DOUG’S NOTE

An Unexpected Free Cash Flow Comment from the SEC Staff

It is surprising how much attention free cash flow continues to generate in SEC disclosures. After all, it’s been used for decades as a non-GAAP financial measure. In fact, back in 2003, the SEC’s non-GAAP financial measure FAQs stated that companies should be “cautious” when using it, noting that it does not have a uniform definition and might inappropriately imply that it represents residual cash flow available for discretionary expenditures.

Fast forward to the much-scrutinized 2016 non-GAAP financial measures C&DIs, which essentially repeated the old free cash flow FAQ, though now companies need only be “aware” of, rather than “cautious” about, the absence of a uniform definition. This softer language presumably reflects the staff’s general softening toward non-GAAP measures, which it now sees as helpful disclosure so long as it’s done properly.

Then unexpectedly (at least to me), Monsanto Company received the following comment in a February letter that appears to have resulted from the staff’s routine review of Monsanto’s Form 10-K:

“We note you define free cash flow as the total of net cash provided or required by operating activities and net cash provided or required by investing activities. Pursuant to Question No. 102.07 of the Staff’s Compliance & Disclosure Interpretations (“C&DIs”) on Non-GAAP Financial Measures, issued May 17, 2016, please advise of your consideration given to redefining this measure or its computation as the typical calculation of free cash flow (i.e., cash flows from operating activities less capital expenditures). Please provide us with any proposed revisions to your disclosure of free cash flow to be included in future filings.”

The comment seems inconsistent with the staff’s position that free cash flow does not have a uniform definition and that companies need simply provide a “clear description of how this measure is calculated.” The staff expresses no issue with the clarity of Monsanto’s description, but rather just doesn’t seem to like the definition itself.

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Virtual Coins are ‘Securities’ After All

On July 25, the SEC issued a Rule 21(a) investigative report concluding that the sun rises in the east and sets in the west. No, wait, that’s not right. The report actually concluded that tokens offered by an unincorporated “virtual organization” known as The DAO (presumably short for “decentralized autonomous organization”) in what is known as an “initial coin offering” (ICO) were securities and, therefore, are subject to the federal securities laws.

Despite loads of cool-sounding techno-jargon in The DAO’s marketing materials and multiple breathless articles by mainstream media touting ICOs as the next big thing, the SEC had no trouble slotting The DAO tokens into the U.S. Supreme Court’s 71-year-old Howey definition of a “security,” which should come as no surprise to anyone.

What’s going on?

ICO’s have sprung out of nowhere in the past couple of years to rival traditional venture capital in the amount of funds raised for early stage technology projects. In fact, Shawn Langlois, social media editor of MarketWatch, said in a recent column that “the total crypto market cap now stands at a whopping $87 billion.”

Basically, promotors sell virtual coins in ICOs in exchange for U.S. currency or some other form of virtual currency (for example, bitcoin or ether). The ICO proceeds are then ostensibly used to fund development of the company’s digital platform, software or other technology project. The virtual coins typically can be resold in a secondary market on virtual currency exchanges.

Not surprisingly, the SEC says in its related Investor Bulletin that “some promoters … may lead buyers of the virtual coins … to expect a return for their investment or to participate in a share of the returns provided by the project.” And therein lies the problem.

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Insider Trading: Five Reminders From the SEC Division of Enforcement

A recent litigation release from the SEC Division of Enforcement, though seemingly unremarkable, highlights five basic principles that sometimes slip off a company’s insider trading compliance radar.

The SEC’s complaints.

According to the SEC’s complaints against two former employees and the spouse of a former employee of Ariad Pharmaceuticals, Inc., which develops and markets drugs to treat cancer:

  • The husband of an Ariad employee traded Ariad stock before company announcements about the safety profile and FDA approval status of Ariad’s only FDA-approved drug and after his wife learned of material non-public information related to Ariad’s dealings with the FDA. The husband also advised a friend to trade Ariad stock on the basis of non-public information learned from his wife, enabling the friend to obtain profits of $4,188.00.
  • Ariad’s former Senior Director of Pharmacovigilance and Risk Management sold Ariad stock after she had attended meetings with the FDA and had learned of a forthcoming FDA decision to require Ariad to include a safety warning on its product label, thereby avoiding $9,420.00 in losses.
  • Ariad’s former Associate Director of Pharmacovigilance and Risk Management alerted certain of her relatives one day before Ariad publicly announced a pause in all clinical trials for its FDA-approved drug. By selling in advance of Ariad’s announcement, her relatives avoided $2,888.10 in losses.

