Posted on Tuesday, January 30 2018 at 12:58 pm by

Issue-spotting SEC Reporting Suspension Under Exchange Act Section 15(d)—The Real Hotel California Problem

By David M. Eaton

Section 15(d) of the Securities Exchange Act of 1934 requires an issuer who files a registration statement under the Securities Act of 1933 to file Exchange Act reports with the SEC for at least the year in which the registration statement goes effective. This duty to file under § 15(d) is automatically suspended while an issuer is reporting pursuant to Exchange Act § 12—for instance, because the securities are listed on a stock market. The duty to file is also automatically suspended as to any fiscal year, other than the fiscal year during which the registration statement went effective[1], if at the beginning of the year the securities covered by the registration statement are held of record by less than 300 persons in the case of nonbanks, or 1,200 in the case of banks, savings and loans and bank holding companies.

The Ostensible Problem

When securities lawyers refer to the “Hotel California” problem in § 15(d), they are usually referring to the fact that domestic issuers can never really terminate a § 15(d) filing obligation—they can only suspend it.[2] If the filing obligation is suspended by virtue of a superseding § 12 filing obligation, the § 15(d) obligation returns when the § 12 filing obligation falls away. In addition, if a § 15(d) reporting duty is suspended due to the number of record holders falling below the requisite threshold, the duty resumes if the number eventually climbs back to the threshold or above. Hence, in the words of the Eagles’ 1977 classic, “[y]ou can check out any time you like, but you can never leave!”

A Bigger Problem

However, this potential “gotcha” in the securities laws is probably outweighed in significance by a different problem—namely, that you really can’t check out any time you like. The prohibition against reporting suspension during the fiscal year when the offering registration statement went effective, while seemingly straightforward on its face, has historically been interpreted in a manner which often frustrates issuers’ ability to suspend § 15(d) reporting in cases where the record holders are actually below 300.

The problem, in short, is ‘evergreen’ Securities Act registration statements, like Forms S-3 and S-8. These types of registration statements allow securities to be offered from time to time over a period of potentially years—these are sometimes called “shelf” registrations, since securities can be “taken down off the shelf” and sold as needed from time to time. They are generally kept up to date through a company’s routine filing of SEC reports, which are deemed to be incorporated into the previously filed registration statements.

The annual filing of a company’s Annual Report on Form 10-K is considered a more major update to these types of registration statements. The SEC views the Form 10-K as a “post-effective amendment” to a shelf registration statement—in other words, the registration statement is deemed to have gone “effective” again upon the filing of the Form 10-K. This results in the automatic reporting suspension in § 15(d) being unavailable for any year in which a shelf registration statement (covering outstanding securities with a § 15(d) obligation) is automatically updated by the filing of a Form 10-K.[3]

The same result can occur under Exchange Act Rule 12h-3, which under certain conditions permits suspension of reporting duties under § 15(d) when record holders decline below the threshold during the year, but were at or above it at the first of a year (which is a prerequisite for suspension under the actual statute, vs. Rule 12h-3). Reporting suspension under Rule 12h-3 is “unavailable for any class of securities for a fiscal year in which a registration statement relating to that class becomes effective under the Securities Act of 1933, or is required to be updated pursuant to section 10(a)(3) of the Act.” The reference to Securities Act § 10(a)(3) refers to, among other things, the update to certain shelf registrations effected by the filing of an Annual Report on Form 10-K.

To summarize, the passive updating via a Form 10-K of a shelf registration statement filed years ago can frustrate plans to suspend reporting under § 15(d), even if that registration statement has not been used to issue securities in a while.

“Express Checkouts”

There are a couple of “express checkouts” available. In Staff Legal Bulletin 18, the SEC provided interpretative relief in two common situations: (1) the closing of an acquisition of a public company and (2) abandoned IPOs.

When a public company is acquired, the number of holders of its common stock typically goes to one (i.e., the acquiring parent company, in the case of the popular reverse triangular merger structure) or zero. However, if the target had an outstanding shelf registration under which common stock could be issued (like a Form S-8 covering an employee stock incentive plan), and the acquisition closes after the target has filed its Form 10-K with respect the preceding completed fiscal year, suspension of the § 15(d) reporting obligation attached to the common stock would technically be unavailable under § 15(d) and Rule 12h-3.

The abandoned IPO situation involves an issuer, with no existing Exchange Act reporting obligation, filing a Securities Act registration statement which goes effective, but which is withdrawn prior to any securities being sold under it. Since the § 15(d) reporting obligation is triggered merely off of the registration statement going effective, and not the actual completion of the securities offering, issuers technically incur a § 15(d) reporting duty even if they never issue one share.

SLB 18 grants relief from reporting in both of these situations (subject to conditions set forth in the bulletin). The guidance makes good sense. In both the acquired public company and abandoned IPO scenarios, there are no public holders of the company’s common stock that would receive any benefit from SEC reporting.

