DOUG’S NOTE

Compliance Program Oversight—The Board’s Overlooked Role

It’s long been axiomatic that an effective compliance program cannot exist without a strong ethics and compliance culture, which in turn requires the proper “tone from the top.” Yet, when most companies think “top,” they think C-suite. After all, tone starts with the CEO, right? And the C-suite is where you find many CCOs, or the executive to whom the CCO directly reports. Also, that’s where decisions are made about staffing the compliance function, allocating funds to implement the program and the host of other operational matters that determine whether the program is robust, minimalistic or non-existent. Often overlooked, however, is the crucial role of the board of directors.

Most directors have a general understanding that their fiduciary duties include compliance oversight. After all, it’s been more than 20 years since the Delaware Court of Chancery held in its famous Caremark decision that directors could, in certain circumstances, be determined to have breached their fiduciary duty and, therefore, be liable for company losses due to compliance program failures. Later, the Delaware Supreme Court in Stone v. Ritter held that a director’s failure to implement and oversee aspects of a compliance program could constitute an unindemnifiable breach of the duty of loyalty.

But how well do boards really understand their compliance program obligations? And to what extent do many boards devote time and effort to ensuring that their performance would pass muster under the microscope of hindsight when (not if) a compliance breach occurs? Is it enough for them to know that someone in the company has been given the title of CCO? Is it enough to allocate 30 minutes each year to listening to a compliance report from the CCO? How about 15 minutes per quarter? If asked, could each director describe how the company’s compliance program is structured and how it operates? Could they provide convincing assurances to a third party that it operates effectively?

The U.S. Sentencing Guidelines were promulgated by the U.S. Sentencing Commission in 1991 so that sanctions imposed on entities and individuals “will provide just punishment, adequate deterrence, and incentives for organizations to maintain internal mechanisms for preventing, detecting, and reporting criminal conduct.” While there are many important reasons to establish and maintain an effective compliance program beyond simply seeking to minimize criminal penalties, the Sentencing Guidelines are a key consideration in that effort. It is interesting, therefore, to note that Chapter 8 of the Sentencing Guidelines Manual states in plain English that:

“The organization’s governing authority shall be knowledgeable about the content and operation of the compliance and ethics program and shall exercise reasonable oversight with respect to the implementation and effectiveness of the compliance and ethics program.” read more…

A Compliance Calendar Tip: Update for T+2

A few weeks ago, the SEC finalized rules to shorten the standard settlement period for securities transactions from three business days (T+3) to two business days (T+2). Amended Exchange Act Rule 15c6-1(a) will prohibit a broker-dealer from entering into a contract for the purchase or sale of a security (subject to certain exceptions) that provides for payment of funds and delivery of securities later than two business days after the trade date (known as “T”), unless otherwise expressly agreed to by the parties at the time of the transaction. (See this Doug’s Note.)

The shift from T+3 to T+2 will be effective on September 5, 2017 to give everyone sufficient time to plan for, implement and test changes to the various systems, policies and procedures necessary for an orderly transition. Most of this preparation burden will, of course, fall on the direct participants in the securities trading industry. However, any company that pays regular cash dividends may need to adjust its annual compliance calendar to accommodate the new rule. read more…

Jay Clayton Confirmed as SEC Chairman

A new era at the SEC officially began last week when Jay Clayton was sworn in as the 32nd Chairman of the SEC. The Senate’s confirmation of Mr. Clayton on May 2nd by a 61 to 37 vote continued the Trump Administration’s practice of tapping well-known Wall Street professionals to serve in key government positions.

In this case, Mr. Clayton was a partner in the New York office of Sullivan & Cromwell, where according to the SEC’s news release he advised companies on “securities offerings, mergers and acquisitions, corporate governance and regulatory and enforcement proceedings.” These companies notably included Goldman Sachs, which has been a recurring theme with President Trump’s appointees. While his former ties will, no doubt, prevent Mr. Clayton from participating in SEC matters directly related to Goldman Sachs, his Wall Street background could well influence his perspective regarding the SEC’s future regulatory agenda.

