Monthly Archives: July 2021
The first version of the SEC’s semiannual regulatory agenda and plans for rulemaking under the current administration has been published in the federal register. The Spring 2021 Agenda (“Agenda”) is current through April 2021 and contains many notable pivots from the previous SEC regime’s focus. The Unified Agenda of Regulatory and Deregulatory Actions contains the Regulatory Plans of 28 federal agencies and 68 federal agency regulatory agendas. The Agenda is published twice a year, and for several years I have blogged about each publication.
The Agenda is broken down by (i) “Pre-rule Stage”; (ii) Proposed Rule Stage; (iii) Final Rule Stage; and (iv) Long-term Actions. The Proposed and Final Rule Stages are intended to be completed within the next 12 months and Long-term Actions are anything beyond that. The number of items to be completed in a 12-month time frame jumped up to 45 items since Fall, which had only 32 items. Some of the new items are a revisit of previously passed rule changes. Although a big jump from Fall 2020, 45 is in line with prior years. The Spring 2019 Agenda had 42 and the Fall 2019 had 47 on the list.
Items on the Agenda can move from one category to the next or be dropped off altogether. New items can also pop up in any of the categories, including the final rule stage showing how priorities can change and shift within months.
Four items appear in the pre-rule stage including prohibition against fraud, manipulation, and deception in connection with security-based swaps which was also on the Fall Agenda. Added to the list are exempt offerings, third-party service providers and gamification. Third-party service providers refer to the asset management industry and includes services such as index and model providers. Under the gamification category, the SEC is considering seeking public comment on potential rules gamification, behavioral prompts, predictive analytics, and differential marketing. Gary Gensler talked about gamification issues in a recent speech – see HERE
The Agenda indicates that the SEC is now planning on seeking public comment on ways to further updated the SEC rules for exempt offerings “to more effectively promote investor protection, including updating the financial thresholds in the accredited investor definition, ensuring appropriate access to and enhancing information available regarding Regulation D offerings, and amendments related to the integration framework for registered and exempt offerings.” All of these were points of contention during the rule amendment process. Also in August 2020, the SEC updated the definition of an accredited investor and specifically decided not to increase the financial thresholds (see HERE). Seems we could be going back to the beginning in this whole process. As a practitioner I am frustrated by the idea that the SEC’s rulemaking could be so partisan-driven. Historically, that was not the case. Certainly, we have seen a different focus with new administrations but not a seesaw of rulemaking.
Thirty-six items are included in the proposed rule stage, up from just 16 on the Fall 2020 list, and include plenty of brand-new interesting topics. New to the proposed rule list are ESG related items including climate change and human capital disclosure. In addition to many public announcements on the topic of climate change, in March, the SEC issued a statement requesting public input on climate change disclosure with a focus on enhancing and updating the prior 2010 guidance (see HERE), it is now considering rule amendments to further enhance the disclosure requirements. Further proposed items in the ESG category are rules related to investment companies and investments advisors addressing environmental, social and governance factors.
Also new to the list is special purpose acquisition companies (SPACs) which could include a plethora of potential rule changes such as specific exclusion from the protections of Private Securities Litigation Reform Act (PSLRA), enhanced disclosure requirements, amendments to Exchange listing requirements and changes to accounting treatment, among others (see HERE). Rule 10b5-1 and in particular, a review of affirmative defenses available for insider trading cases, has been added to the proposed rule list. This is a topic Gary Gensler and the current SEC top brass have been vocal about in public speeches. Similarly, potential changes to Section 10 liability provisions surrounding loans or the borrowing of securities now appear on the proposed rule list.
Another hot topic amongst the SEC and marketplace has been share repurchase programs by public companies, including the potential they unfairly benefit insiders selling into the upmarket created by the repurchase programs. Share repurchase disclosure modernization has been added to the proposed rule list. Likewise, market structure reform including related to payment for order flow, best execution and market concentration are new to the Agenda in the proposed rule category. Gary Gensler gave a heads-up that this was a priority in his May 6, 2021 speech to the House Financial Services Committee (see HERE). Keeping in the market structure category, the SEC is considering amending the rules to shorten the standard settlement cycle. The historical t+3 was shortened to t+2 back in March 2017 (see HERE) and many believe that technology can currently handle t+1 with a goal of reaching simultaneous settlement (t+0).
