Monthly Archives: July 2020
On June 25, 2020, SEC Chair Jay Clayton gave testimony before the Investor Protection, Entrepreneurship and Capital Markets Subcommittee of the U.S. House Committee on Financial Services on the topic of capital markets and emergency lending in the Covid-19 era. The next day, on June 26, Chair Clayton, William Hinman, Director of the Division of Corporation Finance, Dalia Blass, Director of the Division of Investment Management and Brett Redfearn, Director of the Division of Trading and Markets issued a public statement on the same topic but expanded to include efforts to ensure the orderly function of U.S. capital markets.
Chair Clayton Testimony
Chair Clayton breaks down his testimony over five topics including: (i) market monitoring and regulatory coordination; (ii) guidance and targeted assistance and relief; (iii) investor protection, education and outreach efforts; (iv) ongoing mission-oriented work; and (v) the SEC’s fiscal-year 2021 budget request.
Market Monitoring and Regulatory Coordination
Despite the extraordinary volumes and volatility we have seen in the securities markets over the few months, at a high level, the “pipes and plumbing” of the securities markets have functioned largely as designed and as market participants would expect. The SEC has observed no systemically adverse operational issues with respect to key market infrastructure.
The SEC has also stepped up its market monitoring efforts establishing a cross-divisional Covid-19 Market Monitoring Group to manage and coordinate efforts to monitor markets and respond to issues. The Group has been continuously monitoring the market with respect to prices and price movements, capital flows and credit availability. The Group has also initiated work to: (i) identify, analyze and clarify interconnections across key segments of financial markets with increased specificity; and (ii) analyze the risks and potential pro-cyclical effects of investment strategies and mandates that include or are subject to mechanistic rules, guidelines or restrictions on holdings of assets—for instance, by reference to ratings and downgrades.
The SEC has also been in close contact with other domestic and international financial regulators regarding risks and impacts resulting from Covid-19 on investors, companies, state and local governments, issues and the financial system as a whole. Cybersecurity risks remain a top concern and priority. On the international level, attention is being paid to market impacts and increased risks with a focus on preserving orderly market functions.
Covid-19 Related Guidance and Targeted Regulatory Assistance and Relief
Chair Clayton highlights the various regulatory relief efforts of the SEC in response to Covid, for example temporary relief from filing deadlines, allowing virtual shareholder meetings, transfer agent relief (see HERE), and temporary expedited crowdfunding rules (see HERE). Chair Clayton testified about the SEC’s guidance on disclosures by public companies related to the impact of Covid on their businesses (see HERE) and the importance of those disclosures to the markets.
The SEC has also pursued many actions focused on operational issues, including facilitating the shift to business continuity plans that are consistent with health and safety directives and guidance and implementing a work-from-home system.
Investor Protection, Education and Outreach
Chair Clayton confirms that investor protection is as important as ever and that the SEC’s Office of Compliance Inspections and Examinations (OCIE) and Division of Enforcement remain fully operational and continue their robust efforts to protect investors. As all practitioners have noticed, Enforcement has been actively monitoring the markets for frauds, illicit schemes and other misconduct affecting U.S. investors relating to Covid and has dedicated significant resources to responding quickly to Covid-related misconduct. The SEC has issued over 30 trading suspensions on companies that have made claims related to access to testing materials, development of treatments or vaccines or access to personal protective equipment, and many of these have followed with enforcement actions.
The Office of Investor Education and Advocacy, along with Enforcement’s Retail Strategy Task Force, has issued investor alerts to inform and educate investors about concerns related to recent market volatility and Covid-related schemes. A separate alert warned investors of bad actors using CARES Act benefits to promote high-risk, high-fee investments and other inappropriate products and strategies.
Furthermore, Regulation Best Interest, establishing a new standard of conduct for broker-dealers when making a recommendation of any securities transaction or investment strategy to a retail customer, became effective on June 30, 2020. The SEC set up an investor-facing website explaining Regulation Best Interest and the Form CRS that broker-dealers are required to file.
Ongoing Mission-oriented Work
Despite the work-from-home status of the SEC, planned rulemaking and scheduling has continued unabated. Other initiatives, such as concerns with the risks associated with companies operating in emerging markets, have likewise continued. For more on that topic, see HERE.
Keeping with the national topic of the moment, Chair Clayton testified that the SEC is committed to diversity and inclusion. Over the last weeks, the topic has been brought to the forefront and the SEC recognizes it needs to make improvements and is working diligently with its Office of Minority and Women Inclusion on further initiatives. Chair Clayton also pointed out that in March 2020, the SEC released its first Diversity and Inclusion Strategic Plan to promote diversity and inclusion within the SEC and the entities the SEC regulates, the Office of the Advocate for Small Business Capital Formation recently held its Government-Business Forum on Small Business Capital Formation including a panel on minority- and woman-owned businesses, and the Asset Management Advisory Committee held a public meeting on diversity and inclusion in the asset management industry.
FY 2021 Budget Request
The SEC FY 2021 budget request of $1.895 billion, an increase of 4.4% over FY 2020, is hoped to provide the agency with resources to better execute its responsibilities. Key priorities include: (i) facilitating main street investor access to long-term, cost-effective investment opportunities and expanding outreach to small businesses; (ii) responding to continued evolution and innovation in the securities markets and meeting long-standing and emerging investor protection and oversight needs; and (iii) assessing and securing our data footprint with a focus on cybersecurity.
