Conflict Minerals Rule and Pay Ratio Rule… Are Changes Forthcoming?

Conflict Minerals Rule

Acting SEC Chairman Michael S. Piwowar issued a statement[1] on January 31, 2017 directing the SEC staff to reconsider whether the 2014 Guidance is still appropriate and whether any additional relief is appropriate. The statement also included a 45-day public comment period.

In addition, there has been a leaked draft executive order and rumors that President Donald Trump is going to issue an order that will temporarily suspend the conflict minerals rule for two years based on a “national security interests” rationale.

Additionally, a final ruling on the conflict minerals litigation may be looming. On February 10, 2017, the district court judge ordered the parties in the conflict minerals litigation to file a joint status report, on or before March 10, 2017, indicating whether any further proceedings are necessary, and whether the court should enter an order of final judgement to effectuate the circuit’s decision.

At the recent SEC Speaks conference, Shelly Parratt, acting director of the Division of Corporation Finance, stated that companies must continue to comply with the conflict minerals disclosure rules and that even though the SEC is seeking comments thereon, the rules remain in effect.

What the outcome of the above will ultimately be is unknown. The likelihood of the conflict minerals rule being completely overturned prior to the upcoming May 31st Form SD due date is slim. Accordingly, issuers should steam ahead in their due diligence efforts.

Pay Ratio Rule

A week after issuing the conflict minerals statement described above, Acting SEC Chairman Michael S. Piwowar issued a statement[2] on February 6, 2107 related to the pay ratio disclosure rule in which he explained that it was his “understanding that some issuers have begun to encounter unanticipated compliance difficulties that may hinder them in meeting the reporting deadline.” Therefore, Piwowar stated that he is seeking public comment within 45 days on any unexpected challenges that issuers have experienced as they prepare for compliance and whether relief is needed. In addition, Piwowar directed the SEC staff to reconsider the implementation of the pay ratio rule and whether additional guidance or relief may be appropriate.

At the recent SEC Speaks conference, Shelly Parratt, acting director of the Division of Corporation Finance, stated that companies must continue to comply with the pay ratio disclosure rules and that even though the SEC is seeking comments thereon, the rules remain in effect.

It seems likely that this disclosure rule will be revisited and could be changing.   Nevertheless, at this time, issuers should continue their work in preparing to comply with the pay ratio disclosure rules for the next proxy season.

[1] https://www.sec.gov/news/statement/reconsideration-of-conflict-minerals-rule-implementation.html

[2] https://www.sec.gov/news/statement/reconsideration-of-pay-ratio-rule-implementation.html

Time to Review Your Severance Agreements

In August 2016, the SEC issued cease-and-desist orders against two different companies for using severance agreements which required exiting employees to waive their ability to obtain monetary awards under the SEC’s whistleblower program.

According to the SEC’s order regarding BlueLinx Holdings Inc., beginning prior to August 12, 2011 and continuing through the present, BlueLinx entered into severance agreements with departing employees. While the agreements were not uniform, most contained language prohibiting the departing employees from divulging confidential information, unless compelled to do so by law or legal process. In or about June 2013, BlueLinx reviewed and revised each of its outstanding severance agreements and added provisions which (i) required such former employees to waive their rights to monetary recovery should they file a charge or complaint with the SEC or other federal agencies, and (ii) required such former employees to notify the company’s legal department prior to disclosing any financial or business information to any third parties.

According to the SEC’s order regarding Health Net, Inc., beginning prior to August 12, 2011 and continuing through October 22, 2015, Health Net entered into severance agreements with departing employees. In August 2011, after the whistleblower rules were adopted, Health Net updated its form of severance agreement to add language which prohibited former employees from filing an application for, or accepting, a whistleblower award from the SEC. This language was contained in severance agreement entered into from approximately August 2011 to June 2013. In June 2013, Health Net updated its form of severance agreement to remove the SEC-specific language; however, Health Net retained language that removed the financial incentive for reporting information. On October 22, 2015, Health Net updated its form of severance agreement and struck the restrictive language related to monetary awards.

The SEC charged each of BlueLinx and Health Net with violating Rule 21F-17 under 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.”

BlueLinx consented to the SEC’s cease-and-desist order without admitting or denying the findings. BlueLinx agreed to include in all of its severance agreements after the date of the order language which makes it clear that employees may report possible securities law violations to the SEC and other federal agencies without BlueLinx’s prior approval and without having to forfeit any resulting whistleblower award. In addition, BlueLinx agreed to make reasonable efforts to contact former employees who had executed severance agreements from August 12, 2011 through the present to notify them that BlueLinx does not prohibit former employees from providing information to the SEC staff without notice to BlueLinx or from accepting SEC whistleblower awards. In addition, BlueLinx agreed to pay the SEC a civil penalty of $265,000.

