Posted on Tuesday, July 25 2017 at 10:01 am by

Big Changes Coming to the Form and Substance of Auditor’s Reports

By: David A. Stockton

In early June, the PCAOB adopted a new auditing standard (AS No. 3101) that will fundamentally change the format and substance of the audit reports provided by outside auditors to their public company clients.  This is big news in the world of auditor reports, as the standard one-page form of auditor’s report has not been significantly changed in over 70 years.  The lofty goals of the PCAOB were evidenced by Chairman James Doty’s proclamation that “the changes adopted today breathe life into the audit report …”.  The lifelessness he refers to is due to these reports being mere pass/fail statements, providing absolutely no color on significant issues encountered in the audit.

The new standard requires that the audit report describe “critical audit matters” (“CAMs”), which are defined as material accounts or disclosures that involve especially challenging, subjective or complex auditor judgments.  The pass/fail nature of the report still remains, but investors will now have a view inside the audit through a better understanding of the significant issues encountered during the audit.  This view should give investors a better basis to assess the financial condition and results of an issuer and with which to engage management.

The new standard requires that auditors disclose CMAs in a new section of the audit report.  Each identified CAM must be described, along with the principal consideration that led the auditor to believe that the matter constitutes a CAM, how the CAM was addressed in the audit and the relevant financial statement accounts or disclosures related to the CAM.  The new standard contains a non-exclusive list of factors that should be used by an auditor in determining if a matter constitutes a CAM.  The PCAOB expects this determination to be “principles-based” and driven by the nature and complexity of the audit.

Other changes called for by the new standard include addressing the report to the shareholders and board of directors, a statement that the auditor is independent under SEC and PCAOB rules, and a disclosure of the number of consecutive years of service by the auditor for the issuer.

The new standard is proposed to be implemented in stages.  The formatting and tenure changes would be implemented immediately, i.e., for all fiscal years ending on or after December 15, 2017, which is the current fiscal year for most issuers.  Communications of CAMs have a much longer lead time, not being required until fiscal years ending on or after June 30, 2019 for large accelerated filers and for fiscal years ending on or after December 15, 2020 for all other public companies.

The first concern of most public company issuers considering the new CAM disclosures is how they will relate to the existing disclosures of critical accounting policies and estimates in an issuer’s MD&A.  The new requirements will result in substantially overlapping accounting topics being addressed separately by the issuer and by the auditors, both in the same SEC filing.  There will clearly need to be very focused advance planning and coordination between the auditors and the issuer regarding the content of these sections.  Care will need to be taken to assure that the auditor’s disclosures do not contain previously undisclosed material information about the issuer or information that is contradictory to or inconsistent with the issuer’s disclosures in any material manner.

Another common concern is that this new requirement will lead to voluminous additional disclosures, but only marginally improve the overall quality of disclosure.  Auditors are already focusing on the possibility of litigation against them for improper disclosure or omission of material information regarding a CAM, or failing to disclose a CAM altogether.  It is safe to assume that any area under audit that has been heavily tested and documented will be identified by the auditor as a CAM.  Once a CAM is identified the auditor will have every incentive to provide a full explanation of why this is the case and how the matter was addressed in the audit.  One can envision a long list, each with a full discussion, of every matter that could qualify as a CAM. This would track trends in Risk Factor disclosures, which tend to list every potential risk because it is better to be safe than sorry.  The one-page auditor report clearly will be a thing of the past. By comparison, similiar London Stock Exchange requirements adopted three years ago have resulted in audit reports typically running ten pages or more.

Given these concerns, many question the relative value of requiring this additional disclosure from auditors.  After all, auditors are already active participants in the preparation of an issuer’s MD&A and are in position to comment on and mold disclosures of critical accounting matters.  Auditors already have the leverage to cause an audit matter that meets the definition of a CAM to be included as a critical accounting policy or otherwise fairly discussed in a filing without these new requirements.

These are some of the many matters that must be addressed and resolved before the new CAM disclosures become effective.  While the proposed standard is subject to approval by the SEC, that process is not expected to result in any substantial modifications.  So the accounting profession and their clients should start right away to take advantage of the long runway before the CAM requirements become effective to achieve a mutually satisfactory product.

Posted on Friday, July 14 2017 at 8:33 am by

Kokesh v. SEC: The U.S. Supreme Court Limits SEC Disgorgement Powers

By Paul Foley and John I. Sanders

Since the 1970s, courts have regularly ordered disgorgement of ill-gotten gains in SEC enforcement proceedings.[1] According to the SEC, this was done as a means to both “deprive . . . defendants of their profits in order to remove any monetary reward for violating” securities laws and “protect the investing public by providing an effective deterrent to future violations.”[2] Disgorgement has been one of the SEC’s most powerful tools in recent years.[3] Earlier this week, the Supreme Court issued an opinion that significantly limits the SEC’s ability to disgorge ill-gotten gains.[4]