Rounding out new items on the Agenda appearing on the proposed rule list include disclosure regarding beneficial ownership of swaps including interests in security-based swaps; cybersecurity risk governance which could enhance company disclosure requirements regarding cybersecurity risk; electronic submission of applicators for orders under the Advisors Act, confidential treatment requests for filings on Form 13F, and ADV-NR; open-end fund liquidity and dilution management; incentive-based compensation arrangements at certain financial institutions that have $1 billion or more in total assets; and portfolio margining of uncleared swaps and non-cleared security-based swaps.
Many items remain on the proposed list including mandated electronic filings increasing the number of filings that are required to be made electronically; potential amendment to Form PF, the form on which advisers to private funds report certain information about private funds to the SEC; electronic filing of broker-dealer annual reports, financial information sent to customers, and risk-assessment reports; and records to be preserved by certain exchange members, brokers and dealers.
Amendments to the transfer agent rules still remain on the proposed rule list although it has been four years since the SEC published an advance notice of proposed rulemaking and concept release on new transfer agent rules (see HERE). Former SEC top brass suggested that it would finally be pushed over the finish line last year, but so far it remains stalled (see, for example, HERE).
Another controversial item still appearing on the proposed rule stage list is enhanced listing standards for access to audit work papers and improvements to the rules related to access to audit work papers and co-audit standards. In June 2020, the Nasdaq Stock Market filed a proposed rule change to amend IM-5101-1, the rule which allows Nasdaq to use its discretionary authority to deny listing or continued listing to a company. The proposed rule change will add discretionary authority to deny listing or continued listing or to apply additional or more stringent criteria to an applicant based on considerations surrounding a company’s auditor or when a company’s business is principally administered in a jurisdiction that is a “restrictive market” (see HERE).
Bolstering Nasdaq’s position, the Division of Trading and Markets and the Office of the Chief Accountant are considering jointly recommending (i) amendments to Rule 2-01(a) of Regulation S-X to provide that only U.S. registered public accounting firms will be recognized by the SEC as a qualified auditor of an issuer incorporated or domiciled in non-cooperating jurisdictions for purposes of the federal securities laws, and (ii) rule amendments to enhance listing standards of U.S. national securities exchanges to prohibit the initial and continued listing of issuers that fail to timely file with the SEC all required reports and other documents, or file a report or document with a material deficiency, which includes financial statements not prepared by a U.S. registered public accounting firm recognized by the SEC as a qualified auditor.
It is not just the pre-rule stage that reflects a re-do of recently enacted rules. The disclosure of payments by resource extraction issuers (proposed rules published in December 2019 – see HERE and finalized in December 2020 (see HERE) is now on the proposed rule list to determine if additional amendments might be appropriate. Keeping with a seeming willingness to subject the marketplace to continued regulatory uncertainty, back on the proposed list is amendments to the rules regarding the thresholds for shareholder proxy proposals under Rule 14a-8. After years of discussion and debate, the SEC adopted much-needed rule changes in September 2020 (see HERE) which are now apparently back on the table. The complete proxy advisory rule changes (see HERE) are also back in play on the proposed rule list. Finally, amendments to the whistleblower program which had dropped off the list as completed, are now back on for further review.
Several items have moved from long term actions to the proposed rule stage. Executive compensation clawback (see HERE), which had been on the proposed rule list in Spring 2020 and then moved to long-term action, is back on the proposed list. Clawback rules would implement Section 954 of the Dodd-Frank Act and require that national securities exchanges require disclosure of policies regarding and mandating clawback of compensation under certain circumstances as a listing qualification. This topic has been batting around since 2015. Also, clawbacks of incentive compensation at financial institutions moved from long-term to proposed.
