Dear clients and friends,

We present our traditional year-end issue of Snell & Wilmer’s Corporate Communicator to help you prepare for the upcoming annual report and proxy season. This issue highlights SEC reporting and corporate governance considerations that will be important this annual meeting season as well as in the upcoming year.

During 2016, members of our Corporate & Securities group will continue to publish the Corporate Communicator, host business presentations, participate in seminars that address key issues of concern to our clients, and sponsor conferences and other key events. First on the calendar is our Eighth Annual Public Company Proxy Season Update, which will be held in our Phoenix office on January 7, 2016 and in our Orange County office on January 12, 2016. Finally, we are pleased to present our 2015 Tombstone, which highlights selected deals that Snell & Wilmer’s Corporate & Securities group helped our clients close during the year.

As always, we appreciate your relationship with Snell & Wilmer and we look forward to helping you make 2016 a successful year.

Very truly yours,

Snell & Wilmer
Corporate & Securities Group

SEC DEVELOPMENTS

SEC Adopts Rule for Pay Ratio Disclosure

On August 5, 2015, the SEC adopted final rules relating to pay ratio disclosure, as mandated by the Dodd-Frank Act. Such disclosure will be required in annual reports on Form 10-K, proxy and information statements and registration statements (other than in IPO registration statements) where executive compensation disclosure under Item 402 of Regulation S-K is required. The new rules require a company to include in its executive compensation disclosure:

• the annual total compensation of all its median compensated employee, except the CEO;
• the annual total compensation of its CEO; and
• the ratio of these two amounts.

The SEC has specified that the term “employees” includes all U.S. and non-U.S. (subject to certain exceptions described below), full-time, part-time, temporary and seasonal employees of a company on a date within the last three months of its last completed fiscal year. However, for purposes of identifying the employee population, any individual employed by unaffiliated third parties or independent contractors is not considered to be an employee. In addition, certain non-U.S. employees can be excluded under the following situations:

• non-U.S. employees that are employed in a jurisdiction with data privacy laws that make a company unable to comply with the rule without violating those laws (requires a legal opinion from counsel); and
• up to 5 percent of the company’s total employees who are non-U.S. employees (includes any non-U.S. employees excluded under the aforementioned data privacy exemption).

In order to identify the median employee, the SEC has adopted what it deems a "flexible approach” that allows companies to select a methodology based on their own facts and circumstances—that is, companies are permitted to choose a method for identifying the median employee that is appropriate to the size, structure and compensation practices of their business. A company may use statistical sampling of the total employee population and/or other reasonable methods to choose a smaller group of employees for purposes of identifying the median. A company may, for example, identify the median employee in the total employee population or statistical sampling by using (i) annual total compensation as determined under existing executive compensation rules set forth in Item 402(c) of Regulation S-K or (ii) any consistently applied compensation measure from compensation amounts reported in its payroll or tax records.

A company may choose to identify the median employee once every three years. However, if there has been a change in the company’s employee population or compensation that the company reasonably believes would result in a significant change to its pay ratio disclosure, the company will need to identify a new median employee upon those circumstances.

Once the median employee is identified, total compensation for the identified median employee for purposes of the pay ratio is calculated under existing executive compensation rules set forth in Item 402(c) of Regulation S-K. Further, companies are permitted to use reasonable estimates in calculating the annual total compensation of such median employee.

In connection with the pay ratio rules, companies will need to disclose information such as:

• a brief description of the methodology used to identify the median employee;
• any material assumptions, adjustments or estimates relating to the identification of the median employee or in calculating annual total compensation of such employee (e.g., cost of living adjustments where the median employee resides in a different jurisdiction than the CEO);
• a description of any consistently applied compensation measure (such as from compensation amounts reported in payroll or tax records), if used to identify a median employee; and
• clear identification of any estimates used.

Companies are required to provide the pay ratio disclosure for their first fiscal year beginning on or after January 1, 2017. Consequently, for a company that has a fiscal year ending December 31^st, pay ratio disclosure will be required starting with its 2018 proxy. Pay ratio disclosure is not required to be made by emerging growth companies, smaller reporting companies and foreign private issuers, among others. For newly reporting companies, companies engaging in business combinations or acquisitions, and companies that cease to be smaller reporting companies or emerging growth companies, certain transitional rules are available.