The question before the Supreme Court in Kokesh v. SEC was whether disgorgement, as it has been used by the SEC, constitutes a “penalty.”[5] Under federal law, a 5-year statute of limitations applies to any “action, suit or proceeding for the enforcement of any civil fine, penalty, or forfeiture, pecuniary or otherwise.”[6] The SEC has long argued that disgorgement does not constitute a “penalty” and, therefore, is not subject to a 5-year statute of limitations. The Supreme Court unanimously rejected the SEC’s position by holding that disgorgement constitutes a “penalty.”[7] As a result, the SEC will be precluded from collecting ill-gotten gains obtained by the defendant more than five years before the date on which the SEC files its complaint.[8]

In the Kokesh case, the Supreme Court’s decision means that the defendant may retain $29.9 million of the $34.9 million in allegedly ill-gotten gains because that amount was received outside of the 5-year state of limitations.[9] The Kokesh decision is also likely to have a significant long-term impact on SEC enforcement proceedings by reducing the leverage the SEC can apply while negotiating settlements.

Paul Foley is a partner with Kilpatrick Townsend & Stockton’s Winston-Salem and New York offices.  John I. Sanders is an associate based in the firm’s Winston-Salem office.

[1] SEC v. Texas Gulf Sulphur Co., 312 F. Supp. 77, 91 (SDNY 1970), aff ’d in part and rev’d in part, 446 F. 2d 1301 (CA2 1971).

[2] Id. at 92.

[3] SEC, SEC Announces Enforcement Results for FY 2016 (Oct. 11, 2016), available at https://www.sec.gov/news/pressrelease/2016-212.html (illustrating that the SEC has obtained more than $4 billion in disgorgements and penalties in each of the three most recent fiscal years).

[4] Kokesh v. SEC, available at www.supremecourt.gov.

[5] Id. (“This case presents the question whether [28 U.S.C.] §2462 applies to claims for disgorgement imposed as a sanction for violating a federal securities law.”).

[6] 28 U.S.C. §2462 (2017).

[7] Kokesh v. SEC, supra note 4, available at www.supremecourt.gov. (“SEC disgorgement thus bears all the hallmarks of a penalty: It is imposed as a consequence of violating a public law and it is intended to deter, not to compensate.”).

[8] Id.

[9] Id.

Posted on Tuesday, July 11 2017 at 5:11 pm by

Plan Early to Avoid Failing the Directors 75% Meeting Attendance Test

By:  W. Randy Eaddy

Securities counsel typically works hand‑in‑glove with a public company’s corporate secretary throughout a typical year, with their collaboration intensifying when planning the annual shareholders’ meeting and related year‑end disclosures.  The “big ticket” items, while numerous, are well‑known and appear on any decent planning checklist.  I want to focus on a lower profile item that is a candidate for insufficient early attention – i.e., the requirement to disclose in a company’s annual meeting proxy statement whether any director did not attend at least 75% of the aggregate meetings of the Board of Directors and Board committees on which the director served during the last fiscal year (the “75% Meeting Attendance Test” or the “75% Test”).

The 75% Meeting Attendance Test may appear innocuous to the uninitiated.  After all, the calculation appears to be straight‑forward; there is no legal consequence for any director who attends a lesser number of meetings; the disclosure per se is easy to write, if it must be made; and the failure does not disqualify the director for continued service on the Board or any of its committees.  There is, however, the following potentially significant practical consequence.  Avoiding it requires early planning – well in advance of the year end – and real‑time monitoring.

Institutional Shareholder Services (“ISS”) has used a director’s failure of the 75% Meeting Attendance Test as a basis to recommend voting against (or withholding a vote for) reelection of the director.  It is possible that other shareholder advisory firms, such as Glass Lewis and Egan‑Jones, could do the same.  If a significant number of a company’s institutional or other large shareholders follow such a recommendation, the director’s reelection could be jeopardized.  Even if reelection is not in jeopardy, the director might be subject to an embarrassingly low positive vote, which the company must disclose publicly.  Regardless of what might be said openly, the latter is not a “non‑event” inside the company.  Fingers will likely be pointed at someone if the situation could have been avoided with appropriate early planning.

Effective planning to avoid failing the 75% Meeting Attendance Test can be a trap for the unwary.  All meetings of a company’s audit, compensation and nominating committees count for purposes of the 75% Test.  (It is possible and likely, as discussed below, that other committees a Board might establish are not required or permitted to be included.)  Where some directors serve on multiple committees and/or where the Board or a committee has several special meetings during a particular year, the trap becomes larger.  Just one missed meeting can be determinative.

Consider this realistic scenario for a director who serves on the Board’s Audit and Compensation Committees.  In a typical fiscal year, the Board and Compensation Committee each has four regularly scheduled meetings, and the Audit Committee has eight regularly scheduled meetings, for a total of 16 meetings for this director.  This fiscal year, however, the Board and the Audit Committee has each had two special meetings, bringing the total possible meetings for this director to 20.  The director attends four of the six Board meetings, eight of the ten Audit Committee meetings and three of the four Compensation Committee meetings, for an attendance profile of 15 of the 20 total Board and committee meetings.  That’s a lot of meetings for one person to attend in a year, but the director is at exactly 75% and has just barely avoided failing the 75% Meeting Attendance Test.

