Monthly Archives: December 2019
As my firm does not practice in the enforcement arena, it is not an area I always write about, but this year I found a few trends that are interesting. In particular, just by following published enforcement matters on the SEC’s website, I’ve noticed a large uptick in actions to suspend the trading in, or otherwise take action against, micro- and small-cap companies, especially delinquent filers. I’ve also noticed a large uptick of actions against smaller public and private companies that use misleading means to raise capital from retail investors, and the concurrent use of unlicensed broker-dealers. Of course, there have always been a significant number of actions involving cryptocurrencies. In light of my own observations, I decided to review and report on the SEC’s view of its actions.
As an aside, before discussing the report, I note that the Government Accountability Office (GAO) has raised concerns about the quality of record keeping and documentation maintained by the SEC and used to generate the enforcement report. The GAO report states, “[E]nforcement has written procedures for recording and verifying enforcement-related data (including on investigations and enforcement actions) in its central database. However, Enforcement does not have written procedures for generating its public reports (currently, the annual report), including for compiling and verifying the enforcement statistics used in the report. To produce the report, Enforcement staff told GAO that staff and officials hold meetings in which they determine which areas and accomplishments to highlight. Enforcement was not able to provide documentation demonstrating that the process it currently uses to prepare and review the report was implemented as intended.”
Keeping in mind that the report may not be completely accurate, in fiscal year 2019, the SEC brought 862 enforcement actions, including 526 stand-alone actions. These actions addressed a broad range of significant issues, including issuer disclosure/accounting violations; auditor misconduct; investment advisory issues; securities offerings; market manipulation; insider trading; and broker-dealer misconduct. Through these actions, the SEC obtained judgments and orders totaling more than $4.3 billion in disgorgement and penalties and returned approximately $1.2 billion to investors. The number of enforcement actions rose by more than 30% over the prior fiscal year with more than half of the new actions targeting investment advisers, investment companies or broker-dealers. In 2019, the two-year hiring freeze was lifted and enforcement added 22 new positions.
The Enforcement Report highlights new initiatives by the SEC, including (i) the Retail Strategy Task Force; (ii) the Cyber Unit; and (iii) the Share Class Selection Disclosure Initiative. The Retail Strategy Task Force has two primary objectives: (i) developing data-driven, analytical strategies for identifying practices in the securities markets that harm retail investors and generating enforcement matters in these areas; and (ii) collaborating with internal and external partners, such as OIEA and the Department of Justice, on retail investor advocacy and outreach. The focus on retail investors has resulted in a significant uptick in actions against investment advisors, investment companies and broker-dealers. The Share Class Selection Disclosure Initiative was directed at investment advisory firms that purchased mutual fund shares from a fee paying mutual fund when a lower- or no-cost share class of the same mutual fund was available.
Gatekeepers continued to be an enforcement focus including broker-dealers, the Options Clearing Corporation, auditors and audit firms and attorneys. The SEC also used its power under the Sarbanes-Oxley Act of 2002 to pursue actions against individuals including CEOs and CFOs, usually related to activities to manipulate reported financial results including revenue. In fiscal 2019, 69% of enforcement proceedings included actions against individuals. The SEC always seeks both monetary and non-monetary relief, especially against individuals. Settled proceedings almost always include injunctive relief prohibiting not only future violations but also officer, director bars, penny stock bars, investment restrictions and the like.
Like last year, the SEC prosecuted several cryptocurrency, digital asset and distributed ledger technology cases. The cases involved the usual unregistered sale of securities but also actions were brought related to the promotion of an ICO, touting by celebrities and operating unlicensed trading platforms. In 2019 the SEC reached settlements with three digital asset issuers that resulted in guidance for compliance and registration. The SEC report touts that these actions send the clear message that, if a product is a security, regardless of the label attached to it, those who issue, promote, or provide a platform for buying and selling that security must comply with the investor protection requirements of the federal securities laws.
Cybersecurity continues to be the target of many investigations and enforcement proceedings. In addition to actions against cyber-criminals, the SEC has turned to a review of industry participants and compliance with Regulation Systems, Compliance and Integrity (see HERE), resulting in an enforcement proceeding against the Options Clearing Corporation.
The SEC has encouraged defendant cooperation and as a result, in fiscal 2019, 76% of defendants cooperated, a record high. Law enforcement and interagency coordination also plays a big role in SEC enforcement matters. The SEC regularly works with the Department of Justice, FBI and state attorney general offices where a matter goes beyond civil enforcement. In 2019, more than 400 investigations included a parallel criminal proceeding.
The whistleblower program continues to result in a significant number of enforcement proceedings. However, the SEC receives thousands of tips per year, which is much more than it can efficiently review and process. As a result, it is working on streamlining the process and accelerating the evaluation of claims to determine viable information.
In June 2017, the Supreme Court case of Kokesh v. SEC limited the SEC’s claims for disgorgement to a five-year statute of limitations. The Kokesh case had a significant impact on SEC enforcement proceedings, which often involve many years of complex fraudulent activity. The SEC estimates that Kokesh reduced disgorgement judgments by as much as $1.1 billion in filed cases.
