This newsletter discusses noteworthy updates, key regulatory decisions and upcoming compliance reminders. You are welcome to contact us to discuss any of the topics. You can view previous versions at this link.

In this edition, we review:

SEC Penalizes Company for Non-Compliance with Equal or Greater Prominence Requirement in Earnings Releases

Critical Audit Matters: One Year Out

SEC Adopts Hedging Disclosure Rules

Evolving Trends in ESG Disclosures

Corporate Governance Trends

Caught Between a Rock and a Hard Place: #MeToo Movement Creates Challenges for Directors

ISS Updates its U.S. Compensation and Equity Compensation Plan Policies for 2019

SEC Penalizes Company for Non-Compliance with Equal or Greater Prominence Requirement in Earnings Releases

By R. Randall Wang

In late December, the SEC settled its first “equal or greater prominence” enforcement action under its non-GAAP rules against ADT, Inc., for which the company agreed to a cease and desist order and to pay a $100,000 civil monetary penalty for non-compliance in two earnings releases.  It does not appear that the staff of the SEC had preceded the enforcement action with any comment letters.  In fact, ADT had completed its IPO less than two months earlier, so the earnings releases at issue were its first as a public company. As a result, companies should recognize that the staff of the SEC may give increased focus on instances of non-compliance with those rules.

Item 10(e)(1)(i)(A) of Regulation S-K requires that companies that present a non-GAAP measure must present the most directly comparable GAAP measure with equal or greater prominence. This requirement applies to non-GAAP measures presented in SEC filings as well as earnings releases furnished under Item 2.02 of Form 8-K.

In May 2016, the staff of the SEC released a comprehensive set of updated interpretations, or CDIs, providing guidance regarding a number of scenarios. In CDI 102.10, the staff presented a list of examples of disclosures in which a non-GAAP measure was given improper prominence, including “[a] non-GAAP measure that precedes the most directly comparable GAAP measure (including in an earnings release headline or caption).”

In this case, ADT published two earnings releases in the first half of 2018 that included non-GAAP financial measures such as adjusted EBITDA, adjusted net income and free cash flow before special items, without giving equal or greater prominence to the comparable GAAP measures.  In particular, the SEC noted that ADT presented adjusted EBITDA in headlines (indicating an increase of 8% in the FY 2017 release and 7% in the Q1 2018 release) without mentioning net income or loss.  In addition, ADT included bullets in the Q1 2018 release highlighting results that included adjusted EBITDA (up 7%), adjusted net income (up 26%) and adjusted net income per share (up 10%) without mentioning net income or loss.  Only later in that release did the company disclose that GAAP net loss had significantly increased over the prior period.

The order makes clear that the SEC views mere disclosure of the comparable GAAP measure in the same document as insufficient.  Instead, companies should take care to give equal or greater prominence to the GAAP measure.

Critical Audit Matters: One Year Out

By Paul William

In 2017 the Public Company Accounting Oversight Board (“PCAOB”) adopted Auditing Standard 3101. The first phase of implementation of the new standard is now effective.  Audit reports for the fiscal year ended December 31, 2018 now include statements about the auditor’s tenure and statements that the auditor is required to be independent. Starting with audits of large accelerated filers for periods ending on or after June 30, 2019, auditors will be required to communicate critical audit matters (“CAMs”) in their auditor’s reports.

This article reviews the rules related to reporting CAMs and reviews early lessons from the efforts of auditors and large accelerated filers to attempt a “dry run” at implementation in connection with the fiscal 2018 audit.

CAMs represent new required disclosures within the auditor’s report that seek to increase transparency by providing a reader new insight.  Informally, the new disclosure is to describe the issues that keep the auditor up at night.  Formally, AS 3101 defines a CAM as any matter arising from the audit of the financial statements 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 judgment.