Change the above facts just slightly, but again realistically, and the outcome is radically different.  Assume that the Audit Committee had only one special meeting rather than two ‒ e.g., someone had the “bright” idea to have the Audit Committee act by unanimous written consent in lieu of holding a second special meeting ‒ but the subject director missed the one special meeting that was held.  Everything else remains the same.

In this modified scenario, the director will have attended 14 of the now 19 total Board and committees meetings.  Still a lot of meetings, but the director’s attendance would now be only 73.6%.  He/she will fail the 75% Meeting Attendance Test; the negative attendance disclosure will be triggered; the votes for reelecting the director may be adversely affected as a result; and someone will be blamed.

Indeed, someone should be blamed in that situation.  If the attendance situation is being monitored closely in real‑time, a fix could be easy.  For example, any one of the Board, Audit Committee or Compensation Committee could call one more special meeting, scheduled for a time that the subject director’s attendance is assured.  Of course, determining which of the Board and two committees should call the additional meeting should include consideration of the respective meeting attendance profiles of the other directors and committee members.  One should not fix the attendance situation for Director X by putting Director Y’s attendance percentage in jeopardy.

The rigid nature of the 75% Meeting Attendance Test makes such strategic calculations possible because all meetings count, without regard to their purpose or substance otherwise.  That might be a flaw in the rule, but it should be used when helpful.  In the modified hypothetical scenario above, perhaps it was not such a “bright” idea to have the Audit Committee act by written consent, if it would have been possible to hold a short telephone meeting that the subject director was available to join.

The above illustrations highlight the importance of real‑time monitoring throughout the fiscal year.  It is too late if the 75% Meeting Attendance Test failure is discovered after year‑end.  Item 407 of Regulation S‑K ‒ to which Item 7(d) of Schedule 14A refers for disclosure about the 75% Meeting Attendance Test ‒ does not address excluding any missed meeting from the count.  And, while ISS has a category of three “acceptable reasons” that can permit it to exclude a particular missed meeting in deciding whether to recommend against a director who failed the 75% Test, ISS applies them narrowly and rigidly, and it requires express disclosure of the reason in the company’s proxy statement.  One should not want to rely on ISS approving an exclusion in a close case.

As alluded to above, there may be an issue of whether other possible Board committees (beyond the audit, compensation and nominating committees) are required or permitted to be included in the 75% Meeting Attendance Test.  It is possible to read Item 407(b) of Regulation S‑K as covering every grouping of directors that a Board might label as a “committee”.  However, in light of Item 407’s exclusive focus on the nominating, audit and compensation committees otherwise, I believe Item 407(b) is properly read as directing the 75% Meeting Attendance Test to only those three Board committees.

It is inarguable that the trio of the audit, compensation and nominating committees stands apart, conceptually and functionally, from all other committees in the corporate governance pantheon.  That is not to say that other committees are inherently less important, but these three have become universally fundamental among U.S. public companies, and they constitute a common referential baseline for comparison and other purposes.  To require or permit inclusion of other committees in the 75% Meeting Attendance Test would create simultaneously a gaping loophole and a gaping trap.  I do not believe such a result is intended or desirable for any purpose.

Posted on Monday, June 5 2017 at 4:16 pm by

Regulation 14C and the Effectiveness of a Non‑Unanimous Shareholders’ Written Consent

By: W. Randy Eaddy

Securities lawyers know that the regulatory regime for disclosure and shareholder communications under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), when action is being taken by shareholders, includes the low‑profile Regulation 14C as well as the high‑profile Regulation 14A.  Regulation 14A covers the predominant scenario, which involves “soliciting” the public shareholders to support or oppose the subject action.  Regulation 14C covers the much less frequent scenario in which the public shareholders are not being “solicited”.  A typical no‑solicitation scenario – usually involving small to mid‑size public companies – is where a small cohort of shareholders own enough shares to approve an action by written consent without soliciting the public shareholders (a “Non‑Unanimous Written Consent”).  It can raise some interesting questions about the applicability and effect of Regulation 14C.

Most state corporate codes permit shareholder action by Non‑Unanimous Written Consent, and typically require only that reasonably prompt written notice be provided to all shareholders in order to inform them of the action that was taken, by whom it was taken and the effective date of the action taken.  The effective date is typically not tied to the delivery of such written notice; it can be any date beginning with the date on which the last acting shareholder whose consent is necessary to reach the required shareholder approval threshold (the “Last Required Consent”) signs the written consent.

No part of the Exchange Act’s regulatory regime prevents the use of a Non‑Unanimous Written Consent approach.  However, Regulation 14C stands sentinel, and its requirements must be addressed if it applies in that context.  When it applies, Regulation 14C requires the filing with the SEC, and delivery to the public shareholders, of an information statement that meets the disclosure requirements of Schedule 14C (an “Information Statement”).  And, Regulation 14C has implications for the timing of the effectiveness of the subject action.  The answers to whether Regulation 14C applies, and its effects, in certain written consent scenarios are not all clear.  First, the easy answers.