The SEC’s complaints charged each defendant with violating Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder and sought various injunctions, disgorgements with interest, and civil penalties.

The five reminders.

First: The SEC remains vigilant against insider trading of all shapes and sizes. For example, consider that:

  • Ariad was relatively small and low profile, not an S&P 500 company or media darling.
  • The amounts of profits or avoided losses involved were relatively insignificant.
  • The relevant persons were not Ariad’s most senior executives.

It remains clear, therefore, that insider trading enforcement remains a focus of the SEC and Department of Justice, no matter how seemingly minor the violation may be.

Second: Tipping remains in the SEC’s crosshairs, despite the Second Circuit’s 2014 Newman decision, which narrowed the scope of “personal benefits” sufficient to establish tipper/tippee liability.  (See this Doug’s Note.) read more…

What’s Happening with Pay Ratio Disclosures?

Well, we’re more than half-way through the year, Independence Day has come and gone, the 2018 proxy season is closer than it used to be, and we still don’t know whether pay ratio disclosures will go away.

A brief background.

Dodd-Frank Act Section 953(b) requires that the SEC amend Item 402 of Regulation S-K to mandate pay ratio disclosures. In 2015, the SEC dutifully adopted the mandated rules, which state that all companies required to provide executive compensation disclosure under Item 402(c) of Regulation S-K must provide new executive compensation disclosure regarding:

  • the median of annual total compensation of all employees,
  • the annual total compensation of the CEO, and
  • the ratio of those two amounts.

The new rules, which are complex and involve much time-consuming preparation, require companies to report the pay ratio disclosure for their first fiscal year beginning on or after January 1, 2017. This means that, for calendar-year companies, the new disclosures are required in 2018 proxy statements.

Companies generally reacted with an initial howl of outrage over the perceived arbitrary uselessness of these disclosures, observed that the implementation date was nearly three years away, and then studiously ignored the issue, hoping that in the meantime Section 953(b) would be modified or repealed.

Yet, as 2017 rounded into view, the Division of Corporation Finance issued guidance regarding some of the rule’s vaguer points, seemingly in part to remind companies that the rule was still out there and that much work was required to comply with its provisions. But just as companies reluctantly began to gear up (or to think about gearing up) to collect the necessary compensation data and draft the related disclosures, then-acting SEC Chairman Michael Piwowar issued a statement directing the SEC staff to take a fresh look at the rule because some companies “have begun to encounter unanticipated compliance difficulties that may hinder them in meeting the reporting deadline” and ordered a 45-day public comment period.

And there was much rejoicing.

Then, on June 8, the U.S. House of Representatives passed the Financial CHOICE Act of 2017, which would outright repeal Dodd-Frank’s Section 953(b). More good news, right? Well, not necessarily since many prognosticators believe that the Financial CHOICE Act is unlikely to make it through the Senate and become law. And even if it does, the SEC could still choose to leave the new pay ratio disclosure rules in place, particularly since it received more than 14,000 letters supporting the new rule during acting Chairman Piwowar’s comment period.

So, what should companies do?

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What Lawyers Should Know About the New Auditor’s Report Revisions

After more than six years of deliberations, it looks like the revised auditor’s report is about to become reality. On June 1, the PCAOB adopted a new auditing standard that substantially modifies the long-familiar content of that venerable report. Now the SEC must consider and act on the PCAOB’s recommendation, a process that typically involves another public comment period.

What’s changing?

CAM disclosure. The biggest change will be communication in the report by the auditors of “critical audit matters” applicable to the current period covered by the report. CAMs are defined as:

“any matter … that was communicated or required to be communicated to the audit committee and that relates to accounts or disclosures that are material to the financial statements and involved especially challenging, subjective, or complex auditor judgments.”

The new standard notes that the determination of a CAM is principles-based, though it also provides a non-exclusive list of factors for the auditor to consider in its determination. The PCAOB emphasizes that this disclosure should be client-specific and should not be boilerplate.