Also moved up from long-term action to proposed is corporate board diversity (although nothing has been proposed, it is a hot topic); reporting on proxy votes on executive compensation (i.e., say-on-pay – see HERE); amendments to the custody rules for investment advisors (which was moved from proposed to long term and now back to proposed); money market fund reforms; registration and regulation of security-based swap execution facilities; prohibitions of conflicts of interest relating to certain securitizations; broker-dealer liquidity stress testing, early warning, and account transfer requirements; and electronic filing of Form 1 by a prospective national securities exchange and amendments to Form 1 by national securities exchanges; Form 19b-4(e) by SROs that list and trade new derivative securities products; and short sale disclosure reforms.
Bouncing back to the proposed list from the long-term list in Fall after spending one semi-annual period on the proposed rule list are amendments to Rule 17a-7 under the Investment Company Act concerning the exemption of certain purchase or sale transactions between an investment company and certain affiliated persons.
Nine items are included in the final rule stage, down from 14 on the Fall Agenda, none of which are new to the Agenda. Implementation of Dodd-Frank’s pay for performance jumped from the long-term list where it had sat for years, to the final rule stage (see HERE). Establishing the form and manner with which security-based swap data repositories must make security-based swap data available to the SEC also jumped from a long-term action item to the proposed rule list. Likewise, amendments to the NMS Plan for the consolidated audit trail data security have been added.
Investment company summary shareholder report and modernization of certain investment company disclosures moved from the proposed to final rule stage, as did amendments to Regulation ATS for the registration of and reporting by alternative trading systems (ATS) for government securities.
Moving quickly from the proposed rule stage to final rule stage are the controversial amendments to the Rule 144 holding period and Form 144 filings. In December 2020, the SEC surprised the marketplace by proposing amendment to Rule 144, which would prohibit the tacking of a holding period upon the conversion of variably priced securities (see HERE. The responsive comments have been overwhelmingly opposed to the change, with only a small few in support and those few work together in plaintiff’s litigation against many variably priced investors. Many of the opposition comment letters are very well thought out and illustrate that the proposed change by the SEC may have been a knee-jerk reaction to a perceived problem in the penny stock marketplace. I wholly oppose the rule change and hope the SEC does not move forward. For more on my thoughts on the damage this change can cause, see HERE.
Still listed in the final rule stage is universal proxy process. Originally proposed in October 2016 (see HERE), the universal proxy is a proxy voting method meant to simplify the proxy process in a contested election and increase, as much as possible, the voting flexibility that is currently only afforded to shareholders who attend the meeting. Shareholders attending a meeting can select a director regardless of the slate the director’s name comes from, either the company’s or activist’s. The universal proxy card gives shareholders, who vote by proxy, the same flexibility. The SEC re-opened comments on the rule proposal in April 2021 (see HERE). Although things can change, final action is currently slated for October 2021.
Also, still in the final rule stage are filing fee processing updates including changes to disclosures and payment methods (proposed rules published in October 2019); and an amendment to the definition of clearing agency for certain activities of security-based swaps dealers.
Seventeen items are listed as long-term actions, down from the 32 that were on the Fall list, including many that have been sitting on the list for years and one that is new. Although the already implemented amendments to the proxy process and rules are under new review as discussed above, additional proxy process amendments dropped from the proposed list to a long-term action item. New to the list in long-term action is investment company securities lending arrangements.
Continuing their tenure on the long-term list is conflict minerals amendments; stress testing for large asset managers; custody rules for investment companies; requests for comments on fund names; amendments to improve fund proxy systems; end user exception to mandatory clearing of security-based swaps; removal of certain references to credit ratings under the Securities Exchange Act of 1934; definitions of mortgage-related security and small-business-related security; additional changes to exchange-traded products; amendments to Rules 17a-25 and 13h-1 following creation of the consolidated audit trail (part of Regulation NMS reform); credit rating agencies’ conflicts of interest; amendments to requirements for filer validation and access to the EDGAR filing system and simplification of EDGAR filings; amendments to municipal securities exemption reports; and amendment to reports of the Municipal Securities Rulemaking Board.
Several items have dropped off the Agenda as they have now been implemented and completed, including amendments to the Investment Advisors Act of 1940 regarding investment adviser advertisements and compensation for solicitation; use of derivatives by registered investment companies and business development companies; market data infrastructure, including market data distribution and market access; and amendments to the SEC’s Rules of Practice.
