Up To Date: Current Developments In Securities Laws - January 2014 (No. 14) - Executive Remuneration

DISCLOSURE TRENDS

Disclosure Pendulum May Start Swinging Back

During the last decade, practitioners have been continuously amazed with the increasing level of public company regulation. The general direction of the Sarbanes-Oxley Act and the Dodd-Frank Act, and naturally the SEC rules implementing these acts, has always been more and more disclosure (the more granular and detailed—the better). It seemed like the disclosure pendulum was swinging higher and higher towards overregulation and that it would never go back. But the report on public company disclosure issued by the SEC on December 20, 2013, as mandated by the JOBS Act, gives a lot of hope that the disclosure pendulum may eventually start swinging back.

This Report on Review of Disclosure Requirements in Regulation S-K, which largely follows the concepts outlined by SEC Chair Mary Jo White in her October speech before the National Association of Corporate Directors, recommended to Congress a comprehensive review of SEC disclosure rules and forms focusing on the following potential areas:

modernizing and simplifying Regulation S-K requirements in a manner that reduces the costs and burdens on companies while still providing material information;
eligibility for further scaling of disclosure requirements and definitional thresholds for smaller reporting companies, accelerated filers and large accelerated filers;
evaluating whether Industry Guides still elicit useful information and conform to industry practice and trends;
reviewing financial reporting requirements of Regulation S-X and financial statement disclosure requirements of Regulation S-K (e.g., annual and quarterly selected financial data disclosure and the ratio of earnings to fixed charges); and
disclosure requirements contained in SEC rules and forms (e.g., Forms 10-Q and 8-K).

The Staff provided detailed guidance on its suggested review of Regulation S-K, which would address the following issues:

principles-based approach as an overarching component of the disclosure framework (e.g., using a disclosure model of current MD&A requirements) (which may have an unintended consequence of leading to more disclosure rather than less);
current scaled disclosure requirements and whether further scaling would be appropriate for emerging growth companies or other categories of issuers;
filing and delivery framework based on the nature and frequency of the disclosures (e.g., a "core" disclosure or "company profile" filing with information that changes infrequently, periodic and current disclosure filings with information that changes from period to period, and transactional filings that have information relating to specific offerings or shareholder solicitations); and
readability and navigability of disclosure documents (e.g., the use of hyperlinks) as well as replacing quantitative thresholds (e.g., Item 103 (Legal Proceedings), Item 404 (Transactions with Related Persons, Promoters and Certain Control Persons) and Item 509 (Interests of Named Experts and Counsel)) with general materiality standards.

In addition to these issues, the Staff identified the following specific areas of Regulation S-K disclosure that could benefit from further review:

risk-related requirements, such as risk factors, legal proceedings and other quantitative and qualitative information about risk and risk management, with potential consolidation into a single requirement;
relevance of current requirements for the description of business and properties;
corporate governance disclosure requirements (to confirm that the information is material to investors);
executive compensation disclosure (to confirm that the required information is useful to investors);
offering-related requirements (in light of the changes in offerings and the shift from paper-based offering documents to electronically-delivered offering materials); and
exhibits to filings (to confirm whether the required exhibits remain relevant and whether other documents should be added).

CORPORATE GOVERNANCE

NASDAQ Amended its Independence Standards for Compensation Committee Members

On December 11, 2013, the SEC published a notice of filing and immediate effectiveness of the proposed rule change related to the independence of compensation committee members under the listing standards of The NASDAQ Stock Market LLC (Rule 5605(d)(2)(A) and IM-5605-6). NASDAQ replaced the prohibition on the receipt of compensatory fees by compensation committee members with a requirement that a board of directors instead consider the receipt of such fees when determining eligibility for compensation committee membership. NASDAQ cited the feedback that it had received from listed companies as the reason for these changes. The new rules are almost identical to the NYSE's rules related to compensation committee independence and, if adopted, would remove the anomaly of NASDAQ listing rules being more stringent than NYSE rules.

The new Rule 5605(d)(2)(A) states that in affirmatively determining the independence of any compensation committee member, the board must consider all factors specifically relevant to determining whether a director has a relationship to the company which is material to that director's ability to be independent from management in connection with the duties of a compensation committee member, including, but not limited to:

the source of compensation of such director, including any consulting, advisory or other compensatory fee paid by the company to such director; and
whether such director is affiliated with the company, a subsidiary of the company or an affiliate of a subsidiary of the company.

