At the Corp Fin Workshop last week, a segment of PLI’s SEC Speaks 2024, the panel focused on disclosure review, a task that occupies 70% of Corp Fin attorneys and accountants. The panel discussed several key topics, looking back to 2023 and forward to 2024. Some of the presentations are discussed below.
[Based on my notes, so standard caveats apply.]
Overview. Director Erik Gerding opened with an overview. The SEC is required to review each company’s disclosure at least once every three years, and, Gerding said, in 2023, the SEC reviewed 3,300 companies’ filings. The SEC also reviewed about 2,200 registration statements related to sales of about $1 trillion in the aggregate. The top comment areas were issues related to China-based companies, non-GAAP financial measures, MD&A, revenue recognition and financial statement presentation, as well as areas of emerging risks, including market disruption in the banking industry, cybersecurity and inflation, and new rules, such as pay versus performance. With regard to the rules under the HFCAA for China-based companies, he noted that all identified companies were reviewed for compliance. For the first year of review of disclosures under the new PVP rules, the staff issued mostly futures or forward-looking comments—they were not intended to be “gotcha” comments. Given the forward-looking nature of the comments issued, however, the staff did not expect this first year to reflect “settled practice.” For some of the most common issues, the staff has posted CDIs. (See this PubCo post and this PubCo post.) Gerding insisted that the SEC was trying to be more transparent in the disclosure review process. (Was that a reaction to remarks by Commissioner Hester Peirce? See this PubCo post.) While they don’t disclose the criteria for review, they do disseminate comments and responses (although they are tailored to the particular issuer) and sometimes provide sample “dear issuer” letters focused on emerging issues.
For 2024, Corp Fin expects to focus on financial reporting areas involving judgment or new standards, such as segment reporting (see this PubCo post), non-GAAP financial measures, critical accounting estimates, MD&A and supplier finance programs (see this PubCo post). And many of the issues from 2023 are expected to continue, such as China-based issuers, inflation (no boilerplate please), banking disruption (interest rate and liquidity risks), AI, commercial real estate, clawbacks, SPACs and cyber. In other words, everything.
Artificial intelligence. A Corp Fin panelist reported that, among large accelerated filers, 59% mentioned AI in their Forms 10-K last year, up markedly from 27% the year before. Discussions appeared in business, MD&A and risk factors, including risks regarding data privacy, bias, intellectual property, consumer protection, regulatory compliance and macroeconomic risks. The speaker advised that a company should provide disclosure about the use and development of AI that is tailored to that company’s facts and circumstances. The speaker noted that, to the extent the company discusses opportunities arising out of AI, the company should be sure that its characterization is accurate and that it has a proper basis for the claim—an issue that SEC Chair Gary Gensler has previously raised as “AI washing.” (See this PubCo post.) With regard to governance, the panelist suggested that companies should consider discussing the role of the board in overseeing the ethical and responsible use of AI. Many companies also disclose that they have policies regarding the use and prohibited use of AI, balancing the risks and benefits. He observed that an Executive Order has been issued promoting a coordinated approach to the use of AI and directing the development of standards. There is also a NIST framework to which some companies refer, as well as a new EU AI Act, which provides a comprehensive risk-based regime with stiff penalties for violation that could impact some issuers and may warrant risk disclosure.
Cybersecurity. Another panelist discussed cybersecurity disclosure (see this PubCo post), specifically the importance, in reporting an event, of discussing both the quantitative financial impact and the impact on qualitative factors, such as reputation, competition and vendor relationships. With regard to timing of the need to file an 8-K to report an incident, the rule requires that filings be made “without unreasonable delay” following a materiality determination. But companies don’t need to wait until completion of their investigations to determine materiality. If they determine materiality prior to completion, they can so indicate in their filings and file an amendment when the omitted information becomes available. In annual disclosures, the rules require information about governance and oversight processes, with a number of non-exclusive examples provided. The rules are not intended, he emphasized, to influence how companies manage their cyber risks. In addition, he stressed that, as discussed in remarks last year by Gerding and in CDIs (see this PubCo post), the requirements are not intended to act as a disincentive to consult with law enforcement about breaches, including before a materiality assessment has been made. Consultation with the DOJ or other law enforcement does not mean that the company has determined that the event is material. Corp Fin wants to encourage companies to engage in these consultations.
Clawback checkboxes. The clawback rules added a requirement to include new checkboxes on the cover pages of Form 10-K, Form 20-F and Form 40-F to indicate separately (a) whether the financial statements of the issuer included in the filing reflect correction of errors to previously issued financial statements, and (b) whether any of those error corrections are restatements that required a recovery analysis of incentive-based compensation received by any of the issuer’s executive officers during the relevant recovery period. (See this PubCo post.) There have been so many questions about the checkboxes that one panelist devoted her entire remarks to the topic. The two boxes have different scopes, with the second box being narrower in scope than the first. For the first box, in considering whether a change to previously issued financial statements is an error, companies should look at the definition of “error” in GAAP. The definition includes any error in recognition, measurement, presentation or disclosure in financial statements resulting from a mathematical mistake, mistakes from the application of GAAP or oversight or misuse of facts existing at the time the financials were prepared. It does not include the adoption of new accounting standards that require retrospective application, a disaggregation of line items or a change in accounting principles. The first box applies to both “big R” and “little r” restatements, as well as voluntary restatements. What is that? The speaker explained that, when an error is immaterial to the prior year and correction in the current year would also be immaterial, it’s ok to correct the error in an out-of-period adjustment to the current year and not restate the prior year. In that case, the box would not be checked because there is no revision of previously issued financials. But if the company chooses to correct the prior year, it’s a voluntary restatement and the box should be checked.