Moved from the proposed rule stage to a long-term action item are proposed changes to Rule 701 (the exemption from registration for securities issued by non-reporting companies pursuant to compensatory arrangements) and Form S-8 (the registration statement for compensatory offerings by reporting companies). In May 2018, SEC amended the rules and issued a concept release (see HERE and HERE). In November 2020, the SEC proposed new rules to modernize Rule 701 and S-8 and to expand the exemption to cover workers in the modern-day gig economy. This no longer seems to be a priority.
Dropped from the Agenda are amendments to Form 13F filer thresholds. Amendments to the 13F filer thresholds were proposed in July 2020, increasing the threshold for the first time in 45 years. Surprisingly, the proposal was met with overwhelming pushback from market participants. There were 2,238 comment letters opposing the change and only 24 in support. Although the SEC continues to recognize that the threshold is outdated, it seems to be focusing on other, more pressing matters.
Other items dropped from the Agenda without action include amendments to asset-backed securities disclosures (last amended in 2014); earnings releases and quarterly reports were on the fall 2018 pre-rule list, moved to long-term on the Spring 2019 list and up to proposed in Fall 2019 and Spring 2020 back down to long-term in Fall 2020 and now has been dropped altogether. The SEC solicited comments on the subject in December 2018 (see HERE), but has yet to publish proposed rule changes and is clearly not making this topic a top priority.
Also dropped without action is amendments to Guide 5 on real estate offerings and Form S-11 (though some changes were made in relation to the acquisition of businesses by blind pools); and amendments to the family office rule (though I expect this will be partly covered by the item on the proposed list related to disclosure regarding beneficial ownership of swaps including interests in security-based swaps).
In January, NYSE Regulation sent out its yearly Compliance Guidance Memo to NYSE American listed companies. Although we are already halfway through the year, the annual letter has useful information that remains timely. As discussed in the Compliance Memo, the NYSE sought SEC approval to permanently change its shareholder approval rules in accordance with the temporary rules enacting to provide relief to listed companies during Covid. The SEC approved the amended rules on April 2, 2021.
Amendment to Shareholder Approval Rules
The SEC has approved NYSE rule changes to the shareholder approval requirements in Sections 312.03 and 312.04 of the NYSE Listed Company Manual (“Manual”) and the Section 314 related party transaction requirements. The rule changes permanently align the rules with the temporary relief provided to listed companies during Covid (for more on the temporary relief, see HERE
Prior to the amendment, Section 312.03 of the Manual prohibited certain issuances to (i) directors, officers or substantial shareholders (related parties), (ii) a subsidiary, affiliate, or other closely related person of a related party; or (iii) any company or entity in which a related party has a substantial direct or indirect interest. In particular, related party issuances were prohibited if the number of shares of common stock to be issued, or if the number of shares of common stock into which the securities may be convertible or exercisable, exceeds either 1% of the number of shares of common stock or 1% of the voting power outstanding before the issuance. The rule had limited exception if the issuances were for cash, above a minimum price, no more than 5% of the outstanding common stock and the related party was a related party solely because it is a substantial shareholder of the company.
The amended rules modify the class of persons for which shareholder approval would be required prior to an issuance. The amended rules only require shareholder approval prior to issuances to directors, officers and substantial shareholders. The restriction on a subsidiary, affiliate, or other closely related person of a related party or any company or entity in which a related party has a substantial direct or indirect interest has been removed. In addition, the amended rule broadens the exception such that all cash sales at or above the minimum price would be exempted. Other provisions of the NYSE rules may still require shareholder approval prior to issuances to officers and directors, such as the equity compensation rules that require shareholder approval for issuances to employees, officers, directors and service providers.
The amendment also adds a provision whereby shareholder approval is required prior to any acquisition transaction or series of related transactions in which any related party has a 5% or greater interest (or such persons collectively have a 10% or greater interest), directly or indirectly, in the company or assets to be acquired or in the consideration to be paid in the transaction and the present or potential issuance of common stock, or securities convertible into common stock, could result in an increase in either the number of shares of common stock or voting power outstanding of 5% or more before the issuance.