Commissioner Hester M. Peirce’s Statement on Enforcement Report
One of the reasons I was interested in the 2019 Enforcement Report is that SEC Commissioner Hester Peirce took the time to speak about it and, as usual, her thoughts are similar to mine. Commissioner Peirce analogizes the current SEC environment with “broken windows,” reminding me of the strategy heralded in by former SEC Chair Mary Jo White back in 2013 (see HERE). However, Commissioner Peirce was not referring to the former policy, but rather her point that if the SEC had three broken windows, it “would count them and then issue press releases and reports, and journalists and academics would write all sorts of catchy articles based on those delicious statistics. But just as one cannot derive much of a pattern from the three broken windows in my lobby in 2019, one ought to be wary of drawing conclusions from our enforcement statistics.”
Commissioner Peirce’s point is that enforcement proceedings are fluid, with some taking longer than others. Publishing reports and statistics based on the ones that happen to finish during a particular period of months ends up providing arbitrary and not particularly useful information. Moreover, even breaking up cases by type is arbitrary as the factual differences in each case provide the important precedence.
Likewise, penalty amounts are not that important. She points out that low-dollar cases can provide important meaning, such as the case with the Options Clearing Corporation, which was a relatively low dollar amount but included important ongoing undertakings to address several issues. Ms. Peirce states, “[O]ur enforcement program is not a set of data points. Instead, our program consists of the judgments made by a group of hard-working, experienced, bright attorneys, accountants, economists, paralegals, data analysts, computer experts, and support staff dedicated to safeguarding the integrity of our markets.”
In that regard, Commissioner Peirce repeats a mantra she has said before, and that is that the SEC should be selective in its enforcement efforts. SEC resources are limited and not every matter opened should lead to a settlement or ligation action. The SEC should also be looking within to improve the enforcement program. Part of that process is looking for rules that need to be written, eliminated or rewritten. As an example, she points to the advertising rule banning testimonials about investment advisors. Reviews and testimonials are a basic part of consumer decision making in today’s world, and she doesn’t understand why investment advisors should be different. Commissioner Peirce succinctly states, “[R]ather than enforcing anachronistic rules, we should rewrite them and instead devote enforcement resources to the problems of today, of which, I can assure you, there are many.”
Commissioner Peirce also spends time talking about the much-needed overhaul to Rule 15c2-11 (see HERE). Micro-cap fraud is a systemic problem that results in an environment of distrust negatively impacting the legitimate capital-raising efforts by small and development-stage companies. A redo of 15c2-11 will definitely have an impact on the micro-cap space in general and certainly fraud in particular. Commissioner Peirce points out what I have been hearing from my colleagues, and that is that the comments and responses to the proposed rules have been voluminous and largely negative (I haven’t had time to read them yet). The early sentiment is that the proposed rules would shut down an important trading market for day traders and sophisticated investors that trade in the non-reporting or minimal information space on a regular basis, or even for a living. Commissioner Peirce recognizes that a balance must be had that “hinders fraudsters without killing the market for micro-cap stocks.”
Another area of needed regulatory modernization deals with the regulation of transfer agents, which has remained virtually unchanged since 1977. Commissioner Peirce points to the four-year-old concept release (see HERE) and seems to be hopeful that actual proposed rule changes will be forthcoming.
Commissioner Peirce points out that the lack of regulation can be as problematic is improper regulation. An area that is badly in need of attention relates to the regulation of finders. Commissioner Peirce points out, “[I]n the absence of rulemaking, these would-be good actors are forced to discern the path from a murky mishmash of staff no-action letters and enforcement actions.” Commissioner Peirce recognizes that the current broker-dealer framework is inappropriate for finder’s working to make a few connections between investors and companies in need of capital. I’ve been very vocal about the need for a finder’s regulatory framework – see HERE.
Commissioner Peirce also thinks that the current regulatory framework for digital assets hinders innovation and growth: “The only guidance out of the SEC is a parade of enforcement actions and a set of staff guidance documents and staff no-action letters.” She supports creating a non-exclusive safe harbor period within which a token network could blossom without the full weight of the securities laws crushing it before it becomes functional.
In addition to rules, the SEC can improve enforcement by focusing more on compliance. The Office of Compliance, Inspections and Examinations can work with broker-dealers, investment advisors and market participants to improve their systems and remediate issues found during a review rather than making an enforcement referral.
Another recommendation to improve the enforcement program involves further utilizing technology. Although technology and data processing has been effective in uncovering insider trading and cherry-picking schemes, it comes at the expense of privacy. The Consolidated Audit Trail project, for example, tracks all trading activity in the equity and options markets and as such could be abused by overzealous regulators and cybercriminals. Once again, Ms. Peirce hits the nail on the head, stating, “[I] would rather have an enforcement program that respects the liberty and privacy of American investors, even if it comes at the cost of lost enforcement opportunities, than an enforcement program that has a hundred-percent success rate at catching wrongdoers.”