SEC Proposes Pay-Versus-Performance Rules

In April 2015, the SEC proposed rules requiring companies to disclose the relationship between executive compensation and the financial performance of a company. These “pay-versus-performance” rules are mandated by Dodd-Frank and as proposed would be contained in a new paragraph (v) of Item 402 of Regulation S-K.

As proposed, the new rules would require companies to include a new table in their executive compensation disclosure in the following format:

• Column (a): Disclosure in the new table will be required for each of the last five fiscal years (three years for smaller reporting companies), subject to phase-in provisions described below.
• Column (b): This amount will be the total compensation paid to the PEO as set forth in the Summary Compensation Table pursuant to Item 402 of Regulation S-K.
• Column (c): Compensation actually paid will represent the amount from column (b) with adjustments to the amounts included for pensions (not required for smaller reporting companies) and equity awards. Generally, pension amounts would be adjusted by deducting the change in pension value reflected in the Summary Compensation Table and adding back the actuarially determined service cost for services rendered by the PEO during the applicable year. For the equity award adjustment, equity awards would be considered actually paid on the date of vesting and at fair value on that date, rather than fair value on the grant date as required in the Summary Compensation Table. Both adjustments will need to be disclosed in the footnotes to the new table.
• Column (d): This amount will be the average of the total compensation paid to the other NEOs (i.e., NEOs other than the PEO) as set forth in the Summary Compensation Table pursuant to Item 402 of Regulation S-K.
• Column (e): Similar to column (c), this amount will be the average of the compensation actually paid to the other NEOs as set forth in column (d) with adjustments to the amounts included for pensions and equity awards as described above.
• Column (f): This amount will be the company’s total shareholder return (TSR) on a cumulative annual basis as calculated pursuant to Item 201(e) of Regulation S-K (i.e., the performance graph standard).
• Column (g): This amount (not required for smaller reporting companies) will be the TSR on a cumulative annual basis of the companies in a peer group, using the peer group identified by the company pursuant to Item 201(e) of Regulation S-K or in its compensation discussion and analysis (i.e., the performance graph standard).

Additionally, the SEC has proposed that the pay-versus-performance table, including any footnotes, be provided in interactive data format using XBRL, other than emerging growth companies, registered investment companies and foreign private issuers. For all other reporting companies (other than smaller reporting companies), there will be a phase-in period whereby companies will provide the pay-versus-performance disclosure for three years in the first filing where such disclosure is required (e.g., proxy statement), supplemented with another year of disclosure in each of the two following years. Smaller reporting companies will be permitted to provide the pay-versus-performance disclosure for two years in the first filing and adding the additional year of disclosure in the following year.

SEC Proposes Rules Regarding Clawbacks

On July 1, 2015, the SEC proposed Rule 10D-1 implementing Section 954 of the Dodd-Frank Act. The proposed rule would require the national securities exchanges to require a listed company in the event of an accounting restatement to recover any incentive compensation paid to an executive officer that was in excess of what would have been paid to the executive officer under the accounting restatement.

The definition of executive officer in the proposed rule is based on the definition of “officer” under Section 16 of the Exchange Act.

In addition, the proposed rule would require a listed issuer to disclose:

• its policy relating to recovery of erroneously awarded compensation;
• in the event of a restatement, its actions to recover any erroneously awarded compensation, including whether it decided not to pursue recovery from any individual; and
• the effect of any recovery on the compensation of any executive.

The proposed rule was not unanimously approved by the commissioners. In a 3-2 vote, SEC Chair Mary Jo White and Commissioners Kara Stein and Luis Aguilar voted for the proposed rules and Commissioners Michael Piwowar and Daniel Gallagher dissented. The concerns raised by the dissenting Commissioners include that, under the proposed rule:

• listed issuers would be required to recover erroneously awarded compensation, even if the individual was not at fault for the accounting restatement;
• boards of directors would have very limited discretion in deciding whether to seek recovery of erroneously awarded compensation;
• compensation based on share price or “total shareholder return” would be included in the definition of erroneously awarded compensation even though it would be difficult, if not impossible, to determine what the value of the company’s stock would have been if the accounting restatement was not required; and
• smaller reporting companies, emerging growth companies, foreign private issuers, and registered investment companies would be within the scope of the rule.