Health Net also consented to the SEC’s cease-and-desist order without admitting or denying the findings. Health Net agreed to make reasonable efforts to inform former employees who signed severance agreements from August 12, 2011 through October 22, 2015 that Health Net does not prohibit former employees from seeking and obtaining a whistleblower award from the SEC under Section 21F of the Exchange Act. In addition, Health Net agreed to pay the SEC a civil penalty of $340,000.

In light of the above orders, companies should review new and existing severance agreements that they have or enter into with former employees to make sure that such documents do not restrict such former employees’ ability to provide information to the SEC or from accepting SEC whistleblower awards. The mere existence of such restrictive language in severance agreements in and of itself could be found to be a violation of Section 21F of the Exchange Act.

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.

 

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.

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[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.”

Broker-Dealers Ignoring Red Flags Lead to SEC Releases and Enforcement Action

In October 2014, the SEC’s Division of Trading & Markets issued FAQs to remind broker-dealers of their obligation to conduct a reasonable inquiry when selling securities in an unregistered transaction in reliance on Section 4(a)(4) of the Securities Act. The FAQs explain that “[i]n order to rely on the Section 4(a)(4) exemption, a broker-dealer must conduct a “reasonable inquiry” into the facts surrounding a proposed unregistered sale of securities before selling the securities to form reasonable grounds for believing that a selling customer’s part of the transaction is exempt from Section 5.  . . . [W]hen conducting a reasonable inquiry into whether the transaction would violate Section 5, it is not sufficient for the broker-dealer merely to accept self-serving statements of his sellers and their counsel without reasonably exploring the possibility of contrary facts.  Nor, where there are indicia of an illegal distribution of securities, can a broker-dealer claim that its sales of a security were exempt from registration simply because the stock certificates lack a restrictive legend or a clearing firm or transfer agent raises no objections to the sales.” The FAQs provide a list of factors that the SEC will consider in assessing the reasonableness of a broker-dealer’s inquiry and its reliance on the Section 4(a)(4) exemption.

Simultaneously with the issuance of the FAQs, the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) issued a Risk Alert which summarized deficiencies which OCIE observed in examining 22 broker-dealers. Among other matters, the examinations uncovered deficiencies related to controls put in place to comply with obligations related to sales of securities, including the performance of a reasonable inquiry in connection with unregistered sales of securities in reliance on Section 4(a)(4) of the Securities Act.

In conjunction with the FAQs and the Risk Alert, the SEC announced an enforcement action against certain current and former E*Trade subsidiaries (the “Subsidiaries”) for ignoring red flags in connection with the sale of unregistered penny stocks. The SEC’s order finds that the Subsidiaries were not entitled to rely on the Section 4(a)(4) exemption because they did not perform a “reasonable inquiry.” The Subsidiaries agreed to settle the SEC’s charges by paying back more than $1.5 million in disgorgement and prejudgment interest from commissions they earned on the improper sales. They also must pay a combined penalty of $1 million.

In light of the above, broker-dealers should reexamine their policies and procedures related to the sale of unregistered securities and provide training to their personnel concerning what constitutes a “reasonable inquiry.”

New Revenue Recognition Standard Adopted

The Financial Accounting Standards Board (“FASB”) and the International Accounting Standards Board (“IASB”) issued jointly written revenue recognition standards on May 28, 2014.  The new guidance standardizes how companies should recognize revenue in financial statements under both U.S. generally accepted accounting principles (GAAP) and international financial reporting standards (IFRS). This new revenue recognition standard will replace most of the current revenue recognition guidance, including much of the industry-specific guidance that exists under GAAP today.

 The new guidance aims to:

 1.  Remove inconsistencies and weaknesses in revenue requirements.

 2.  Provide a more robust framework for addressing revenue issues.

 3. Improve comparability of revenue recognition practices across entities, industries,  jurisdictions, and capital markets.

  4.Provide more useful information to users of financial statements through improved disclosure requirements.

  5.Simplify the preparation of financial statements by reducing the numberof requirements to which an entity must refer.

 The core principle of the new guidance is that “an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.” The guidance contains the following five step process:

           Step 1: Identify the contract(s) with a customer.

           Step 2: Identify the performance obligations in the contract.

           Step 3: Determine the transaction price.

           Step 4: Allocate the transaction price to the performance obligations in the contract.