Problem Areas

There are, however, a surprising number of situations that SLB 18 doesn’t cover, which may result in a company theoretically retaining a reporting obligation in situations where it may make no sense for it to do so. Among them:

  • A security (typically a corporate debt security—i.e., a bond) is redeemed, repaid at maturity, defeased, or repurchased during a year in which a registration statement covering the security goes effective or is updated by a Form 10-K filing. The § 15(d) reporting obligation can continue through that year even though there are no securities left outstanding, and thus no holders.
  • A related problem is when a subsidiary guarantor of a parent company’s corporate bond is released from its guarantee—if a registration statement covering the guarantee goes effective or is updated during the year of guarantee release, the subsidiary guarantor may not be able to suspend reporting.
  • An acquired company has its own outstanding debt securities upon closing of the acquisition—typically, no series of bonds would be held of record by 300 or more holders, but, if the target had a registration statement covering the securities that went effective or was updated by a Form 10-K filing during the year the acquisition closes, the § 15(d) reporting suspension is not technically available with respect to that year.
  • Problems can even arise in the benefit plan context. Consider a 401(k) plan that decides to eliminate its issuer common stock investment alternative. Can the plan stop filing its Form 11-K annual report—and assuming it can stop, when?

Relying on No-Action Letters for Solutions—Good News—and a Couple Caveats

The good news is that there are a lot of favorable SEC staff “no-action” letters published in this area—many of them cast as interpretative relief under Rule 12h-3.[4] In some situations, there are sufficient numbers of letters such that counsel may feel comfortable relying on them rather than seeking individual no-action relief. Nevertheless, it is important to analyze a particular situation to make sure it squares with the available letters. If a situation is not on all fours with a line of precedents, counsel may choose to consult with the SEC’s Office of Chief Counsel.

A couple caveats—first, no-action relief is generally denied if the security covered by the registration statement was actually offered and sold pursuant to that registration statement in the year in which reporting relief is sought. The typical situation for no-action relief therefore involves a shelf registration being passively updated by a Form 10-K filing in a year during which no actual offering under the registration statement is made.

Second, whether a company can suspend a § 15(d) reporting obligation (usually accomplished through filing a Form 15) is a different question from whether a reporting company can discontinue including a Regulation S-X Rule 3-10 condensed consolidating note that has previously appeared in the company’s financial statements.

To briefly explain this issue: subsidiary guarantors of the debt securities of a reporting parent commonly do not file their own Exchange Act reports separately from their parent, even though guarantees of debt securities are themselves considered securities that can trigger a reporting obligation if offered pursuant to a registration statement. Instead, the reporting parent will typically include financial information about the subsidiary guarantors in a special footnote in the parent’s financial statements prescribed by Rule 3-10 of Regulation S-X. If a subsidiary guarantor can omit filing its own financial statements because its parent includes the requisite footnote, then Exchange Act Rule 12h-5 exempts that subsidiary guarantor from Exchange Act reporting.

The hitch is that the SEC staff requires, as a condition to the use of the Rule 12h-5 reporting exemption for subsidiary guarantors, that the special Rule 3-10 footnote be included in the parent’s financial statements for as long as the security is outstanding. So, even if the number of guarantee holders falls below 300, and the subsidiary guarantor is consequently able to file a Form 15 to suspend its reporting obligation, the parent’s reports must continue to feature the special footnote (which can be difficult to prepare, depending on the guarantee structure) for so long as the guarantee is held by any holders. If the subsidiary reported separately from the parent in this situation rather than rely on the Rule 12h-5 exemption, it could suspend reporting and the parent would have no special financial statement footnote requirement.[5]

In other words–imagine if you did check out of the hotel, but had to continue paying the bill into perpetuity!


The message here is not that § 15(d) can create insurmountable problems when an issuer seeks to cease reporting with respect to a particular security that is held by somewhere between zero and 299 holders; the real takeaway is that you need to engage in one of the oldest of lawyerly skills—issue-spotting—when considering Exchange Act § 15(d) reporting suspension. Many of the problems you may identify can be addressed through reliance on existing SEC staff guidance (whether the SLB or published no-action letters), but given the wide variety of facts that may pertain, you can encounter situations that don’t square with the guidance. Better to get a handle on any § 15(d) issues early in your process and get comfortable with your solutions, rather than run up against an Exchange Act reporting deadline unsure of whether you can skip the report.

[1] This means you still have to file a Form 10-K with respect to the year of effectiveness, even if the report is actually filed in the subsequent year after the duty to file under § 15(d) is suspended.

[2] Pursuant to Exchange Act Rule 12h-6, adopted in 2007, a foreign private issuer actually can terminate, and not just suspend, its duty under § 15(d) to file SEC reports. The previous inability of foreign private issuers to permanently exit SEC reporting was thought to be a disincentive for foreign companies to access the U.S. capital markets. Rel. No. 34-55540 (June 4, 2007).

[3] SEC Exchange Act Sections Compliance and Disclosure Interpretations Question 153.01.

[4] “No-action” letters are a traditional form of written administrative guidance companies and their lawyers can sometimes obtain from the SEC staff—so named because a favorable response from the staff will conclude with a sentence to the effect that the staff will not recommend to the actual commissioners that any enforcement action be taken against the company requesting relief if it proceeds as outlined in its no-action request.

[5] See, e.g., § 2540.2 of the SEC’s Division of Corporation Finance Financial Reporting Manual.



Posted on Tuesday, December 19 2017 at 10:37 am by

The Businesses Judgment Rule: Time for Conceptual Clarity

By: W. Randy Eaddy

I wager that most readers of this post misunderstand the “business judgment rule” in some important regard, regardless of years of practice experience and whether you are a transactional or litigation corporate lawyer. It is not your fault, however, and so I won’t actually take your money when I win the wager. I will only ask that you support my proposal to bring conceptual clarity and consistency to application of the rule.

Entire books and even multi-volume treatises have been written about the business judgment rule; analysis of it is a de facto “cottage industry”. Regrettably, that commentary mostly rationalizes the conceptual confusion brought on by decades of misunderstanding and frequent misapplication of the rule. Conceptual clarity and straight‑forward application is nonetheless possible, and it is needed, unless one supports the current state of affairs as a way to subvert or marginalize the rule.