Public Statement on SEC’s Targeted Regulatory Relief Related to Covid-19
On June 26, Chair Clayton, William Hinman, Director of the Division of Corporation Finance, Dalia Blass, Director of the Division of Investment Management and Brett Redfearn, Director of the Division of Trading and Markets, issued a public statement on targeted regulatory relief and orderly markets amid the Covid-19 crisis. The statement reiterated much of Chair Jay Clayton’s testimony the day prior as summarized above. However, it also expanded to discuss continued changes and expansion to the relief as the virus crisis continues and is expected to continue to impact businesses and the public markets.
The SEC has reiterated many times that they are taking a health-first approach, prioritizing the health and safety of not only its employees and staff, but also making concessions for businesses to do so as well. All SEC staff is and will continue to work remotely and the SEC intends to extend relief it has provided to market participants to support a remote-work environment, such as virtual annual meetings. The SEC will also continue to provide relief related to the delivery of proxy materials in areas where mail cannot be delivered. Furthermore, the SEC will continue to allow the electronic submission of Form 144s and other documents that are still required to be delivered in paper form.
On the other hand, the SEC has no intention of offering further relief from filing deadlines for periodic reports such as 10-Qs and 10-Ks.
In May 2020 the SEC adopted temporary, conditional expedited crowdfunding access to small businesses using Regulation Crowdfunding (see HERE). The temporary rules provide eligible companies with relief from certain rules with respect to the timing of a company’s offering and the financial statements required. To take advantage of the temporary rules, a company must meet enhanced eligibility requirements and provide clear, prominent disclosure to investors about its reliance on the relief. The relief is scheduled to end on August 31, 2020. The SEC has not yet decided if it will extend this temporary rule.
On April 21, 2020, the SEC Chairman Jay Clayton and a group of senior SEC and PCAOB officials issued a joint statement warning about the risks of investing in emerging markets, especially China, including companies from those markets that are accessing the U.S. capital markets. On July 9, 2020, the SEC held an Emerging Markets Roundtable where Chair Clayton reiterated his concerns about emerging market investment risks. Previously, in December 2018, Chair Clayton, SEC Chief Accountant Wes Bricker and PCAOB Chairman William D. Duhnke III issued a similar cautionary statement, also focusing on China (see HERE).
SEC and PCAOB Joint Statement
On April 21, 2020, SEC Chair Clayton, SEC Chief Accountant Sagar Teotia, SEC Division of Corporation Finance Director William Hinman, SEC Division of Investment Management Director Dalia Blass, and PCAOB Chairman William D. Duhnke III issued a joint public statement warning of the significant disclosure, financial and reporting risks of investing in emerging markets, and the limited remedies where such investments turn bad.
Over the past years, emerging markets have increased their access to U.S. capital markets with China becoming the largest emerging market economy and world’s second largest overall economy. The ability for regulators to enforce financial reporting and disclosure requirements for entities either based in, or with significant operations in, emerging markets is limited and dependent on the cooperation and assistance of local authorities. As a result, in many emerging markets, including China, there is substantially greater risk that disclosures will be incomplete or misleading and, in the event of investor harm, substantially less access to recourse, in comparison to U.S. domestic companies. The joint statement summarizes specific risks and considerations for market participants.
I have written about risk factors and the importance of company-specific risk disclosures in the past (see HERE). Companies that have significant operations in emerging markets often face greater risks and uncertainties, including idiosyncratic risks, than in more established markets. The operational risk disclosures for companies in emerging markets need to be robust including considering industry and jurisdiction-specific factors.
Likewise, the varying standards for financial reporting and oversight in different jurisdictions create unique risks that must be disclosed. Companies should discuss these matters with their independent auditors and where applicable, audit committees, and should disclose the related material risks.
Companies based in emerging markets should consider providing a U.S. domestic investor-oriented comparative discussion of matters such as (i) how the company has met the applicable financial reporting and disclosure obligations, including disclosure control procedures and internal controls over financial reporting and (ii) regulatory enforcement and investor-oriented remedies including, as a practical matter, in the event of a material disclosure violation or fraud or other financial misconduct.
Quality of Financial Information; Varying Requirements and Standards
The foundation of investor confidence in capital markets is high-quality, reliable financial statements. The SEC regulatory regime contains numerous rules and regulations to ensure these high-quality financial statements, including rules related to internal controls over financial statements (ICFR); auditor attestations; CEO and CFO attestations (see HERE); independent audit committees; auditor independence standards, PCAOB review and oversight and SEC review and enforcement.
While the form of disclosure may appear substantially the same as that provided by U.S. issuers and FPIs in many jurisdictions, it can often be quite different in scope and quality. Furthermore, that scope and quality of disclosure can significantly vary from company to company, industry to industry, and jurisdiction to jurisdiction.
In addition, if a foreign entity does not report to the SEC, the information and standards for preparing that information may be completely unreliable. Some jurisdictions have much lower regulatory, accounting, auditing or auditor oversight requirements or none at all.
The bottom line is that investors and financial professionals should carefully consider the nature and quality of financial information, including financial reporting and audit requirements, when making or recommending investments. Companies should ensure that relevant financial reporting matters are discussed with their independent auditors and, where applicable, audit committees.
PCAOB’s Inability to Inspect Audit Work Papers in China
The SEC and PCAOB’s first statement on this matter in December 2018 drilled down on the fact that China will not cooperate with their requests to review, investigate or audit local PCAOB member firms in China, thereby casting doubt and a lack of transparency on the quality and reliability of audits. The newest statement reiterates this situation and specifically notes a lack of improvement despite ongoing efforts. Investors should understand the potential impacts of the PCAOB’s lack of access when investing in companies whose auditor is based in China and public companies with operations in China must disclose these risks in SEC reports.