This proposal is not expected to impact the 2016 proxy season as the latest SEC agenda indicates the final rules may not be adopted until October 2016.

SEC Proposes Rules Regarding Disclosure of Hedging by Employees, Officers and Directors

On February 9, 2015, the SEC proposed rules to implement Section 955 of the Dodd-Frank Act.

The proposed rules would require disclosure, in any proxy or information statement with respect to the election of directors, as to whether the issuer permits employees or directors to purchase financial instruments (including prepaid variable forward contracts, equity swaps, collars and exchange funds) that are designed to or have the effect of hedging or offsetting any decrease in the market value of equity securities granted to the employee or director by the issuer as part of his or her compensation or held directly or indirectly by the employee or director.

While the proposed rules would not require issuers to prohibit hedging transactions or to otherwise adopt practices or policies addressing hedging by any category of individuals, we expect there will be pressure to do so as proxy advisory firms have indicated that they may recommend votes against incumbent directors of issuers that permit hedging transactions.

This proposed rule is not expected to impact the 2016 proxy season as the latest SEC agenda indicates the final rules may not be adopted until October 2016.

SEC Enforcement Updates

We observed several noticeable trends in enforcement at the SEC in 2015. Of note the SEC continued pursuing insider trading prosecutions with vigor (in the fiscal year ended September 2015, the SEC had charged 87 parties in cases involving insider trading), but following a high profile loss, the SEC may shift its focus to other priorities.

The notable defeat came in October when the SEC decided not to oppose a motion for summary judgment in a civil suit brought against hedge fund portfolio managers Todd Newman and Anthony Chiasson accusing them of insider trading. The SEC’s decision followed an unsuccessful criminal case against Newman and Chiasson.

In December 2012, Newman and Chiasson were convicted of securities fraud and conspiracy to commit securities fraud in a U.S. District Court for the Southern District of New York. On appeal, the U.S. Court of Appeals for the Second Circuit vacated the convictions. In its ruling, the Second Circuit clarified two key aspects of insider trading law. First, the Court ruled that a remote tippee must know that an insider received a benefit in exchange for inside information. Second, the Court held that evidence of an insider’s friendship with tippees is insufficient in-and-of-itself to meet the “personal benefit” requirement absent additional evidence of a close personal relationship resulting in an exchange that is objective, consequential and represents at least a potential gain of a pecuniary or similarly valuable nature. Prosecutors in the case appealed the Second Circuit’s decision to the U.S. Supreme Court, which denied the petition. Within the light of the Second Circuit’s narrowing of the definition of insider trading, the SEC, facing an uphill battle in the civil suit, elected not to pursue it further. It remains to be seen whether the defeat will take the wind out of the SEC’s sails when it comes to insider trading enforcement actions.

Another trend that emerged in 2015 was the SEC’s increased focus on enforcement surrounding financial reporting. The SEC’s capabilities in this area were aided significantly by a few relatively new tools that the SEC has at its disposal - the Accounting Quality Model (AQM), a data analytics tool to identify financial fraud, and the Corporate Issuer Risk Assessment (CIRA) program, a tool to assist SEC staff in detecting anomalous patterns in financial reporting. Notable cases in 2015 involving financial fraud included the SEC’s charging of Computer Sciences Corporation and certain of its former executives with manipulating financial results and concealing significant problems about the company’s largest and most high-profile contract, resulting in a $190 million settlement in addition to compensation clawbacks and additional penalties for executives, and the SEC’s charging of Deutsche Bank AG with filing misstated financial reports during the height of the financial crisis that failed to take into account a material risk for potential losses, estimated to be in the billions of dollars, resulting in Deutsche Bank agreeing to pay a $55 million penalty to settle the charges.

Finally, we observed increased focus by the SEC on what it previously labeled “Operation Broken Gate,” an initiative by the SEC to hold gatekeepers accountantable for the role they play in the securities industry. The SEC’s efforts in this area included enforcement efforts targeting attorneys, accountants and other gatekeepers accountable for failures to comply with professional standards.

Conflict Minerals—Next Step the Supreme Court?