Because of the large volume of commentary on the rule, most corporate lawyers believe they know its historical conception and objectives, A brief review will both dispel that notion and set the stage for my clarifying view of how the rule was intended to (and should) operate.

Overview and Conceptual Fundamentals

The historical baseline conception of the business judgment rule is that the substantive merits of business decisions made by directors are afforded protection from second-guessing by courts, so long as the directors reached those decisions through deliberations and other procedural processes that satisfied their fiduciary duties under state law. That baseline reflects an underlying policy position that directors’ fiduciary duties do not subject their decisions to strict liability. Directors can be wrong in deciding some matter and yet not have their decision overturned, if the directors were loyal, careful and followed certain rigorous procedural protocols in making it. As so conceived, the business judgment rule was intended to be a protective measure for directors who acted properly, even though they may have gotten something wrong.

If that is your understanding of the historical conception of the rule, you are correct, so far. My analysis of the leading cases indicates that things begin to get off-track — leading to confusion, complexities and problems — because of well-intentioned courts, trying to “do good”, in situations with “bad facts” that cried out for equity. In any event, that baseline conception has been frequently distorted to such an extent that some courts and commentators have come to refer to the rule as a legal standard for conduct and/or an actual duty or responsibility owed by directors or a board. It was neither.

Rule of Procedure — Rebuttable Presumption

Properly understood, the business judgment rule was (and I believe it should remain) a rule of procedure that establishes the following, fairly straight-forward, rebuttable presumption. In making a business decision, directors are presumed to have acted in accordance with their fiduciary duties if the directors followed certain procedural protocols. The presumption is not that the directors’ decision was substantively correct, but simply, albeit significantly, that the directors fulfilled their fiduciary duties in making it. If so, the decision is entitled to be respected and not be second-guessed simply because it looks or feels wrong with hindsight. Such presumed fulfillment of fiduciary duties can be rebutted, of course, by persuasive factual evidence that the directors’ fiduciary duties were not actually fulfilled. If they were not, then a second-guessing review of the substantive merits of the decision is appropriate.

Some courts (with Delaware courts typically in the lead) have allowed a so-called enhanced presumption of propriety in certain situations, such as where a majority of the board of directors making a particular decision are independent directors, or where a special committee of independent directors is appointed to decide the particular matter. It is arguable, but essentially unimportant here, whether such a putative enhancement is useful. The key point is that, in all situations, the decisions of disinterested directors should be entitled to the presumption of propriety afforded by the business judgment rule, if those directors followed appropriate procedural protocols.

Even in the conceptual confusion currently surrounding the rule, the elements of those protocols are fairly well‑established as meaning that the directors:

  • make an affirmative decision to act or refrain from acting, as opposed to defaulting to a particular result by not making a decision;
  • act in good faith;
  • act in the honest belief that their action is in the best interest of the company;
  • stay informed of all material facts, and proceed with care and circumspection in their decision-making processes; and
  • have a rational business purpose for their decision.

With a caution about the last element — i.e., it is not really a separate element, but is the de facto cumulative effect of the other elements being present — those elements are a good and effective set of procedural protocols for application of the rule. They are qualitative and rigorous as a basis for testing the directors’ fulfillment of their fiduciary duties, and thus for determining whether the presumption should be sustained, without getting into the substantive merits of the underlying decision.

Two‑Step Approach for Rebutting the Presumption

Whether the presumption of the rule is sustained or rebutted is a two-step process. As the first step, the plaintiff must present credible factual evidence indicating that a breach of a fiduciary duty occurred, based on one or more of the above procedural protocols. The plaintiff’s threshold rebuttal presentation leads to the second step, by shifting to the defendant directors the burden of producing countering evidence that they actually discharged their fiduciary duties in making the decision.

In the second step, the court assesses the competing evidence, based on the satisfaction or not of above procedural protocols only. If the defendant directors’ countering evidence is more persuasive than the evidence presented by the plaintiffs, then the decision should be respected and accepted, and the substantive merits should not be second-guessed by the court. On the other hand, if the evidence provided by the defendant directors is not persuasive, then the court should turn to analyzing the substantive merits of the decision using the relevant standard for such a substantive review under applicable law.

Regrettably, consistent compliance with that two-step approach has not been the norm. Instead of assessing and weighing the evidence presented by the two sides, and then abiding by the outcome of the determination whether the directors proved that they satisfied their fiduciary duties, courts have often undertaken a review of the substantive merits of the decision, without making (or regardless of) that determination. Again, I believe that occurred because the courts were actually peeking, during the second step, at the perceived or suspected “inequity” of the decision’s substantive outcome and trying to get around the rule. While I can understand that temptation, it simply is inconsistent with the rule as conceived.

Most of the leading commentary (and many subsequent courts) have sought to rationalize such cases, rather than recognizing the departure from the historical conception of the business judgment rule, typically in one or both of two problematic ways: (1) reading such cases to mean that the rule per se is not considered to be applicable to those particular situations; or (2) indicating that the rule itself actually permits the court to second-guess the substantive merits of a decision in some situations, whether or not the directors proved that they actually satisfied their fiduciary duties. From there, it has been a fairly short step for many to begin describing directors’ action in such a situation as being “outside” the business judgment rule.

