Are you a US private company looking for capital? Regulation A+ may be your answer.

The amended Regulation A became effective on June 19, 2015, and the SEC has recently provided helpful guidance about it.  On June 18, 2015, the SEC made available “Amendments to Regulation A: A Small Entity Compliance Guide” summarizing provisions of the new Regulation A, and on June 23, 2015, the SEC issued new Compliance and Disclosure Interpretations (C&DIs) clarifying certain provisions of the new Regulation A.

The new Regulation A mandated by the JOBS Act is often dubbed as Regulation A+, as a sign of significant improvement over the old Regulation A, which was rarely used as a capital-raising vehicle. The new Regulation A+ provides for two tiers of offerings:

  • Tier 1, for offerings of securities of up to $20 million in a 12-month period, with not more than $6 million in offers by selling security-holders that are affiliates of the issuer; and
  • Tier 2, for offerings of securities of up to $50 million in a 12-month period, with not more than $15 million in offers by selling security-holders that are affiliates of the issuer.

Under Regulation A+, an entity organized under the laws of the United States or Canada with its principal place of business in the United States or Canada that is not subject to Section 13 or 15(d) of the Securities Exchange Act of 1934 immediately prior to the offering is considered an eligible issuer for the purposes of Regulation A+. The new C&DIs clarify such eligibility requirement and provide that the following companies are eligible to benefit from the provisions of Regulation A+:

  • A company with headquarters located in the United States or Canada, but whose business primarily involves managing operations that are located outside such countries; provided its officers, partners, or managers primarily direct, control and coordinate the issuer’s activities from the United States or Canada.
  • A company that was previously required to file reports with the SEC under Section 15(d) of the Exchange Act, but that has since suspended its Exchange Act reporting obligation; provided the company has satisfied the statutory provisions for suspension in Section 15(d) of the Exchange Act or the requirements of Exchange Act Rule 12h-3.
  • A voluntary filer under the Exchange Act, i.e., a filer that is not obligated to file Exchange Act reports pursuant to either Section 13 or 15(d) of the Exchange Act.
  • A private wholly-owned subsidiary of an Exchange Act reporting company parent; provided such reporting company parent is not a guarantor or co-issuer of the securities of the private wholly-owned subsidiary.

Generally, Regulation A+ has been viewed as a vehicle that private companies can use to raise money to expand their business or to buy out a shareholder. In the new C&DIs, the SEC also clarified that Regulation A+ can be relied upon by an issuer for business combination transactions, such as a merger or acquisition. However, the SEC indicated that Regulation A+ would not be available for business acquisition shelf transactions.

Regulation A+ allows issuers to “test-the-waters” by trying to determine whether there is any interest in a contemplated securities offering. Rule 255 of Regulation A+ requires companies to include certain mandatory cautionary statements in such “test-the-waters” communications. The SEC has previously recognized the issuers interest in using social media (for example, Twitter) to communicate with security holders, and the new C&DIs permits an issuer to “test the waters” in a Regulation A+ offering on a platform that limits the number of characters or amount of text that can be included, and thus technically prevents the inclusion in such communication of the Rule 255 information. The SEC has solved this problem by allowing the use of an active hyperlink to satisfy the requirements of Rule 255 in the following circumstances:

  • The electronic communication is distributed through a platform that has technological limitations on the number of characters or amount of text that may be included in the communication;
  • Including the required statements in their entirety, together with the other information, would cause the communication to exceed the limit on the number of characters or amount of text; and
  • The communication contains an active hyperlink to the required statements that otherwise satisfy Rule 255 and, where possible, prominently conveys, through introductory language or otherwise, that important or required information is provided through the hyperlink.

However, if an electronic communication is capable of including the entire required statements, along with the other information, without exceeding the applicable limit on number of characters or amount of text, the SEC considers the use of a hyperlink to the required statements to be inappropriate. This approach is consistent with the SEC’s position on other communications with shareholders under the Securities Act and Exchange Act rules.

Under Regulation A+, state securities (Blue Sky) registration requirements are not preempted for Tier 1 offerings, but such preemption exists for primary offerings of securities by the issuer or secondary offerings by selling security-holders in Tier 2 offerings. The new C&DIs make it clear that Blue Sky registration and qualification requirements are not preempted with respect to resales of securities purchased in a Tier 2 offering. Resales of securities purchased in a Tier 2 offering must be registered, or offered or sold pursuant to an exemption from registration, with state securities regulators.

