SEC faults internal controls, employee training and requires retention of independent consultant

Using analysis that could easily be applied to other areas of disclosure, the SEC recently underscored the need for appropriate training of company employees tasked with preparing SEC filings and for appropriate disclosure controls and procedures. In the enforcement action, which was recently settled, Dow Chemical was determined to have underreported executive perquisites in its proxy statements from 2011 through 2015 by approximately $3 million. These proxy statements, in turn, were incorporated by reference into Dow’s Annual Reports on Form 10-K, which resulted in violations of Exchange Act section 13(a) and Exchange Act Rules 13a-1 and 12b-20.

Much of the enforcement release described how Dow used an incorrect standard for determining whether a corporate benefit was a disclosable perquisite. Perhaps more noteworthy, however, are the SEC’s analysis, findings of fact and required remedial actions, which are over and above the $1.75 million civil penalty. (Dow cannot use this penalty as a setoff in any private litigation arising out of the same set of facts.) The enforcement action states:

  • Contrary to Item 402 of Regulation S-K and the SEC’s guidance, Dow applied a “business purpose” standard to determine that a benefit was not a perquisite that required disclosure – as a result, Dow did not satisfy the SEC’s regulations and guidance.
  • Dow did not adequately train employees in key roles, including those tasked with drafting the CD&A section of the proxy statement and compiling the executive compensation tables, to ensure that the proper standard was applied for perquisites disclosure.
  • Dow had inadequate processes and procedures to ensure proper reporting of perquisites.
  • Dow did not fully comply with its own policies that called for conducting an annual review of changes to SEC rules and regulations from the prior year, market response, audit feedback, analysis of other companies’ disclosures, and changes in Dow’s compensation benefit programs.

Independent Consultant Required

Dow is required by the order to retain, at its own expense, an independent consultant, not unacceptable to the SEC staff, to conduct a review of Dow’s policies, procedures, controls, and training relating to the evaluation of whether payments and other expense reimbursements should be disclosed as perquisites. That consultant would be required, within 180 days of being retained, to issue a written report to Dow and the SEC staff that recommends appropriate policies, procedures, controls, and training reasonably designed to ensure Dow’s compliance with disclosure requirements relating to executive perquisites and confirms that Dow has processes and internal controls in place to reasonably ensure payments and other expenses are properly evaluated for perquisite disclosure under the securities laws. Although Dow is not required to adopt any recommendation that it considers unnecessary, unduly burdensome, impractical or costly, it must propose an alternative policy, procedure, or system designed to achieve the same objective or purpose. With respect to any recommendation on which Dow and the consultant do not agree, if the parties are unable to agree on an alternative proposal within 30 days, Dow must abide by the determinations of the consultant.

Dow’s processes and procedures that the SEC deemed flawed are merely a part of a public company’s required “disclosure controls and procedures” – which must be designed to ensure that information required to be disclosed in Exchange Act reports is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms. The effectiveness of those disclosure controls and procedures is required to be reviewed and certified quarterly by the company’s CEO and CFO.

Having effective disclosure controls and procedures is not a “one size fits all” exercise – knowledge of the company, its business and how information flows within the company are critical to establishing and maintaining these controls. Effective disclosure controls and procedures require, among other things:

  • an effective disclosure committee,
  • documentation of the company’s controls, including updating them as necessary to conform its documentation to the company’s current practice,
  • periodic discussions among the disclosure committee of what is “material” in the context of the company’s business,
  • identification of the officer(s) or employee(s) who are the most likely to be the first ones aware of a triggering event,
  • periodic review of authorization policies (e.g.¸ identifying and restricting those persons who can commit the company to actions that trigger a filing requirement, such as entering into a material contract or an exit or disposal activity), and
  • periodic education of the board and senior executives of the requirements under the U.S. federal securities laws.

In the wake of the Dow enforcement action, companies would be wise to review and revisit their disclosure controls and ensure their effectiveness.