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.

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 (hereinafter, SEC Opinion).

[2] In re KCD Financial, Inc., FINRA Complaint No. 2011025851501 (Aug. 3, 2016), available at (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).

Subscribe to Kilpatrick Townsend's Legal Alerts to help you stay current of new and noteworthy legal issues that may affect your business.