I’ve written several times about Nasdaq listing requirements including the general listing requirements and the significant listing standards changes enacted in August of this year. This blog will drill down on audit committees which are part of the corporate governance requirements for listed companies. Nasdaq Rule 5605 delineates the requirements for a Board of Directors and committees. The Nasdaq rule complies with SEC Rule 10A-3 related to audit committees for companies listed on a national securities exchange.
SEC Rule 10A-3
SEC Rule 10A-3 requires that each national securities exchange have initial listing and ongoing qualification rules requiring each listed company to have an audit committee comprised of independent directors. Although the Nasdaq rules detail its independence requirements, the SEC rule requires that at a minimum an independent director cannot directly or indirectly accept any consulting, advisory or other compensation or be affiliated with the company or any of its subsidiaries. The prohibition against compensation does not include a reasonable compensation for serving as a director.
Like the Nasdaq rules, the SEC allows for different independence standards for foreign private issuers (FPI) following their home country rules and even allows for affiliation as long as the person is not an executive officer of the FPI.
The audit committee of each listed company, in its capacity as a committee of the board of directors, must be directly responsible for the appointment, compensation, retention and oversight of the work of any registered public accounting firm engaged for auditing and audit-related services. Furthermore, the SEC requires that an executive officer of a listed company promptly notify the national exchange if he or she becomes aware of any material non-compliance with the audit committee requirements by that listed company.
Although charter requirements are detailed in the Nasdaq rule, the SEC rule requires that the audit committee establish certaDrill Down On NASDAQ Audit Comin processes and procedures for handling complaints regarding accounting, internal financial controls and auditing matters, including for the confidential submission by employees. The SEC rule also requires that an audit committee be given the power, authority and funding to engage independent counsel and other advisors to carry out its tasks. Funding must also be provided to hire audit firms and pay administrative expenses.
The SEC allows for a phase-in for compliance when a company is completing an initial public offering. In particular, all but one director may be dependent for 90 days following the IPO and a minority of the audit committee may be dependent for one year from effectiveness of the registration statement. The SEC rule also contains general exemptions from the audit committee requirements including: (i) for consolidated subsidiaries that are listed on another exchange with similar audit committee requirements; (ii) FPI’s that follow home country rules and have a similar committee to an audit committee and satisfy certain additional conditions; and (iii) related to the listing of certain options, futures, asset-backed issuers, investment trusts, a passive trust or foreign governments. Specific disclosure is required when an exemption is being relied upon including an assessment of whether, and if so, how, such reliance would materially adversely affect the ability of the audit committee to act independently and to satisfy the other requirements of Rule 10A-3.
The SEC rule specifically requires that an exchange must give a listed company the opportunity to cure a defect in the audit committee requirements prior to delisting. Moreover, the SEC rule provides that if an independent director on the audit committee loses independence as a result of factors outside of their control, that person may remain on the audit committee until the next annual shareholders meeting or one year from the date of the occurrence that caused the board member to no longer be independent.
Nasdaq Rule 5605
Audit Committee Composition
One of the corporate governance related listing requirements is that a company have an audit committee consisting solely of independent directors who also satisfy the requirements of SEC Rule 10A-3 and who can read and understand fundamental financial statements including a balance sheet, income statement and cash flow statement. The audit committee must have at least three members. One member of the audit committee must have employment experience in finance or accounting, an accounting certification or other experience that results in the individual’s financial sophistication.
None of the committee members can have participated in the preparation of the financial statements of the company or any of its current subsidiaries for the prior three years. An individual will be considered to have participated in the preparation of the company’s financial statements if the individual has played any role in compiling or reviewing those financial statements, including a supervisory role. An interim officer who signed or certified the company’s financial statements will be deemed to have participated in the preparation of the company’s financial statements and, therefore, could not serve on the audit committee for three years.
The eligibility requirements to serve on the audit committee apply to all committee members whether or not such member is afforded non-voting status or other limitations on their participation with the committee.
Nasdaq has a limited exception to the independence requirements where a director meets the independence standards in SEC Rule 10A-3 but not the more detailed requirements of Nasdaq rules, is not currently an executive officer, employee or family member of an executive officer and exceptional circumstances makes the appointment of the person in the best interests of the company and its shareholders. Specific disclosures are required when relying on this exception including the nature of the relationship that makes the person non-independent and the reasons for the board’s determination. A committee member appointed under this exception may not serve for more than two years and cannot be chair of the audit committee. Unlike the implementation of many exceptions to Nasdaq rules (such as for example the 20% rule), the limited exception for audit committee compliance for exceptional circumstances does not require Nasdaq approval.
Audit Committee Charter
Rule 5605(c) requires that each company must certify that it has adopted a formal written committee charter and that the audit committee will review and reassess the charter on an annual basis. The certification is submitted one time and a copy of the actual charter does not need to be provided to Nasdaq. However, Item 407(d)(1) of Regulation S-K requires that companies report whether a current copy of its audit committee charter is available on its website and provide the website address. If the charter is not on the website, companies should include the charter as an appendix to its proxy statement at least once every three years or in any year in which the charter has been materially amended.