In IM-5605-6, NASDAQ clarified that when considering the sources of a director's compensation in determining compensation committee member independence, the board should consider whether the director receives compensation from any person or entity that would impair the director's ability to make independent judgments about the company's executive compensation, including compensation for board or board committee services.

The approach to the affiliation prong of the independence analysis is not significantly changed in the new rules. However, NASDAQ revised IM-5605-6 to explain that the board should consider whether the affiliate relationship places the director under the direct or indirect control of the company or its senior management, or creates a direct relationship between the director and members of senior management, in each case of a nature that would impair the director's ability to make independent judgments about the company's executive compensation.

Companies are required to comply with the compensation committee composition aspects of the NASDAQ rules by the earlier of the date of their first annual meeting after January 15, 2014, or October 31, 2014.

PROXY SEASON

Board Diversity and Political Contributions Disclosure Continue to Get ISS Support

On December 19, 2013, ISS published its U.S. Proxy Voting Summary Guidelines that are effective for meetings of stockholders held on or after February 1, 2014. This article highlights ISS' position on two social issues: board diversity and political contributions.

Board Diversity

Consistent with its guidelines last year, ISS continues to recommend voting for stockholder requests for reports on a company's efforts to diversify the board unless:

the gender and racial minority representation of the company's board is reasonably inclusive in relation to companies of similar size and business; and
the board already reports on its nominating procedures and gender and racial minority initiatives on the board and within the company.

ISS will make recommendations on a case-by-case basis on proposals asking a company to increase the gender and racial minority representation on its board. In providing its recommendation, ISS will take into account the following factors:

the degree of existing gender and racial minority diversity on the company's board and among its executive officers;
the level of gender and racial minority representation that exists at the company's industry peers;
the company's established process for addressing gender and racial minority board representation;
whether the proposal includes an overly prescriptive request to amend nominating committee charter language;
the independence of the company's nominating committee;
whether the company uses an outside search firm to identify potential director nominees; and
whether the company has had recent controversies, fines, or litigation regarding equal employment practices.

Political Contributions

In connection with proposals related to political contributions, ISS continues to generally recommend voting for proposals requesting greater disclosure of a company's political contributions and trade association spending policies and activities, considering:

the company's current disclosure of policies and oversight mechanisms related to its direct political contributions and payments to trade associations or other groups that may be used for political purposes, including information on the types of organizations supported and the business rationale for supporting these organizations; and
recent significant controversies, fines, or litigation related to the company's political contributions or political activities.

However, recognizing that businesses are affected by legislation at the federal, state and local level, ISS recommends voting againstproposals barring a company from making political contributions. ISS is being practical and concedes that barring political contributions can put the company at a competitive disadvantage.

JOBS ACT UPDATE

SEC Proposed "Regulation A+" Amendments

The SEC has proposed regulations to amend Regulation A as required by the Jumpstart Our Business Startups Act (JOBS Act). Title IV of the JOBS Act directed the SEC to write regulations providing for an exemption from Securities Act registration for public offerings of up to an aggregate of $50 million of equity, debt or convertible debt securities in a 12 month period. This provision has been termed "Regulation A+" by some observers because it is designed to be an improvement upon the SEC's Regulation A, which permits exempt public offerings of up to $5 million by non-SEC reporting companies. Regulation A has been infrequently used because, for one thing, the $5 million limit is too low.

The SEC's proposed rules would update and expand the Regulation A exemption by creating two tiers of Regulation A offerings:

Tier 1, which would consist of those offerings already covered by Regulation A—that is securities offerings of up to $5 million in a 12-month period, including up to $1.5 million for the account of selling security-holders.
Tier 2, which would consist of securities offerings of up to $50 million in a 12-month period, including up to $15 million for the account of selling security-holders.

For offerings up to $5 million, the company could elect whether to proceed under Tier 1 or 2.

Basic Requirements

Under Tier 1 and Tier 2, companies would be subject to basic requirements, including ones addressing issuer eligibility and disclosure that are drawn from the existing provisions of Regulation A. The proposed rules also would update Regulation A to, among other things:

Require issuers to electronically file offering statements with the SEC.
Provide that an offering statement and any amendment can be qualified only by order of the SEC.
Permit companies to submit draft offering statements for nonpublic SEC review prior to filing.
Permit the use of "testing the waters" solicitation materials both before and after filing of the offering statement.
Modernize the qualification, communications, and offering process in Regulation A to reflect analogous provisions of the Securities Act registration process, including permitting issuers to satisfy their delivery requirements as to the final offering circular under an "access equals delivery" model when the final offering circular is filed and available on EDGAR.