When a meeting of shareholders is being held at which the subject action will be taken (even though no shareholder is being “solicited” with respect to the action), it is manifest that Regulation 14C applies.  Rule 14c‑2(a)(1), which establishes the scope of Regulation 14C’s applicability, is less than a paragon of clarity in one important regard that we discuss below, but there is no doubt that Regulation 14C applies where a written consent is “[i]n connection with . . . [an] annual or other meeting of [security holders] . . . .”

Whenever Regulation 14C applies, Rule 14c‑2(b) states that the Information Statement must be delivered to the public shareholders “at least 20 calendar days prior to the earliest date on which the corporate action may be taken.”  The prerequisites for the Information Statement delivery are analogous to those for a Schedule 14A proxy statement when Regulation 14A applies, including its filing with the SEC no later than its first dissemination to the shareholders.  As a result, Regulation 14C operates to impose at least a 20‑day delay on the effectiveness of the subject action, calculated from the date of the Last Required Consent.

Query, then, the effective date ‒ and the validity of the subject action per se ‒ in a situation where a Non‑Unanimous Written Consent purports to be “effective immediately” on the date of receiving the Last Required Consent?  And, what result if there is no filing or delivery of a compliant Information Statement?  We return to those questions in a moment; but, first, the other part of the threshold applicability issue.

Regulation 14C’s applicability is less clear in the written consent scenario where no meeting is being held (which we will call the “Non‑Unanimous Written Consent, No Meeting Scenario”).  Rule 14c‑2(a)(1) is admittedly and unfortunately ambiguous in this regard.  It states the coverage of written consents (the “Written Consent Clause”) in the form of a dependent clause ‒ i.e., “including the taking of corporate action by the written authorization or consent of security holders . . .” ‒ in a sentence that begins:  “In connection with every annual or other meeting of [security holders] . . . .”  That grammatical structure allows one to read the overall sentence as meaning that the Written Consent Clause does not apply where there is no shareholders meeting.  Under such a reading, Regulation 14C would not apply in the Non‑Unanimous Written Consent, No Meeting Scenario.

We believe such a reading is misguided and problematic, and that Regulation 14C applies in the Non‑Unanimous Written Consent, No Meeting Scenario.  To read Rule 14c‑2(a)(1) otherwise would make the Written Consent Clause non‑sensical.  It would then only cover a tiny (and strange) universe of situations ‒ i.e., where a meeting is being held even though the subject action is being taken by written consent.  We can envision a happenstance scenario where a Non‑Unanimous Written Consent is being executed around the same time that a completely unrelated meeting of shareholders is otherwise scheduled.  However, it is inconceivable that such a happenstance scenario is the intended focus of the Written Consent Clause.  Yet, that is precisely what non‑applicability of Regulation 14C to the Non‑Unanimous Written Consent, No Meeting Scenario would mean.

As a result, we believe Regulation 14C operates to impose the 20‑day delay on the effectiveness of the subject action in the hypothetical situation we describe above.  However, we do not believe it would invalidate the action per se if such delayed effectiveness does not otherwise have the practical effect of doing so.  That said, where a company never files and delivers a compliant Information Statement as contemplated by Regulation 14C, we believe the effectiveness of the purported action will be open to potential challenge, if a claimant can establish the requisite interest in the matter to bring a lawsuit (the de facto equivalent of standing) and harm to the claimant.

We have found no explicit definitive discussion of those matters, whether by the SEC or securities law commentators.  All discussions we have seen presume applicability of Regulation 14C in the Non‑Unanimous Written Consent, No Meeting Scenario, and none of them address specifically the effectiveness timing issue.

On the other hand, we have seen at least one instance ‒ actually, it is a series of consistent actions by one company ‒ where a company (and apparently its counsel) appear to believe otherwise.  That company filed a Form 8‑K on multiple occasions to disclose corporate actions that had been taken via Non‑Unanimous Written Consents by a small group of affiliated shareholders.  In each case, the company did not file or deliver an Information Statement pursuant to Regulation 14C, and it stated the subject action as being “effective immediately”.  We doubt the soundness of that approach and do not recommend it.

Posted on Thursday, May 18 2017 at 11:03 am by

General Solicitations of Certain Regulation D “Private” Securities Offerings: SEC Affirms Zero-Tolerance Policy.

By Paul Foley and John I. Sanders

On March 29, 2017, the Securities and Exchange Commission (the “SEC”) issued a noteworthy opinion in In re KCD Financial Inc.,[1] a review of a FINRA disciplinary action.[2] While the opinion affirmed FINRA’s disciplinary action,[3] it also affirmed the SEC’s zero-tolerance policy regarding general solicitations made in the course of certain Regulation D offerings. Those relying on or contemplating relying on Regulation D exemptions from registration should review the SEC’s opinion.