Limited Rights or Remedies
The SEC, U.S. Department of Justice (“DOJ”) and other authorities often have substantial difficulties in bringing and enforcing actions against non-U.S. companies and non-U.S. persons, including company directors and officers, in certain emerging markets, including China. Likewise, shareholder claims, including class action lawsuits, can be difficult or impossible to pursue in emerging markets. Even if investors successfully sue in the U.S., judgments may be impossible to enforce or collect upon.
Companies should clearly disclose the related material risks in their SEC reports.
Passive investing strategies, such as through or following an index fund, often fail to consider the increased and specific risks associated with emerging markets.
Investment Advisers, Broker-Dealers and Other Market Participants Should Consider Emerging Market Risks
The SEC reminds investment professionals to consider the risks discussed in their statement when making investment decisions or providing investment advice or recommendations involving emerging markets.
A company that is classified as an accelerated or large accelerated filer is subject to, among other things, the requirement that its outside auditor attest to, and report on, management’s assessment of the effectiveness of the issuer’s internal control over financial reporting (ICFR) as required by Section 404(b) of the Sarbanes-Oxley Act (SOX). The JOBS Act exempted emerging growth companies (EGCs) from this requirement. Moreover, historically the definition of a smaller reporting company (SRC) was set such that an SRC could never be an accelerated or large accelerated filer, and as such would never be subject to Section 404(b) of SOX.
In June 2018, the SEC amended the definition of an SRC to include companies with less than a $250 million public float (increased from $75 million) or if a company does not have an ascertainable public float or has a public float of less than $700 million, an SRC is one with less than $100 million in annual revenues during its most recently completed fiscal year (see HERE). At that time the SEC did not amend the definitions of an accelerated filer or large accelerated filer. As a result, companies with $75 million or more of public float that qualify as SRC’s remained subject to the requirements that apply to accelerated filers or large accelerated filers, including the accelerated timing of the filing of periodic reports and the requirement that these accelerated filers provide the auditor’s attestation of management’s assessment of internal control over financial reporting required by Section 404(b) of SOX.
Under the new rules, smaller reporting companies with less than $100 million in revenues are not required to obtain an attestation of their internal controls over financial reporting (ICFR) from an independent outside auditor under Section 404(b) of SOX. In particular, the amendments exclude from the accelerated and large accelerated filer definitions a company that is eligible to be an SRC and that had no revenues or annual revenues of less than $100 million in the most recent fiscal year for which audited financial statements are available.
All Exchange Act reporting companies, whether an SRC or accelerated filer, will continue to be required to comply with SOX Rule 404(a) requiring the company to establish and maintain ICFR and disclosure control and procedures and have their management assess the effectiveness of each. This management assessment is contained in the body of all quarterly and annual reports and amended reports and in separate certifications by the company’s principal executive officer and the principal financial officer.
The new rules also increase the transition thresholds for accelerated and large accelerated filers becoming a non-accelerated filer from $50 million to $60 million and for exiting large accelerated filer status from $500 million to $560 million and add a revenue test to the transition thresholds for exiting both accelerated and large accelerated filer status.
Like the change to the definition of an SRC, it is thought the new rules will assist with capital formation for smaller companies and reduce compliance burdens while maintaining investor protections. The SEC also hopes that the amendments will catch the attention of companies that have delayed going public in recent years and as such, may help stimulate entry into the U.S. capital markets.
In the press release announcing the rule change, Chair Jay Clayton stated: “[T]he JOBS Act provided a well-reasoned exemption from the ICFR attestation requirement for emerging growth companies during the first five years after an IPO. These amendments would allow smaller reporting companies that have made it to that five-year point, but have not yet reached $100 million in revenues, to continue to benefit from that exemption as they build their businesses, while still subjecting those companies to important investor protection requirements.”
The topic of disclosure requirements under Regulation S-K as pertains to disclosures made in reports and registration statements filed under the Exchange Act of 1934 (“Exchange Act”) and Securities Act of 1933 (“Securities Act”) has been prolific over the past few years with a slew of rule changes and proposed rule changes. Regulation S-K, as amended over the years, was adopted as part of a uniform disclosure initiative to provide a single regulatory source related to non-financial statement disclosures and information required to be included in registration statements and reports filed under the Exchange Act and the Securities Act.
The SEC disclosure requirements are scaled based on company size. The SEC categorized companies as non-accelerated, accelerated and large accelerated in 2002 and introduced the smaller reporting company category in 2007 to provide general regulatory relief to these entities. The only difference between the requirements for accelerated and large accelerated filers is that large accelerated filers are subject to a filing deadline for their annual reports on Form 10-K that is 15 days shorter than the deadline for accelerated filers.
The filing deadlines for each category of filer are:
|Filer Category||Form 10-K||Form 10-Q|
|Large Accelerated Filer||60 days after fiscal year-end||40 days after quarter-end|
|Accelerated Filer||75 days after fiscal year-end||40 days after quarter-end|
|Non-Accelerated Filer||90 days after fiscal year-end||45 days after quarter-end|
|Smaller Reporting Company||90 days after fiscal year-end||45 days after quarter-end|
Significantly, both accelerated filers and large accelerated filers are required to have an independent auditor attest to and report on management’s assessment of internal control over financial reporting in compliance with Section 404(b) of SOX. Non-accelerated filers are not subject to Section 404(b) requirements. Under Section 404(a) of SOX, all companies subject to SEC Reporting Requirements, regardless of size or classification, must establish and maintain internal controls over financial reporting (ICFR), have management assess such ICFR, and file CEO and CFO certifications regarding such assessment (see HERE).