Such analyses and descriptions — whether they are misguided rationalizations or intentional attempts to subvert or marginalize the business judgment rule — distort the original conception of the rule and introduce confusion and uncertainty. It is one thing to take a straight-up, principled position that the rule is being abandoned or radically changed, but it is disingenuous and unhealthy to claim that such analyses and descriptions are consistent with the rule as conceived. Unless and until the former is done through proper channels, and for policy reasons that are clearly established, we should insist upon clarity and consistent application of the business judgment rule as it was conceived.

Proposal for Conceptual Clarity

Despite the current state of complexity and confusion, the business judgment rule can be made clear via an approach that it is both straight-forward and fair to all constituents. Doing so requires cutting the Gordian knot into which the rule has been tied by a legion of misguided (or perhaps intentionally marginalizing) cases and commentary. It begins with establishing the following two-part precept for the rule:

(1)        All properly challenged decisions of directors will be subject to a review of the substantive merits (i.e., second-guessing) if a breach of a fiduciary duty by the directors is proven, but no directors’ decision will be second-guessed in the absence of such proof; and

(2)        There will be a rebuttable presumption in all situations that the directors complied with their fiduciary duties, unless the subject decision was taken by less than a majority of the independent directors.

Implicit in the second part is that there is no presumption of propriety by the directors where a challenged decision was made by less than a majority of disinterested directors. In such situations, there is no presumption to be rebutted — in other words, such decisions would truly be “outside” the business judgment rule. Where the presumption is applicable, the basic precept would operate with the two-step rebuttal approach discussed earlier, and the current procedural protocols I also discussed earlier would continue to apply.

My proposed approach would benefit both shareholders (potential plaintiffs) and directors (potential defendants). Plaintiffs would be assured of being able to challenge the substantive merits of any decision they believe was wrong, if they can prove an actual breach by directors of a fiduciary duty. That ability is currently uncertain, as a practical matter, in the confusion of the current state of affairs. Directors would avoid the use of possible distortions of the business judgment rule to expand the zone of de facto strict liability in certain situations, which can potentially become the practical effect of not accepting and following the outcome of the two-step rebuttal approach.

A Threshold Policy Matter

Despite its mind-numbing complexities, distortions and resulting confusion, the prevailing view of the business judgment rule has held sway for several decades. It will be difficult to correct and reorient for that reason alone. Moreover, because my proposal would actually help to fortify the rule, it has an underlying policy implication, and that could be a legitimate basis for resistance. In other words, as alluded to above, the current confusion and uncertainty may be the desired result by some who want to subvert or marginalize the rule for policy reasons. While such a policy position may have merit, it should be presented straight-up and in the open, and should not be advanced by subterfuge.

The virtue and acceptability of a protective presumption about anything presupposes confidence in the integrity and rationality of the thing to which or for whom the presumption is afforded. Because the business judgment rule, at its essence, is a presumption about the propriety of directors’ actions in performing their fiduciary duties, a fortification of the rule is a policy position. I believe it is an appropriate and beneficial policy position, notwithstanding that confidence in much of corporate America, including corporate directors, has been shaky in the wake of numerous corporate scandals of which we are all aware. As a result, supporting my proposal may require a profile in courage. But, I expect no less if you took, and therefore lost, my wager.

Posted on Monday, October 16 2017 at 9:43 am by

Regulation S-K Amendments Promise FAST Relief

By Paul Foley, John I. Sanders, and Lauren Henderson

On October 11, 2017, the SEC issued a Proposed Rule to modernize and simplify disclosure requirements in Regulation S-K.[1] The Proposed Rule, authorized by the Fixing America’s Surface Transportation Act (the “FAST Act”), is intended to reduce the costs and burdens on registrants while still providing investors with disclosures that are user friendly, material, and free of unnecessary repetition.[2]

The Proposed Rule, if adopted, would amend rules and forms used by public companies, investment companies, and investment advisers.[3] The most notable provisions of the Proposed Rule include the following:

  • Eliminating risk factor examples from Item 503(c) of Regulation S-K because the examples do not apply to all registrants and may not actually correspond to the material risks of any particular registrant;[4]
  • Revising description of property owned by the registrant in Item 102 of Regulation S-K to emphasize materiality;[5]
  • Eliminating undertakings that are unnecessarily repetitious from securities registration statements;[6]
  • Changing exhibit filing requirements and allowing flexibility in discussing historical periods in the registration statement section dedicated to Management’s Discussion and Analysis;[7]
  • Permitting registrants to omit confidential information (e.g., personally identifiable information and material contract exhibits) from Item 601 without submitting a confidential treatment request;[8] and
  • Using hyperlinks in forms to help investors access to documents incorporated by reference.[9]

The SEC will accept public comments on the Proposed Rule for sixty days before determining whether to issue a final rule or amend the proposal and seek additional public comment.[10] We anticipate that the Proposed Rule will be well-received by all stakeholders and be finalized relatively quickly.

We invite you to contact us directly if you have any questions about the SEC’s Proposed Rule or Regulation S-K generally.

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

[1] SEC, SEC Proposes Rules to Implement FAST Act Mandate to Modernize and Simplify Disclosure (Oct. 11, 2017), available at

[2] Id.

[3] Id.

[4] SEC, Proposed Rule: FAST Act Modernization and Simplification of Regulation S-K,

Release No. 33-10425; 34-81851; IA-4791; IC-32858, available at

[5] Id.

[6] Id.

[7] Id.

[8] Id.

[9] Id.

[10] Id.