Factual Background

KCD Financial, Inc. (“KCD”) is an independent broker-dealer.[4] In 2011, KCD signed an agreement with one of its affiliates (“Westmount”) under which it would solicit accredited investors for a particular private fund (the “Fund”) sponsored by Westmount.[5] Westmount did not plan to register the offering. Westmount instead planned to rely on a Rule 506(b) exemption from registration.[6]

Prior to KCD selling any interest in the Fund, Westmount issued a press release describing Fund.[7] Two Dallas newspapers published articles based on the press release and made the articles available on their respective public websites.[8] One of those newspaper articles was then posted on a public website belonging to a Westmount affiliate.[9] Westmount’s outside counsel informed Westmount that the newspaper articles constituted general solicitations, which are prohibited in Rule 506(b) offerings.[10]

After KCD and Westmount officers were told that the articles were general solicitations prohibited under Rule 506(b), they did not end the offering, register the securities, or seek to rely on an alternative exemption. Instead, KCD’s CCO and Westmount’s Vice President of Capital Markets instructed the representatives to sell interests in the Fund only to (i) those with an existing relationship to KCD or Westmount and (ii) accredited investors who had not learned of the offering through the general solicitations.[11] Under those guidelines, at least one person was refused an opportunity to purchases interests in the Fund.[12]

During a FINRA examination of KCD, the examiner found that the newspaper article about the offering had not been removed from Westmount-affiliated website.[13] Subsequently, FINRA filed a complaint against KCD alleging that the firm’s registered representatives sold securities that were unregistered and not qualified for an exemption from registration, thereby violating FINRA Rule 2010.[14] FINRA also alleged that KCD failed to reasonably supervise the offering, thereby violating FINRA Rule 3010.[15] FINRA’s Hearing Panel found that KCD violated those rules.[16] FINRA censured KCD and imposed a fine of $73,000.[17] The National Adjudicatory Counsel affirmed FINRA’s decision.[18] KCD then requested an SEC review.[19]

SEC Review

KCD admitted that the Fund interests it offered were not registered, but argued that offers were made pursuant to Rule 506(b).[20] The SEC rejected KCD’s contention,[21] finding that where a party relying on the Rule 506(b) exemption makes a general solicitation, the exemption then is unavailable “regardless of the number of accredited investors or the knowledge and experience of the purchasers who were not accredited investors.”[22] In this context, whether purchasers were accredited or had prior relationships with KCD and Westmount was “irrelevant to whether or not the newspaper articles constituted a general solicitation” and precluded reliance on Rule 506(b).[23]

KCD also argued, assuming the newspaper articles constituted general solicitations, it could still rely on a Rule 506(b) exemption because “KCD did not generally solicit any of the actual investors in the [Westmount] Fund.”[24] This argument confused the notion of what is prohibited under Rule 506(b). It is making an offer by general solicitation which precludes reliance on a Rule 506(b) exemption.[25] Whether a sale results directly from the general solicitation is irrelevant.[26]

Practical Implications

The SEC’s opinion affirms its view that exemptions from registration in securities offerings are narrowly construed and must be adhered to strictly.[27] Where, as here, the exemption prohibits a general solicitation, any general solicitation forever forfeits the issuer’s ability to rely on the exemption in making the offering (i.e., the toothpaste cannot go back into the tube).

Those making exempt offerings in reliance on Rule 504,[28] Rule 505,[29] and Rule 506(b)[30] should review their sales practices in light of the KCD opinion. In reviewing practices, issuers should look beyond the obvious means of making a general solicitation (e.g., a press release that is published by a widely-circulated newspaper). Websites and social media accounts of those participating in the offerings are equally capable of precluding use of a valuable registration exemption.

Paul Foley is a partner with Kilpatrick Townsend & Stockton’s New York and Winston-Salem, North Carolina offices.  John Sanders is an associate based in the firm’s Winston-Salem office.

[1] In re KCD Financial, Inc., SEC Release No. 34-80340 (March 29, 2017), available at www.sec.gov/litigation/opinions/2017/34-80340.pdf (hereinafter, SEC Opinion).

[2] In re KCD Financial, Inc., FINRA Complaint No. 2011025851501 (Aug. 3, 2016), available at http:www.finra.com (hereinafter, FINRA Opinion).

[3] SEC Opinion, supra note 1, at p. 1.

[4] Id., at p. 2.

[5] Id.

[6] Id.

[7] Id, at p. 3.

[8] Id.

[9] Id. at p. 4.

[10] Id.

[11] Id.

[12] Id.

[13] Id.

[14] Id.

[15] Id.

[16] FINRA Opinion, supra note 2, at p. 4.

[17] Id.

[18] Id.

[19] Id.

[20] SEC Opinion, supra note 1, at 2.

[21] Id.

[22] Id. at 7.

[23] Id. at 9.

[24] Id at 10.

[25] Id.

[26] Id. at 11

[27] Id. at 7.

[28] 17 CFR 230.504 (2017).

[29] 17 CFR 230.505 (2017).

[30] 17 CFR 230.506(b) (2017).