An ICFR system must be sufficient to provide reasonable assurances that transactions are executed in accordance with management’s general or specific authorization and recorded as necessary to permit preparation of financial statements in conformity with US GAAP or International Financial Reporting Standards (IFRS) and to maintain accountability for assets. Access to assets must only be had in accordance with management’s instructions or authorization and recorded accountability for assets must be compared with the existing assets at reasonable intervals and appropriate action be taken with respect to any differences. These requirements apply to any and all companies subject to the SEC Reporting Requirements.
Likewise, all companies subject to the SEC Reporting Requirements are required to provide CEO and CFO certifications with all forms 10-Q and 10-K certifying that such person is responsible for establishing and maintaining ICFR, have designed ICFR to ensure material information relating to the company and its subsidiaries is made known to such officers by others within those entities, and evaluated and reported on the effectiveness of the company’s ICFR.
Furthermore, auditors review ICFR even where companies are not subject to 404(b). Audit risk assessment standards allow an auditor to rely on internal controls to reduce substantive testing in the financial statement audit. A necessary precondition is testing such controls. Also, an auditor must test the controls related to each relevant financial statement assertion for which substantive procedures alone cannot provide sufficient appropriate audit evidence. Naturally, a lower revenue company has less risk of improper revenue recognition and likely less complex financial systems and controls. In any event, in my experience auditors not only test ICFR but make substantive comments and recommendations to management in the process.
The Section 404(b) independent auditor attestation requirements are considerably more cumbersome and expensive for a company to comply with. In addition to the company requirement, Section 404(b) requires the company’s independent auditor to effectively audit the ICFR and management’s assessment. The auditor’s report must contain specific information about this assessment (see HERE). As all reporting companies are aware, audit costs are significant and that is no less true for this additional audit layer. In fact, companies generally find Section 404(b) the most costly aspect of the SEC Reporting Requirements. Where a company has low revenues, the requirement can essentially be prohibitive to successful implementation of a business plan, especially for emerging and growing biotechnology companies that are almost always pre-revenue but have significant capital needs.
The SEC has come to the conclusion that the added benefits from 404(b) are outweighed by the additional costs and burdens for SRC’s and lower revenue companies. I am a strong proponent of supporting capital markets for smaller companies, such as those with less than a $700 million market cap and less than $100 million in revenues.
Detail on Amendments to Accelerated Filer and Large Accelerated Filer Definitions
Prior to the June 2018 SRC amendments, the SRC category of filers generally did not overlap with either the accelerated or large accelerated filer categories. However, following the amendment, a company with a public float of $75 million or more but less than $250 million regardless of revenue, or one with less than $100 million in annual revenues and a public float of $250 million or more but less than $700 million, would be both an SRC and an accelerated filer.
The SEC has now amended the accelerated and large accelerated filer definitions in Exchange Act Rule 12b-2 to exclude any company that is eligible to be an SRC and that had annual revenues of less than $100 million during its most recently completed fiscal year for which audited financial statements are available. The effect of this change is that such a company will not be subject to accelerated or large accelerated filing deadlines for its annual and quarterly reports or to the ICFR auditor attestation requirement under SOX Section 404(b).
The rule change does not exclude all SRC’s from the definition of accelerated or large accelerated filers and as such, some companies that qualify as an SRC would still be subject to the shorter filing deadlines and Section 404(b) compliance. In particular, an SRC with greater than $75 million in public float and greater than $100 million in revenue will still be categorized as an accelerated filer.
The chart below illustrates the effect of the amendments:
|Relationships between SRC’s and Non-Accelerated and Accelerated Filers|
|Status||Non-Affiliated Public Float||Annual Revenues|
|SRC and Non-Accelerated Filer||Less than $75 million||N/A|
|$75 million to less than $700 million||Less than $100 million|
|SRC and Accelerated Filer||$75 million to less than $250 million||$100 million or more|
|Accelerated Filer (not SRC)||$250 million to less than $700 million||$100 million or more|
|Large Accelerated Filer (not SRC)||Over $700 million||N/A|
The amendments also revise the public float transition threshold for accelerated and large accelerated filers to become a non-accelerated filer from $50 million to $60 million and increase the exit threshold in the large accelerated filer transition provision from $500 million to $560 million in public float to align the SRC and large accelerated filer transition thresholds. Finally, the amendments allow an accelerated or a large accelerated filer to become a non-accelerated filer if it becomes eligible to be an SRC under the SRC revenue test.
The chart below illustrates the effect of the amendments on transition provisions:
|Amendments to the Non-Affiliate Public Float Thresholds|
|Initial Public Float Determination||Resulting Filer Status||Subsequent Public Float Determination||Resulting Filer Status|
|$700 million or more||Large Accelerated Filer||$560 million or more||Large Accelerated Filer|
|Less than $560 million but$60 million or more||Accelerated Filer|
|Less than $60 million||Non-Accelerated Filer|
|Less than $700 million but $75 million or more||Accelerated Filer||Less than $700 million but$60 million or more||Accelerated Filer|
|Less than $60 million||Non-Accelerated Filer|
Determining Non-Affiliated Public Float
To determine the value of the public float, a company must multiply the aggregate worldwide number of shares of common equity held by non-affiliates by the price at which it was last sold, or the average of the bid and asked prices, in the principal trading market. Derivative securities such as options, warrants and other convertible or non-vested securities are not included in the calculation. An “affiliate” of, or a person “affiliated” with, a company, is a person that directly, or indirectly through one or more intermediaries, controls, or is controlled by, or is under common control with, the company. The term “control” (including the terms “controlling,” “controlled by” and “under common control with”) means the possession, direct or indirect, of the power to direct or cause the direction of the management and policies of a company, whether through the ownership of voting securities, by contract, or otherwise.