CAMs will be described in a separate section of the auditor’s report. The auditor must identify the CAM, describe the principal considerations that led the auditor to determine it was a CAM, describe how the CAM was addressed in the audit and reference the accounts or disclosures related to the CAM. In the unlikely event that a report contains no CAMs, it must affirmatively so state.

Emerging growth companies and employee stock purchase, savings and similar plans are excluded from the CAM disclosure requirements.

Additional changes. The modified auditor’s report also must:

  • State the year the auditor began serving as the company’s auditor,
  • Provide an enhanced description of the auditor’s role, responsibilities and independence, and
  • Satisfy certain format requirements designed to enhance readability.

When are the changes effective?

Subject to the SEC’s expected approval, all changes to the report except for communication of CAMs is effective for audits of fiscal years ending on or after December 15, 2017.

Communication of CAMs becomes effective for large accelerated filers for fiscal years ending on or after June 30, 2019 and, for all other companies, for fiscal years ending on or after December 15, 2020.

Auditors may, however, elect to comply with the new standards at any time after SEC approval.

What should you be doing now?

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Sustainability Reporting After the Paris Climate Accord

It’s fair to say that President Trump’s June 1 announcement that the U.S. will withdraw from the Paris climate accord has been widely reported. It’s also fair to say that the announcement triggered a host of passionate reactions, positive and negative, around the world. Within corporate America, a number of high-profile corporations (for example, Apple, Disney, Facebook, General Electric, Google, Salesforce, Tesla and Twitter) pledged to continue their efforts to cut greenhouse gas emissions and adhere to the spirit of the accord.

This leads one to wonder whether withdrawal from the Paris climate accord might, per the law of unintended consequences, actually increase investor emphasis on corporate social responsibility (CSR) and the number of companies that voluntarily report their sustainability initiatives. It’s an intriguing possibility.

Momentum for sustainability reporting has been building for years. In fact, the vast majority of S&P 500 companies now publish some type of sustainability or CSR report, and disclosures have begun to appear in SEC filings, particularly proxy statements. Mid-size and smaller companies, lacking the resources of their larger brethren, have been slower to do so, though some have begun and others are giving it serious consideration. Increased pressure from institutional investors, employees and other stakeholders, now coupled with widespread concern over withdrawal from the accord, could tip the reporting balance, especially for companies in sustainability-sensitive industries or companies that otherwise want to send a certain message.

One challenge for all companies is to make sense out of the CSR reporting landscape. First of all, the terminology itself—sustainability, CSR, environmental, social and governance (ESG), and triple bottom line, to name a few—is confusingly ambiguous and overlapping. Fundamentally, it all speaks to a company’s commitment to certain aspects of non-traditional, long-term value creation and to a broader range of stakeholders.

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Introducing a Fresh Perspective on Governance, Risk and Compliance

With the fifth anniversary of Doug’s Note fast approaching (and more than 250 posts and 250,000 reads in the rearview mirror), it seemed like a good time to consider where to go from here. Where, as it turns out, was to create a companion blog devoted to governance, risk and compliance, which are among the hottest issues in corporate America these days.

Parker Poe’s GRC Blog reflects the joint contributions of our GRC team, co-led by Jane Lewis-Raymond, former chief compliance officer and general counsel of a large public company, and by me. Together, we provide more than 50 years of experience counseling public and private companies of all shapes and sizes on compliance program design, risk assessment, enterprise risk management, crisis management, remediation and training.

Essential to the blog’s success are the contributions of our larger GRC team, which consists of attorneys whose practices focus on such key areas of corporate compliance as:

  • Anti-Bribery & Anti-Corruption
  • Antitrust & Consumer Protection
  • Criminal & Regulatory White Collar Compliance
  • Crisis Management
  • Cybersecurity & Data Privacy
  • Employment
  • Environmental
  • Government Contracting & False Claims Act Compliance
  • Immigration
  • SEC Reporting & Compliance
  • Tax
  • Trade Compliance

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Brexit’s Impact on the U.S. Capital Markets

You may have heard by now that the U.K. plans to leave the European Union at some point in the next few years. Since the British voted back on June 23, 2016, there has been no shortage of learned analysis/rank speculation about Brexit’s future impact on the U.K. and EU economies and financial markets. Opinions range from dire to blasé, with reality likely to fall (as it is wont) somewhere in the middle.