That agenda is expected to shift toward re-analyzing the regulations implemented as a result of Dodd-Frank while Congress seeks to roll back many of that act’s statutory imperatives. For example, a bill currently making its way through the House, known as the Financial Choice Act, would among other things and according to its executive summary:

  • Provide an “off-ramp” from the post-Dodd-Frank supervisory regime and Basel III capital and liquidity standards for banking organizations that maintain high levels of capital, including easing restrictions on their ability to pay dividends and the maintenance of leverage ratios,
  • Repeal the designation of firms as “systematically important financial institutions” and modify the bankruptcy code to accommodate the failure of large, complex financial institutions, thereby eliminating Dodd-Frank’s “orderly liquidation authority,”
  • Repeal the Consumer Financial Protection Bureau’s authority to ban bank products or services that it deems “abusive” and to prohibit arbitration,
  • Impose enhanced penalties for financial fraud and self-dealing, promote greater transparency and accountability in the civil enforcement process and increase the maximum criminal fines for individuals and firms that engage in insider trading and other corrupt practices,
  • Repeal sections of Dodd-Frank, including the Volcker Rule, that limit capital formation,
  • Repeal the SEC’s authority to eliminate or restrict securities arbitration,
  • Permit all companies to communicate confidentially with the SEC pre-IPO, and
  • Prohibit regulation by the SEC of proxy access.

Of course, the Financial Choice Act will go through multiple revisions and may never actually become law, but it provides insight into the types of issues Congress is currently considering. read more…

Whistleblower Retaliation Remains in the SEC’s Crosshairs

Whistleblower tips and awards for securities law violations have increased dramatically over the past year, according to the staff of the SEC Enforcement Division’s Office of the Whistleblower. Also during that time, the Whistleblower Office has stepped up its vigilance over retaliation by companies against whistleblowers, imposing penalties against companies more frequently and expanding the scope of what constitutes illegal retaliation. Furthermore, there is so far no reason to think the new Trump Administration will seek to reverse this trend.

Direct retaliation can take many forms, most of which are recognizable by attentive management. Note, however, that certain less obvious behaviors may also be deemed retaliatory. For example, in one case an employee submitted a complaint about the company’s accounting practices through its internal procedures and to the SEC. When the SEC notified the company of its decision to investigate that complaint, the company was able to determine the whistleblower’s identity and revealed it in an internal email related to the investigation. The Fifth Circuit Court of Appeals in Halliburton, Inc. v. Administrative Review Board, United States Department of Labor concluded that illegal retaliation had occurred, stating that the “undesirable consequences” of being revealed to one’s colleagues as having accused them of fraud were “obvious.” (See this Doug’s Note.)

The SEC has also focused recently on indirect forms of illegal retaliation embedded in company policies and agreements. Provisions in such documents may inadvertently violate Rule 21F-17(a) under the Securities Exchange Act, which provides that:

“No person may take any action to impede an individual from communicating directly with the Commission staff about a possible securities law violation, including enforcing, or threatening to enforce, a confidentiality agreement….”

Essentially, language that prohibits an employee from disclosing confidential information without an express carve-out for reports to a government agency or that prohibits the recovery of monetary damages or awards may violate Rule 21F-17(a).

In addition, the SEC continues to expand the scope of its retaliation oversight. Examples include recent enforcement actions for retaliation where the whistleblower only reported internally, rather than to the SEC, and where the SEC elected not to pursue the company’s alleged securities law violation itself.

Penalties for violations are likely to include:

  • Hundreds of thousands of dollars of monetary fines,
  • Amending the relevant documents, and
  • Contacting all affected persons to inform them as to their revised rights.

Action Steps read more…

Securities Act and Exchange Act Form Revisions

In 2012, the Jumpstart Our Business Startups (JOBS) Act created a new category of companies known as “emerging growth companies (EGCs).” The JOBS Act also requires that, once every five years, the SEC indexes various EGC thresholds to reflect changes in the Consumer Price Index for All Urban Consumers. Last week, those new thresholds became effective upon their publication in the Federal Register.

The SEC simultaneously revised the cover pages of various Securities Act and Exchange Act forms used by virtually all public companies. Two new check boxes must now appear on the covers of:

  • Forms S-1, S-3, S-4, S-8, S-11 and the corresponding foreign private issuer “F” forms, and
  • Forms 10-K, 10-Q, 8-K and 10.

The new boxes must indicate:

  • Whether the person filing the report is an EGC, and
  • If so, whether the company has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 7(a)(2)(B) of the Securities Act.

The takeaways read more…

Conflict Minerals–What Just Happened and What Didn’t

The conflict minerals saga continues.