From a top line, directors, executive officers and their spouses and relatives living with them are always considered affiliates as are trusts and corporations of which that director, executive officer or their spouses control in excess of 10%. There is a rebuttable presumption that 10% or greater stockholders are affiliates. Beyond that, the SEC has consistently refused to provide definitive guidance on the matter, rather requiring companies and their management to make an analysis based on their individual facts and circumstances.
Through various guidance, including comment letters and SEC enforcement actions, important facts to consider in determining control/affiliate status include:
- Distribution of voting shares among all stockholders – Consider whether a stockholder has a large percentage of the company’s voting stock as compared to all other stockholders;
- Impact of possible resale – if a particular larger shareholder threatens to sell their stock into the market unless management takes certain actions, and management believes that such sale would have a material negative impact on the stock price, that person could be considered to have control;
- Influence of a stockholder – a particular stockholder could have influence because of their general position or power over other stockholders – this could be because of a direct or indirect relationship with other stockholders or because of the person’s reputation as a whole. For example, certain activist shareholders such as Carl Icahn can exert control over management of companies in which they invest;
- Voting agreements – if a person has the right to vote on behalf of other people’s shares, they may have control;
- Contractual arrangements – any other contract that gives a person the right to assert control over management decisions.
In February, the Office of Management and Budget released the proposed fiscal 2021 United States government budget. The beginning of the Budget contains a message from President Trump delineating a list of key priorities of the administration including better trade deals, preserving peace through strength, overcoming the opioid crisis, regulation relief and American energy independence. The budget has some notable aspects that directly relate to the capital markets and its participants.
As the federal government has been doing for all agencies, the 2021 Budget seeks to eliminate agency reserve funds. Specifically regarding the SEC, the Budget cuts the SEC reserve by $50 million. The reduction in reserve fund is thought to increase overall accountability as the SEC would need to go to Congress to ask for additional funds if needed, with an explanation, instead of just accessing a reserve account. Reserve fund cuts are sent to the U.S. Treasury for deficit reduction.
However, the Budget also increases the overall SEC financing by 5.6% for a total of $1.9 billion including allowing for a 2.9% increase in workforce. The budget also increases the SEC’s annual funding for cybersecurity from $41.8 million to $46.6 million.
One of the overarching stated principals in the Budget is to reduce overlapping and duplication and in particular, “when multiple agencies or programs have similar goas, engage in similar activities or strategies, or target similar beneficiaries” they should be consolidated or the duplicated functions eliminated. In that regard, the 2021 budget proposed moving the now autonomous PCAOB under the SEC with a mandate that the SEC and PCAOB start to consolidate their duplicative functions. “Consolidating these functions within SEC will reduce regulatory ambiguity and duplicative statutory authorities,” the proposed Budget states.
The PCAOB was originally created by the Sarbanes-Oxley Act of 2002 in response to a series of accounting frauds including involving Enron Corp. However, the SEC is also tasked with investigation, oversight and enforcement against the same accounting firms that must be members of the PCAOB. The PCAOB has faced a series of controversies in recent years.
In December 2017, following a scandal involving the leak of confidential information about future inspections of KPMG LLP to auditors at the accounting firm, the SEC replaced the PCAOB’s entire board. A month later criminal charges were unsealed for three former PCAOB employees and three former KPMG executives.
In May 2018, five key division and office heads departed the regulator. Also in 2018, the number of settled disciplinary proceedings made public by the PCAOB dropped by 63%. In May 2019, a group of current and former PCAOB employees filed a whistleblower complaint alleging infighting, a hostile work environment and retaliatory conduct.
To top off the issues, in September 2019,a nonpartisan government oversight report found that over its full 16-year life, the PCAOB had only brought 18 enforcement actions against the big four accounting firms despite having found 808 instances of defective audits by those same firms. The report found that the PCAOB had only collected a total of $6.5 million in fines despite having the authority to demand as much as $15 million per violation. Finally, the report found an incestuous relationship between the PCAOB and the big four accounting firms with a frequent interchange of employees. In short, the PCAOB has not proved itself worth its expense nor effective in its mission.
Like other savings, the savings from folding in the PCAOB with the SEC would be used to reduce the federal deficit. It is expected that the joining of the two would result in a savings of $57 million in 2022 and a total of $580 million over ten years.
It is widely acknowledged that the increase in digital assets and cryptocurrencies has increased the prevalence of money laundering and funding for criminal activities including cybercriminals and terrorist activities. As an example, in August of last year, the Treasury Department’s Office of Foreign Assets Control (“OFAC”) blacklisted the cryptocurrency addresses of Chinese nationals involved in trafficking and producing the drug fentanyl. It is believed that the perpetrators were laundering funds using cryptocurrency. At the time, FinCEN issued an advisory to financial institutions outlining some of the common schemes used to launder funds.