The litigation surrounding the SEC’s conflict minerals rules remains ongoing. Following the ruling by the United States Court of Appeals for the D.C. Circuit in National Association of Manufacturers, et. al. v. SEC, in which the Court, among other things, struck down on First Amendment grounds the provision that requires companies to describe their products manufactured as “not found to be ‘DRC conflict free,’” the Court ruled slightly to the contrary in another case, American Meat Institute v. U.S. Dept. of Agriculture, on a similar First Amendment issue related to a “country-of-origin” labeling requirement imposed by the U.S. Department of Agriculture. In light of the American Meat Institute opinion, the Court granted a petition from the SEC for a panel rehearing of the First Amendment issue in National Association of Manufacturers. A three-judge panel issued its ruling on the rehearing in August 2015, reaffirming its April 2014 decision. For the time being, the decision means that the SEC Division of Corporation Finance’s April statement that companies would not be required to describe their products as “DRC conflict free,” as “DRC conflict undeterminable,” or as having “not been found to be ‘DRC conflict free’”, still stands. Following the decision, the SEC sought an en banc rehearing, which the Court denied in November 2015.

The next available step for the SEC would be to petition the U.S. Supreme Court for a writ of certiorari to review the decision of the Court of Appeals. Until the Supreme Court grants or denies the petition, it appears for the moment that companies will not be required to describe their products as “DRC conflict free,” as “DRC conflict undeterminable,” or as having “not been found to be ‘DRC conflict free.’” And, current guidance from the SEC suggests that unless a company declares its products as “DRC conflict free,” it will not be required to obtain an independent audit for 2015.

PROXY AND CORPORATE GOVERNANCE CONSIDERATIONS

Proxy Advisory Firms Update: Going Overboard

On November 20, 2015, Institutional Shareholder Services (ISS) issued its annual proxy voting guideline updates, which are effective for annual meetings held on or after February 1, 2016. Glass, Lewis & Co. (Glass Lewis) also recently issued its updated guidelines for the 2016 proxy season.

ISS Updates

As in past years, ISS’ latest policy updates focus on issues concerning board composition and governance, as well as unilateral board actions (e.g., charter and bylaw amendments) that diminish shareholder rights. These updates were informed by a global public outreach effort.

Below is a summary of the key policy updates for the U.S. market:

• Director “Overboarding”
  • Background: ISS believes the time commitment required to be an effective public company director has risen sharply in recent years, driven by new regulations, among other factors. ISS cited academic research showing a negative association between board “business” (often defined to result from a director serving on three or more boards) and company performance.
  • New Policy: Going forward, ISS will deem non-CEO directors to be “overboarded” if they serve on more than five public company boards (down from six).
  • Transition Year: During the 2016 proxy season, ISS will note in its analysis if a director (other than the CEO) is serving on more than five public company boards—but it will not begin recommending against those directors until the 2017 proxy season (to allow directors serving on six or more public company boards time to reduce their board commitments).
  • CEO Directors: For CEOs, the “overboard” limit will continue to be two public company boards (other than the CEO’s “home board”). In leaving the limit applicable to CEOs unchanged, ISS noted as “valid” the view of some institutional investors and directors that CEOs should serve on no more than one outside board.
• Unilateral Governance Changes that Adversely Affect Shareholder Rights
  • Background: In recent years, ISS has focused on board actions that diminish shareholder rights, such as board-approved charter and bylaw amendments that are not submitted for shareholder approval or ratification. Under existing ISS policy, these types of amendments typically result in adverse voting recommendations with respect to individual directors, or the full board. Unilateral board actions to classify the board, or establish supermajority voting requirements for charter/bylaw amendments, are viewed as especially problematic. That said, ISS has acknowledged that investors may have different expectations for newly (versus established) public companies, so it has bifurcated this policy for 2016.
  • New Policy:
    • For established public companies, the updated policy generally calls for continuing to withhold votes from directors who have unilaterally adopted a classified board structure or implemented supermajority vote requirements.
    • For newly public companies that have taken action to diminish shareholder rights prior to or in connection with their IPO, the updated policy calls for a case-by-case approach in subsequent years, with significant weight given to shareholders’ ability to change the governance structure in the future through a simple majority vote and their ability to hold directors accountable through annual director elections. A public commitment by the company to put the adverse provisions to a shareholder vote within three years after the IPO can be a mitigating factor.

ISS also updated its policies regarding proxy contests/proxy access (clarifying the framework for evaluating director candidates nominated pursuant to proxy access); shareholder proposals relating to stock ownership requirements applicable to senior executive officers (e.g., requiring executives to maintain holdings past retirement); and environmental and social issues (e.g., animal welfare and climate change).

