Disclosure Pendulum May Start Swinging Back

During the last decade, I have been continuously amazed with the increasing level of public company regulation.  The general direction of the Sarbanes-Oxley Act and the Dodd-Frank Act, and naturally the SEC rules implementing these acts, has always been more and more disclosure (the more granular and detailed — the better).  It seemed like the disclosure pendulum was swinging higher and higher towards overregulation and that it would never go back.  But the report on public company disclosure issued by the SEC on December 20, 2013, as mandated by the JOBS Act, gives a lot of hope that the disclosure pendulum may eventually start swinging back. 

This Report on Review of Disclosure Requirements in Regulation S-K, which largely follows the concepts outlined by SEC Chair Mary Jo White in her October speech before the National Association of Corporate Directors, recommended to Congress a comprehensive review of SEC disclosure rules and forms focusing on the following potential areas:

  • modernizing and simplifying Regulation S-K requirements in a manner that reduces the costs and burdens on companies while still providing material information;
  • eligibility for further scaling of disclosure requirements and definitional thresholds for smaller reporting companies, accelerated filers and large accelerated filers;
  • evaluating whether Industry Guides still elicit useful information and conform to industry practice and trends;
  • reviewing financial reporting requirements of Regulation S-X and financial statement disclosure requirements of Regulation S-K (e.g., annual and quarterly selected financial data disclosure and the ratio of earnings to fixed charges); and
  • disclosure requirements contained in SEC rules and forms (e.g., Forms 10-Q and 8-K).

The Staff provided detailed guidance on its suggested review of Regulation S-K, which would address the following issues:

  • principles-based approach as an overarching component of the disclosure framework (e.g., using a disclosure model of current MD&A requirements) (which may have an unintended consequence of leading to more disclosure rather than less);
  • current scaled disclosure requirements and whether further scaling would be appropriate for emerging growth companies or other categories of issuers;
  • filing and delivery framework based on the nature and frequency of the disclosures (e.g., a “core” disclosure or “company profile” filing with information that changes infrequently, periodic and current disclosure filings with information that changes from period to period, and transactional filings that have information relating to specific offerings or shareholder solicitations); and
  • readability and navigability of disclosure documents (e.g., the use of hyperlinks) as well as replacing quantitative thresholds (e.g., Item 103 (Legal Proceedings), Item 404 (Transactions with Related Persons, Promoters and Certain Control Persons) and Item 509 (Interests of Named Experts and Counsel) with general materiality standards.

In addition to these issues, the Staff identified the following specific areas of Regulation S-K disclosure that could benefit from further review:

  • risk-related requirements, such as risk factors, legal proceedings and other quantitative and qualitative information about risk and risk management, with potential consolidation into a single requirement;
  • relevance of current requirements for the description of business and properties;
  • corporate governance disclosure requirements (to confirm that the information is material to investors);
  • executive compensation disclosure (to confirm that the required information is useful to investors);
  • offering-related requirements (in light of the changes in offerings and the shift from paper-based offering documents to electronically-delivered offering materials); and
  • exhibits to filings (to confirm whether the required exhibits remain relevant and whether other documents should be added).

I cannot wait for the SEC to start proposing rules implementing these suggestions and creating a more effective disclosure mechanism that would work for the 21st century.   


Board Diversity and Political Contributions Disclosure Continue to Get ISS Support

On December 19, 2013, ISS published its U.S. Proxy Voting Summary Guidelines that are effective for meetings of stockholders held on or after February 1, 2014.  This blog post highlights ISS’ position on two social issues: board diversity and political contributions.  

Board Diversity

Consistent with its guidelines last year, ISS continues to recommend voting for stockholder requests for reports on a company’s efforts to diversify the board unless:

  • the gender and racial minority representation of the company’s board is reasonably inclusive in relation to companies of similar size and business; and
  • the board already reports on its nominating procedures and gender and racial minority initiatives on the board and within the company.