Posted on , May 18 2017 at 11:00 am by

SEC Amends Crowdfunding Rules

By Paul Foley and John I. Sanders

Under the Jumpstart our Business Startups Acts of 2012 (the “JOBS Act”), the Securities and Exchange Commission (the “SEC”) adopted rules allowing for securities-based crowdfunding in 2015.[1] The JOBS Act required the SEC to adjust dollar limits placed on the amount that could be invested or raised through securities-based crowdfunding at least every five years to account for inflation.[2] On April 5, 2017, the SEC issued a final rule adjusting those limits for the first time.[3] We encourage those interested in issuing securities through a securities-based crowdfunding offering to review the final rule and call us with any questions you may have.

Paul Foley is a partner with Kilpatrick Townsend & Stockton’s New York and Winston-Salem, North Carolina offices.  John Sanders is an associate based in the firm’s Winston-Salem office.

[1] SEC, Release No. 33-9974 (Oct. 9, 2015), available at https://www.sec.gov/rules/final/2015/33-9974.pdf.

[2] Id. at 15.

[3] SEC, Release No.33-10332 (April 5, 2017), available at https://www.sec.gov/rules/final/2017/33-10332.pdf.

Posted on Tuesday, May 16 2017 at 8:26 am by

The Sexennial Vote On Frequency of Say-on-Pay: Know When to Say When, or Risk Compromising S-3 Eligibility

By: Edward G. Olifer

We are in the bloom of annual meeting season for calendar year filers. Reporting companies are dutifully reporting annual meeting results under Item 5.07 of Form 8-K within four business days of their annual meetings. However, this year is a little different.

For the first time in six years, many SEC reporting companies are again required to place before shareholders a non-binding resolution on the frequency of their “say-on-pay” vote. The advisory vote seeks shareholder input as to when future say-on-pay proposals will be voted on by shareholders: every year, every two years or every three years. The reporting requirements for this one-every-six year proposal are different than those for other proposals. Companies heading home following their annual meetings should be careful to timely touch all of the proposal’s disclosure bases to avoid compromising their S-3 eligibility, as numerous companies did in the proposal’s inaugural reporting season six years ago.

Under Form 8-K Item 5.07(b), for votes on the frequency of say-on-pay proposals, companies must disclose the number of votes cast for each of the proposal’s options, as well as the number of abstentions.  In addition to the vote tally, Item 5.07(d) requires a company to report its decision, in light of the shareholders’ vote, as to how frequently the company will actually include a say-on-pay proposal in its future proxy materials. The decision must be reported either in the Form 8-K reporting the annual meeting results or in a later filed amendment to that Form 8-K. Alternatively, companies may report annual meeting results in a Form 10-Q or 10-K that is filed on or before the due date that an Item 5.07 Form 8-K would otherwise be due. If the 10-Q/10-K disclosure does not report the company’s decision as to how frequently it will include future say-on-pay proposals in its proxy materials, the company may file a new Item 5.07 Form 8-K, rather than an amended Form 10-Q or 10-K, to report that decision. See Form 8-K General instruction B.3 and question 121A.04 of the SEC’s Form 8-K Compliance and Disclosure Interpretations.

In any case, Item 5.07(d) requires that companies must report their decision on the frequency of say-on-pay proposals by no later than 150 days after the shareholder meeting at which shareholders voted on the frequency of say-on-pay, but in no event later than 60 days prior to the deadline for submitting shareholder proposals as disclosed in the company’s most recent proxy statement for shareholder meeting at which shareholders voted on say-on-pay frequency. The enhanced reporting obligation was overlooked by numerous reporting companies in 2011. As Item 5.07 is not one of the enumerated items for which General Instruction I.A.3(b) of Form S-3 provides relief, the oversight caused some severe cases of S-3 eligibility anxiety. Transgressors seeking to make use of registration statements on Form S-3 scrambled to amend their original Item 5.07 Forms 8-K to report their boards’ decisions on say-on-pay frequency and to seek Form S-3 eligibility waivers (d/b/a “non-objections”) from the Office of Chief Counsel.

Companies seeking to avail themselves of the waiver process may contact the Chief Counsel’s Office at 202.551.3500.  Waiver requests must be submitted in writing using the following portal: https://www.sec.gov/forms/corp_fin_noaction. The contents of waiver requests are specific to each situation and the Office will counsel filers as to what should be included, but filers should expect to provide the Staff with the following information:

  • Description of the company and its reporting status (“large accelerated filer”, etc.);
  • Description of the untimely report;
  • Basis for the non-objection request;
  • Reason(s) why the non-objection request should be granted;
  • Confirmation that the company has timely satisfied all other Exchange Act filing requirements and otherwise meets the Form S-3 eligibility requirements;
  • Company’s prior filing history and whether it has previously filed late reports;
  • Controls and procedures adopted to ensure future reporting compliance; and
  • Explanation of timing of requested non-objection.

Staff determinations on these requests are delivered to the company telephonically, not in writing. Neither the request nor the determination is posted on EDGAR.

The bottom line is to stay focused on reporting the board’s decision on when shareholders should expect to see say-on-pay proposals in future proxy statements.  After that, see you in another six years.

Posted on Tuesday, May 9 2017 at 4:27 pm by

How to Register Additional Securities on Form S-3: Rule 413(b) or Rule 462(b)?