Glass Lewis Updates

Glass Lewis addressed many of the same governance issues in its policy updates for the 2016 proxy season:

• Director “Overboarding”

  • 2016 Policy: Like ISS, Glass Lewis will review director board commitments during the 2016 proxy season and may note areas of concern where non-executive directors are serving on more than five total boards (or executives are serving on more than two total boards)—but will not change the thresholds used for purposes of determining its voting recommendations until 2017.

  • Limits Reduced in 2017: Beginning in 2017, Glass Lewis will generally recommend voting against a director who serves as a public company executive while serving on a total of more than two public company boards, and any other director who serves on a total of more than five public company boards. (Note that, unlike ISS, Glass Lewis intends to reduce the “overboard” limit applicable to executive officers in 2017.)

• Exclusive Forum Provisions

  • Newly Public Companies: Glass Lewis will no longer recommend a vote against the chair of the nominating and governance committee in situations where a newly-public company includes an exclusive forum provision in its governing documents in connection with an IPO. Instead, Glass Lewis will weigh the presence of an exclusive forum provision in conjunction with analyzing other provisions that may limit shareholder rights, such as classified boards or supermajority requirements to amend the company’s governing documents.

  • Established Public Companies: For established public companies that adopt exclusive forum provisions without shareholder approval, however, Glass Lewis’ policy to recommend a vote against the nominating and governance committee chair will not change.

In addition to updating its environmental and social risk oversight policies, and clarifying the factors it uses to evaluate equity compensation plans, Glass Lewis also outlined its approach to analyzing conflicting proposals by management and shareholders. Glass Lewis indicated it will consider the following factors in determining whether to support such proposals:

• the nature of the underlying issue;
• the benefit to shareholders from implementation of the proposal;
• the materiality of the differences between the terms of the shareholder proposal and management proposal;
• the appropriateness of the provisions in the context of a company’s shareholder base, corporate structure and other relevant circumstances; and
• a company’s overall governance profile and, specifically, its responsiveness to shareholders as evidenced by a company’s response to previous shareholder proposals and its adoption of progressive shareholder rights provisions.

ISS Focus on Proxy Access

In February 2015, ISS issued its much anticipated FAQs on proxy access. In the FAQs, ISS indicates that it will generally recommend in favor of management and shareholder proposals for proxy access if the proposal features:

• an ownership threshold of not more than 3 percent of the voting power;
• a holding period of no longer than three years of continuous ownership for each member of the nominating group;
• minimal or no limits on the number of shareholders permitted to form a nominating group; and
• nominations for up to 25 percent of the board.

Adhering to these guidelines, throughout 2015, ISS recommended against several proxy proposals that did not contain these features. Most notably, ISS recommended against several proposals which provided for an ownership threshold of 5 percent for three years. In addition, in at least one instance, when presented with both a management proposal and a shareholder proposal where the management proposal met the ISS guidelines but the shareholder proposal contained less restrictive provisions, ISS recommended in favor of the shareholder proposal and against the management proposal. We expect increased focus by ISS on troublesome proxy access proposals, particularly in light of ISS’ 2015-2016 global voting policy survey, in which 90 percent of investor respondents indicated that a required ownership duration of greater than three years, or an ownership threshold requirement in excess of 5 percent, could be grounds for negative votes.

SEC Legal Bulletin re Omission of Conflicting Shareholder Proposal

On October 22, 2015, the SEC Division of Corporation Finance released Staff Legal Bulletin No. 14H that provides guidance to companies and shareholders regarding Proxy Rule 14a-8(i)(9). Rule 14a-8(i)(9) permits a company to exclude a shareholder proposal “[i]f the proposal directly conflicts with one of the company’s own proposals to be submitted to the shareholders at the same meeting.” Under the Legal Bulletin, the SEC will allow a company to exclude a proposal “if a reasonable shareholder could not logically vote in favor of both proposals, i.e., a vote for one proposal is tantamount to a vote against the other proposal.”

The Legal Bulletin came as a result of a controversial no-action letter issued in December 2014 to Whole Foods, which allowed Whole Foods to exclude a shareholder proposal related to proxy access. Following the controversy, Chair Mary Jo White announced that the Division would take a “no view” stance on 14a-8(i)(9) proposals during the 2015 proxy season while the Division of Corporation Finance reviewed and reported on the scope and application of Rule 14a-8(i)(9).