ISS will make recommendations on a case-by-case basis on proposals asking a company to increase the gender and racial minority representation on its board.  In providing its recommendation, ISS will take into account the following factors:

  • the degree of existing gender and racial minority diversity on the company’s board and among its executive officers;
  • the level of gender and racial minority representation that exists at the company’s industry peers;
  • the company’s established process for addressing gender and racial minority board representation;
  • whether the proposal includes an overly prescriptive request to amend nominating committee charter language;
  • the independence of the company’s nominating committee;
  • whether the company uses an outside search firm to identify potential director nominees; and
  • whether the company has had recent controversies, fines, or litigation regarding equal employment practices.

Political Contributions

In connection with proposals related to political contributions, ISS continues to generally recommend voting for proposals requesting greater disclosure of a company’s political contributions and trade association spending policies and activities, considering:

  • the company’s current disclosure of policies and oversight mechanisms related to its direct political contributions and payments to trade associations or other groups that may be used for political purposes, including information on the types of organizations supported and the business rationale for supporting these organizations; and
  • recent significant controversies, fines, or litigation related to the company’s political contributions or political activities.

However, recognizing that businesses are affected by legislation at the federal, state and local level, ISS recommends voting against proposals barring a company from making political contributions. ISS is being practical and concedes that barring political contributions can put the company at a competitive disadvantage.

NASDAQ Proposes to Align its Independence Standards for Compensation Committee Members with the NYSE’s Approach to Such Standards

On November 26, 2013, The NASDAQ Stock Market LLC proposed to amend its listing rules on compensation committee composition (Rule 5605(d)(2)(A) and IM-5605-6) to replace the prohibition on the receipt of compensatory fees by compensation committee members with a requirement that a board of directors instead consider the receipt of such fees when determining eligibility for compensation committee membership.  NASDAQ cited the feedback that it had received from listed companies as the reason for these changes.  The proposed rules are almost identical to the NYSE’s rules related to compensation committee independence and, if adopted, would remove the anomaly of NASDAQ listing rules being more stringent than NYSE rules.

The proposed Rule 5605(d)(2)(A) states that in affirmatively determining the independence of any compensation committee member, the board must consider all factors specifically relevant to determining whether a director has a relationship to the company which is material to that director’s ability to be independent from management in connection with the duties of a compensation committee member, including, but not limited to:

  • the source of compensation of such director, including any consulting, advisory or other compensatory fee paid by the company to such director; and
  • whether such director is affiliated with the company, a subsidiary of the company or an affiliate of a subsidiary of the company.

In IM-5605-6, NASDAQ proposes to clarify that when considering the sources of a director’s compensation in determining compensation committee member independence, the board should consider whether the director receives compensation from any person or entity that would impair the director’s ability to make independent judgments about the company’s executive compensation, including compensation for board or board committee services. 

The approach to the affiliation prong of the independence analysis is not significantly changed in the proposed rules.  However, NASDAQ proposes to revise IM-5605-6 to explain that the board should consider whether the affiliate relationship places the director under the direct or indirect control of the company or its senior management, or creates a direct relationship between the director and members of senior management, in each case of a nature that would impair the director’s ability to make independent judgments about the company’s executive compensation.

Companies are required to comply with the compensation committee composition aspects of the NASDAQ rules by the earlier of their first annual meeting after January 15, 2014, or October 31, 2014.  NASDAQ intends to implement the proposed changes before companies suggest changes to board and committee composition in connection with their 2014 annual meetings.

Should Pay Ratio Disclosure Be “Furnished” or “Filed”?