Sec Proposes Anticipated Rules on Pay-Versus-Performance Disclosure

On April 29, 2015, the SEC, in a 3-2 vote of the SEC Commissioners, approved proposed rules (the “pay-versus-performance disclosure”) that would require an issuer to disclose the relationship between the issuer’s executive compensation and the issuer’s financial performance. The proposed rules would implement a disclosure obligation required under Section 953(a) of the Dodd-Frank Act. Chair White noted, in the SEC press release announcing the proposed rules, that the pay-versus-performance disclosure “would better inform shareholders and give them a new metric for assessing a company’s executive compensation relative to its financial performance.”

In particular, the proposed rules would amend Item 402 of Reg. S-K by adding a new Item 402(v) which would require issuers to disclose, in each proxy or information statement requiring executive compensation disclosure under Item 402 of Reg. S-K, the following:

  • the executive compensation “actually paid” to the issuer’s principal executive officer (“PEO”);
  • the executive compensation “actually paid” to the issuer’s named executive officers (“NEOs” ), expressed as an average for all such NEOs;
  • the issuer’s total shareholder return (“TSR” ); and
  • the TSR of a peer group of issuers.

Like all disclosures required under Item 402 of Reg. S-K, the pay-versus-performance disclosure would be subject to the say-on-pay advisory vote.

Compensation Actually Paid

Under the proposed rules, the executive compensation “actually paid” by an issuer means the total compensation for a particular executive disclosed in the summary compensation table adjusted by certain amounts related to pensions and equity awards. The adjusted disclosure represents an attempt by the SEC to reflect the compensation awarded to, or earned by, such executive officer in a particular year of service. In order to calculate the compensation “actually paid” to a particular executive officer, the total compensation disclosed for such executive officer in the summary compensation table would be adjusted to:

  • deduct the aggregate change in the actuarial present value of all defined benefit and actuarial pension plans reported in the Summary Compensation Table;
  • add back the actuarially determined service cost for services rendered by the executive officer during the applicable year;
  • exclude the grant date value of any stock and option awards granted during the applicable year that are subject to vesting; and
  • add back the value at vesting of stock and option awards that vested during the applicable year, computed in accordance with the fair value guidance in FASB ASC Topic 718.

An issuer would need to include footnotes to the pay-versus-performance summary table (see below for the form table) which describes the amounts excluded from and added to the total compensation reported in the summary compensation and the issuer’s vesting date valuation assumptions used (if materially different from the grant date assumptions disclosed in the issuer’s financial statements).

In addition to the required disclosure, an issuer would be permitted to make disclosures to capture the issuer’s specific situation and industry, provided that any supplemental disclosure is not misleading and not presented more prominently than the required pay-versus-performance disclosure. Examples of supplemental disclosure provided in the proposed rules include the disclosure of “realized pay” or “realizable pay” or additional years of data beyond the time periods required.

Peer Group

The peer group utilized for the TSR comparison would be the same peer group used by the issuer in its stock performance graph or in describing the issuer’s benchmarking compensation practices in its CD&A.

Format

The pay-versus-performance disclosure must be provided in tabular form as set forth below.

Year(a) Summary Compensation Table Total For PEO(b) Compensation Actually Paid to PEO(c) Average Summary Compensation Table Total for non PEO Named Executive Officers(d) Average Compensation Actually Paid to non PEO Named Executive Officers(d) Total Shareholder Return(f)

Peer Group Total Shareholder Return

(g)

Following the pay-versus-performance disclosure table, the issuer would be required to describe the relationship between the issuer’s executive compensation actually paid and the issuer’s TSR and the relationship between the issuer’s TSR and the peer group’s TSR.

Issuers will generally need to make the pay-versus-performance disclosure for its five (or three years, in the first applicable filing following the effectiveness of the proposed rule) most recently completed fiscal years.  However, smaller reporting companies will only need to make the disclosure for three years (or two years, in the first applicable filing following the effectiveness of the proposed rule).  In addition, a smaller reporting company would not be required to (i) disclose amounts relating to pensions (consistent with current executive compensation disclosure obligations); nor (ii) present the TSR of a peer group in its pay-versus-performance disclosure.

XBRL

Companies would be required to tag the pay-versus-performance disclosure using XBRL.  Smaller reporting companies would not be required to comply with the tagging requirement until the third filing in which the pay-versus-performance disclosure is provided.