The charter must specify: (i) the scope of the audit committee’s responsibilities and how it carries out those responsibilities including structure, processes and membership requirements; (ii) the audit committee’s responsibility to ensure they receive written statements from the outside auditor regarding relationships between the auditor and the company and actively taking steps for ensuring the independence of the auditor; (iii) the committee’s purpose of overseeing the accounting and financial reporting processes of the company and the audits of the financial statements of the company; and (iv) the specific audit committee responsibilities and authority.
Furthermore, the charter must establish procedures for the confidential, anonymous submission by employees of the listed company of concerns regarding questionable accounting or auditing matters.
Audit Committee Responsibilities and Authority
The audit committee is responsible for items delineated in SEC Rule 10A-3 and in particular related to: (i) registered public accounting firms, (ii) complaints relating to accounting, internal accounting controls or auditing matters, (iii) authority to engage advisers, and (iv) funding as determined by the audit committee.
All non-compliance with audit committee requirements requires prompt notification to Nasdaq.
Consistent with SEC Rule 10A-3, if a member of the audit committee loses independent status for reasons outside the member’s reasonable control, the audit committee member may remain on the audit committee until the earlier of its next annual shareholders meeting or one year from the occurrence of the event that caused the failure to comply with this requirement. A company relying on this provision must provide notice to Nasdaq immediately upon learning of the event or circumstance that caused the noncompliance.
If noncompliance is a result of dropping below the minimum member requirements (three members), the company will have until the earlier of the next annual shareholders meeting or one year from the occurrence of the event that caused the failure to comply with this requirement – provided, however, that if the annual shareholders meeting occurs no later than 180 days following the event that caused the vacancy, the company shall instead have 180 days from such event to regain compliance. A company relying on this provision must provide notice to Nasdaq immediately upon learning of the event or circumstance that caused the noncompliance.
If a company has a class of equity securities listed on another exchange with SEC Rule 10A-3 audit committee requirements, they may list securities of a consolidated subsidiary on Nasdaq without having a separate audit committee for that subsidiary.
Laura Anthony, Esq.
Anthony L.G., PLLC
A Corporate Law Firm
Securities attorney Laura Anthony and her experienced legal team provide ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded public companies as well as private companies going public on the Nasdaq, NYSE American or over-the-counter market, such as the OTCQB and OTCQX. For more than two decades Anthony L.G., PLLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker-dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions, securities token offerings and initial coin offerings, Regulation A/A+ offerings, as well as registration statements on Forms S-1, S-3, S-8 and merger registrations on Form S-4; compliance with the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers; applications to and compliance with the corporate governance requirements of securities exchanges including Nasdaq and NYSE American; general corporate; and general contract and business transactions. Ms. Anthony and her firm represent both target and acquiring companies in merger and acquisition transactions, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. The ALG legal team assists Pubcos in complying with the requirements of federal and state securities laws and SROs such as FINRA for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the small-cap and middle market’s top source for industry news, and the producer and host of LawCast.com, Corporate Finance in Focus. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.
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As anticipated on November 5, 2019, the SEC issued two highly controversial rule proposals. The first is to amend Exchange Act rules to regulate proxy advisors. The second is to amend Securities Exchange Act Rule 14a-8 to increase the ownership threshold requirements required for shareholders to submit and re-submit proposals to be included in a company’s proxy statement. For a review of my blog on the Rule 14a-8 proposed amendments, see HERE. The new proposed rules are very controversial, but overdue and necessary. I am in support of both rules.
The SEC has been considering the need for rule changes related to proxy advisors for years as retail investors increasingly invest through funds and investment advisors where the asset managers rely on the advice, services and reports of proxy voting advice businesses. It is estimated that between 70% and 80% of the market value of U.S. public companies is held by institutional investors, the majority of which use proxy advisory firms to manage the decision making and logistics of voting for thousands of proposals within a concentrated period of a few months. Proxy voting advice businesses provide a variety of services including research and analysis on matters to be voted upon; general voting guidelines that clients can adopt; giving specific voting recommendations on specific matters subject to a shareholder vote; and handling the administrative process of returning proxies and casting votes. The administrative tasks are usually electronic and, at times, can involve an automated completion of a ballot based on programed voting instructions.
In 2010 the SEC issued a concept release seeking public comment on the role and legal status of proxy advisory firms within the U.S. proxy system. In 2013, the SEC held a roundtable on the use of proxy advisory firm services by institutional investors and investment advisers and in 2014, it issued a Staff Legal Bulletin (SLB 20) to provide guidance about the availability and use of exemptions from the proxy rules by proxy advisory firms. Another roundtable was held in November 2018 on the subject and in August 2019, the SEC issued new guidance clarifying that proxy advisors engage in “solicitations” within the meaning of the proxy rules.
This blog addresses the proposed rule changes related to the governance of proxy advisory firms. The proposed rules in essence codify the August 29, 2019 SEC guidance (see my blog HERE). In particular, the proposed rule changes the definition of “solicitation” in Exchange Act Rule 14a-1(l) to specifically include proxy advice subject to certain exceptions, provides additional examples for compliance with the anti-fraud provisions in Rule 14a-9 and amends rule 14a-2(b) to specifically exempt proxy voting advice businesses from the filing and information requirements of the federal proxy rules.