By: Isabelle A. Dinerman

The general rule (as set forth in Rule 413(a) under the Securities Act) is that a company cannot register additional securities on a registration statement that is already in effect; instead, a company must file a new registration statement to register any additional securities—even when the additional securities are of the same class as those already registered. While this is always the case for a registration statement on Form S-8, there are fortunately some exceptions for a registration statement on Form S-3. The exceptions, however, require that you start with an automatic shelf registration statement. Thus, using a post-effective amendment to register additional securities only becomes possible for a public company that qualifies as a “well-known seasoned issuer” or “WKSI” (a category of issuer established in 2005 under the SEC’s Securities Offering Reform (SEC Release No. 33-8591) for the most widely followed public companies in the U.S. marketplace).

A WKSI enjoys special benefits due to its issuer status—in particular, it is eligible to register certain offerings of securities on a Form S-3 registration statement that will be automatically effective upon filing with the SEC. If an issuer does not qualify for WKSI status, it is not eligible to file an automatic shelf registration statement. Pursuant to Rule 413(a), this would preclude it from registering additional securities of any class on a post-effective amendment. Further, even if an issuer does qualify for WKSI status as of the most recent eligibility determination date, it cannot amend an already effective shelf to convert it into an automatic shelf.

If a WKSI does have an automatic shelf in effect, it can utilize the exception in Rule 413(b) to register additional securities (or additional classes of securities) by filing a post-effective amendment to the automatic shelf, but only if the new securities are either (1) of a different class than those already registered on the automatic shelf or (2) of a majority-owned subsidiary and permitted to be included in an automatic shelf.

Although WKSIs have more flexibility than other categories of issuers and are not required to specify a maximum aggregate offering price or number of shares in the base prospectus of an automatic shelf, they may choose to do so.  However, Rule 413(b) noticeably omits any reference to adding securities of the same class as those already registered.

This begs the question— if a WKSI has specified a number of shares in the base prospectus, can it use a post-effective amendment to register additional securities of the same class as those already registered on its automatic shelf? The SEC Staff eventually addressed this very question in question 210.03 of the Compliance and Disclosure Interpretations on the Securities Act Rules. The Staff confirmed that the answer is yes, “an issuer may add to the automatic shelf registration statement on Form S-3, by post-effective amendment, more securities of the same class already registered.” A couple of examples include a post-effective amendment to an automatic shelf filed by Tesla, Inc. (formerly known as Tesla Motors, Inc.) on September 28, 2012 and, more recently, a post-effective amendment to an automatic shelf filed by Delta Air Lines, Inc. on March 30, 2017. Pursuant to Rule 462(e) under the Securities Act, just like the automatic shelf itself, a post-effective amendment to an automatic shelf would automatically become effective upon filing with the SEC.

If an issuer cannot utilize Rule 413(b) (because it either does not qualify as a WKSI or the applicable registration statement is not an automatic shelf) and must file a new registration statement to register additional securities, there may still be some welcome relief available under Rule 462(b) under the Securities Act.  The timeframe for its utilization is limited, however, and thus it is not the functional equivalent of the Rule 413(b) exception.

Rule 462(b) provides for immediate effectiveness, upon filing with the SEC for a new registration statement, if (1) the new registration statement registers additional securities of the same class as were included in an earlier registration statement for the same offering and was declared effective by the SEC, (2) the new registration statement is filed prior to the time confirmations are sent or given, and (3) the new registration statement registers additional securities in an amount and at a price that together represent no more than 20% of the maximum aggregate offering price included in the earlier registration statement. Thus, Rule 462(b) allows a non-WKSI to react quickly and upsize an offering by up to 20% if desired.

Another benefit of Rule 462(b) is that an issuer utilizing the rule can file a short-form registration statement. As set forth in General Instruction IV.A to Form S-3, a new registration statement filed pursuant to Rule 462(b) may consist of only (1) the facing page, (2) a statement that the contents of the earlier registration statement, identified by file number, are incorporated by reference, (3) required opinions and consents, (4) the signature page, and (5) any price-related information omitted from the earlier registration statement pursuant to Rule 430A that the registrant decides to include in the new registration statement.

Accordingly, while only WKSIs can register additional securities by post-effective amendment to an automatic shelf, non-WKSIs may still be able to take advantage of Rule 462(b) to expeditiously register additional securities in certain circumstances.

Posted on Wednesday, April 26 2017 at 2:36 pm by

Your SEC Filing Cover Page is (Probably) Wrong!

By: David M. Eaton

If you blinked, you may have missed this one—in a release deceptively titled “Inflation Adjustments and Other Technical Amendments Under Titles I and III of the JOBS Act,” the SEC amended the cover pages of a slew of its forms, including Securities Exchange Act Forms 10-K, 10-Q and 8-K, and Securities Act Forms S-1, S-3 and S-8.  These amendments were effective April 12, 2017, so most forms public companies would have filed since then should have had a slightly different cover page than comparable forms filed before that date.