Companies to which Disclosure Requirement Applies

The proposed pay-versus-performance disclosure rules would apply to all reporting companies, except registered investment companies, foreign private issuers and emerging growth companies.

Conclusion

It is unclear whether the pay-versus-performance disclosure will be adopted (and in effect) in time for the 2016 proxy season.  The SEC is seeking comments on the proposed rules for 60 days following their publication in the Federal Register.

The Alphabet Soup of Raising Capital: Regulation A or Regulation D — What Would You Prefer?

On June 19, 2015, amended Regulation A recently adopted by the SEC will become effective. The new Regulation A, mandated by the JOBS Act and often dubbed as Regulation A+, is a significant improvement over the old Regulation A, which was rarely used as a capital raising vehicle. The old Regulation A permits unregistered offerings of up to $5 million of securities in any 12-month period, including no more than $1.5 million of securities offered by security holders of the company. Permissible thresholds of Regulation A+ are much higher. It provides for two tiers of offerings: “Tier 1, for offerings of securities of up to $20 million in a 12-month period, with not more than $6 million in offers by selling security-holders that are affiliates of the issuer; and Tier 2, for offerings of securities of up to $50 million in a 12-month period, with not more than $15 million in offers by selling security-holders that are affiliates of the issuer.”

However, will Regulation A+ become a more popular choice for smaller companies than Regulation D in raising capital? Is Regulation A+ a workable compromise between the company’s need to have access to capital and the SEC’s goal of investor protection?

Rule 506 of Regulation D is one of the most widely used capital raising exemptions under the US securities laws. The main reason of its popularity is its flexibility. Although Rule 506 does not provide an opportunity for selling security holders to participate in the offering as Regulation A+ does, Rule 506 does not have any caps on the dollar amount that can be raised. In addition, any company: public or private, US or foreign can raise capital under Rule 506. However, only a US or Canadian issuer that is not (i) a reporting company under the Securities Exchange Act of 1934 immediately prior to the offering, (ii) an investment company, or (iii) a blank check company is considered an “eligible issuer” under Regulation A+. Note that “bad actor” disqualification applies to both Rule 506 and Regulation A+ offerings. Also, a company that had its registration revoked under Section 12(j) of the Exchange Act within five years before the filing of the offering statement or that has been delinquent in filing required reports under Regulation A+ during the two years before the filing of the offering statement (or for such shorter period that the issuer was required to file such reports) is not eligible to do an offering under such Regulation.

In some instances, Regulation A+ appears to be more accommodating than Rule 506. For example, Rule 506 allows an unlimited number of accredited investors as purchasers (with Rule 506(b) also permitting up to 35 non-accredited investors), and Tier 1 of Regulation A+ does not have any limitation on the number or type of investors. Tier 2 also does not have any limitations on the number of investors, but imposes a per-investor cap for non-accredited investors (unless the securities are listed on a national exchange) of the aggregate purchase price to be paid by the purchaser for the securities to be no more than 10% of the greater of annual income or net worth for individual investors or revenue or net assets most recently completed fiscal year for entities.  In addition, Regulation A+ allows issuers to “test-the-waters” by trying to determine whether there is any interest in a contemplated securities offering (assuming such practice is allowed under applicable blue sky laws for Tier 1 offerings), while the traditional Rule 506(b) does not allow for general solicitation and advertising (Rule 506(c) permits general solicitation and advertisement).

The biggest downside of Regulation A+ structure is that blue sky registration requirements are not preempted for Tier 1 offerings, which significantly limits the use of Tier 1 for offerings in multiple states. Such preemption exists for Rule 506 offerings as well as Tier 2 of Regulation A+ offerings. But the welcomed flexibility of doing nationwide offerings under Tier 2 comes with a heavy price tag of ongoing reporting. After a Tier 2 offering, an issuer must file with the SEC annual reports on Form 1-K, semi-annual reports on Form 1-SA and current reports on Form 1-U (within 4 business days of the event). The SEC also noted that companies may “voluntarily” file quarterly financial statements on Form 1-U, but the practical effect of desired compliance with Rules 15c2-11 and Rule 144 to maintain placement of quotes by market makers and resales of securities, will lead to “voluntary” quarterly reporting becoming essentially mandatory.