In the recently proposed pay ratio rules, the SEC acknowledged that some commenters had suggested that pay ratio information should be deemed “furnished” and not “filed” for purposes of the Securities Act of 1933 and Securities Exchange Act of 1934, and no commenters had asserted that pay ratio disclosure should be “filed.”[1]  However, the SEC rejected these suggestions based on an extremely literal reading of Section 953(b) of the Dodd-Frank Act, which mandates the SEC to amend Item 402 of Regulation S-K to require disclosure of the pay ratio in any filing of the issuer described in Item 10(a) of Regulation S-K.  The SEC concluded that “the use of the word ‘filing’ in Section 953(b) is consistent with the disclosure being filed and not furnished” and proposed that “the pay ratio disclosure would be considered “filed” for purposes of the Securities Act and Exchange Act and, accordingly, would be subject to potential liabilities under such acts.”[2]  For additional information about the proposed pay ratio rules, see our September blog post.

 Information Disclosed in a Filing Does not Have to be Filed with the SEC

 I believe the SEC gave disproportionate weight to the use of the word “filing” in Section 953(b).  “Filings” described in Item 10(a) of Regulation S-K include, without limitation, registration statements under the Securities Act and Exchange Act, annual and other reports under Sections 13 and 15(d) of the Exchange Act, and proxy and information statements under Section 14 of the Exchange Act.  However, some of these filings include disclosures that are considered “furnished” and “not filed”.   For example, a current report on Form 8-K is considered a “filing” described in Item 10(a) of Regulation S-K.  However, information included in a Form 8-K pursuant to Item 2.02 (Results of Operations and Financial Condition) or Item 7.01 (Regulation FD Disclosure) is not “deemed to be ‘filed’ for purposes of Section 18 of the Exchange Act or otherwise subject to the liabilities of that section, unless the registrant specifically states that the information is to be considered “filed” under the Exchange Act or incorporates it by reference into a filing under the Securities Act or the Exchange Act.”[3]  Therefore, it seems that the legislative mandate to disclose the pay ratio in any filing described in Item 10(a) of Regulation S-K does not mean that such disclosure cannot be afforded the furnished status.  I believe, Section 953(b) of the Dodd-Frank Act only prescribes the type of documents in which pay ratio disclosure should appear and does not dictate whether such disclosure should be furnished or filed.  

 The Proper Response is the Ballot, not Litigation Challenging the Disclosure

 The proposed pay ratio rules are very flexible and allow a registrant to use (i) a methodology that uses reasonable estimates to identify the median and (ii) reasonable estimates to calculate the annual total compensation or any elements of total compensation for employees other than the PEO. Moreover, in determining the employees from which the median is identified, the registrant may use not only its total employee population, but also statistical sampling or other reasonable methods.  The ability to use various estimates and statistical sampling for a complex analysis required by the proposed pay ratio rules leads to potentially subjective disclosure that may be difficult to verify and that should not serve as potential grounds for shareholder litigation.    

 In contrast, the SEC views the flexibility of identifying the median and the ability to use reasonable estimates as arguments against the pay ratio disclosure being furnished.  The SEC believes that the proposed transition periods, flexibility of identifying the median and the ability to use estimates should mitigate registrants concerns about compiling and verifying the pay ratio disclosure.”[4]  Such argument contradicts the SEC’s original rationale for granting other compensation-related information “not filed” status. In1992, the SEC issued Release No. 33-6962, Executive Compensation Disclosure, which adopted amendments to the executive officer and director compensation disclosure requirements (the “1992 Release”).  The 1992 Release recognized that the newly adopted Compensation Committee Report on Executive Compensation and Performance Graph raised significant concerns about the potential for litigation and increased an issuer’s exposure to liability with respect to these disclosures.  To accommodate these concerns, the SEC stated that the information required by the Compensation Committee Report on Executive Compensation and Performance Graph “shall not be deemed to be ’soliciting material’ or to be ’filed’ with the Commission or subject to Regulations 14A or 14C …, or to the liabilities of Section 18 of the Exchange Act …, except to the extent that the registrant specifically requests that such information be treated as soliciting material or specifically incorporates it by reference into a filing under the Securities Act or the Exchange Act.”[5] 

 The SEC’s reasoning in connection with the “not filed” status of the Compensation Committee Report was that “[i]f shareholders are not satisfied with the decisions reflected in the report, the proper response is the ballot, not resort to the courts to challenge the disclosure.”[6]  This same reasoning should apply to pay ratio disclosures.  Instead of treating the disclosure that most companies will base on subjective estimates and statistical sampling as “filed” and thus subject it to the liability provisions of the Exchange Act and Securities Act, this disclosure should be afforded the “furnished” status and shareholders should use voting as the venue for objecting to a specific ratio.  