Additional Tier 2 Requirements

In addition to the basic requirements, companies conducting Tier 2 offerings would be subject to the following additional requirements:

Investors would be limited to purchasing no more than 10 percent of the greater of the investor's annual income or net worth.
The financial statements included in the offering circular would be required to be audited.
The company would be required to file annual and semiannual ongoing reports and current event updates that are similar to the requirements for public company reporting.

Eligibility

Regulation A would be available to companies organized in and with their principal place of business in the United States or Canada, as is currently the case under Regulation A.

The exemption would not be available to companies that:

Are already SEC reporting companies and certain investment companies.
Have no specific business plan or purpose or have indicated their business plan is to engage in a merger or acquisition with an unidentified company.
Are seeking to offer and sell asset-backed securities or fractional undivided interests in oil, gas, or other mineral rights.
Have not filed the ongoing reports required by the proposed rules during the preceding two years.
Are or have been subject to a SEC order revoking the company's registration under the Exchange Act during the preceding five years.
Are disqualified under the proposed "bad actor" disqualification rules.

Preemption of Blue Sky Law

In view of the range of investor protections provided under the proposal, state securities law requirements would be preempted for Tier 2 offerings.

The SEC seeks public comment on the proposed rules. Let's see whether the commenters give the proposed rules an "A+"?

PRIVATE PLACEMENT CORNER

SEC Guidance on "Bad Actor" Disqualifications from Rule 506 Offerings

On December 4, 2013 and January 3, 2014, the SEC issued new Compliance and Disclosure Interpretations (C&DIs) clarifying the application of the "bad actor" disqualifications from Rule 506 offerings. Generally, under the new Rule 506(d), an issuer may not rely on the Rule 506 registration exemption if the issuer or any other person covered by Rule 506(d) has a relevant conviction, judgment, suspension or other disqualifying event that occurred on or after September 23, 2013 (the effective date of Rule 506(d)). Please see below a summary of some C&DIs issued by the SEC.

When is an issuer required to determine whether bad actor disqualification under Rule 506(d) applies? An issuer must determine if it is subject to "bad actor" disqualification any time it is offering or selling securities in reliance on Rule 506. After the initial inquiry, an issuer may reasonably rely on a covered person's agreement to provide notice of a potential or actual bad actor triggering event pursuant to, for example, contractual covenants, bylaw requirements, or an undertaking in a questionnaire or certification. However, if an offering is continuous, delayed or long-lived, the issuer must update its factual inquiry periodically through bring-down of representations, questionnaires, certifications, negative consent letters, periodic re-checking of public databases, and other steps, depending on the circumstances.

If a placement agent or one of its covered control persons becomes subject to a disqualifying event while an offering is still ongoing, could the issuer continue to rely on Rule 506 for that offering? Yes, if a placement agent or one of its covered control persons, such as an executive officer or managing member, becomes subject to a disqualifying event while an offering is still ongoing, the issuer could rely on Rule 506 for future sales in that offering if the engagement with the placement agent was terminated and the placement agent did not receive compensation for the future sales. If the triggering disqualifying event affected only the covered control persons of the placement agent, the issuer could continue to rely on Rule 506 for that offering if such persons were terminated or no longer performed roles with respect to the placement agent that would cause them to be covered persons for purposes of Rule 506(d).

What does it mean to participate in the offering? Participation in an offering is not limited to solicitation of investors. For example, participation in an offering includes participation or involvement in due diligence activities or the preparation of offering materials (including analyst reports used to solicit investors), providing structuring or other advice to the issuer in connection with the offering, and communicating with the issuer, prospective investors or other offering participants about the offering. However, to constitute "participation," such activities must be more than transitory or incidental. Administrative functions, such as opening brokerage accounts, wiring funds, and bookkeeping activities, would generally not be deemed to be participating in the offering. Is disqualification triggered by actions taken overseas? No, disqualification under Rule 506(d) is not triggered by convictions, court orders, or injunctions in a foreign court, or regulatory orders issued by foreign regulatory authorities.

When does the "reasonable care" exception apply? The reasonable care exception to the new rule applies whenever the issuer can establish that it did not know and, despite the exercise of reasonable care, could not have known that a disqualification existed under Rule 506(d). This may occur when, despite the exercise of reasonable care, the issuer was unable to determine the existence of a disqualifying event, was unable to determine that a particular person was a covered person, or initially reasonably determined that the person was not a covered person but subsequently learned that determination was incorrect. An issuer may need to seek waivers of disqualification, terminate the relationship with covered persons, provide additional disclosure under Rule 506(e), or take other remedial steps to address the Rule 506(d) disqualification.