The amendments facilitate an SEC registrant identifying itself as an “emerging growth company” (a new-ish category of recently public registrants established by the 2012 JOBS Act that are eligible for various disclosure/reporting and corporate governance breaks). An emerging growth company (“EGC”) must also indicate by check box whether or not it is relying on a particular benefit extended to EGCs—delaying complying with new or revised accounting standards until the time non-public companies are required to adopt them.  See our prior legal alert on the JOBS Act for more on EGCs.

Even though the changes are currently effective, the SEC may not have updated all of the affected forms on its forms list by the time you read this (look at the “Last Updated” column for a date of April 2017 or later to confirm). In light of this, please confer with us if you want to make sure your cover page is compliant.

Posted on Tuesday, April 25 2017 at 12:54 pm by

Disclosing Election of a New Director: Remember Item 5.02(d) of Form 8-K When Doing a Merger

By: W. Randy Eaddy and David A. Stockton

All competent securities lawyers know that Item 5.02(d) of Form 8‑K requires a filing, on Form 8‑K, whenever a public company elects a new director other than pursuant to a shareholder vote at an annual meeting or a special meeting that was convened for that purpose. That requirement typically does not present any compliance problems. The information required to be disclosed is fairly straight forward, and most companies usually obtain and prepare the relevant information for purposes of a press release or other public disclosure as part of the transaction or other corporate event leading to the election of the new director.

So, no big deal, unless one forgets that no such press release or other public disclosure ─ including, for example, a merger proxy statement ─ satisfies the Item 5.02(d) filing requirement. And, there is at least one significant adverse consequence of a missed Form 8‑K ─ i.e., Form S‑3 eligibility.

For most companies with even a modestly sophisticated capital structure, eligibility to use Form S‑3 to register securities is an important element of its ongoing securities issuance compliance regime. And, a baseline eligibility requirement for use of Form S‑3 is that a company be current with all filings under the Securities Exchange Act of 1934, as amended, for the past 12 months. Missing even a seemingly innocuous Form 8‑K filing will fail that test.

A disarming context that has led to more than a few instances of unwitting Item 5.02(d) non‑compliance is where a public company acquires a privately held business and elects as a new director a person who was involved with the privately held acquisition target. In that context, the company typically files a Form S‑4 registration statement that includes a proxy statement (if the acquisition consideration includes issuing stock to the target’s owners), or a proxy statement otherwise if the acquiror’s shareholders must approve the acquisition transaction.  (For convenience, we assume the acquisition is structured as a merger, and we refer to the transaction‑related disclosure document as a “merger proxy statement”.  The same issues discussed here are present regardless of that deal structure.)

Good and customary disclosure by the company in its merger proxy statement will include that the person associated with the target is being elected as a new director as part of consummating the merger, and that person’s background information will be included in the merger proxy statement. Also, as a part of typical corporate governance and disclosure hygiene, the planned election of such a new director will likely be included as part of the company’s press release to announce the upcoming merger and/or the meeting being held to approve it. In any case, the information provided to the public about the new director is likely to cover everything required, as a matter of substance, by Item 5.02(d).

Even more disarming is where a Form 8‑K is required and has been filed, pursuant to Item 1.01, to disclose the anticipated merger, with information about the planned election of the new director expressly included as part of that disclosure.  And, the merger is thereafter approved and consummated as so disclosed.

Ah, but there’s the rub. Unless a Form 8‑K is timely filed after consummation of the merger, and the election of the new director is disclosed in that Form 8‑K, the Item 5.02(d) requirement has not been met. Not even a Form 8‑K filing pursuant to Item 2.01 (to disclose completion of the merger) will be sufficient for Item 5.02(d) compliance purposes, if the loop is not closed by referring expressly to the new director’s actual election as previously anticipated.  After all, there can be last minute changes in the deal.

In that context, compliance with the Item 5.02(d) requirement is ripe for being overlooked. After all, the public has been informed, conspicuously and, probably, on multiple occasions, that the subject person would be elected as a new director of the company if and when the merger is completed, and the public has been informed by the Item 2.01 filing that the merger is effective. What could possibly have been missed? Well, the prescribed Item 5.02(d) filing, that’s what.

We have no empirical data, but we have great confidence, that there are many missed Form 8‑K filings in such an acquisition context.  We believe that many go unrecognized, and that they won’t be recognized, unless there is a later, specific occasion – such as the due diligence process for a future, unrelated transaction – to test for Form S‑3 eligibility. That is not a good time to make the discovery. So, make sure the Item 5.02(d) filing is a specific, post‑consummation item on the comprehensive checklist for managing the transaction.

That said, in a pinch, it might be possible to obtain a de facto waiver from the Staff of the SEC. We are aware that the Staff of the Division of Corporation Finance has taken a verbal “no objection” position with respect to a company’s use of Form S‑3 notwithstanding a missed Item 5.02(d) filing in a situation analogous to that described above. We believe the Staff’s position was based on a compelling demonstration by the company of “no harm, no foul” because the company had otherwise provided a conspicuous, substantially equivalent, timely disclosure of the same information.  But, don’t plan on such an outcome; remember the Item 5.02(d) filing.

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