One surprising consequence, however, may be Brexit’s impact on U.S. capital markets. In a recent Heard on the Street column in The Wall Street Journal, Paul J. Davies theorizes from London that post-Brexit EU companies may have no choice but to tap the U.S. capital markets to make up for less convenient access to U.K. investors. It’s an intriguing, and believable, hypothesis.

Mr. Davies notes that much of the capital used to fund business expansion comes from savings, mostly in the form of pension funds, insurance companies and investment funds. He cites statistics provided by the Financial Stability Board, Investment Company Institute, European Central Bank and OECD showing that eurozone savings total less than 150% of its total GDP, as compared to more than 250% of GDP in the U.K. and 240% of GDP in the U.S. He notes further that there currently is no single set of capital markets laws and standards within the EU, making it hard to raise capital simultaneously in several eurozone countries. Therefore, frequent or large eurozone issuers often turn to the U.K.’s massive capital markets. Post-Brexit, that may not be feasible. As a result, Mr. Davies says, EU companies may be far more inclined to access the U.S. capital markets, even if that means setting up overseas subsidiaries and satisfying U.S. reporting and other regulatory standards.

This is particularly interesting in light of the SEC’s current push to re-invigorate the U.S. IPO market. In fact, the SEC on May 10 co-hosted the SEC-NYU Dialogue on Securities Market Regulation: Reviving the U.S. IPO Market. In his opening remarks, Commissioner Michael S. Piwowar first noted that the numerous benefits of IPOs to the U.S. economy “cannot be overstated.” He then said:

“between 30 percent and 50 percent of worldwide IPOs occurred in the United States during the 1990s. … In the last 15 years, however, the reduction in IPO activity has been dramatic … despite the fact that there has been no downward trend in the creation of new companies over the same period. … Strikingly, the fraction of worldwide IPOs occurring on U.S. markets fell below 10 percent between 2007 and 2011.”

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Thwarting Shareholder Activism Through Engagement

As the 2017 proxy season draws to a close for most companies, it is obvious that shareholder activism remains alive and well, though the actual number of public activist campaigns appears to have tapered off slightly as compared to recent years. Activism takes many forms, ranging from takeover proxy battles to proxy access proposals to single-issue social welfare proposals. Particularly noteworthy is an apparent trend among institutional investors to target small and mid-size companies, perhaps believing (perhaps correctly) that these companies are ill-prepared to resist their forays.

Companies have a wide array of defensive techniques at their disposal, depending on the nature of the activist’s approach, one of which is effective shareholder engagement. The good news is that more and more institutions are welcoming, and even encouraging, engagement with their portfolio companies. And while small and mid-size companies still sometimes struggle to get the attention of major institutions, this has become less problematic now that shareholder engagement is standard practice in corporate America.

Although many of the governance benefits of shareholder engagement are widely known, often overlooked is its ability to thwart shareholder activism. Better communication between the company and its major shareholders reduces misunderstandings about management’s strategy or the reasons behind its latest moves. Misunderstandings, in turn, may lead to activism, or a willingness to side with activists. Strong relationships with traditionally non-activist institutional shareholders (by far the larger percentage) have the ability to actually deter activist behavior before it even happens, or to nip it before it gains too much momentum.

For example, many activist shareholders own a relatively small percentage of the target company, particularly as compared to the well-known institutional behemoths. Therefore, the success of an activist’s initiative will depend, in part, on its ability to enlist the backing of multiple institutional shareholders. If it is obvious that the target company has open lines of communication with, and the general support of, its major shareholders, an activist is less likely to spend much energy launching a major campaign. Even social welfare proposals are less likely if an activist feels that they will fall largely on deaf ears. Furthermore, the influence of shareholder advisory services (SASs) continues to wane as companies have become more proactive in addressing SAS hot buttons and institutional shareholders have realized that SAS methodologies are not infallible.

The summer months are an excellent time to plan an effective shareholder engagement strategy for the fall. Most companies are fresh off of evaluating governance issues related to their proxy statements and may even have received shareholder overtures (formal or informal) during the proxy season. It’s the perfect time, therefore, to consider lessons learned and possible changes in approach. Summer will quickly become fall, which is the best time for actual engagement because institutional shareholders and SASs have more time to focus on your company. read more…

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…