In addition, the proposed new rules enhance the quality of the disclosures about material conflicts of interest that proxy voting advice businesses provide their clients, provide that companies and other soliciting parties be given an opportunity to review and provide feedback to identify errors in the proxy voting advice, as long as the relevant definitive proxy materials have been filed 25 days or more in advance of a meeting, and add provisions to improve how investors are informed about differing views on advice.
Rule 14a-1(l) – Definition of “Solicit” and “Solicitation”
The fedederal proxy rules can be found in Section 14 of the Securities Exchange Act of 1934 (“Exchange Act”) and the rules promulgated thereunder and apply to any company which has securities registered under Section 12 of the Act. Exchange Act Rule 14(a) makes it unlawful for any person to “solicit” a proxy unless the follow the specific rules and procedures. Currently, under Exchange Act Rule 14a-1(l), a solicitation includes, among other things, a “communication to security holders under circumstances reasonably calculated to result in the procurement, withholding or revocation of a proxy,” and includes communications by a person seeking to influence the voting of proxies by shareholders, regardless of whether the person himself/herself is seeking authorization to act as a proxy. The SEC’s August guidance confirmed that proxy voting advice by a proxy advisory firm would fit within this definition of a solicitation.
The proposed amendments would amend Rule 14a-1(l) to specify the circumstances when a person who furnishes proxy voting advice will be deemed to be engaged in a solicitation subject to the proxy rules. In particular, the Rule would be amended to include “any proxy voting advice that makes a recommendation to a shareholder as to its vote, consent, or authorization on a specific matter for which shareholder approval is solicited, and that is furnished by a person who markets its expertise as a provider of such advice, separately from other forms of investment advice, and sells such advice for a fee,“ within the definitions of “solicit” or “solicitation.”
The SEC provide for certain exemptions to the definition of a “solicitation” including: (i) the furnishing of a form of proxy to a security holder upon the unsolicited request of such security holder as long as such request is not to a proxy advisory firm; (ii) the mailing out of proxies for shareholder proposals, providing shareholder lists or other company requirements under Rule 14a-7 related to shareholder proposals; (iii) the performance by any person of ministerial acts on behalf of a person soliciting a proxy; or (iv) a communication by a security holder who does not otherwise engage in a proxy solicitation stating how the security holder intends to vote and the reasons therefor. This last exemption is only available, however, if the communication: (A) is made by means of speeches in public forums, press releases, published or broadcast opinions, statements, or advertisements appearing in a broadcast media, or newspaper, magazine or other bona fide publication disseminated on a regular basis, (B) is directed to persons to whom the security holder owes a fiduciary duty in connection with the voting of securities of a registrant held by the security holder (such as financial advisor), or (C) is made in response to unsolicited requests for additional information with respect to a prior communication under this section.
By maintaining a broad definition of a solicitation, the SEC can exempt certain communications, as it has in the definition and in Rule 14a-2(b) discussed below and through no-action relief, while preserving the application of the anti-fraud provisions. In that regard, the proposed SEC rules (and the August guidance) specifically states that a proxy advisory firm does not fall within the carve-out in Rule 14a1(I) for “unsolicited” voting advice where the proxy advisory firm is hired by an investment advisor to provide advice. Proxy advisory firms do much more than just answer client inquiries, but rather market themselves as having an expertise in researching and analyzing proxies for the purpose of making a voting determination. On the other hand, when a shareholder reaches out to their financial advisor or broker with questions related to proxies, the financial advisor or broker would be covered by the carve-out for unsolicited inquiries.
Rule 14a-2(b) – Exemptions from the Filing and Information Requirements
Subject to certain exemptions, a solicitation of a proxy generally requires the filing of a proxy statement with the SEC and the mailing of that statement to all shareholders. Proxy advisory firms can rely on the filing and mailing exemption found in Rule 14a-2(b) if they comply with all aspects of that rule. Currently, Rule 14a-2(b)(1) provides an exemption from the information and filing requirements for “[A]ny solicitation by or on behalf of any person who does not, at any time during such solicitation, seek directly or indirectly, either on its own or another’s behalf, the power to act as proxy for a security holder and does not furnish or otherwise request, or act on behalf of a person who furnishes or requests, a form of revocation, abstention, consent or authorization.” Rule 14a-2(b)(3) generally exempts voting advice furnished by an advisor to any other person the advisor has a business relationship with, such as broker-dealers, investment advisors and financial analysts.
Nevertheless, solicitations that are exempt from the federal proxy rules’ filing requirements remain subject to Exchange Act Rule 14a-9, which prohibits any solicitation from containing any statement which, at the time and in the light of the circumstances under which it is made, is false or misleading with respect to any material fact. Also, as an aside I note that the exemption in Rule 14a-2(b)(1) does not apply to affiliates, 5% or greater shareholders, officers or directors, or director nominees nor does it apply where a person is soliciting in opposition to a merger, recapitalization, reorganization, asset sale or other extraordinary transaction or is an interested party to the transaction.