In the Legal Bulletin, the Division recognized that its definition of “direct conflict” imposes a “higher burden for some companies seeking to exclude a proposal” than was the case under the Division’s earlier position, but stated that it felt the revised formulation was more consistent with the rule’s history and purpose. Going forward, the Division will focus its analysis of no-action requests on “whether a reasonable shareholder could logically vote for both proposals.” For example, the Division will allow a company to exclude a shareholder proposal if a company seeks shareholder approval of a merger, while a shareholder proposal asks shareholders to vote against a merger. On the other hand, the Division will not conclude that a shareholder proposal is excludable if “a reasonable shareholder, although possibly preferring one proposal over the other, could logically vote for both.” For example, for a proxy access proposal, the Division will not issue a no-action letter if a shareholder submitted a proposal permits shareholders holding at least 3 pecent of the company’s outstanding stock for at least three years to nominate up to 20 pecent of the directors while a competing company proposal would only permit shareholders holding at least 5 percent of the company’s outstanding stock for at least five years to nominate up to 10 percent of the directors.

The Division recognized that in some cases, this may mean that two proposals – one shareholder and one company – may end up on the proxy and the company’s management would be tasked with considering the effect of both proposals. One suggestion given by the Division for a company to alleviate any confusion due to having two related proposals is to explain in the proxy materials the difference between the two proposals and how they would expect to consider the resulting votes.

REMINDER: NYSE AND NASDAQ REQUIRE NOTICE WHEN YOU RELEASE MATERIAL NEWS

Listed companies sometimes forget that, when it comes to releasing material news, complying with SEC rules is necessary—but not sufficient. Both NYSE and NASDAQ also require notification in advance of such news releases. “Material news” can include, for example (from NASDAQ’s IM-5250-1, Disclosure of Material Information):

• Financial-related disclosures, including quarterly or yearly earnings, earnings restatements, pre-announcements or “guidance.”
• Corporate reorganizations and acquisitions, including mergers, tender offers, asset transactions and bankruptcies or receiverships.
• New products or discoveries, or developments regarding customers or suppliers (e.g., significant developments in clinical or customer trials, and receipt or cancellation of a material contract or order).
• Senior management changes of a material nature or a change in control.
• Resignation or termination of independent auditors, or withdrawal of a previously issued audit report.
• Events regarding the listed company’s securities (e.g., defaults on senior securities, calls of securities for redemption, repurchase plans, stock splits or changes in dividends, changes to the rights of security holders, or public or private sales of additional securities).
• Eignificant legal or regulatory developments.
• Any event requiring the filing of a Form 8-K.

Last fall, NYSE and NASDAQ updated certain aspects of their policies regarding material news announcements. Summaries of the key updates are provided below:

NYSE

• NYSE requires listed companies to notify it at least 10 minutes before the release of material news between 7:00 a.m. and 4:00 p.m. ET. (Prior to September 28, 2015, the pre-notification requirement began at 9:30 a.m. ET.)
• After the market closes, listed companies are advised (but not required) to wait until the earlier of (i) publication of their official closing price, or (ii) 15 minutes after the close of trading, to release material news.
• NYSE now has the authority to halt trading in a listed company’s securities (i) during pre-market hours (only at the company’s request), or (ii) when NYSE believes it is necessary to request information from a listed company. Previously, NYSE was only permitted to halt trading due to the release of material news during market hours.

NASDAQ

• NASDAQ requires listed companies to notify its MarketWatch Department (generally, through NASDAQ’s electronic notification system) at least 10 minutes before the release of material news between 7:00 a.m. and 8:00 p.m. ET.
• If the public release of material news occurs outside of those hours, the listed company must notify MarketWatch prior to 6:50 a.m. ET.
• NASDAQ recommends that listed companies releasing material news around the time the market closes wait until at least 4:01 p.m. ET—and preferably until 4:05 p.m. ET—to allow the closing price to be calculated and fully disseminated before the news is released.
• NASDAQ also reminded listed companies that changes in their earnings release dates, earnings announcement dated, dividend record dates and dividend payment dates may be material news (requiring disclosure and pre-notification) due to their potential impact on the price of the company’s securities.

What Should Listed Companies Do?