Rule 506 offerings are usually accompanied by private placement memoranda, or PPMs, (even when offerings are solely to accredited investors) to protect issuers from Rule 10b-5 liability under the Exchange Act. There is no prescribed format for such PPMs and they are not reviewed by the SEC. In connection with Regulation A+ offerings, an issuer must file Form 1-A (a “mini” registration statement) through EDGAR with the SEC (first-time issuers are eligible to initially do a non-public submission of a draft of Form 1-A). Such Forms 1-A are subject to the SEC review and comment process, which increases the cost of the transaction and extends the time from the beginning of the transaction and the closing.

The good news is that Regulation A+ provides a new way for smaller companies to raise capital and get some liquidity in their securities. However, if a company is confident that it can raise money through the traditional Rule 506 private placement, it may still want to avoid the SEC review process, the hassle of blue sky compliance under Tier 1 or ongoing reporting obligations of Tier 2 introduced by Regulation A+.

Beware of Confidentiality Agreements with Employees; Make Sure They Don’t Stifle Whistleblowing

On April 1, 2015, the SEC announced its first enforcement action against a company for utilizing language in a confidentiality agreement which could discourage whistleblowing.

The SEC charged KBR, Inc., a Houston-based global technology and engineering firm, with violating Rule 21F-17 of the Exchange Act. Rule 21F-17, adopted pursuant to the Dodd-Frank Act, 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.”

As part of its compliance program, KBR regularly receives allegations from its employees of potential illegal or unethical conduct by KBR or its employees. In looking into such matters, KBR would typically conduct an internal investigation which would include interviewing KBR employees.   In connection with such internal investigation interviews, KBR required witnesses to sign confidentiality statements which provided that such witnesses could face disciplinary action and even be fired if they discussed the matters discussed in the interview with outside parties without the prior approval of KBR’s legal department.  Because such investigations could involve violations of securities laws, the SEC claimed that the restrictive language in the KBR confidentiality statements violated Rule 21F-17. Notably, the SEC was not aware of any instance where (i) this restrictive language prevented a KBR employee from communicating with the SEC about potential securities violations, or (ii) KBR took any action to enforce such language in its confidentiality statements.

In order to settle the enforcement action, without admitting or denying the SEC’s charges, KBR (i) agreed to pay a $130,000 penalty, (ii) agreed to make reasonable efforts to contact KBR employees in the U.S. who had signed the confidentiality statement since August 21, 2011 to clarify that such employees are free to report possible violations of federal law or regulation to governmental agencies without obtaining the permission of KBR’s general counsel, and (iii) amended its confidentiality statement to include the following language:

“Nothing in this Confidentiality Statement prohibits me from reporting possible violations of federal law or regulation to any governmental agency or entity, including but not limited to the Department of Justice, the Securities and Exchange Commission, the Congress, and any agency Inspector General, or making other disclosures that are protected under the whistleblower provisions of federal law or regulation. I do not need the prior authorization of the Law Department to make any such reports or disclosures and I am not required to notify the company that I have made such reports or disclosures.”

In light of the above enforcement action, companies should review agreements that they have with their employees, as well as Company policies, to make sure that such documents do not contain language that would potentially stifle whistleblowing.

 

Is SEC Regulation of Political Spending Dead?

It is unlikely that it is dead, but it certainly is on life support.  But, I believe that board oversight, and disclosure, of corporate political expenditures will continue to increase.

In 2011, the Committee of Corporate Political Spending, a group of ten academics focusing on corporate and securities law, submitted a petition for rulemaking to the SEC asking the SEC to adopt rules to require public companies to disclosure to shareholders the use of corporate resources for political activities. In the following months, the SEC received in excess of one million comments to the petition. Reportedly, most of the comments expressed support for the requested rulemaking. In 2012, the SEC placed disclosure by public companies of their political expenditures on its rulemaking agenda. It would seem that with disclosure of political expenditures being on the SEC’s rulemaking agenda, combined with broad public interest in such a rule (as evidenced by other one million comments on the petition), the SEC would move forward with rulemaking. But, that didn’t happen.

The SEC dropped from its rule making agenda political expenditures disclosure in 2013.   But, the issue was not dead; press coverage continued.   For example, on October 29, 2014, the New York Times published an editorial advocating for an SEC rule requiring disclosure of corporate political expenditures. In a letter to the editor of the New York Times responding to the editorial, Commissioner Daniel M. Gallagher stated “[m]andatory political contribution disclosure deserves no place on the agency’s agenda, and I will fight to keep it that way.” Given the removal of political expenditures disclosure from the SEC’s rulemaking agenda and Commissioner Gallagher’s public opposition to any such rule, it is probably a fairly safe bet that, unless prodded by congress, the SEC will not take any rulemaking action with respect to disclosure of corporate political expenditures in the near future.