In a move to increase law enforcement in this sector, after nearly two decades of control under of the U.S. Department of Homeland Security, the 2021 Budget proposes moving the Secret Service to the Department of the Treasury. The Budget cites the need for increased efficiencies in combating threats stemming from financial technology, including cryptocurrencies. The Budget would also provide the Secret Service with $2.4 billion in funding and allow for an additional 119 Secret Service agents.
The budget also proposes funding $127 million to support the Financial Crimes Enforcement Network, which “links law enforcement and intelligence agencies with financial institutions and regulators.” The budget outlines that the funding would help support FinCEN’s actions under the Bank Secrecy Act and would “expand its efforts to combat emerging virtual currency and cybercrime threats.” FinCEN regulates and monitors anti-money laundering and countering the financing of terrorism (AML/CFT) obligations under the Bank Secrecy Act (BSA).
AML/CFT obligations apply to entities that the BSA defines as “financial institutions,” such as futures commission merchants and introducing brokers obligated to register with the CFTC, money services businesses (MSBs) as defined by FinCEN (for more information on MSBs see HERE), and broker-dealers and mutual funds obligated to register with the SEC. The AML/CFT requirements under the BSA include establishing effective processes and procedures, recordkeeping and reporting and filing suspicious activity reports (SARs). For more information, see HERE.
The Budget also allocated $173 million to the Department of Treasury’s Office of Terrorism and Financial Intelligence which combats terrorists, rogue regimes, proliferators of weapons of mass destruction, human rights abusers, and other illicit actors by denying their access to the financial system, disrupting their revenue streams, and degrading their ability to cause harm.
As an aside, in addition to the Secret Service, Budget will also move the Bureau of Alcohol, Tobacco, Firearms and Explosives and the Organized Crime and Drug Enforcement Task Force to the Department of Treasury. The ATF has historically been under the Department of Justice.
Small Business Administration (SBA)
The SBA was established to aid, counsel and assist small businesses. The Budget supports $43 billion in business lending to assist U.S. small business owners in accessing affordable capital to start, build, and grow their businesses though loans will have an up-front administrative fee to offset costs.
Other Points of Interest – Technology and Cybersecurity
The Administration is prioritizing technology and industries of the future across the board with an emphasis on artificial intelligence. The Department of Defense Budget invests over $14 billion in science and technology programs that support key investments in industries of the future, such as artificial intelligence, quantum information science, and biotechnology, as well as core Department of Defense modernization priorities such as hypersonic weapons, directed energy, 5G, space, autonomy, microelectronics, cybersecurity, and fully networked command, control, and communications.
The Department of Commerce provides $718 million for the National Institute of Standards and Technology (NIST) to advance U.S. innovation and technological development, as part of an all-government approach to ensure that the US leads the world in the areas of AI, quantum information science, advanced manufacturing, and next generation communications technologies such as 5G. The Budget doubles NIST’s AI funding in order to accelerate the development and adoption of AI technologies and help ensure AI-enabled systems are interoperable, secure and reliable.
The Department of Energy has a new Artificial Intelligence and Technology Office responsible for providing department wide guidance and oversight on AI technology development and application. The Budget provides $5 million for this new office to enhance AI R&D projects already underway. In addition, the Department of Energy is allocated $5.8 billion for the Office of Science to continue its mission of focusing on early-stage research. Within this amount: $475 million is requested for Exascale computing to help secure the United States as a global leader in supercomputing; $237 million is requested for quantum information science; $125 million is requested for AI and machine learning; and $45 million is requested to enhance materials and chemistry foundational research to support U.S.- based leadership in microelectronics. Moreover, to support broad, interagency cybersecurity efforts, the Budget provides funding in multiple programs, including $185 million for the Office of Cybersecurity, Energy Security, and Emergency Response.
The Department of Education Budget includes $2 billion for Career and Technical Education Grants to ensure that all high schools can offer high-quality technological educations.
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.
Ms. Anthony is a member of various professional organizations including the Crowdfunding Professional Association (CfPA), Palm Beach County Bar Association, the Florida Bar Association, the American Bar Association and the ABA committees on Federal Securities Regulations and Private Equity and Venture Capital. She is a supporter of several community charities including siting on the board of directors of the American Red Cross for Palm Beach and Martin Counties, and providing financial support to the Susan Komen Foundation, Opportunity, Inc., New Hope Charities, the Society of the Four Arts, the Norton Museum of Art, Palm Beach County Zoo Society, the Kravis Center for the Performing Arts and several others. She is also a financial and hands-on supporter of Palm Beach Day Academy, one of Palm Beach’s oldest and most respected educational institutions. She currently resides in Palm Beach with her husband and daughter.
Ms. Anthony is an honors graduate from Florida State University College of Law and has been practicing law since 1993.
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Last week the SEC Office of the Chief Accountant (OCA) made a public statement on the importance of high-quality financial reporting for investors in light of Covid-19 on the same day that the Division of Corporation Finance issued an updated Disclosure Guidance Topic No. 9A on operations, liquidity, and capital resources disclosures related to the virus. Disclosure Guidance Topic No. 9A supplements the previously issued Topic No. 9 (see HERE) and follows the SEC’s virtual Investor Advisory Committee (“IAC”) meeting where investors testified as to additional information that should be relayed to the capital markets by public companies (see HERE).
OCA Statement on Financial Reporting
On April 3, 2020, the SEC Office of the Chief Accountant (OCA) made its first public statement on the importance of high-quality financial reporting for investors in light of Covid-19. At that time, many companies were in the process of preparing Q1 results and reports. Now that Q2 is coming to a close, the OCA has issued a new statement, specifically addressing (i) OCA’s engagement and work related to high quality financial reporting; (ii) engagement with the FASB and PCAOB; (iii) engagement with international standard setters and other regulators; and (iv) engagement with and the vital role of audit committees.
