Securities Law

Archive for July 2017

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.

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