While it appears that the SEC will not take action any time soon, the idea of requiring public companies to disclose political expenditures has certainly not gone away. As we have written about in the past, Institutional Shareholder Services continues to generally recommend that shareholders vote for proposals to require greater disclosure of a company’s political contributions and trade association spending policies and activities. Further, a majority of companies reviewed by the Center for Political Accountability and the Zicklin Center for Business Ethics Research (generally, the top 300 companies in the S&P 500) continue to have some level of board oversight of their political contributions and expenditures. The Shareholders Protection Act of 2015 was also recently introduced in the House of Representatives. If passed (which is unlikely), the bill would amend The Securities Exchange Act of 1934 to require not only disclosure, but shareholder approval of political expenditures and require national securities exchanges and associations to require a board of directors vote for political expenditures in excess of $50,000.

I, for one, hope that Commission Gallagher is successful in his efforts to keep political expenditures disclosure off the SEC’s rulemaking agenda. Existing disclosure documents are already far too long and far too complex. Heaping more disclosure obligations on public companies would simply contribute to that problem. While new SEC rulemaking appears to be unlikely, pressure from shareholders, shareholder groups and others will likely lead to increasing board oversight, and increased voluntary disclosure, of corporate political expenditures.

MD&A Lessons Learned from Broadwind Energy

On February 5, 2015, the Securities and Exchange Commission charged Broadwind Energy, Inc. (Broadwind), its former Chief Executive Officer and its Chief Financial Officer for accounting and disclosure violations that, as the SEC stated in its press release, “prevented investors from knowing that reduced business from two significant customers had caused substantial declines in the company’s long-term financial prospects.”  The penalties were not earth-shattering: subject to the court’s approval, Broadwind agreed to pay, $1 million penalty and its former CEO and its CFO agreed to pay approximately $700,000 in combined disgorgement and penalties.

The SEC brought various charges, including, but not limited to, the violation of Section 17(a)(2) of the Securities Act (in connection with an offering conducted by Broadwind) and the violation of Section 13 of the Exchange Act and Rule 13a-14 under such act, but this case is interesting because it deals with the eternal question that public company management and their securities lawyers are dealing with every day: how much disclosure is enough disclosure for the investors to make a reasonable decision whether to buy or sell the company’s securities?

Broadwind’s fact pattern, as outlined in the SEC’s complaint filed in the U.S. District Court for the Northern District of Illinois, makes it clear that during the third quarter of 2009, Broadwind began to plan more definitively for the impairment of its subsidiary’s intangible assets related to contracts with two major customers and Broadwind’s internal documents identified an expected impairment charge of $48 million related to the contract with one of such customers.  Broadwind shared this expectation and these documents with its outside audit firm, its investment bankers and the subsidiary’s primary lender. Broadwind also incorporated impairment in its planning for the upcoming audit of 2009 financial results. Broadwind’s revenues from the two major customers declined 43% and 25%, respectively, for the nine months ended September 30, 2009 compared to the same period ended September 30, 2008.

The SEC argued that Broadwind’s disclosure in the Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) section of its Form 10-Q for the third quarter of 2009 was materially misleading.  Such disclosure read, in part, as follows:

[A] continued economic slowdown may result in impairment to our fixed assets, goodwill and intangible assets. We perform an annual goodwill impairment test during the fourth quarter of each year, or more frequently when events or circumstances indicate that the carrying value of our assets may not be recovered. The recession that has occurred during 2008 and 2009 has impacted our financial results and has reduced purchases from certain of our key customers. We may determine that our expectations of future financial results and cash flows from one or more of our businesses has decreased or a decrease in stock valuation may occur, which could result in a review of our goodwill and intangible assets associated with these businesses. Since a large portion of the value of our intangibles has been ascribed to projected revenues from certain key customers, a change in our expectation of future cash from one or more of these customers could indicate potential impairment to the carrying value of our assets.