The proposed amendments would revise Rule 14a-2(b)(1) and 14a-2(b)(3) such that in order to rely on the exemption, a proxy voting advice business would need to: (i) include disclosure of material conflicts of interest in their proxy voting advice, including any reports, electronic platforms or other materials; (ii) provide companies and certain other soliciting persons with the opportunity to review and provide feedback on the proxy voting advice before it is issued, with the length of the review period depending on the number of days between the filing of the definitive proxy statement and the shareholder meeting; and (iii) allow companies and certain other soliciting persons to request that proxy voting advice businesses include a hyperlink or similar electronic link in their voting advice directing recipients to a written statement by the company or other soliciting person.
Conflicts of Interest
The rule release provides some good examples of conflicts of interest that would require disclosure, including: (i) providing proxy advice to voters while collecting fees from the company for advice on governance or compensation policies; (ii) providing advice on a matter in which one of its affiliates or other clients has a material interest, such as a transaction; (iii) providing voting advice on corporate governance standards while at the same time working with the company on matters related to those same standards; and (iv) providing voting advice related to a company where affiliates of the proxy advisory business hold major shareholder, board or officer positions.
The current rules do generally require disclosure of material interests, but the amended rules require a more specific and robust disclosure. In particular, the amended rules would require disclosure of: (i) any material interests, direct or indirect, of the proxy advisory firm or its affiliates in the matter or parties concerning which it is providing advice; (ii) any material transactions or relationships between the proxy advisory firm or its affiliates and the company, any other soliciting party, a shareholder proponent or in connection with the subject matter of the vote; (iii) any other information regarding the interest, transaction or relationship that is material to assessing the objectivity of the proxy voting advice; and (iv) any policies and procedures used to identify and steps taken to address material conflicts of interest.
The proposed amendments would permit proxy voting advice businesses to require companies and other soliciting persons to enter into confidentiality agreements for materials exchanged during the review and feedback period, and would allow proxy voting advice businesses to rely on the exemptions where failure to comply with the new conditions was immaterial or unintentional.
Review and Feedback on Proxy Advisory Materials
Although some of the largest proxy advisory firms such as ISS and Glass Lewis voluntarily provide S&P 500 companies with an opportunity to review and provide some feedback on advice, there is still a great deal of concern as to the accuracy and integrity of advice, and the need to formally allow all companies and soliciting parties an opportunity to review and provide input on such advice prior to it being provided to solicitation clients. The proposed amendments to Rule 14a2-(b) would require one standardized opportunity for timely review and feedback by companies of proxy voting advice before such advice is disseminated to clients, regardless of whether the advice is adverse to or agreeable to the company’s own position. The same opportunity must be provided to other soliciting parties only if the matter upon which they are soliciting is contested and to persons who intend to deliver their own proxy materials to voters.
The time for review depends on the timing of the definitive proxy statement compared to the meeting. If the definitive proxy statement is filed less than 45 but at least 25 calendar days before the meeting, the proxy advisory firm must provide a minimum of three business days for review and feedback. If the definitive proxy statement is filed more than 45 calendar days before the meeting, the proxy advisory firm must provide a minimum of five business days for review and feedback. If the definitive proxy statement is filed less than 25 calendar days before the meeting, the advisory firm has no obligation to provide a review and feedback period.
In addition to the review and feedback period, in order to rely on the exemptions in Rules 14a-2(b)(1) or (b)(3), a proxy voting advice business would be required to provide companies and certain other soliciting persons with a final notice of voting advice. This final notice must be provided no later than two business days prior to delivery of same to the proxy advisory firm’s clients. This final notice gives the company or other soliciting person a chance to decide whether or not to provide a written statement and request a hyperlink to that statement be provided by the proxy advisory firm. At the end of the two-day period, the proxy advisory firm has no further notice obligations.
Inclusion of Hyperlink to Written Statement
Under proposed Rule 14a-2(b)(9)(iii), as a condition to the exemptions found in Rules 14a2(b)(1) and 14a-2(b)(3), a proxy voting advice business must, upon request, include in its proxy voting advice and in any electronic medium used to deliver the advice a hyperlink (or other analogous electronic medium) that leads to the company’s statement about the proxy advisor’s voting advice. The hyperlink must be included upon request regardless of whether the voting advice is adverse to the company’s position. The written statement itself would be considered a solicitation and therefore subject to the filing and information requirements and anti-fraud rules. Like the notice and feedback rules, the proxy advisory firm is only require to provide a hyperlink for other soliciting parties only if the matter upon which they are soliciting is contested and to persons who intend to deliver their own proxy materials to voters.
