruments, but whose securities are not actively traded or do not trade at all in the private markets; or (2) are well-capitalized and do not need additional equity capital but would still like to offer liquidity to their investors and employees. However, we do not expect these proposed changes to fundamentally alter the stock exchange listing landscape in light of the fact that Nasdaq has completed only “about a half-dozen direct listings of private companies since 2006,” according to a recent Wall Street Journal article.
The NYSE initially filed its proposed rule change with the SEC in March 2017. The SEC did not receive any comments on the NYSE’s proposal. On May 12, 2017, the SEC extended its review period of the proposal to June 29, 2017. During this period, the NYSE also filed Amendment No. 1 to the proposed rule change on May 16, 2017 and Amendment No. 2 to the proposed rule change on May 24, 2017, both of which were subsequently withdrawn. On June 6, 2017, the NYSE filed Amendment No. 3 to the proposed rule change, which was withdrawn by the NYSE on June 19, 2017. On June 13, 2017, the NYSE submitted a substantially similar rule proposal to the SEC that provided additional rationale for the proposed changes, along with several clarifications and technical trading rule changes. The NYSE has requested accelerated effectiveness of the proposed rule changes because the proposed changes have been out for public comment since mid-March and the SEC has not received any comments on the proposed rule changes.
How to Avoid Being the Target of a Disclosure-Only Lawsuit
The plaintiff-side M&A bar is notoriously creative in discovering new avenues to challenge transactions. The approach de jeur is to file a lawsuit seeking to enjoin the shareholder vote on an acquisition for insufficient disclosure, and then settle the suit when the company agrees to make additional disclosures and pay plaintiffs’ attorneys a “reasonable fee.” This type of litigation is tantamount to corporate extortion – the claims are often meritless, but corporations do not want to risk disrupting their transaction by challenging the plaintiff in court. These lawsuits are frustrating but avoidable. Below is an overview of the litigation in this area and how you can draft your disclosures to minimize the likelihood of becoming a target.
How These Lawsuits Work
When a company announces an acquisition, a plaintiff’s firm will review the disclosures and try to identify any relevant information the company has omitted. The firm will then file a lawsuit against the company and its board of directors, claiming the disclosures are inadequate to allow investors to make informed decisions on the acquisition. These claims come in various forms – chiefly as breach of the duty of candor and violations of Section 14(a) of the Securities Exchange Act of 1934. The plaintiff will ask the court to enjoin a vote on the transaction unless the company provides the additional information.
Common Omissions Identified
Most of the disclosures at issue in these suits fall within two categories: information related to the seller’s financial advisor’s fairness opinion, and disclosure of conflicts of interest. Plaintiffs regularly argue that shareholders require more detail regarding the fairness opinion to make an informed decision. This detail includes the projections underlying the opinion, fees paid to the financial advisor, and the methodology for valuing the business or certain assets. With regard to conflicts of interest, companies are targeted for failing to disclose affiliations between the target’s board and the buyer; promises of employment or board positions to current board members; and conflicts between the company, the board and the financial advisor.
How Cases Are Resolved
With the acquisition at risk, companies are in a difficult position. If they fight the preliminary injunction or move to dismiss the complaint, they risk delaying the acquisition as the court makes its decision. Plaintiffs’ lawyers offer an alternative: If the company makes the supplemental disclosures and pays the lawyers’ fees, the plaintiff will ‒ on behalf of all shareholders ‒ dismiss the suit and release the company and the board from any liability arising from the acquisition. Weighing these two options, most companies determine it makes more financial sense to settle the case. Some courts, particularly in Delaware, have been questioning the value of these suits to shareholders and refusing to approve plaintiffs’ counsel’s fee awards except in cases featuring clear omissions of obviously material information. Unfortunately, the pushback has not yet been strong enough to deter these suits altogether. Instead, plaintiffs’ firms are filing more complaints outside of Delaware, with California, New York and North Carolina becoming popular venues.
How to Draft to Avoid
Though these lawsuits are common, not all acquisitions prompt a disclosure-only lawsuit. The primary difference between transactions that are targeted and those that are not is the nature of the disclosures. Plaintiffs’ lawyers want sure things, which is why they focus their lawsuits on information that courts generally agree is important to shareholders: financial information and conflicts of interest. Companies and directors can reduce their exposure by providing more comprehensive disclosures of information in these two areas. While no two situations are identical, and it can be difficult to reconcile some of the decisions in this area, practitioners can find substantial guidance in the case law on how to address these matters in a manner that will discourage ill-founded claims.
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