What does it mean to be a beneficial owner of at least 20% of voting equity securities? A shareholder that becomes a 20% beneficial owner of the issuer's outstanding voting equity securities upon completion of a sale of securities is NOT a 20% beneficial owner at the time of such sale. However, it would be a covered person with respect to any sales of securities in the offering that were made while it was a 20% beneficial owner.

The term "beneficial owner" under Rule 506(d) means any person who, directly or indirectly, through any contract, arrangement, understanding, relationship or otherwise, has or shares, or is deemed to have or share: (1) voting power, which includes the power to vote, or to direct the voting of, such security; and/or (2) investment power, which includes the power to dispose, or to direct the disposition of, such security. In addition, for purposes of determining 20% beneficial owners under Rule 506(d), it is necessary to "look through" entities to their controlling persons because beneficial ownership includes both direct and indirect interests (see Exchange Act Rule 13d-3).

If some of the shareholders have entered into a voting agreement under which each shareholder agrees to vote its shares of voting equity securities in favor of director candidates designated by one or more of the other parties, which effectively means that such shareholders have formed a group, then the group beneficially owns the shares beneficially owned by its members (see Exchange Act Rules 13d-3 and 13d-5(b)). In addition, the parties to the voting agreement that have or share the power to vote or direct the vote of shares beneficially owned by other parties to the agreement (through, for example, the receipt of an irrevocable proxy or the right to designate director nominees for whom the other parties have agreed to vote) will beneficially own such shares. Parties that do not have or share the power to vote or direct the vote of other parties' shares would not beneficially own such shares solely as a result of entering into the voting agreement (see another new C&DI issued by the SEC on January 3, 2014). If the group is a 20% beneficial owner, then disqualification or disclosure obligations would arise from court orders, injunctions, regulatory orders or other triggering events against the group itself. If a party to the voting agreement becomes a 20% beneficial owner because shares of other parties are added to its beneficial ownership, disqualification or disclosure obligations would arise from triggering events against that party.

SEC Issued Guidance on Private Placements Involving General Solicitation

On November 13, 2013, the SEC issued new C&DIs related to Rule 506(c) offerings. The new C&DIs provide guidance on various aspects of Rule 506(c) offerings including the following:

If an issuer commenced an offering in reliance on Rule 506 before September 23, 2013 and decides to continue that offering after September 23, 2013 in accordance with Rule 506(c), the issuer must file an amendment to the previously-filed Form D to indicate that the issuer is now relying on the Rule 506(c) exemption. If the issuer decides to continue the offering in reliance on Rule 506(b), no amendment to the previously-filed Form D is required solely to reflect this decision.
An issuer will not lose the ability to rely on Rule 506(c) for an offering if a person who does not meet the criteria for any category of accredited investor purchases securities in the offering, so long as the issuer took reasonable steps to verify that the purchaser was an accredited investor and had a reasonable belief that such purchaser was an accredited investor at the time of the sale of securities.
An issuer will not be able to rely on the Rule 506(c) exemption for an offering if the issuer does not take reasonable steps to verify the accredited investor status of purchasers (even if the purchasers actually meet the financial and other criteria to be accredited investors). The verification requirement in Rule 506(c) is separate from and independent of the requirement that sales be limited to accredited investors. The verification requirement must be satisfied even if all purchasers happen to be accredited investors. Under the principles-based method of verification, however, the determination of what constitutes reasonable steps to verify is an objective determination based on the particular facts and circumstances of each purchaser and transaction.
An issuer may satisfy the verification requirement of Rule 506(c) by either using the principles-based method of verification or relying upon one of the specific, non-exclusive verification methods listed in the rule. Although the use of the non-exclusive verification methods is not required, an issuer that chooses to use one of such methods must satisfy the specific requirements of that method. In order to comply with the net worth verification method provided in the rule's non-exclusive list, the relevant documentation must be dated within the prior three months of the sale of securities. If the documentation is older than three months, the issuer may not rely on the net worth verification method, but may instead determine whether it has taken reasonable steps to verify the purchaser's accredited investor status under the principles-based method of verification.
The third-party verification method in the non-exclusive list of verification methods in Rule 506(c) includes written confirmations from an attorney or certified public accountant who is licensed or duly registered, as the case may be, in good standing in a foreign jurisdiction. This method of verification is not limited to written confirmations from attorneys and certified public accountants who are licensed or registered in a jurisdiction within the United States.
The verification method for existing investors in the non-exclusive list of verification methods does not apply to new issuers that have the same sponsor as the issuer in which the investor purchased securities in a prior Rule 506(b) offering. This non-exclusive method of verification is, by its terms, limited to verification of existing investors who purchased securities in the same issuer's Rule 506(b) offering as accredited investors prior to September 23, 2013 and continue to hold such securities.
If an issuer commences an offering intending to rely on Rule 506(c) but does not engage in any form of general solicitation in connection with the offering, the issuer may subsequently determine to rely on Rule 506(b) for the offering, as long as the conditions of Rule 506(b) have been satisfied with respect to all sales of securities that have occurred in the offering. To the extent the issuer already filed a Form D indicating its reliance on Rule 506(c), it must amend the Form D to indicate its reliance on Rule 506(b) instead, as that decision represents a change in the information provided in the previously-filed Form D.
If an issuer commenced an offering in reliance on Rule 506(b), the issuer may determine, prior to any sales of securities in the offering, to rely on Rule 506(c) for the offering, as long as the conditions of Rule 506(c) are satisfied with respect to all sales of securities in the offering. To the extent the issuer already filed a Form D indicating its reliance on Rule 506(b), it must amend the Form D to indicate its reliance on Rule 506(c) instead, as that decision represents a change in the information provided in the previously-filed Form D.
If the conditions of Rule 506(c) are not met in a purported Rule 506(c) offering, the issuer will not be able to rely on the Securities Act Section 4(a)(2) private offering exemption if the issuer engaged in general solicitation. The use of general solicitation continues to be incompatible with a claim of exemption under Section 4(a)(2).