 It will be interesting to see whether after the comment process the final SEC release would still support the “filed” status of pay ratio disclosure.  



[1] See Release No. 33-9452, p. 75 and Note 138.

[2] See id at p. 75.

[3] See Form 8-K, General Instruction B.2.

[4] See Release No. 33-9452, pp 75-76.

[5] See 1992 Release, Item 402(a)(9).  Both the Compensation Committee Report and Performance Graph have retained this “not filed” status in SEC Regulation S-K. See Item 402(e)(5), Instructions to Item 407(e)(5) and Item 201(e), Instruction 8 of Regulation S-K.

[6] See id.

Board Oversight of Political Contributions Is Steadily Rising

In September 2013, the Center for Political Accountability and the Zicklin Center for Business Ethics Research published their third annual index of political accountability and disclosure (2013 Index), which focuses on political spending disclosure of the top 200 companies in the S&P 500 Index. The Index reviews companies’ policies disclosed on their websites and describes:

  • the ways that companies manage and oversee political spending;
  • the specific spending restrictions that many companies have adopted; and
  • the policies and practices that need the greatest improvement.

The 2013 Index demonstrates that of the 195 companies reviewed in both 2012 and 2013, 78% of companies improved their overall scores for political disclosure and accountability.  In particular, data from the 2013 Index indicates that a growing number of companies have some level of board oversight of their political contributions and expenditures.  For example,

  •  62% of companies said that their boards of directors regularly oversee corporate political spending in 2013, compared to 56% in 2012;
  • 57% of companies said that a board committee reviews company policy on political spending in 2013, compared to 49% in 2012; and
  • 56% of companies said that a board committee reviews company political expenditures in 2013, compared to 45% in 2012.

Insider Trading Updates: Cuban Jury to SEC – No Cigar; Heinz Tippees Revealed (But Who Were the Tippers?)

The SEC loses some and wins some insider trading cases:

The SEC’s five year old insider trading case against Dallas Mavericks owner, Mark Cuban, came to a sad conclusion for the SEC on Wednesday when a federal jury acquitted Mr. Cuban of insider trading charges.

The SEC had accused Mr. Cuban of insider trading in the securities of Mamma.com, a publicly traded Internet search engine company. According to the complaint, in June 2004, Mr. Cuban sold his entire 600,000 share position in Mamma.com after learning from the CEO that the company was planning to conduct a PIPE offering. The complaint alleged that Cuban avoided losses in excess of $750,000 by selling his stock prior to the public announcement of the PIPE offering.

The SEC alleged that Mr. Cuban verbally agreed to keep confidential and not trade on the information that the CEO gave him about the private offering. Mr. Cuban denied any such agreement and the jury agreed. Possibly hurting the SEC’s position was the fact that their main witness, the Mamma.com CEO, did not testify in person.

And now for a win.

The SEC announced that they had come to a settlement with the previously unknown inside traders who pocketed 1.8 million in profits by trading call options in advance of the public announcement of the sale of the H.J. Heinz Company.

The SEC filed an emergency enforcement action earlier this year to freeze assets in a Swiss-based trading account used to reap the illegal trading profits in advance of the Heinz announcement.