The determination of whether a matter is a CAM involves application of principles-based requirements, and the PCAOB standard does not specify that any matter(s) will always be a CAM. The standard specifies a nonexclusive list of factors for the second bullet above:

  • The auditor’s assessment of the risks of material misstatement, including significant risks;
  • The degree of auditor judgment related to areas in the financial statements that involved the application of significant judgment or estimation by management, including estimates with significant measurement uncertainty;
  • The nature and timing of significant unusual transactions and the extent of audit effort and judgment related to these transactions;
  • The degree of auditor subjectivity in applying audit procedures to address the matter or in evaluating the results of those procedures;
  • The nature and extent of audit effort required to address the matter, including the extent of specialized skill or knowledge needed or the nature of consultations outside the engagement team regarding the matter; and
  • The nature of audit evidence obtained regarding the matter.

It is worth noting that despite the focus on audit risk, the standard does not provide that a matter determined to be a significant risk would always constitute a CAM. Some significant risks may be CAMs, but not every significant risk will involve especially challenging, subjective, or complex auditor judgment.

Auditing firms have begun performing “dry runs” of the CAM requirements for select clients. These dry runs involve practicing the identification and drafting of CAMs, as well as the communication required with management and audit committees. The Center for Audit Quality published a December 2018 report of early lessons from these efforts. Moreover, practitioners have begun to share information about those “dry runs.” The following are highlights of what we have picked up from those early lessons and anecdotes.

  • What will be the most common CAMs? As the rules would imply, the most common CAMs will be in those areas involving high degrees of estimation that require significant judgment. The most common CAMs are expected to be: goodwill and intangible asset impairment, business combinations, elements of revenue recognition, income taxes, legal contingencies, and hard to fair value financial instruments.
  • How will the CAMs differ from the registrant’s existing Critical Accounting Estimates? While Critical Accounting Estimates will be fertile ground to overlap with CAMs, utilizing the principles approach outlined in AS 3101, not every critical accounting estimate will involve especially challenging, subjective or complex auditor judgment. Despite the complexity of the registrant’s accounting and the complexity of wording used to describe the accounting, the auditor’s task may not be that difficult.
  • How many CAMs will be normal? While it is possible that no CAM is identified, the PCAOB has indicated that it expects that an audit will identify at least one CAM.  Anecdotally, the “dry runs” have identified between two and four CAMs. This may increase as CAMs become a prominent focus in fiscal 2019 audits compared to a mere theoretical exercise in fiscal 2018 audits. As a point of comparison, a similar 2013 PCAOB rule applicable to certain UK public companies resulted in one to eight disclosures by the auditors with an average of four new disclosures in the first year of implementation, according to a PCAOB white paper.

For more information about this update, please contact a member of Bryan Cave Leighton Paisner’s Securities Team or one of the authors of this newsletter.

SEC Adopts Hedging Disclosure Rules

By Bill Cole and Jim Havel

In December 2018, the SEC adopted final rules regarding disclosure of hedging policies and practices.  The disclosures rules are set forth in new Item 407(i) of Reg. S-K.   The purpose of the rules are to provide transparency to shareholders about whether a company’s employees or directors may engage in transactions that reduce or avoid the alignment of equity ownership in reporting companies.  The hedging policy disclosure requirement originated with Section 955 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.  The SEC originally proposed rules in 2015.  The final rules are here.  The proposed rules are here.

Scope of the Rules

Item 407(i) requires a company to describe any practices or policies (written or otherwise) adopted by the company regarding the ability of employees (including officers), directors, or designees of such persons to engage in certain hedging transactions in the company’s equity securities.  The rules apply to equity securities held directly, or indirectly, whether or not granted as compensation.

The rules require a “fair and accurate” summary of the applicable practices and policies, including the categories of persons covered and any categories of transactions that are specifically permitted or disallowed.  The SEC did not define “fair and accurate.”   Companies can also disclose their practices or polices in full.

The rule does not mandate that a company have such a policy.  If a company does not have such a policy, it is required to disclose that fact and state that such transactions are generally permitted.