Background

In April 2014, the Court of Appeals for the D.C. Circuit in National Association of Manufacturers v. SEC held that the conflict minerals rule’s requirement that companies state that their products have not been found to be “DRC conflict free” violated the First Amendment. Subsequently, the SEC staff released guidance relieving issuers of the obligation to put those labels in their reports. The case was subsequently remanded to the district court for further consideration, and on August 18, 2015, the Court of Appeals reaffirmed its prior decision.

In response to these developments, Acting SEC Chairman Michael S. Piwowar issued a statement in January 2017 declaring that he had “directed the staff to reconsider whether the 2014 guidance on the conflict minerals rule is still appropriate and whether any additional relief is appropriate.” (See this Doug’s Note.)

Last week, the D.C. Circuit Court entered final judgment in the case, which upheld its prior rulings, and remanded it to the SEC for appropriate action.

This past Friday, the SEC issued a statement noting that the D.C. Circuit’s remand to the SEC has “presented significant issues for the Commission to address” and that several comments were received in response to Acting Chairman Piwowar’s January request. Therefore, “in light of the uncertainty regarding how the Commission will resolve those issues,” the Division of Corporation Finance will not recommend enforcement action if companies “only file disclosure under the provisions of paragraphs (a) and (b) of Item 1.01 of Form SD,” which conspicuously excludes the need to comply with paragraph (c).

What does this mean?

Companies that use conflict minerals that are necessary to the functionality or production of products manufactured (or contracted to be manufactured) still must comply with Item 1.01(a), which requires that they:

  • conduct a good faith reasonable country of origin inquiry (RCOI), and
  • file a Form SD with the SEC not later than May 31st.

Companies that conclude that their conflict minerals do not come from a covered country (or come from recycled or scrap materials) still must comply with the Item 1.01(b) requirement to disclose that conclusion on Form SD and on its website.

Paragraph (c) of Item 1.01, on the other hand, relates to the requirement to conduct due diligence on the source and chain of custody of conflict minerals and the need for a related independent private sector audit. If a company’s RCOI gives it reason to believe that its conflict minerals may have originated in a covered country (and are not from recycled or scrap materials), then it must conduct due diligence on the chain of custody and describe those efforts in a report attached to Form SD.

By eliminating the need to comply with Item 1.01(c), the SEC is saying that companies with conflict minerals do not have to:

  • trace the smelters or refiners used by suppliers,
  • provide the related chain of custody disclosures, or
  • have such disclosures audited by a third party.

What should you do? read more…

The Downside of Sustainability Reporting

Not long ago, I wrote about the growth of sustainability reporting among public companies. (See this Doug’s Note.) It is now widely believed that effective sustainability reporting, also called “corporate social responsibility” reporting, facilitates a perception among investors, employees, customers, suppliers and other stakeholders that a company is committed to operational, compliance and governance values that enhance its reputation and increase shareholder value. This increase in quantity and quality of reporting has been encouraged by various non-profit organizations formed to flesh out and standardize disclosures.

It is important to remember, however, that the evolution of CSR reporting from fringe puff pieces to mainstream disclosure means that companies must also be alert to possible liability for misstatements or other inaccuracies. In fact, the last few years have seen a rise in the number of law suits claiming violations of securities or consumer protection laws due to CSR statements.

Basically, companies must analyze all CSR communications, whether in an SEC report, on their websites, in a special report, or otherwise, in accordance with their established disclosure controls and procedures. Resist the temptation to treat CSR disclosures as nothing more than soft marketing or public relations materials unrelated to the company’s “real” disclosures. Be sure that they are thoroughly reviewed prior to dissemination and are subject to the same layers of scrutiny, which may include the disclosure committee, chief risk officer, chief compliance officer, board risk oversight committee and other persons performing similar duties.

Here are some tips to keep in mind: read more…

T+2 is a Reality

Last September, the SEC proposed rules that would shorten the standard settlement period for securities transactions from three business days (T+3) to two business days (T+2). As predicted, the rules have now been finalized in short order and without controversy.

Background

This is the latest, though probably not the last, step in the evolution of trade settlements. Trades actually settled on a T+5 cycle until 1993, when the adoption of Rule 15c6-1 mandated T+3 in an effort to reduce credit risk (the risk that the credit quality of one party to the transaction will deteriorate) and market risk (risk that the value of traded securities will change between trade execution and settlement).

Since then, the settlement cycle has been stuck on three business days despite dramatic advances in technology, multiple industry-driven recommendations to shorten the cycle and the adoption of a shorter settlement cycle in almost every other significant non-U.S. trading market. For example, T+2 (or less) already exists in most European markets, the U.K, Israel, Saudi Arabia and China, while others markets, like Australia, New Zealand, Japan and Canada, are expected to adopt T+2 in the near future.