           Step 5: Recognize revenue when (or as) the entity satisfies a performance obligation.

 Public companies using GAAP will be required to apply the new revenue recognition standard for annual reporting periods beginning after December 15, 2016, including interim reporting periods therein. Public companies are not permitted to apply this new standard early.

 

SEC Issues Partial Stay of Conflict Minerals Rule

On Friday, the SEC issued an official order staying the effective date for compliance with the portions of the conflict mineral rules that would require issuers to make statements that the United States Court of Appeals for the District of Columbia held would violate the First Amendment.  This order does not provide companies with additional relief than that already provided in the SEC’s Statement on the Effect of the Recent Court of Appeals Decision on the Conflict Minerals Rule which was issued on April 29th. (See my earlier blog describing such statement).

SEC Issues Statement Regarding the Status of the Conflict Minerals Rule

Today the SEC issued a Statement on the Effect of the Recent Court of Appeals Decision on the Conflict Minerals Rule.   (See our earlier blogs regarding the conflict minerals rule and the legal challenge thereto).  Form SD did not go away and compliance with the conflict minerals rule was not stayed. The SEC tried to reach some sort of a compromise and provided the following in its statement:

“Subject to the guidance below and any further action that may be taken either by the Commission or a court, the Division expects companies to file any reports required under Rule 13p-1 on or before the due date. The Form SD, and any related Conflict Minerals Report, should comply with and address those portions of Rule 13p-1 and Form SD that the Court upheld. Thus, companies that do not need to file a Conflict Minerals Report should disclose their reasonable country of origin inquiry and briefly describe the inquiry they undertook. For those companies that are required to file a Conflict Minerals Report, the report should include a description of the due diligence that the company undertook. If the company has products that fall within the scope of Items 1.01(c)(2) or 1.01(c)(2)(i) of Form SD, it would not have to identify the products as “DRC conflict undeterminable” or “not found to be ‘DRC conflict free,’” but should disclose, for those products, the facilities used to produce the conflict minerals, the country of origin of the minerals and the efforts to determine the mine or location of origin.

No company is required to describe its products as “DRC conflict free,” having “not been found to be ‘DRC conflict free,’” or “DRC conflict undeterminable.” If a company voluntarily elects to describe any of its products as “DRC conflict free” in its Conflict Minerals Report, it would be permitted to do so provided it had obtained an independent private sector audit (IPSA) as required by the rule.  Pending further action, an IPSA will not be required unless a company voluntarily elects to describe a product as “DRC conflict free” in its Conflict Minerals Report.

The Division will consider the need to provide additional guidance in advance of the filing due date. Companies with questions about the content of the Form SD and Conflict Minerals Report should contact the Office of Rulemaking in the Division of Corporation Finance at (202) 551-3430.”

Conflict Minerals Rules…What Action will the SEC Take?

The recent opinion by the United States Court of Appeals for the District of Columbia has ignited much debate in the legal community as to what action the SEC will or should take in response.

 Today, SEC Commissioners Daniel M. Gallagher and Michael S. Piwowar issued a Joint Statement on the Conflict Minerals Decision in which they stated that they think the SEC should stay the effectiveness of the conflict minerals rules and no further regulatory obligations should be imposed, pending the outcome of the conflict minerals litigation. Moreover, Commissioners Gallagher and Piwowar further state that in their view the District Court should determine that the entire rule is invalid.

 In contrast, last week members of Congress wrote a letter to the SEC Chair urging the SEC to continue the implementation of the conflict minerals rules as scheduled.

Many public companies who are busy preparing their initial Form SD are anxious to know how the SEC will respond. But, it remains to be seen as to what official action the SEC will take.

Conflict Minerals…the Legal Saga Continues…

Yesterday, the United States Court of Appeals for the District of Columbia issued its opinion on the conflict minerals legal challenge. (See our earlier blogs regarding the conflict minerals rules and the legal challenge thereto). The ruling rejected a number of the petitioner’s arguments, but agreed with the petitioner’s first amendment challenge. Specifically, the court held that the conflict minerals rules “violate the First Amendment to the extent the statute and rule require regulated entities to report to the Commission and to state on their website that any of their products have ‘not been found to be DRC conflict free.’” Accordingly, the three-judge panel affirmed the district court’s judgment in part and reversed in part and remanded the case back to the district court for further proceedings.

It is not crystal clear what practical effect the Court of Appeal’s decision will have on the conflict minerals rules or what actions the SEC may take in response to such decision. Despite yesterday’s ruling, companies should “keep the course” and continue preparing their initial Form SD which, as of now, is still due on June 2, 2014.