The SEC did not define “hedging.”  Specifically, the rules cover policies relating to the ability to purchase financial instruments (including prepaid variable forward contracts, equity swaps, collars, and exchange funds), or otherwise engage in transactions, that hedge or offset, or are designed to hedge or offset, any decrease in the market value of a company’s equity securities.  The SEC acknowledged that the language could be read to be far reaching, including potentially covering portfolio diversification transactions.  However, companies only need to describe the types of transactions if its hedging practice or policy addresses them.

Disclosure Location

The disclosure is required in proxy statements and information statements relating to director elections.  Companies will not have to make separate Item 407(i) disclosure in the Form 10-Ks.

The SEC views the item more as a corporate governance disclosure than as an executive compensation disclosure.  The rules do not change the current CD&A requirement (relating to named executive officers) to describe, if material, any company policies regarding hedging the economic risk of such ownership.  The SEC noted that companies could include Item 407(i) disclosure outside of CD&A and continue to provide separate CD&A disclosure.  Or, companies could incorporate the broader Item 407(i) disclosure within CD&A directly or by cross reference.

Timetable and Covered Companies

The rules generally apply to SEC reporting companies’ proxy and information statements with respect to the election of directors during fiscal years beginning on or after July 1, 2019.  Smaller reporting companies and emerging growth companies must comply for fiscal years beginning on after July 1, 2020.  Item 407(i) does not apply to closed-end funds or foreign private issuers.

Potential Action Items

Although hedging policies are not required, the rules put further emphasis on these policies and may further motivate companies to adopt or to revise their policies.  Companies may consider expanding policies to cover all employees and may consider how to define the scope of transactions allowed or prohibited.

Evolving Trends in ESG Disclosures

By Steve Poplawski

On October 1, 2018, investors representing over $5 trillion in assets under management petitioned the Securities Exchange Commission (SEC) to develop regulations to bring more rigor and transparency to corporate disclosures regarding Environmental Social and Governance (ESG) issues.  (the “October Petition”).   Two years earlier, in 2016, the SEC had issued a concept release (the “Concept Release”) entitled “Disclosure of Information Relating to Public Policy and Sustainability Matters” that essentially requested comment from the investment community regarding the need for specific regulations regarding ESG disclosure (the “Concept Release”).  

In the Concept Release, the SEC noted the possibility of regulating ESG disclosure, stating:

“The role of sustainability and public policy information in investors’ voting and investment decisions may be evolving as some investors are increasingly engaging on certain ESG matters.” (emphasis added). 

The SEC  Concept Release correctly predicted increasing engagement on ESG issues, as the October Petition noted that over 26,500 comments were filed on the Concept Release.  .  Moreover, the October Petition states that not just “some” investors but investors controlling $64 trillion in assets are committed to considering ESG factors in making their voting and investment decisions though their engagement in the UN Principles for Responsible Investment. 

While the October Petition is replete with Concept Release comments in support of more specific requirements for ESG reporting, significant players in the markets filed Concept Release comments suggesting that specific ESG disclosure requirements were not necessary because the materiality standard would require companies for whom ESG was materiality to disclose without specific requirements burdening companies for whom many ESG issues may not be material.   For example, Nasdaq, in its comments on the Concept Release stated:

 “[W]e believe the proper benchmark for whether disclosure in general is required should be materiality and, therefore, also believe that sustainability disclosure should be mandatory only in cases where it is material to a particular company. In all other cases, disclosure related to sustainability, as well as other public policy issues, is better addressed by other means.…. Increasingly, it is in companies’ interests for management to focus on sustainability issues and to highlight their sustainability performance and achievements as more investor money flows to sustainability investment strategies. Most companies provide some form of sustainability information, whether in periodic reports, on their websites, in separate sustainability reports, or in response to questionnaires. Because transparency around sustainability is more and more often viewed as a good business practice, Nasdaq believes that market-based forces will result in more optimal sustainability related disclosure by public companies than that driven by a Commission mandate.” (emphasis added)

While they may agree with Nasdaq that “it is in companies’ interest for management to focus on sustainability issues,” the October Petition signatories respectfully disagreed that “market-based” forces are currently resulting in “more optimal sustainability related disclosure by public companies.”  Among the criticisms of current market-driven disclosure cited in the October Petition is the lack of consistency in the format, content and timing of sustainability reporting even among companies within the same industries . An even more pointed criticism of relying on market-based resolution of ESG reporting standards is that “twenty-five years of development of voluntary sustainability disclosure has not led to the production of consistent, comparable, highly reliable ESG information reporting in the market.” 