To prevent involuntary trading halts and other adverse consequences, all listed companies should review their disclosure controls and procedures to ensure that applicable NYSE and NASDAQ notification requirements are incorporated.

OTHER ITEMS OF INTEREST

Enhanced Related Party Audit Procedures

In 2014, the Public Company Accounting Oversight Board adopted (and the SEC approved) new Auditing Standard No. 18. The new standards are designed to enhance audit procedures in three areas:

• related party transactions;
• significant transactions that are outside the normal course of business (or that otherwise appear unusual due to timing, size or nature); and
• a company’s financial relationships and transactions with its executive officers.

The new standards require the auditor to:

• undertake specific procedures to obtain an understanding of a company’s transactions and relationships with related parties;
• determine whether a company has properly identified related parties and transactions;
• execute specific procedures if the auditor determines the existence of an undisclosed transaction; and
• make enhanced reports to the audit committee.

Specifically, the new standards require the auditor to perform procedures to identify significant unusual transactions and understand the business purpose (or lack thereof) to those identified unusual transactions. The new standards further require the auditor to gain an understanding and evaluate financial relationships and transactions between a company and its executive officers. The impetus for this standard is concern that the unique position of executive officers gives them the ability to influence accounting and disclosures, which can create incentives and pressure to meet financial targets, which in turn can lead to improper accounting or disclosures (i.e., material misstatements). The new standards are designed to intensify the auditor’s consideration of incentives and pressures to achieve a particular result. Companies should expect more scrutiny of related party transactions and relationships and we believe that identifying and monitoring related party transactions (particularly the identification aspect) will become even more important going forward.

FASB Proposes New Standard on Materiality

Earlier this year, the Financial Accounting Standards Board (FASB) issued two exposure drafts that recommend a series of changes relating to the concept of materiality. The proposed changes are part of a bigger ongoing project to improve the effectiveness of disclosures in notes to financial statements by more clearly communicating the information required by Generally Accepted Accounting Principles (GAAP) that is most important to the users of financial statements. The exposure drafts address the use of materiality in (i) helping organizations employ discretion when determining what disclosures in notes to financial statements should be considered “material” in their particular circumstances and (ii) helping the board of directors understand the reporting environment in which it sets financial accounting and reporting standards. Regarding the concept of materiality, the exposure draft containing amendments to FASB Concepts Statement No. 8, Conceptual Framework for Financial Reporting, is intended to clarify the concept of materiality.^[1] As proposed, the Accounting Standards Codification would provide the following principles for assessing materiality:

• Materiality is applied to quantitative and qualitative disclosures individually and in the aggregate in the context of the financial statements taken as a whole; therefore some, all or none of the requirements in a disclosure section may be relevant.
• Materiality is a legal concept.
• The omission of immaterial disclosures is not an accounting error.

The FASB indicated in the exposure draft that it has received feedback that the definition of materiality in the existing GAAP framework is inconsistent with the concept defined by the United States Supreme Court in the famous Basic v. Levinson case.^[2] The FASB acknowledges that this inconsistency can lead to excess disclosure of immaterial information.

Importantly, the FASB would redefine materiality as a legal concept. The FASB noted that while the Supreme Court’s definition is established, it may change due to future court decisions and interpretations. As a result, no single definition of materiality can be relied on to identify what may be material in every specific circumstance. As stated by leading public accounting firm KPMG, “the FASB’s proposal would observe materiality, not promulgate it.”^[3]

Within the existing GAAP framework, “Information is deemed material if omitting it or misstating it could influence decisions that users make on the basis of the financial information of a specific reporting entity.”^[4] The Supreme Court’s definition, considered by many to establish a higher threshold for disclosing information, provides that a specific disclosure is considered material if there is a substantial likelihood that the disclosure of the omitted fact would have been viewed by a reasonable investor has having significantly altered the total mix of information available.

If adopted, the new concepts may eliminate uncertainty about disclosure obligations and eliminate excess disclosures that can have the result of diluting truly material information.

Notes:

^[1] Proposed Accounting Standards Update, Notes to Financial Statements (Topic 235): Assessing Whether Disclosures Are Material.

^[2] 485 U.S. 224 (1988).

^[3] KPMG, Defining Issues, September 2015, No. 15-42.

^[4] FASB Concept Statement No. 8.