The SEC actually considered T+1 and T+0 settlement cycles in its deliberations, but rejected them as requiring more extensive changes to technology and post-trade processes that would delay the benefits of moving to a T+2 cycle. Nevertheless, it would be reasonable to expect movement toward shorter trade settlements in the U.S. in the future.

The amended rule

Exchange Act Rule 15c6-1(a) has been amended to prohibit a broker-dealer from entering into a contract for the purchase or sale of a security (subject to certain exceptions) that provides for payment of funds and delivery of securities later than two business days after the trade date (known as “T”), unless otherwise expressly agreed to by the parties at the time of the transaction.

The T+2 requirement generally will apply to the same securities transactions currently covered by the T+3 settlement period. The T+2 will not apply to certain specified categories of securities, including, for example, exempted, government and municipal securities.

Effective date

The shift from T+3 to T+2 will be effective on September 5, 2017, which the SEC noted was sufficient time to plan for, implement and test changes to the various systems, policies and procedures necessary for an orderly transition. One commenter on the proposed rules also helpfully noted that September 5th effectiveness has the advantage of letting everyone work through the Labor Day weekend to deal with last-minute bugs. read more…

Don’t Forget the Say-on-Frequency Form 8-K

The proxy rules require that public companies submit a nonbinding proposal to their shareholders every six years regarding how often they should hold say-on-pay votes, known as “say-on-frequency.” Most companies held their first say-on-frequency vote in 2011 and will be including another vote in their 2017 proxy statements. (“Smaller reporting companies” were not required to hold their first say-on-frequency vote until 2013, meaning that they won’t have to do it again until 2019, and there are special rules for “emerging growth companies.”) Shareholders may choose to vote on executive compensation every year, every two years or every three years, or they may choose to abstain.

Though the vote is nonbinding, the charter of most compensation committees requires them to consider the outcome of the shareholder vote when deciding how best to proceed. Indeed, companies must amend their initial post-meeting Item 5.07 Form 8-K (which reports voting results) no later than 150 calendar days after the end of the shareholder meeting at which the vote was taken in order to “disclose the company’s decision in light of such vote as to how frequently the company will include a shareholder vote on the compensation of executives in its proxy materials….”

Back in 2011 when these rules were still new, more than a few companies failed to make the necessary Form 8-K disclosures. While this may not sound like a big deal, in fact it is. A missed Form 8-K filing can render a company ineligible to use Form S-3 during the 12 months following the date that the Form 8-K should have been filed. For companies planning to raise capital in the public markets, that could be a major problem.

A practical way to be sure this filing doesn’t fall through the cracks is to include the required disclosure in the initial post-meeting Item 5.07 Form 8-K (filed within four business days after the meeting), rather than waiting until after consideration at a subsequent compensation committee meeting. Because the overwhelming majority of companies will be recommending annual consideration of executive compensation and because most institutional shareholders and proxy advisory firms prefer annual frequency, it is safe to assume that shareholders will strongly support the board’s recommendation. read more…

Sustainability Reporting Continues to Mature

Several years ago, voluntary sustainability reporting in proxy statements, annual reports to shareholders, websites and special sustainability reports to various stakeholders began to take hold, even as the SEC continued to resist calls for mandatory sustainability reporting and even in the general absence of guidance regarding what to disclose and how. (See this Doug’s Note.) Around the same time, several non-profit organizations formed for the purpose of bringing order to these disclosures. Among them was the Sustainability Accounting Standards Board (SASB), which enjoys a board of directors made up of a particularly distinguished list of executives, investors, professionals and academics, and chaired by Michael Bloomberg.

Since then, sustainability reporting has continued to increase in quantity and quality, and SASB has maintained its position as a well-known, respected standard-setter. In keeping with the maturation of these disclosures, SASB recently published an interesting and detailed “staff bulletin” describing its Approach to Materiality for the Purpose of Standards Development.

The bulletin explains the SASB’s efforts to align its disclosure standards with existing federal securities law concepts of materiality (as set forth, for example, in TSC Industries v. Northway, Basic v. Levinson and the SEC’s MD&A rules and guidance). It caught my eye because the alignment of mandatory SEC reporting and voluntary sustainability reporting is essential not only to effective disclosure controls and procedures, but also to consistent and meaningful stakeholder communications. read more…