In the Concept Release, the SEC also pointed out that, traditionally, critics of mandating ESG disclosure reporting have said that “adopting sustainability or policy-driven disclosure requirements may have the goal of altering corporate behavior, rather than producing information that is important to voting and investment decisions.”  The authors of the October Petition refuted this criticism by citing the 88% of empirical studies which show that companies with better E, S or G practices demonstrate better operating performance. The evidence of correlation between better ESG practices and operational performance suggests that, to the extent investor concerns about ESG is promoting better ESG practices, those investor concerns are achieving the “goal of altering corporate behavior” on a fundamental metric for voting and investment decisions – improvement of operational performance.  The October Petition submits, however, that the current ad hoc nature of ESG disclosure reporting is not sufficiently consistent, comparable or reliable to assist in determining the better corporate ESG practitioners.

Finally, stock exchanges and other investment regulatory authorities around the world are increasingly requiring ESG disclosure regardless of whether the SEC takes up the October Petition.  Accordingly, as noted in the October Petition, not only may U.S. reporting and disclosure on ESG become outdated, but U.S. Companies who under-report on ESG due to the lack of SEC mandates, may fall behind in the competition for capital with those overseas companies who provide better ESG information due to more rigorous ESG reporting standards overseas. 

Since the October Petition will not result in a final SEC regulation specifying the requirements of appropriate ESG disclosure reporting, we are left with the following legal guidance:

“The Commission … has determined that disclosure relating to environmental and other matters of social concern should not be required of all registrants unless appropriate to further a specific congressional mandate or unless, under the particular facts and circumstances, such matters are material.  Information is material if there is a substantial likelihood that a reasonable investor would consider it important in deciding how to vote or make an investment decision.” (emphasis added)

Thus, even if there is no SEC ESG rulemaking, trillions of dollars in assets under management are increasingly being required by the market to evaluate corporate ESG performance, and as a result, the market is moving in a direction where an argument will be made that disclosure on ESG issues is not just material “under the particular facts and circumstances” but is almost always material for most companies on at least some issues in some form.  If a company is in an industry where more than 50% of its competitors are reporting on certain ESG performance criteria in a certain way and that company is not similarly reporting its ESG performance, will a shareholder of that company eventually contend in a proxy vote or in shareholder litigation over the declining performance of the company’s stock that the company’s disclosures were materiality inadequate?  Given the growing adoption of more rigorous ESG reporting (including increasing third party verification of ESG reporting metrics), it may only be a matter of time before judicial decisions, rather than an SEC rulemaking, aredetermining when ESG disclosures are materially inadequate. Articles about the adequacy of Pacific Gas & Electric’s (PG&E) disclosure of ESG risk leading up to and since PG&E’s filing of bankruptcy due to potential liabilities from the Camp Fire reveal how a company’s disclosures will be reassessed when investors have lost everything (for example,  “Investor’s Ignore PG&E’s Warning About Disasters”).    The Claims Journal article notes that, “of the about 1200 green and sustainability funds tracked by Bloomberg, only 34 held shares of PG&E as of their latest filings.  But many conventional money managers were paying less attention to environmental risks.” (emphasis added).  So even if a company’s disclosures are adequate, investors may then question the performance of their investment advisors or fund managers and whether they are sufficiently evaluating ESG in making their investment decisions.

The October Petition sets forth many of the resources available to help your company make sure that it is either adequately disclosing its ESG performance or making sound investment decisions by appropriately taking ESG into account. In particular, corporate due diligence in acquisitions should be taking a hard look at the ESG performance of target companies.  It will be essential to keep track of your own industry and what other markets are requiring to mitigate against the potential for shareholder and other stakeholder complaints that your ESG disclosures are materially inadequate. 