SEC COMMENT LETTER TRENDS

Looking Back—2013 SEC Comment Letter Trends

As the 2014 10-K and proxy season approaches, practitioners like to take a look back at the crop of comment letters issued by the Securities and Exchange Commission staff in 2013. While there were a number of trends, following are two that caught our attention.

Cybersecurity

In 2012, the SEC staff commented heavily on registrant's disclosure regarding computer security and related topics. While the number of comment letters issued in 2013 relating to cybersecurity was significantly lower than in 2012, the SEC staff continues to issue comment letters focusing on cybersecurity and related risks. From our review of the comment letters and other materials:

Expect continued SEC focus. SEC Chairman Mary Jo White, in her May 1, 2013 letter responding to an inquiry from Senator John D. (Jay) Rockefeller, IV, stated that she has asked the SEC staff to provide her a "briefing of the current disclosure practices and overall compliance with" the SEC's cybersecurity guidance, as well as any recommendations regarding further action they may have.
If your company suffered some form of cybersecurity breach and it was reported in the media, evaluate whether the consequences of the breach were material so as to warrant disclosure in your SEC filings and be prepared to discuss with the SEC staff why disclosure is not required if the disclosure is not provided.
Consider discussing cybersecurity issues in your MD&A. Simply providing risk factor disclosure may not be sufficient. If cybersecurity issues could have a material adverse effect on your results of operations or if cybersecurity risks may constitute a material known trend or uncertainty, discussion in your MD&A may be appropriate.

Executive Compensation

The SEC staff has been focusing on executive compensation for quite some time and there is no reason to expect 2014 to be any different. Benchmarking and performance targets continued to draw a significant number of comments from the SEC staff in 2013.

If your company's discussion of compensation mentions "compensation survey", "peer group" or "market data" and does not indicate that the company engages in benchmarking and provide all of the disclosure relating to benchmarking called for by Item 402(b)(2) (xiv) of Regulation S-K (such as identifying the benchmark, its components and peer companies), be prepared to defend the non-disclosure as the SEC staff is likely to comment.
The SEC staff also continues to focus on disclosure relating to performance targets and frequently requests additional disclosure regarding performance targets or objectives. While a formal request for confidential treatment is not required when omitting disclosure of performance target levels or other factors or criteria pursuant to Instruction 4 of Item 402(b) of Regulation S-K, consider preparing a file memo at the time the proxy disclosure is being drafted to support the decision to omit the information. A contemporaneous file memo (or other contemporaneous record, such as a self-addressed e-mail) should help the company to be prepared to respond to any SEC inquiry about the omitted information.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

United States: Up To Date: Current Developments In Securities Laws - January 2014 (No. 14)