Item 303 of Regulation S-K requires a public company to disclose in its MD&A “any known trends or any known demands, commitments, events or uncertainties that will result in or that are reasonably likely to result in the registrant’s liquidity increasing or decreasing in any material way.”  MD&A also requires a description of “any known trends or uncertainties that have had or that the registrant reasonably expects will have a material favorable or unfavorable impact on net sales or revenues or income from continuing operations.”

The SEC’s position outlined in the complaint is that, based on the revenue decline combined with the customers’ lower forecasts of revenue and other developments, Broadwind and its CEO (the CFO started at Broadwind in mid-August 2009) “should have known that the intangible assets were impaired.” However, Broadwind “failed to disclose the impairment of its assets in Form 10-Q” for the quarter ended September 30, 2009, but instead used a “generalized risk disclosure of the possibility of such a charge.”  The SEC also stated in its complaint that if Broadwind had conducted impairment testing in connection with its Form 10-Q for the 3rd quarter 2009, Broadwind would have concluded that its contracts with two significant customers were fully impaired and recorded impairment charges of approximately $60 million in connection with such contracts.” Broadwind ultimately disclosed the impairment in its Form 10-K for the fiscal year ended December 31, 2009. Following the disclosure of the impairment charge, the stock price declined by 29%.

Putting aside the speculation about when it was the right time for Broadwind to conduct the impairment testing, it has been the SEC’s position for more than a decade that MD&A “trends” disclosure should include the “[q]uantification of the material effects of known material trends and uncertainties,” which can promote better understanding of whether the company’s past performance is indicative of future performance.  The SEC’s 2003 Interpretive Release: Commission Guidance Regarding MD&A (Release No. 33-8350) made it clear that “[a]scertaining this indicative value depends to a significant degree on the quality of disclosure about the facts and circumstances surrounding known material trends and uncertainties in MD&A. … Quantitative disclosure should be considered and may be required to the extent material if quantitative information is reasonably available.”

In light of the current 10-K season, the SEC’s complaint in SEC v. Broadwind is a timely reminder that “boiler plate” generalized MD&A disclosure regarding known trends may be inadequate and misleading if management had an opportunity to provide more detailed and meaningful information.

SEC Proposes Rules for Hedging Disclosure

On February 9, 2015, the Securities and Exchange Commission, as required by Section 955 of the Dodd-Frank Act[1] , issued proposed rules requiring enhanced proxy disclosure of a company’s hedging policies for its directors, officers and other employees. The proposed rules would require a company to disclose, in any proxy statement or information statement relating to an election of directors, whether its directors, officers or other employees are permitted to hedge or offset any decrease in the market value of equity securities that are either granted by the company as compensation, or held (directly or indirectly) by the individual.

Currently, companies are required to make disclosures regarding their hedging policies in the company’s Compensation Discussion and Analysis (“CD&A”) section of their proxy. In the CD&A section of a proxy, companies are required to disclose material information necessary to an understanding of a company’s compensation policies and decisions regarding its named executive officers. Item 402(b)(2)(xiii) provides that, if material, disclosure regarding a company’s equity or other security ownership requirements or guidelines (specifying applicable amounts and forms of ownership), and any company policies regarding hedging the economic risk of such ownership should be included in the CD&A. The CD&A disclosure requirement does not apply to smaller reporting companies, emerging growth companies, registered investment companies or foreign private issuers. The new proposed rules would expand both the disclosure requirements regarding hedging policies and the types of companies required to make disclosure regarding hedging policies.

The proposed rules would add paragraph (i) to Item 407 of Regulation S-K and would require companies to disclose whether the registrant permits any employees (including officers) or directors, to purchase financial instruments (including prepaid variable forward contracts, equity swaps, collars and exchange funds) or otherwise engage in transactions that are designed to or have the effect of hedging or offsetting any decrease in the market value of a company’s equity securities. Companies that permit hedging by certain employees would be required to disclose the categories of persons who are permitted to engage in hedging transactions and those who are not. In addition, companies would also be required to disclose the categories of hedging transactions that they permit and those that they prohibit. The new disclosure would apply to all issuers registered under Section 12 of the Exchange Act, including smaller reporting companies, emerging growth companies, and listed closed-end funds, but excluding foreign private issuers and other types of registered investment companies.