In an amended complaint filed earlier this month, the SEC alleged that the order to purchase the Heinz options was placed by Rodrigo Terpins while he was vacationing at Walt Disney World in Orlando, and that the trading was based on material non-public information that he received from his brother Michel Terpins. The trades were made through an account belonging to a Cayman Islands-based entity. Rodrigo Terpins purchased nearly $90,000 in option positions in Heinz the day before the announcement, and those positions increased by more than 20 times the next day.

The Terpins brothers agreed to disgorge the entire $1.8 million in illegal profits made from trading Heinz options. The Terpins brothers also will pay $3 million in penalties.

Interestingly, the amended complaint does not reveal the identity of the “tipper” that provided the information to Michel Terpins, other than to say that the SEC believed that the “information source” had disclosed the information about the pending deal “in breach of a duty.”

Is Less More? SEC Chair White Speaks on the Future of Disclosure Reform

SEC Chair Mary Jo White spoke about the future of securities disclosure reform in a speech yesterday before the National Association of Corporate Directors.

Ms. White noted that a common problem today is “information overload” –  when investors are provided “too much” information –  “a phenomenon in which ever-increasing amounts of disclosure make it difficult for an investor to wade through the volume of information she receives to ferret out the information that is most relevant.” The reasons for the increase are several: new rules issued by the Staff, legislative changes such as the Private Securities Litigation Reform Act, which led to a proliferation of risk factors, and the “say-on-pay” vote mandated by the Dodd-Frank Act, which led to 40+ pages of executive compensation disclosures, and a company’s decision (typically prompted by their counsel) to provide more information in an effort to reduce the risk of litigation.  

As required by the JOBS Act, the SEC Staff is reviewing current disclosure requirements to determine how to modernize and simplify the requirements, and to reduce the costs and other burdens of the disclosure requirements for emerging growth companies. Chair White said that the SEC expects to issue this report “very soon.”

The areas of disclosure reform for future consideration noted by Chair White include:

  • Use of a “core document” or “company profile” containing base information that would be updated as required with information about offering, financial statements and significant events.
  • Elimination of repetitive disclosures in filings, such as “legal proceedings” for which the identical information can appear in a Form 10-K four or more times.
  • Revision of the Industry Guides, which, except for oil and gas, have not been updated in decades.  
  • Consideration of whether the applicable disclosure timeframes should be shortened in light of the increased use and speed of technology, including social media and smart phones.
  • Whether there are required disclosures that are not necessary for investors or that investors do not want, such as share prices, dilution disclosures and earnings to fixed charges ratios.

Hopefully, the SEC can quickly complete the remaining rules it is required to write under the Dodd-Frank Act and turns its attention to writing rules designed to streamline the disclosure process.

Proposed Pay Ratio Disclosure – Delicate Balancing Act Between Congressional Mandate and Practical Implementation

On September 18, 2013, the SEC proposed the long-awaited and feared pay ratio rules.  The proposed rules embodied in the new Item 402(u) of Regulation S-K implement the mandate of Section 953(b) of the Dodd-Frank Act to disclose the ratio of the median of annual total compensation of all employees (excluding the CEO) to the annual total compensation of the CEO. 

In the proposed rules, the SEC provided registrants with a lot of flexibility in terms of various calculations that should be performed.   However, the SEC conceded that permitting registrants to select a methodology for identifying the median, rather than prescribing a specific methodology, could enable a registrant to “alter the reported ratio to achieve a particular objective with the ratio disclosure, thereby potentially reducing the usefulness of the information.”

Continue reading “Proposed Pay Ratio Disclosure – Delicate Balancing Act Between Congressional Mandate and Practical Implementation”

Focus on Business Continuity and Disaster Recovery

The Securities and Exchange Commission seems to be awfully worried about disasters lately.  On August 16, 2013, the SEC joined the Commodity Futures Trading Commission’s Division of Swap Dealers and Intermediary Oversight and the Financial Industry Regulatory Authority in issuing a Staff Advisory on business continuity and disaster recovery planning.  Less than two weeks later, the SEC issued a Risk Alert on investment advisers’ business continuity and disaster recovery planning.  This focus on the business continuity and disaster recovery is prompted by the coming one-year anniversary of Hurricane Sandy, which had a devastating effect on many businesses. 