The second box relates to whether the error corrections were restatements that required an analysis of potential recovery under the company’s policy. The box would be checked even if it turned out, after the analysis, that there would be no recovery because, for example, there was no incentive comp paid to executives. Both checkboxes apply only to corrections of errors for prior years and do not apply to errors corrected in the current year. The staff will be monitoring the filing of policies and assessing disclosure when a recovery analysis in triggered.
Pay versus performance. One panelist discussed the review that Corp Fin conducted of last year’s PVP disclosure. (See this PubCo post.) There were comments issued as well as a number of CDIs that the speaker encouraged filers to consult (see this PubCo post and this PubCo post). Some of the areas of frequent comment were the omission of a qualitative discussion of the relationship between pay and performance, the aggregation of the calculations showing compensation actually paid and, for companies’ own selected performance measures that were non-GAAP, the failure to discuss in the proxy how the measure was derived. In that regard, she noted that a full 10(e) reconciliation is not required. In addition, if companies are including supplemental disclosure, the speaker recommended that they review the discussion in the adopting release that describes how to present the information. She also recommended the use of plain English. The staff plans to conduct another review in 2024, which is anticipated to be more robust in light of the guidance issued.
Universal proxy and beneficial ownership. In November 2021, the SEC amended the federal proxy rules to mandate the use of universal proxies in all non-exempt solicitations in connection with contested elections of directors of operating companies. (See this PubCo post.) The panelist reported that, now in the second season of universal proxy, she thinks the rules are working as intended. In the first season, they did not see the flood that some predicted of bare-bones election contests (where the dissident opted to rely on internet delivery and the company paid full price for delivery of the universal proxy cards to all shareholders), nor were there any low-cost single-issue campaigns. The staff focused on ensuring compliance and proper disclosure of voting options and issued new CDIs. (See this PubCo post and this PubCo post.) Season two saw the first ESG-focused, single-issue campaign, but the dissident used a traditional full-blown solicitation, including a proxy solicitor, and ultimately withdrew its candidates. There was also the first three-way contest, the possibility of which the staff had contemplated in crafting the rules. In addition to monitoring compliance and disclosure of voting options and mechanics, in 2024, the staff is monitoring challenges to advance-notice bylaw provisions and company challenges to activist nominations and potential gamesmanship.
This speaker also discussed amendments adopted last year to the beneficial ownership rules, which included shortened deadlines, as well as guidance regarding group formation. (See this PubCo post.) The staff is currently monitoring the implementation. The speaker noted that Enforcement has taken action regarding untimely filing of reports. The speaker observed that reports can be market moving, and so their timeliness is important.
The Workshop panel also discussed issues related to China-based issuers and to commercial real estate.
“Shell company” discussion and shareholder proposals. It’s also worth mentioning that earlier in the day, Corp Fin Chief Counsel discussed a particular transaction structure that has drawn the attention of the staff because it raised issues about shell companies. In this business combination, a public company allocates to its current shareholders, through the issuance of contingent value rights, the future profits of its legacy business, as well as the proceeds of any sale of its legacy business. In the merger, the private company receives some cash and attains public company status. The staff is not taking issue with attempts to maximize profits for the legacy shareholders, but, he cautioned, it must be done in conformity with the law. Some have claimed that, because some assets technically remain on the public company’s books, that the public company isn’t really a shell. But the staff considers that view to privilege form over substance, and views this transaction as a merger with a shell—the reality is that, given that the economics of the legacy business had been assigned away, what was sold was a little cash and public-company status. In that event, there are a number of consequences related to shell companies—a requirement to file a Form 8-K Item 5.06 with full Form 10 disclosure, limitations on the use of Form S-3 and Form S-8 and affiliates deemed underwriters. In addition, he suggested that the contractual arrangement could itself be deemed a security and, if so, questioned how the company would comply with Section 5.
He also briefly discussed shareholder proposals, responding to certain claims made in commentary. First, he pointed out that the volume of no-action requests has grown substantially this year; as of the preceding Friday, there were 261 requests, representing an almost 50% increase from last year (which, he acknowledged, had experienced a big drop-off). But requests were also 13% higher than in 2021-2022. He emphasized that the no-action responses are just informal staff views; contrary to suggestions in some commentary, the staff does not require a company to include or exclude proposals. He also pointed out that some bases for exclusion are procedural, such as ineligibility; some commentary makes it seem as if the staff were weighing in substantively when it was not. Also, he pointed out that the ordinary business exclusion has two components: the proposal can be excluded because of its subject matter (ordinary business operations) and because it micromanages. That is, a proposal can be excluded for micromanaging even if the subject does not relate to ordinary business. When the staff responds to requests, the response is only to those arguments that the company has raised. Some companies do not raise micromanagement as an argument. As a result, responses to requests regarding similar proposals may be different depending on the arguments in the request made by the company; the responses do not necessarily mean that the staff is inconsistent or flip-flopping.
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