The proposed rules do not require a company to prohibit its directors, officers or other employees from engaging in hedging transactions in the company’s securities or to adopt hedging policies. Rather, the proposed rules, consistent with the SEC’s view[2] of the statutory purpose of Section 14(j) of the Exchange Act, are intended to provide investors with additional information, enabling them to ascertain whether a company’s directors, officers or other employees, through hedging transactions, are able to avoid any requirements that they hold stock long-term, and thereby receive their compensation even if their company underperforms. The disclosure aims to give stockholders a better understanding of whether the interests of a company’s directors, officers and other employees are aligned with their own interests.

———————————————————-

[1] Section 955 of the Dodd-Frank Act added Section 14(j) to the Exchange Act. Section 14(j) directs the SEC to require, by rule, each issuer to disclose in any proxy or consent solicitation material for an annual meeting of the shareholders of the issuer whether any employee or member of the board of directors of the issuer, or any designee of such employee or director, is permitted to purchase financial instruments (including prepaid variable forward contracts, equity swaps, collars, and exchange funds) that are designed to hedge or offset any decrease in the market value of equity securities either (1) granted to the employee or director by the issuer as part of the compensation of the employee or director; or (2) held, directly or indirectly, by the employee or director.

[2] The proposing release cites a report issued by the Senate Committee on Banking, Housing, and Urban Affairs which stated that Section 14(j) is intended to “allow shareholders to know if executives are allowed to purchase financial instruments to effectively avoid compensation restrictions that they hold stock long-term, so that they will receive their compensation even in the case that their firm does not perform.”  In this regard, the SEC explained “we infer that the statutory purpose of Section 14(j) is to provide transparency to shareholders, if action is to be taken with respect to the election of directors, about whether employees or directors are permitted to engage in transactions that mitigate or avoid the incentive alignment associated with equity ownership.”

Withdrawal of Whole Foods No-Action Letter Leaves a Hole in Proxy Access Proposal Defense

On January 16, 2015, the Securities and Exchange Commission (SEC) announced  that, for the 2015 proxy season, the Division of Corporation Finance will not express any views as to whether a company may exclude a shareholder proposal from its annual meeting proxy statement based on Exchange Act Rule 14a-8(i)(9).   The announcement was issued in connection with a statement issued by Chair White that, in light of questions about the proper scope and application of the Rule, she directed the SEC staff to review the rule and report to the Commission.  As a result the Whole Foods no-action letter, discussed below, was withdrawn and issuers will not have an easy path in addressing “proxy access” proposals from their shareholders for the 2015 proxy season (and perhaps in subsequent proxy seasons).

Rule 14a-8(i)(9) permits a company to exclude a shareholder proposal that “directly conflicts with one of the company’s own proposals to be submitted to shareholders at the same meeting.”  The Staff has historically granted no-action relief under Rule 14a-8(i)(9) where a shareholder proposal and a company/management proposal present alternative and conflicting decisions for shareholders and where the inclusion of both proposals could lead to inconsistent and ambiguous results.

The SEC’s action comes on the heels of a letter, published  on January 4, 2015, by the Council of Institutional Investors asking the SEC staff to review the application of Rule 14a-8(i)(9) in light of the SEC staff’s issuance of the Whole Foods no-action letter.  In that letter, the SEC Staff took a no-action position to the exclusion of a shareholder proxy access proposal under Rule 14a-8(i)(9).  The shareholder proposal would have amended Whole Foods’ governance documents to allow shareholders holding 3% of the company’s stock for a period of three years to include in the annual meeting proxy statement nominees for up to 20% of Whole Foods’ directors. Whole Foods’ competing proposal would have provided shareholders holding 9% of the company’s stock for a period of five years the right to include such nominees.  Conveniently for Whole Foods, its proposal would have significantly limited the universe of its shareholders who would be entitled, in 2015 and in the future, to proxy access under its amendment. Following the issuance of the Whole Foods no-action letter, a number of companies sought no-action relief from the Staff in connection with similar shareholder proxy access proposals; however, the Whole Foods no-action letter was subsequently withdrawn in connection with the Staff’s announcement of its review of Rule 14a-8(i)(9) and the staff noted in its responses to the other Rule 14a-8(i)(9) requests that it could not express a view in light of the recent announcement.