OCA’s engagement and work related to high-quality financial reporting
Although high-quality timely financial information is important at all times, in times of uncertainty such as created by Covid-19 it is even more important. During this time, many companies have been required to make significant judgments and estimates to address a variety of accounting and financial reporting matters. OCA reiterates that it will not second guess well-reasoned judgments and encourages companies to continue to report judgments and estimates based on the company’s specific facts and circumstances.
All public companies are required to maintain disclosure controls and procedures (DCP) and internal controls over financial reporting (ICFR) (for more on ICFR, see HERE). OCA emphasizes that both DCP and ICFR should be carefully reviewed and adapted to the changing environment. These changes may include consideration on how controls operate or can be tested and if there is any change in the risk of the control operating effectively in a telework environment.
OCA reminds public companies about the need to consider and report any going concern issues. Public companies should carefully consider their ability to meet its obligations as they become due within one year after the issuance of the financial statements. Disclosures should include information about the principal conditions giving rise to the substantial doubt, management’s evaluation of the significance of those conditions relative to the entity’s ability to meet its obligations, and management’s remediation plans. An annual audit report is required to address the company’s ability to continue as a going concern; however, GAAP specifically requires disclosures in the notes to financial statements as well, on both a quarterly and annual basis. OCA reminds auditors that are reviewing quarterly financial statements to be cognizant of disclosures related to going concern issues and to be satisfied that they are sufficient in light of the circumstances.
OCA has processes in place to provide staff views on the application of U.S. GAAP and International Financial Reporting Standards (IFRS) to complex, unique or novel issues. Since the Covid-19 crisis began, the SEC has consulted with many issuers on matters such as the financial reporting of the Coronavirus Aid, Relief, and Economic Security Act (CARES Act), debt modifications, hedging, consolidation, business combinations, lease concessions, revenue recognition and income taxes. OCA believes that current financial reporting standards, together with the ability to seek consultation, adequately address the needs of companies and their financial reporting requirements.
Engagement with FASB and PCAOB
FASB is responsible for setting accounting and reporting standards for U.S. companies. During the crisis, OCA has been working with FASB regarding emerging issues around Covid-19, though no particular reporting standard changes have been implemented. In its statement, OCA applauds the PCAOB for its transition to remote operations and engagement with auditors that were likewise making the same transition.
Engagement with International Standard Setters and Other Regulators
Financial markets are global in nature. OCA notes that U.S. investors hold in excess of $11 trillion of foreign debt and equity securities. The OCA public statement provides general information on the various international groups that OCA engages with, such as the IASB and the International Organization of Securities Commissions, but does not detail any particular Covid-19 initiatives. In general, the International Federation of Accountants is preparing a proposal that would make audits more responsive to all stakeholders and not just equity shareholders, but this is not particularly Covid-related.
Engagement with Audit Committees
OCA emphasizes the importance of audit committees and the need for extra involvement and engagement on the impacts of Covid-19 to the particular financial reporting of each company.
Corporation Finance Topic No. 9A
Back in April, the SEC Division of Corporation Finance issued Disclosure Guidance Topic No. 9 regarding the SEC’s current views on disclosures and the obligations that companies should consider with respect to COVID-19. Last week the SEC updated that guidance issuing Disclosure Guidance Topic No. 9A. The overarching messaging is that a company must consider its COVID-19 impact in its disclosure documents based on that company’s specific facts and circumstances and make necessary material disclosures using a principles-based strategy.
A difference between Topic 9 and Topic 9A is that Topic 9 was focused on assumptions and considering future impacts, whereas, months later, Topic 9A includes a much more robust consideration of actual events and impacts to financial condition.
Many companies have undertaken or are in the process of undertaking a diverse range of operational adjustments in response to the effects of COVID-19. Although each company has its own unique situation, examples of include transitioning to a telework environment, supply chain and distribution changes, and suspending and modifying operations to implement health and safety guidelines. In addition, companies are engaging in differing financing activities in response to Covid including credit facilities, accessing public and private markets, supplier finance programs, modified creditor payments and modified customer receipt payments. It is important that companies provide robust and transparent disclosures about how they are dealing with short- and long-term liquidity and funding risks.
Topic No. 9A expounds upon the considerations for management when considering disclosures, including:
- What are the material operational challenges that management and the Board of Directors are monitoring and evaluating? How and to what extent have you altered your operations, such as implementing health and safety policies for employees, contractors, and customers, to deal with these challenges, including challenges related to employees returning to the workplace? How are the changes impacting or reasonably likely to impact your financial condition and short- and long-term liquidity?
- How has COVID-19 impacted the financial condition and results of operations? How do you expect COVID-19 to impact your future operating results and near-and-long-term financial condition? Do you expect that COVID-19 will impact future operations differently than how it affected the current period?
- How has COVID-19 impacted your capital and financial resources, including your overall liquidity position and outlook? How is your overall liquidity position and outlook evolving? To the extent revenues have been impacted, how has that affected sources and uses of funds? How have assumptions about the magnitude and duration of Covid and its impact on revenues and liquidity changed over time?