Posted on Wednesday, October 11 2017 at 2:57 pm by

Proposal to Change from Quarterly to Annual Periodic Reporting

By: W. Randy Eaddy

This post is not about a recent development or practice tip. It is a “trial balloon” to test, in a public forum, my outlier but serious proposal that has haunted me for almost 20 years. I began a fairly long article about it in 2005, but colleagues and other friends talked me out of it then. I have now escaped their clutches and plan to complete the article, perhaps depending on the reactions to this post. I have already been called a latter‑day Don Quixote, and told that the article is a fool’s errand, by friends. So, don’t be shy or pull any punches.

The Proposal, In Summary

I propose that a company’s fiscal year, rather than quarterly periods, be the periodic reporting cycle for financial and other operating results performance information. As a result, under my proposal, the quarterly report on Form 10-Q would be eliminated. The annual report on Form 10-K and current report on Form 8‑K would both remain, in essentially their respective present forms. The parallel derivative rituals of quarterly earnings releases and quarterly conference calls would also be eliminated, along with any other listing criterion based on quarterly reporting that is imposed by the New York Stock Exchange, the Nasdaq Stock Market or any other trading market that is subject to SEC regulation.

As an integral component of my proposal, all public companies would be required to give guidance about anticipated earnings for the upcoming fiscal year (although not for any interim period thereof) as part of each year’s annual report on Form 10-K. The company would also be required to assess developments over the course of the fiscal year to determine whether operations are on track with the guidance. If some development indicates that a material deviation from the guidance is likely, whether favorable or unfavorable, the company would be required to promptly disclose relevant information about that development and to adjust the prior guidance accordingly.

My proposal would not change any current rule that requires insiders to disclose promptly their trading activities with respect to their companies’ securities.

Principal Reasons and Rationale

There is inherent tension between the short-term nature of our quarterly periodic disclosure regimes, on the one hand, and the stated desire for (and putative imperative of) long-range strategic planning by companies and managements in order to enhance long-term shareholder value, on the other hand. That tension inevitably translates, in practice, into an actual conflict between two competing interests, each of which can be legitimate on its own terms: (a) building and enhancing shareholder value as measured by the intrinsic and long-term strength (or worth) of a company, and (b) lawfully promoting the day-to-day trading prices of the company’s equity security. Such tension is at the root of most problems that lead to both corporate scandals involving misstated earnings (or other operating results) and short-sighted, speculation-driven trading behavior.

Our quarterly periodic disclosure regimes accentuate the disconnection between those two interests and lead corporate actors and investors to focus inordinately on short-term results to the detriment of sound strategic planning for long-term value creation. They ensure that the behavior of managements of public companies will be influenced significantly (if not driven) by achieving performance results on a quarterly basis. The resulting short-term focus and its myriad manifestations – which are captured by the phrase “short-termism” – are a pervasive problem and a malady.

That condition, however, is neither inevitable nor a prerequisite for an efficient or effective capital markets system. It is principally a consequence of our current disclosure regimes having made the three-month quarterly cycle of reports and rituals a major touchstone for tracking and measuring performance by public companies. It can be cured with real medicine.

I believe we have been led to stay this course, ignoring the real cure, by the tempting illusions of the “efficient capital markets theory”, which fosters an ethos of near‑immediate disclosure of virtually all material information about the performance of public companies. The illusions condition us to believe that market participants who are armed with such information will use it rationally in making investment decisions; that such investments reflect and yield logical allocations of capital; that such allocations, in turn, will yield a rational and value-based pricing of the securities; and that good things otherwise have followed (and will continue to follow) for the U.S. capital markets system and the American economy.

As an aspirational model or reference points for developing the substance of public disclosures, that’s all fine. As the fundamental justification or premise for the frequency of such disclosures imposed by our quarterly regimes, however, those beliefs are seriously flawed.

If we want to promote a longer-term and more strategic focus by public companies and their management; if we want analysts, investors and other market participants to focus on long-term value propositions; if we want to curtail short-termism more generally; and if we want to shape and encourage such behaviors, then we must rethink the fundamentally short-term timetable we have established for our periodic disclosure regimes, and administer some real medicine. We cannot expect such long-term focus and behavior, while requiring short-term measures.

Why the Guidance Requirement?

The annual earnings guidance component of my proposal may appear to be gratuitous, because such a requirement arguably is not compelled in order to address the short-termism problem and malady. While my proposal could be implemented without the guidance requirement, I believe it is important. Investors and other capital markets participants will inevitably require certain forward-looking information in order to make strategic and rational investment decisions. The current informal, non-required, practice of providing earnings guidance arose to address that practical reality. There is no reason to believe that that reality would change under my proposed annual disclosure regime. Accordingly, I believe it is better to embrace that reality and develop a system that can help guard against the emergence of behavior that undermines the benefits of changing to an annual periodic reporting regime. I believe instituting a formal, annual earnings guidance requirement would help prevent the reemergence of an informal but wide-spread guidance practice that continues the current quarterly focus.

My proposed guidance requirement is not a long step from either the SEC’s implicit position or prevailing practice. While the SEC does not encourage earnings guidance, it readily accepts the current informal practice, and it otherwise encourages disclosures that look into the future based on “trends” and certain other matters that companies know. Many (if not most) public companies already provide earnings guidance voluntarily. With respect to major public companies that do not presently provide earnings guidance, I suspect their position is based primarily upon an aversion to the quarterly focus for which guidance is expected if it is given, and the resulting problems of short-termism that flow from a quarterly focus.