Despite the lack of no-action relief from the SEC staff for the 2015 proxy season, companies may still utilize a number of mechanisms to exclude shareholder proposals:

  • A company may continue to rely on Rule 14a-8(i)(9) – including complying with the timing and notice requirements of Rule 14a-8 – to exclude the shareholder’s proposal, but without the comfort of a SEC no-action letter.
  • A company may seek judicial relief to exclude the shareholder’s proposal – a challenging path that will involve potentially significant expense and could also result in negative publicity.
  • In addition, a company could, in theory, choose to include its own proposal and the shareholder’s proposal in its annual meeting proxy. This, however, is a novel approach involving significant considerations (including practical and disclosure considerations).
  • Lastly, a company could adopt its own proxy access mechanism (assuming that the company’s board has the authority to amend the relevant portions of the company’s governance documents) and seek to exclude a shareholder’s proposal under Rule 14a-8(i)(10) on the grounds that the Company “has already substantially implemented the proposal.”  This exception is not subject to the SEC’s current suspension of no-action relief for Rule 14a-8(i)(9) matters; however this  alternative may strike some as waiving the white flag.

Consistent with Rule 14a-8, a company seeking to exclude a shareholder proposal under Rule 14a-8(i)(9) or (10) must still submit a no-action request to the SEC staff (technically, the company is required to submit to the SEC its reasons for excluding the proposal), with a copy of the request provided simultaneously to the proposing shareholder, at least 80 days before the company files its definitive proxy statement and form of proxy. A company seeking such relief should also be mindful that proposing shareholders may challenge the company’s exclusion of their proposals in federal court. Courts often give deference to SEC staff positions, including no-action letters, and, in the absence of such no-action letters for the 2015 proxy season, an institutional shareholder whose proposal is excluded from a company’s annual meeting proxy under Rule 14a-8(i)(9) may be more likely to initiate litigation to challenge the exclusion.

Boards Should Put Time and Resources into Cybersecurity Issues – It Is Good for Business and Works as a Defense Strategy

We have previously blogged about Commissioner Aguilar’s recommendations at a NYSE conference, “Cyber Risks and the Boardroom” on what boards of directors should do to ensure that their companies are appropriately considering and addressing cyber threats. On October 20, 2014, the United States District Court for the District of New Jersey dismissed a derivative lawsuit (Palkon v. Holmes, Case No. 2:14-CV-01234) filed against directors and certain officers, including General Counsel, of Wyndham Worldwide Corporation (WWC). The Court’s opinion can be viewed as a real life validation of the principles outlined in the Commissioner’s speech. Continue reading

ISS Guidelines for 2015 Proxy Season – More Holistic Review of Board Leadership Structure

On November 6, 2014, ISS released its 2015 proxy voting guidelines which update its benchmark policy recommendations. The updated policies will be effective for shareholder meetings held on or after February 1, 2015. Benchmark policy changes include ISS’ adoption of a more holistic approach to shareholder proposals calling for independent board chairs. ISS has focused on board leadership because shareholder proposals related to this issue have become quite frequent. ISS also cited a recent study finding that “retention of a former CEO in the role of chair may prevent new CEOs from making performance gains by dampening their ability to make strategic changes at the company” as one of the reasons for the policy update.

ISS has updated its “Generally For” policy with respect to such proposals to add new governance, board leadership, and performance factors to the analytical framework and to look at all of the factors in a holistic manner. Factors, which are not explicitly considered under the current policy, include the “absence/presence of an executive chair, recent board and executive leadership transitions at the company, director/CEO tenure, and a longer (five-year) total shareholder return (TSR) performance period.”

Under the new policy, ISS would recommend to generally vote “FOR” shareholder proposals requiring that the chairman’s position be filled by an independent director, taking into consideration the following:

  • The scope of the proposal (i.e., whether the proposal is precatory or binding and whether the proposal is seeking an immediate change in the chairman role or the policy can be implemented at the next CEO transition);
  • The company’s current board leadership structure (ISS may support the proposal under the following scenarios: the presence of an executive or non-independent chair in addition to the CEO; a recent recombination of the role of CEO and chair; and/or departure from a structure with an independent chair);
  • The company’s governance structure and practices (ISS will consider the overall independence of the board, the independence of key committees, the establishment of governance guidelines, board tenure and its relationship to CEO tenure; the review of the company’s governance practices may include, but is not limited to, poor compensation practices, material failures of governance and risk oversight, related-party transactions or other issues putting director independence at risk, corporate or management scandals, and actions by management or the board with potential or realized negative impact on shareholders);
  • Company performance (ISS’ performance assessment will generally consider one-, three, and five-year TSR compared to the company’s peers and the market as a whole); and
  • Any other relevant factors that may be applicable.