- Consider if the cost of or access to capital and funding sources has changed and whether it is likely to change or continue to change. Have sources and uses of cash been materially impacted? Has the ability to continue to meet ongoing credit agreements changed, or is it materially likely it will change? How has a change, or a potential change, to your credit rating impacted your ability to access funding? Disclosure should also be made as to the course of action a company has taken or proposes to take in light of the material impact on its financial resources.
- Have you accessed revolving lines of credit or raised capital in the public or private markets to address your liquidity needs? Are you at material risk of not meeting covenants in your credit and other agreements? Are your disclosures regarding these actions and any unused liquidity sources providing investors with a complete discussion of your financial condition and liquidity?
- Have COVID-19-related impacts affected your ability to access your traditional funding sources on the same or reasonably similar terms as were available to you in recent periods? Have you provided additional collateral, guarantees, or equity to obtain funding?
- Are you able to timely service your debt and other obligations? Have you taken advantage of available payment deferrals, forbearance periods, or other concessions? What are those concessions and how long will they last? Do you foresee any liquidity challenges once those accommodations end?
- Are you adequately describing metrics and assumptions, such as cash burn rates?
- Have you altered terms with your customers, such as extended payment terms or refund periods, and if so, how have those actions materially affected your financial condition or liquidity? Did you provide concessions or modify terms of arrangements as a landlord or lender that will have a material impact?
- Are you relying on supplier finance programs, otherwise referred to as supply chain financing, structured trade payables, reverse factoring, or vendor financing, to manage your cash flow? Have these arrangements had a material impact on your balance sheet, statement of cash flows, or short- and long-term liquidity and if so, how?
- Have you considered all subsequent events between the end of the financial reporting period and the date the report is filed with the SEC?
- How do you expect COVID-19 to affect assets on your balance sheet and your ability to timely account for those assets? For example, will there be significant changes in judgments in determining the fair value of assets measured in accordance with U.S GAAP or IFRS?
- Do you anticipate any material impairments (e.g., with respect to goodwill, intangible assets, long-lived assets, right of use assets, investment securities), increases in allowances for credit losses, restructuring charges, other expenses, or changes in accounting judgments that have had or are reasonably likely to have a material impact on your financial statements?
- Have you reduced your capital expenditures and if so, how? Have you reduced or suspended share repurchase programs or dividend payments? Have you ceased any material business operations or disposed of a material asset or line of business?
Items that were listed in Topic 9, but that should still be considered, include:
- Have COVID-19-related circumstances such as remote work arrangements adversely affected your ability to maintain operations, including financial reporting systems, internal control over financial reporting and disclosure controls and procedures? If so, what changes in your controls have occurred during the current period that materially affect or are reasonably likely to materially affect your internal control over financial reporting? What challenges do you anticipate in your ability to maintain these systems and controls?
- Have you experienced challenges in implementing your business continuity plans or do you foresee requiring material expenditures to do so?
- Do you expect COVID-19 to materially affect the demand for your products or services?
- Do you anticipate a material adverse impact of COVID-19 on your supply chain or the methods used to distribute your products or services?
- Will your operations or have they been materially impacted by any constraints or other impacts on your human capital resources and productivity? Have you materially reduced or increased your human capital resource expenditures? Are any of these measures temporary in nature, and if so, how long do you expect to maintain them?
- Are travel restrictions and border closures expected to have a material impact on your ability to operate and achieve your business goals?
Specifically related to the CARES Act, companies should consider the short and loan term impact of any assistance received on their financial condition, results of operations, liquidity, and capital resources, as well as the related disclosures and critical accounting estimates and assumptions. Specific items to consider include:
- How does a loan impact your financial condition, liquidity and capital resources? What are the material terms and conditions of any assistance you received, and do you anticipate being able to comply with them? Do those terms and conditions limit your ability to seek other sources of financing or affect your cost of capital? Do you reasonably expect restrictions, such as maintaining certain employment levels, to have a material impact on your revenues or income from continuing operations? Once any such restrictions lapse, do you expect to change your operations in a material way?
- Are you taking advantage of any recent tax relief, and if so, how does that relief impact your short- and long-term liquidity? Do you expect a material tax refund for prior periods?
- Does the assistance involve new material accounting estimates or judgments that should be disclosed or materially change a prior critical accounting estimate? What accounting estimates were made, such as the probability a loan will be forgiven, and what uncertainties are involved in applying the related accounting guidance?
Related to a company’s ability to continue as a going concern, in addition to the points made in the OCA statement, Topic 9A suggests considering:
- Are there conditions and events that give rise to the substantial doubt about the company’s ability to continue as a going concern? For example, have you defaulted on outstanding obligations? Have you faced labor challenges or a work stoppage?
- What are your plans to address these challenges? Have you implemented any portion of those plans?
Not reiterated in Topic 9A, but still relevant, is the SEC’s notes in Topic 9, including that forward-looking information will be protected under either Sections 27A and 21E of the Private Securities Litigation Reform Act of 1995 (PSLRA) or the common law bespeaks caution doctrine as long as proper disclaimers are included (for more information, see HERE).
In addition to other considerations, the SEC companies should be cognizant of their obligations under Item 10 of Regulation S-K and Regulation G related to the presentation of non-GAAP financial measures. The SEC permits companies to present non-GAAP financial measures in their public disclosures subject to compliance with Regulation G and Item 10(e) of Regulation S-K. Regulation G and Item 10(e) require reconciliation to comparable GAAP numbers, and the reasons for presenting the non-GAAP numbers, and govern the presentation format itself including requiring equal or greater prominence to the GAAP financial information. For more on Item 10 and Regulation G, see HERE.