My proposed guidance requirement is logical, reasonable and fair, especially as a trade-off for eliminating the unhealthy consequences of quarterly operating disclosures. It is not unreasonable to require a public company to give its best estimate of what the upcoming fiscal year looks like with respect to earnings. It is certainly reasonable to expect and require the company – which has chosen to invite the public to invest in its securities and thus in its prospects – to think seriously about the matter, and to develop an articulable view on it, as part of the company’s prudent strategic planning for its operations. It is logical, reasonable and fair to expect and require the latter as a condition of public company status.

Addressing Some Legitimate and Fair Concerns

If one has not previously thought about a change from quarterly to annual only periodic reporting, my proposal may be shocking and will likely cause much concern. When the initial shock wears off, however, I believe only the following three will remain as significant legitimate and fair concerns that arise because of my proposal. I believe my proposal answers each of them, but here they are initially without counter‑points.

First, what happens with material operating developments that become known by a company’s management during the current fiscal year, well before the time for the company’s next required annual disclosure of operating performance? Surely, no one benefits from (or should want) such information to be sprung upon an unsuspecting investment community and public in a year-end catharsis.

Second, what about the risk that information about such a development might leak, whether willfully or inadvertently, and be used by a select few to the detriment of the unsuspecting public? It would be naïve to expect that all such developments would remain truly “secret” for the possibly long periods of time that they may be known by a company before the end of its fiscal year.

Third, wouldn’t allowing a full fiscal year before operating performance disclosures are required simply invite (and give more time to orchestrate) all manner of skullduggery?

With respect to the first concern, my proposal would continue Form 8-K, which requires immediate disclosure about several types of events or developments. I believe the requirements of Form 8-K (with modest appropriate tweaking) can address effectively the first concern, without sliding back down the slope into full-blown quarterly operating disclosures. Also, the ongoing assessments aspect of the earnings guidance component would require prompt disclosure and an updating adjustment if any such development affects the earnings guidance that was provided for the current fiscal year.

With respect to the second concern, Regulation FD is an effective tool for regulating the leaking (or other selective disclosure) of information about interim developments, and it would be unchanged under my proposal. There is absolutely no basis for believing that Regulation FD would be less effective under my proposal. And, of course, private as well as administrative lawsuits remain as options to address and remediate unlawful trading on inside information.

With respect to the third (more general) concern, I agree that it is tautological that more time to hide something (or to dissemble with respect to it) increases the likelihood of success at doing so. However, I believe the greatest temptation for disclosure skullduggery is the shortness of the period for measuring and reporting operating results. Moreover, I believe that positing such unlawful behavior as an insurmountable risk of implementing my proposal would presuppose a level of inveterate unscrupulousness by corporate actors that is overly cynical and unwarranted. It would be tantamount to saying that unlawful behavior is innate, and so we should dispense with all law and embrace anarchy.

It is also reasonable to believe and expect that the year-end requirement for an independent audit of a company’s financial statements, along with the attendant year-end processes and the myriad corporate governance protocols imposed by the Sarbanes-Oxley Act, would still operate to help keep folk honest. And, there would be equal amounts of time, over the course of the fiscal year, for those processes to help ferret out possible skullduggery.

Concluding Observations

I have not conducted any surveys or other empirical investigations. But, over the course of 37 years of practice, I have represented and otherwise observed and interacted with hundreds of executives and directors of public companies and investors in such companies. On that substantial albeit anecdotal basis, I believe most executives and directors would applaud a movement to an annual periodic disclosure regime, after the possible taint of them being perceived as iconoclasts or mavericks has been removed. I also believe most small investors — the prototypical “moms and pops” who may be at the top of the heap of casualties under the current quarterly disclosure regimes — and most of the investing public generally would likewise recognize that eliminating quarterly disclosure of financial and other operating results can actually lead to more meaningful and useable information for their investment activity.

This post is only a summary of the discussions I plan for the article. In the article, I employ amusing metaphors and humor (or at least I try to) in presenting more detail about each of (a) the short-termism problem and malady afflicted by the current quarterly periodic reporting regimes, (b) the rationale for (and benefits of) my proposed change and (c) the broader context and history of our approach to public company disclosures. Many thanks if you have read this far. I am curious about your reactions, regardless of what they are.

Posted on Tuesday, August 29 2017 at 8:59 am by

Second Circuit Clarifies its Post-Salman Position, Affirms Insider Trading Conviction

By Paul Foley and John I. Sanders

On August 23rd, the Second Circuit issued its much-anticipated opinion in U.S. v. Martoma, affirming the 2014 insider trading conviction of S.A.C. Capital Advisors portfolio manager Matthew Martoma.[1] In doing so, it clarified an important point regarding what is required to convict a person who trades on a tip received from an insider. We believe this decision will have an immediate impact on how hedge fund portfolio managers and other investment advisers interact with third party resources.

Section 10(b) of the Securities Exchange Act of 1934[2] and Rule 10b-5[3] promulgated thereunder prohibit insider trading. The basic elements of insider trading are: (i) engaging in a securities transaction, (ii) while in possession of material, non-public information, (iii) in violation of a duty to refrain from doing so.

Under the classic theory of insider trading, a corporate insider trades in shares of his employer while in possession of material, non-public information (e.g., advance notice of a merger). In addition to the classic theory of insider trading, case law has extended the liability to persons who receive tips from insiders (i.e., individuals whose duty to refrain from trading is derived or inherited from the corporate insider’s duty). Thus, not only may insiders be liable for insider trading, but those to whom they pass tips, either directly (tippees) or through others (remote tippees) may be liable if they trade on such tips.