Corporate Governance Trends

By Todd Kaye

Recent studies show some interesting developments on a variety of corporate governance fronts, and a lack of change on others.  In particular, Boards of Directors of public companies have become increasingly likely to be led by a Board Chair who is both not the CEO and independent.  In addition, recent studies show the increasing presence of women in executive leadership positions and on Boards of Directors, but a lack of efforts to address Board refreshment issues.

Board Leadership

The separation of the CEO and Board Chair roles is one of the areas in which the governance of public companies in the U.S. has changed most dramatically.  Historically, the CEO and Board Chair was the same person at the vast majority of companies. However, over the last couple of decades, institutional investors and other corporate governance advocates have pushed for the separation of these roles.  The core rationale behind this movement was the belief the corporations will run more effectively if the CEO focuses on corporate strategy, operations and other organizational issues, while the Board, led by the Board Chair, focuses its efforts on evaluating management’s performance, executive compensation, succession planning and other oversight tasks. 

This movement has been extremely successful.  In 2000, just 27% of S&P 1500 companies had separate individuals in the CEO and Chair roles. As of 2018, this figure had more than doubled to 60%.  Similarly, there has been a dramatic increase in the rate of Board chairs being independent (under applicable stock exchange rules) during this time period. In 2000, just 7% of S&P 1500 companies had an independent Board Chair, while by 2018 this number had grown nearly six-fold to 40%.  Interestingly, smaller companies have advanced further than their large peers on these bases, with SmallCap 600 and MidCap 400 companies having higher rates of CEO and Board Chair separation and independent Board Chairs than their S&P 500 counterparts.  In terms of policies mandating that the CEO and Board Chair roles be separated, about 12% of S&P 500 companies have such policies, with another 12% having a policy against the separation of such roles.  In the coming years, it will be very interesting to see whether board leadership practices continue to evolve further away from a joint CEO and Board Chair, or whether practice has largely settled out in this respect.

Women in Leadership

The rate of women in leadership roles has risen significantly in recent years. A recent survey of S&P 500 companies found that 13% had a female CEO, 12% had a female CFO and 1% had both a female CEO and CFO.  In addition, 23% of all S&P 500 Board seats are held by women, with 15% of companies having 30% of more women on the Board and 3% having 40% or more women.  Recent studies have shown that having increasing numbers of women on the Board have a positive impact on stock performance.  For example, Boards with at least one woman have on average a 3% greater stock return than Boards with no women.  Similarly, Boards with a greater number of women on the Board than average realize on average a 4% greater stock return than those with a below average number of women. 

The major proxy advisory firms and a number of very large and influential institutional investors have taken an interest in the issue by announcing policies of recommending votes against or voting against, as applicable, the Chair of the Nominating and Governance Committee of  Boards with no women.  In addition, in October 2018, California became the first state to require all public companies that are based in the State to have at least one woman on the Board by the end of 2019.  It will be interesting to see if additional states adopt similar bills in response to the California requirement, but as of mid-February, no such known bills have been passed.

Board Refreshment

One enduring criticism of public Boards of Directors by many commentators is that they often have too little turnover and therefore many long tenured directors and few new voices.  Critics suggest that Boards with not enough turnover can suffer in the long term.  A recent study of S&P 500 companies found an average Board tenure of 9 years, with 62% of Board members having served for 6-10 years, with 22% having a tenure of ten years or more.  Interestingly, while 78% of S&P 500 companies have a mandatory retirement age, with a typical mandatory retirement age in the range of 70-75, only 5% of Boards have adopted term limits as a means of ensuring some level of Board turnover.  This of course means that for a company with a 75 year old retirement age, a Board member who joins the Board at the age of 45 could stay on for 30 years, whereas a member who joined at the age of 60 could only stay on for 15 years. Some commentators have suggested that term limits would be a more equitable way to ensure adequate board turnover, but the statistics show the most Boards disagree and stick solely with a mandatory retirement age.