Chart of Timing
The following chart included in the SEC rule proposal is helpful:
Person conducts solicitation exempt under
§ 240.14a-2 or submits shareholder proposal pursuant to Exchange Act Rule 14a-8
N/A. Proposed rules do not apply
Registrant and/or soliciting person conducts non-exempt solicitation and files definitive proxy statement for shareholder meeting N/A. Proposed rules do not dictate when the registrant and/or soliciting person files its definitive proxy statement
Proxy voting advice business provides the registrant and/or soliciting person with the version of the voting advice† that the business intends to deliver to its clients
[proposed Rule 14a-2(b)(9)(ii)]
Subject to the proxy voting advice business’s discretion, so long as it provides its voting advice to the registrant and/or soliciting person and complies with the required review and feedback and final notice periods in proposed Rule 14a-2(b)(9)(ii) prior to the distribution of such advice to the business’s clients
Review and feedback period:
Registrant and/or soliciting person has an opportunity to review and provide feedback, if any, on the proxy voting advice business’s voting advice [proposed Rules 14a- 2(b)(9)(ii)(A)(1) and (A)(2)]
· If definitive proxy statement is filed at least 45 calendar days before the date of the meeting, registrant and/or soliciting person has at least five business days to review and provide feedback; or
· If definitive proxy statement is filed less than 45 but at least 25 calendar days before the date of the meeting, registrant and/or soliciting person has at least three business days to review and provide feedback; or
· If definitive proxy statement is filed less than 25 calendar days before the date of the meeting, the proxy voting advice business is not required to provide its voting advice to registrant or soliciting person
Proxy voting advice business may revise its voting advice, as applicable N/A. Subject to the proxy voting advice business’s discretion
Final notice of voting advice:
Proxy voting advice business provides a copy of its voting advice that it will deliver to its clients to allow the registrant and/or soliciting person to assess whether or not to provide a statement with its response to the advice [proposed Rules 14a-2(b)(9)(ii)(B) and 14a-2(b)(9)(iii)]
No earlier than upon expiration of review and feedback period.
Registrant and/or soliciting person has at least two business days to provide a hyperlink (or other analogous electronic medium) with its response, if any
Registrant holds its shareholder meeting N/A
Rule 14a-9 – the Anti-Fraud Provisions
All solicitations, whether or not they are exempt from the federal proxy rules’ filing requirements, remain subject to Exchange Act Rule 14a-9, which prohibits any solicitation from containing any statement which, at the time and in the light of the circumstances under which it is made, is false or misleading with respect to any material fact. The proposed amendments would modify Rule 14a-9 to include examples of when the failure to disclose certain information in the proxy voting advice could, depending upon the particular facts and circumstances, be considered misleading within the meaning of the rule.
The types of information a proxy voting advice business may need to disclose could include the methodology used to formulate the proxy voting advice, sources of information on which the advice is based, or material conflicts of interest that arise in connection with providing the advice, without which the proxy voting advice may be misleading. Currently the Rule contains four examples of information that may be misleading including: (i) predictions as to specific future market values; (ii) information that impugns character, integrity or personal reputation or makes charges concerning improper, illegal or immoral conduct; (iii) failure to be clear as to who proxy materials are being solicited by; and (iv) claims made prior to a meeting as to the results of a solicitation.
The proposed rule would add to these examples the information required to be disclosed under 14a2-(b) including the failure to disclose the proxy voting advice business’s methodology, sources of information and conflicts of interest. Particularly the proxy advisor must provide an explanation of the methodology used to formulate its voting advice on a particular matter (including any material deviations from the provider’s publicly announced guidelines, policies, or standard methodologies for analyzing such matters). In its rule release, the SEC uses as an example a case where a proxy advisor recommends a vote against a director for the audit committee based on its finding that the director is not independent while failing to disclose that the proxy advisor’s independence standards differ from SEC and/or national exchange requirements and that the nominee does in fact meet those legal requirements.
Likewise, a proxy advisor must make disclosure to the extent that the proxy voting advice is based on information other than the company’s public disclosures, such as third-party information sources, disclosure about these information sources and the extent to which the information from these sources differs from the public disclosures provided by the company.
Chair Jay Clayton supports the proposed amendments as part of the necessary modernization of the proxy process. Chair Clayton points out that the increased disclosures will improve transparency and trust during the proxy process without adding undue burdens or delays to the process.
Commissioner Roisman also supports the proposed rule changes. He is aware that some are debating that the SEC is regulating beyond its mission and authority but firmly pushes back on that argument noting that the SEC has always regulated disclosures and fraud in the proxy solicitation process. Proxy advisors are utilized by thousands of investment advisors and institutional investors. In light of the power they hold in the voting process, disclosures on methodologies and conflicts are not only proper but imperative. Commissioner Roisman’s statement is well thought out, pointing out both sides of the arguments, and concluding that the proposed rules find a workable middle ground after much thought and effort on the SEC’s part.
Commissioner Hester Peirce supports the rule changes but points out that they are only part of the overall solution to the problems in the proxy process. Ms. Peirce points out that there is a misperception that investment advisors have a fiduciary duty to vote all of their clients proxies. As the number of retail clients investing through advisors has grown dramatically, they have naturally turned to proxy advisory firms for assistance resulting in a voting process that may or may not take into account a particular client’s views or goals. She hopes that the proposed rules encourage investment advisors and institutional investors to do more due diligence on the proxy advisory firms they use and how they are voting on their clients’ behalf.