As the SEC noted in its August 16, 2013 and August 27, 2013 press releases, the Staff Advisory and Risk Alert make observations and suggest effective practices to address:

  • Preparation for widespread disruption
  • Planning for alternative locations
  • Telecommunications services and technology
  • Communication plans
  • Regulatory and compliance considerations
  • Preparedness of key vendors
  • Reviewing and testing

While the Staff Advisory and Risk Alert focused on the financial industry, they do provide a helpful reminder for all businesses to consider how natural disasters and other disruptive events can impact their businesses as well as useful guidance for planning for potential disruptions.  In addition, the Staff Advisory and Risk Alert serve as a reminder for all public companies to consider whether their periodic reports and offering materials provide adequate disclosure, including risk factors, with respect to their exposure to natural disasters and other potential business disruptions.

Companies Listing on the NYSE Can Appoint an Internal Auditor Within a Year after an IPO

On August 22, 2013, the SEC approved the NYSE’s proposal that permits a company listing in conjunction with an IPO to comply with the internal audit function requirement of Section 303A.07(c) of the NYSE Listed Company Manual within one year of the listing date.  NYSE rules now require such company to have an internal audit function in place no later than the first anniversary of its listing date[1].  Previously, NYSE rules only required each listed company to have an internal audit function but did not provide any transition period for companies listing in connection with an IPO.  

The new one-year transition period for compliance with an internal audit function requirement expanded NYSE corporate governance provisions, to which a transition period applies in connection with an IPO.  Such provisions relate to the composition of the board of directors as well as the composition of the nominating, compensation and audit committees (see Section 303A.00). 

The NYSE believes that a transition period for establishing an internal audit function will make the company’s process of implementation of such function more effective and will reduce the costs it faces in its first year as a public company.  The NYSE also expects that this transition period would enable the company’s audit committee to play a significant role in the design and implementation of the company’s internal audit function. 

In case of a company availing itself of a one-year transition period with respect to its internal audit function, the audit committee must:

  • assist board oversight of the design and implementation of the internal audit function; and
  • meet periodically with the company personnel primarily responsible for the design and implementation of the internal audit function.

Once the company establishes its internal audit function, the audit committee must (i) assist board oversight of the performance of the company’s internal audit function, and (ii) meet periodically with internal auditors or other personnel responsible for the internal audit function.

In addition, if the listed company does not yet have an internal audit function because it is using the internal audit function transition period, the audit committee’s review with the independent auditor of any audit problems should include a discussion of management’s plans with respect to the responsibilities, budget and staffing of the internal audit function and its plans for the implementation of the internal audit function.  Once the transition period is over, the audit committee’s review with the auditors should include a discussion of the responsibilities, budget and staffing of the company’s internal audit function.

The audit committee should also discuss with the board management’s activities with respect to the design and implementation of the internal audit function during the transition period, and after the transition period, the audit committee should review with the full board any issues that arise with respect to the performance of the internal audit function.

 Generally, a listed company must maintain an internal audit function to provide management and the audit committee with ongoing assessments of the company’s risk management processes and system of internal control, and the company can outsource an internal audit function to a third party service provider (other than the company’s independent auditor).   




[1] It is interesting to note that The NASDAQ Stock Market LLC (NASDAQ) does not have an internal audit function requirement.  Earlier this year, NASDAQ proposed, and later withdrew, an amendment to its listing requirements that each listed company establish and maintain an internal audit function to provide management and the audit committee with ongoing assessments of the company’s risk management processes and system of internal control.  The SEC received 42 comment letters on the proposal, and NASDAQ stated in its withdrawal that it was withdrawing the proposal to fully consider such comments and that it intends to file a revised proposal (see SEC Release No. 34-69792).