ISS generally opposes proposals to impose term limits or a mandatory retirement age; however, it will scrutinize boards where the average tenure exceeds 15 years for independence from management and sufficient turnover to ensure new perspectives. Glass Lewis prefers review of the specific composition of boards and their stewardship rather than inflexible rules; however, it believes boards should enforce any term or age limits that are in place and will oppose nominating/governance committees that waive such limits without sufficient justification.

Caught Between a Rock and a Hard Place: #MeToo Movement Creates Challenges for Directors

By Elaine Koch and Vicki Westerhaus

The #MeToo movement continues to make headlines across the globe, toppling more than 200 powerful U.S. company leaders in entertainment, media, sports and a variety of other industries.  According to EEOC reports, sexual harassment charges have increased by 14% and EEOC-filed lawsuits asserting harassment have increased by 50%.  Larger amounts of cash are being paid to settle harassment suits, and those amounts may be minor compared to the reputational damage of being tried in the court of public opinion.

Directors have long grappled with how to oversee company "culture" and employee behaviors.  Now many boards find themselves wedged between a rock and a hard place, as they struggle to balance the need for swift action when a complaint is made versus the need for appropriate due process rights for the accused. 

Boards increasingly are expected to investigate stale and non-actionable claims and off-duty conduct.  They are also expected to treat wrongdoers swiftly and severely.  Employees and stockholders push for transparency in investigations, as boards temper the need for transparency with the risks of defamation, tort or other claims that may be brought by the accused, as well as personal privacy rights when dealing with controversial, off-duty conduct.

The potential unintended consequence of polarizing genders also must be monitored by the board.  Recent research found that two-thirds of male executives hesitate to hold one-on-one meetings with women in more junior positions for fear they could be misconstrued.  This behavior effectively deprives one gender of valuable mentorship and opportunities to interact with senior management.  Boards need to ensure that executives and all employees understand that it is illegal to interact with and mentor only people like themselves.

While there are no easy answers to address the board's dilemmas in a #MeToo era, the following proactive steps may help mitigate the risks:

  • Clarify the board's role in investigations and follow-up actions. Boards should oversee investigations and engage independent counsel to conduct the investigation.
  • Boards should ensure company policies and the code of ethics are up to date with current industry standards and take a clear stance against sexual harassment and discrimination in the workplace.
  • Boards should request reports of any allegation of harassment or misconduct involving the C-suite. To better understand a company's history of handling sexual harassment claims, a board may want to undertake an independent audit of allegations and investigations.
  • Directors should attend training and support training of entry-level employees to C-suite executives. All participants should be informed that illegal harassment and discrimination at work will not be tolerated.  Having a director make an introduction at the beginning of each training session can help emphasize the importance of fair treatment of all company employees.
  • Boards should specifically assign oversight of cultural risks to a board committee, preferably with diverse members.
  • Boards should regularly refresh board membership to avoid close ties with (and possible control by) management.
  • Boards should seek to tie compensation incentives to cultural goals, in addition to financial goals, and consider clawback policies and loss of severance packages in harassment situations.
  • Boards should ensure that everyone works together toward solutions to workplace problems, rather than making this a gender battle.

By following the proactive action steps above, boards should be better prepared to face difficult decisions in alleged harassment situations.  They can decisively evaluate investigation results and act objectively and responsibly, in the best interests of the company, its shareholders and its employees.  As society's expectations change and directors' decisions are increasingly scrutinized in hindsight, boards must work diligently to mitigate the risks of a #MeToo crisis.

ISS updates its U.S. Compensation and Equity Compensation Plan Policies for 2019

By Adam Braun and Jennifer Stokes

In December 2018, Institutional Shareholder Services (“ISS”) published updates to its FAQs for its U.S. Compensation Policies and its policies related to U.S. Equity Compensation Plans with respect to annual meetings occurring on or after February 1, 2019.  While ISS did not make major changes for 2019, reporting companies should be aware of key updates, as described in the Firm’s recent blog post.