The seminal case involving tippee liability is Dirks v. SEC.[4] In Dirks, the U.S. Supreme Court held the following:

In determining whether a tippee is under an obligation to disclose or abstain, it is necessary to determine whether the insider’s “tip” constituted a breach of the insider’s fiduciary duty. Whether disclosure is a breach of duty depends in large part on the personal benefit the insider receives as a result of the disclosure. Absent an improper purpose, there is no breach of duty to stockholders. And absent a breach by the insider, there is no derivative breach.[5]

The question of what constituted a “personal benefit” was left ill-defined until the Second Circuit gave it shape in U.S. v. Newman.[6] Newman held that a tipper and tippee must have a “meaningfully close personal relationship” and that the insider information be divulged in exchange for “a potential gain of a pecuniary or similarly valuable nature” for the court to find the tipper had breached his fiduciary duty to the source.[7] For a period of time after the Second Circuit issued its opinion in Newman, it seemed that Martoma’s conviction was likely to be overturned.

Unfortunately for Martoma, the U.S. Supreme Court issued its opinion in U.S. v. Salman while Martoma’s appeal was pending.[8] In Salman, the U.S. Supreme Court flatly rejected certain aspects of the Newman holding and called others into question.[9] Accordingly, the Second Circuit held in Martoma that “Salman fundamentally altered the analysis underlying Newman’s ‘meaningfully close relationship’ requirement such that the ‘meaningfully close personal relationship’ requirement is no longer good law.”[10]

In Martoma, the court held that rather than looking at objective elements of the relationship between tipper and tippee, the proper inquiry is now whether the corporate insider divulged the relevant information with the expectation that the tippee would trade on it.[11] This is “because such a disclosure is the functional equivalent of trading on the information himself and giving the cash gift to the recipient.”[12]

Please contact us if you have any questions about the Second Circuit’s opinion in Martoma or the law concerning insider trading generally.

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] U.S. v. Martoma, available at

[2] 15 U.S.C. 78j (2016).

[3] 17 CFR 270.10b-5 (2016).

[4] Dirks v. SEC, 463 U.S. 646 (1983).

[5] Id. at 647.

[6] U.S. v. Newman, 773 F.3d 438 (2d Cir. 2014).

[7] Id. at 452.

[8] Salman v. U.S., available at

[9] Id. at 10.

[10] U.S. v. Martoma, supra note 1, at 24.

[11] Id. at 25.

[12] Id.

Posted on Sunday, August 27 2017 at 9:34 am by

Delaware Encourages Use of “Blockchain” Technology for Corporate Recordkeeping

By: David A. Stockton

Amendments to the Delaware General Corporation Law (“DGCL”) allowing for the use of “distributed ledgers”, or “Blockchain” technology, for corporate recordkeeping, including stock ledgers, became effective on August 1, 2017. These amendments reflect the Delaware bar’s continued efforts to stay at the forefront of corporation law developments.  These innovative changes were promoted by the Delaware Blockchain Initiative, led by a former Delaware governor.  Vice Chancellor J. Travis Laster of the Delaware Court of Chancery has also been actively promoting the use this new technology to “fix the plumbing” of the voting and stockholding infrastructure of the U.S. securities markets.

What is Blockchain technology?  

According to Don & Alex Tapscott, authors of Blockchain Revolution (2016), “The blockchain is an incorruptible digital ledger of economic transactions that can be programmed to record not just financial transactions but virtually everything of value.” Information held on a blockchain is a shared and continually reconciled database.  The blockchain database isn’t stored in any single location.  Instead, it consists of a distributed system of registers which are accessible to anyone on the internet and are all connected through a secure validation mechanism.

The first and still most popular application of Blockchain technology was the Bitcoin payment network, and its usage has now spread to many other new cryptocurrencies.  The same Blockchain technology can be applied to corporate recordkeeping.  It would theoretically allow for the issuances and transfers of shares without a third-party intermediary, thereby increasing the accuracy of recording such issuances and transfers and minimizing the potential for clerical mistakes.

The Amendments

The specific amendments to Sections 219 and 224 of the DGCL permit (but do not require) the use of “distributed electronic networks or databases”, allowing a corporation’s shares to be recorded and transferred on a decentralized electronic network rather than on a centrally located stock ledger.  This new distributed ledgers technology is by definition only applicable to corporations with uncertificated shares.  Section 224 still requires that records be capable of being converted into a clearly legible paper form within a reasonable time period.

The amendment to Section 224 of the DGCL further requires the blockchain stock ledger to perform three main functions:  (i) to enable the corporation to prepare a list of shareholders, (ii) to record various voting information as required by the DGCL, and (iii) to transfer stock as governed by Article 8 of the Uniform Commercial Code.  The overall effect of these amendments is to validate blockchain technology as a means of complying with all share recordkeeping requirements of the DGCL.

Potential Benefits

Potential benefits from using a blockchain stock registry could be extraordinarily significant.

First and foremost, it has the potential to eliminate the current nominee system for registering ownership of stock, where depositories such as the Depository Trust Company hold stock certificates as owners of record and track transfers using their own electronic book-entry system.  This separation of record ownership by the depository from beneficial ownership by the client was implemented in the 1970’s by the SEC.  It was in response to dramatically increased trading volumes during the 1960’s and 1970’s, which had overwhelmed the traditional system of presenting share certificates for transfer to the issuer or its transfer agent.  The solution was to take the burden of tracking record ownership off of the issuer by allowing most market transactions to be effected in the electronic system of the depository.  DTC was charged with running a centralized electronic book-entry system covering all the shares it owned of record (which today is substantially all shares of most public companies).