Commissioner Jackson is not in favor of the rule change believing it weakens the relationship between investment advisors and their proxy advisor business consultant. He also believes that the new process adds burdens to an advisor that recommends against a company proposal. I simply can’t agree. Requiring proper disclosure, just as a company is required to make proper disclosure, evens the playing field and prevents small private groups from putting forth undisclosed personal interests without any transparency.
Commissioner Allison Herren Lee also disagrees with the proposed rule. Although she agrees that proxy advice should be based on the most reliable accurate information, she thinks it already is and therefore no new rules, or burdens, should be added. She also believes that there is no basis for assuming that greater issuer involvement would improve proxy voting advice.
Nasdaq Rule 5605 delineates the listing qualifications and requirements for a board of directors and committees, including the independence standards for board members. Nasdaq requires that a majority of the board of directors of a listed company be “independent” and further that all members of the audit, nominating and compensation committees be independent.
Under Rule 5605, an “independent director” means a person other than an executive officer or employee of a company or any individual having a relationship which, in the opinion of the company’s board of directors, would interfere with the exercise of independent judgment in carrying out the responsibilities of a director. In other words, the question of independence must ultimately be determined by the board of directors who must make an affirmative finding that a director is independent. However, the Nasdaq rules specify certain relationships that would disqualify a person from being considered independent. Stock ownership is not on the list and is not enough, without more, to preclude independence.
Rule 5605 specifies that the following people cannot be considered independent:
(i) a director who is, or at any time during the past three years was, employed by the company, provided however, interim employment of less than one year would not be a disqualifier as long as such employment had since terminated. In addition, employment by an entity that was later acquired by the company would not disqualify a director from being independent provided the former officer was not employed by the company after the acquisition;
(ii) a director who accepted or who has a family member who accepted any compensation from the company in excess of $120,000 during any period of twelve consecutive months within the three years preceding the determination of independence, other than: (a) compensation for board or board committee service; (b) compensation paid to a family member who is an employee but not an executive of the company; (c) benefits under a tax-qualified retirement plan, or non-discretionary compensation; or (d) compensation received while acting as an interim officer as long as such employment lasted for less than a year and has since terminated. Options received for services should be valued using a commonly accepted option pricing formula, such as the Black-Scholes or binomial model at the time of grant. The option value is considered a payment upon grant even if the option does not immediately vest or if there are conditions to vesting or exercise. This prohibition is meant to capture any compensation that directly benefits the director or family member and as such would include political contributions to a campaign by either. However, it is not meant to capture ordinary course business transactions such as interest on an arm’s-length loan;
(iii) a director who is a family member of an individual who is, or at any time during the past three years was, employed by the company as an executive officer;
(iv) a director who is, or has a family member who is, a partner in (other than limited partner), or a controlling shareholder or an executive officer of, any organization to which the company made, or from which the company received, payments for property or services in the current or any of the past three fiscal years that exceed 5% of the recipient’s consolidated gross revenues for that year, or $200,000, whichever is more, other than the following: (a) payments arising solely from investments in the company’s securities; or (b) payments under non-discretionary charitable contribution matching programs;
(v) a director of the company who is, or has a family member who is, employed as an executive officer of another entity where at any time during the past three years any of the executive officers of the company serve on the compensation committee of such other entity; or
(vi) a director who is, or has a family member who is, a current partner of the company’s outside auditor, or was a partner or employee of the company’s outside auditor who worked on the company’s audit at any time during any of the past three years.
Reference to the “company” includes parents and subsidiaries or any other entities that the company consolidates financial statements with, including variable interest entities. Executive officer refers to any person covered by SEC Rule 16a-1(f) and in particular the company’s president, principal financial officer, principal accounting officer, any vice-present in charge of a principal business unit, division or function or any officer or person who performs a policymaking function, which can include officers of a parent or subsidiary.
For purposes of Rule 5605, “family member” means a person’s spouse, parents, children and siblings, whether by blood, marriage or adoption, or anyone residing in such person’s home. This definition technically encompasses stepchildren as they are children “by marriage.” However, when applying the three-year look-back provisions, a company does not have to consider a person who is no longer a family member as a result of legal separation, divorce, death or incapacitation.
In June 2019, Nasdaq proposed to amend the definition of “family member” to narrow who can be included and add a level of certainty. In particular, Nasdaq proposed to change the definition to “a person’s spouse, parents, children, siblings, mothers and fathers-in-law, sons and daughters-in-law, brothers and sisters-in-law, and anyone (other than domestic employees) who shares such person’s home.” In the proposed rule change release, Nasdaq admitted that it did not intend to include stepchildren and that the change would correct this mistake. The new proposed language matches the NYSE definition.
However, in September 2019, the SEC instituted proceedings to determine whether to disapprove the proposed rule change. The SEC basically thinks Nasdaq is over-correcting in its new proposed rule. Certainly it would make sense to exclude a stepchild where the parents marry after the child is an adult and no parental relationship exists, but not where the step-parent raises or is otherwise close to the stepchild. The SEC also does not necessarily believe that the term “children” excludes stepchildren, nor as noted, should it. As of publication of this blog, no further action has been taken.