In its time the electronic book-entry system was an innovative technology that allowed the markets to continue to function. Forty plus years later, however, it still causes many opportunities for errors and inefficiencies arising from the multiple parties and transactions required for beneficial owners to vote on matters and to transfer shares.  Blockchain technology is thought to have the potential to entirely eliminate the need for such intermediaries and the distinction between record holder and beneficial owner.  It is viewed in effect as the new and improved form of electronic tracking system, replacing the DTC system of record and beneficial owners with a system that operates with only one type of owner, the record owner.

Another potential benefit is that Blockchain technology enables direct transactions without the need for intermediary verification and processing, meaning that settlements could occur immediately rather than in a matter of days or longer, which would also reduce transaction costs.  Plus, comprehensive real-time share ownership information would be continuously available to any participant in the system, i.e., complete transparency.

Finally, because a Blockchain system is an “incorruptible digital ledger”, inconsistencies in corporate records regarding share counts and ownership interests could be reduced or even eliminated.

The Long Path Ahead

Despite these substantial potential benefits, the Delaware amendments are really nothing more than a means of encouraging consideration of Blockchain technology for use in maintaining corporate records.  The amendments make clear that these technologies are consistent with Delaware corporation law, but they do not attempt to address any of the mechanics of how such a system actually would work.  Many practical issues are yet to be addressed and resolved, including:

  • Who will be able to input and access data on the distributed ledgers?
  • How will data be secured?
  • How will the transaction validation process work?
  • Who/what will have organizational control of the distributed ledgers?
  • How can the data be audited?

But all these issues have been addressed and adequately resolved in the Bitcoin application, so there is reason to believe that they can be worked out in the context of corporate recordkeeping as well.

These amendments are just the opening salvo in the effort to apply a very innovative technology to the very traditional world of corporate recordkeeping, which will no doubt be a long and difficult path.  But they are a promising beginning which should encourage issuers, investors and financial market professionals to begin the process of investigating the use of Blockchain technology to maintain stock ledgers.

Posted on Thursday, August 24 2017 at 11:48 am by

SEC Expands Confidential Review of IPO Registration Statements

By: David M. Eaton

The SEC announced earlier this summer (and supplemented that announcement late last week with additional information) that it has expanded the availability of its popular procedure for confidential non-public review of, and comment on, draft initial public offering registration statements.  This procedure was originally mandated by 2012’s JOBS Act.

In its pre-existing iteration, the procedure allows “emerging growth companies” (EGCs) to submit draft registration statements confidentially to the SEC for review, provided that (1) the issuer has not yet sold common stock in an SEC-registered IPO and (2) the draft registration statements and all amendments thereto are publicly filed at least 15 days prior to any “road show”.  This process is available not just for a common stock IPO registration statement, but also for any pre-IPO registration statement an EGC might file.  An EGC is a company with annual gross revenues of less than $1.07 billion during its most recent fiscal year.

Now, in addition to the confidential review process for EGCs which remains in effect, the SEC announced that it will review, on a confidential basis, draft submissions of the following registration statements filed by any issuer (including foreign private issuers)—not just EGCs:

  • IPOs.  Securities Act IPO registration statements (or other initial Securities Act registrations)—again, from any issuer.  This will permit larger pre-public companies to take advantage of the confidential submission process.
  • Listings, But No OfferingsSpin Offs.  Securities Exchange Act registration statements that relate to an initial direct listing on a stock exchange without a concurrent public offering.  This will be useful to companies going public via a “spin off” from another public company.
  • Follow-On Offerings.  Securities Act registration statements for an offering within a year of the company’s initial Securities Act or Securities Exchange Act registration statement.  This should prove useful to companies conducting a “follow-on” stock offering in the wake of a successful IPO.  In addition to raising additional capital for the company, follow-ons have traditionally allowed pre-public shareholders to sell some of their holdings in the common situation where underwriters were reluctant to let them “piggy back” on the IPO registration statement (although often the follow-on registration statements are not selected for SEC review, as the recent IPO registration statement would have received a full inspection).

As with the EGC process, IPO and direct listing registration statements and amendments must be filed at least 15 days prior to any IPO roadshow, or 15 days prior to the requested effective date of the registration statement if there isn’t a road show.  One difference for follow-on offering registrations is that the SEC will only review the first draft submission confidentially, not subsequent amendments.

The confidential submission process has several advantages for issuers.  It allows the company to keep the registration statement and its exhibits out of the public domain until the company decides that it is ready to move forward with the offering, if at all.  If it abandons the offering before committing to a road show, its submission remains confidential.  In this manner, the company can avoid the risk of being perceived by the market as “damaged goods” by dint of abandoning its IPO.  It also facilitates pursuing “dual track” exit strategies for founders and/or venture investors—that is, exploring a sale of the company and an IPO simultaneously.

Even if the company goes forward with the offering, and consequently makes its confidential submissions publicly available, there is value to companies in not having to endure, in real time, the intense microscope of the media on the sometimes painful SEC review process. (On the other hand, some would probably say that undergoing that process in the open is beneficial to investors).

While the expansion of the useful confidential submission review process is a welcome development, it can fairly be characterized as an incremental improvement, not a transformational one.  Such “baby steps” may not be enough to reverse the continuing reduction in the overall number of U.S. publicly traded companies, a trend which is attracting growing concern.

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 (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

[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 (“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.

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