The amendments more closely align the NYSE rules with those of the NYSE American and Nasdaq. For a review of the NYSE American and Nasdaq rules for affiliate issuances associated with acquisitions, see HERE. For a review of the NYSE American and Nasdaq rules governing equity compensation shareholder approval requirements, see HERE.
The NYSE has also amended its 20% Rule. In particular, NYSE Section 312.03(c) requires shareholder approval of any transaction relating to 20% or more of the company’s outstanding common stock or voting power outstanding before such issuance but provides the following exceptions: (i) any public offering for cash; and (ii) any bona fide private financing involving a cash sale of the company’s securities that comply with the minimum price requirement. A “bona fide private financing” referred to a sale in which either: (i) a registered broker-dealer purchases the securities from the issuer with a view to the private sale of such securities to one or more purchasers; or (ii) the issuer sells the securities to multiple purchasers, and no one such purchaser, or group of related purchasers, acquires, or has the right to acquire upon exercise or conversion of the securities, more than 5% of the shares of the issuer’s common stock or voting power before the sale.
Under the amended rules, the NYSE has replaced the term “bona fide financing” with “other financing (that is not a public offering for cash) in which the company is selling securities for cash.” This change eliminated the requirement that the issuer sell the securities to multiple purchasers, and that no one such purchaser, or group of related purchasers, acquires more than 5% of the issuer’s common stock or voting power. Also, under the rule change, the provision related to broker-dealer purchases becomes moot.
Of course, the new rules would not eliminate shareholder voting requirements under other NYSE rules such as the acquisition rules where the issuance equals or exceeds 20% of the common stock or voting power. Like the affiliate rule change, the amendment is meant to further align NYSE rules with those of the NYSE American and Nasdaq. For a review of the NYSE American and Nasdaq 20% rules, see HERE.
The NYSE has also made a change to Section 314 of the Manual requiring related party transactions to be reviewed by the audit committee. The Exchange has updated the definition of “related party” from officers, directors and principal shareholders to align with the definition provided in Item 404 of Regulation S-K of the Exchange Act.
Annual Compliance Guidance Memo
The NYSE Memo provides a list of important reminders to all exchange listed companies, starting with the requirement to provide a timely alert of all material news. Listed companies may comply with the NYSE’s Timely Alert/Material News policy by disseminating material news via a press release or any other Regulation FD compliant method. For news being released between 7:00 a.m. and 4:00 p.m. EST, a company must call the NYSE’s Market Watch Group (i) ten minutes before the dissemination of news that is deemed to be of a material nature or that may have an impact on trading in the company’s securities; or (ii) at the time the company becomes aware of a material event having occurred and take steps to promptly release the news to the public and provide a copy of any written form of that announcement at the same time via email.
For news releases outside the hours of 7:00 a.m. and 4:00 p.m. EST companies are generally not required to call the Exchange in advance of issuing news, although companies should still provide a copy of material news once it is disclosed, by submitting it electronically through Listing Manager or via e-mail to email@example.com. Where the news is related to a dividend or stock distribution, advance notice must be provided regardless of the time of the announcement either by a call within operating hours or in writing after hours.
The requirement to provide the exchange with advance notice of the public release of information also applies to verbal information such as part of a management presentation, investor call or investor conference. In practice, companies usually file their scripts and any presentation materials via a Form 8-K immediately prior to the verbal release of information.
Between the hours of 9:25 a.m. and 4:00 p.m. EST, NYSE will determine if a temporary trading halt should be implemented to allow the market time to fully absorb the news. Between the hours of 7:00 a.m. and 9:25 a.m. EST, NYSE will implement news pending trading halts only at the request of the company.
Companies are prohibited from publishing material news after the official closing time for the NYSE’s trading session until the earlier of 4:05 p.m. EST or the publication of the official closing price of the listed company’s security. This requirement is designed to alleviate confusion caused by price discrepancies between trading prices on other markets after the NYSE official closing time, which is generally 4:00 p.m. EST, and the NYSE closing price upon completion of the auction, which can be after 4:00 p.m. EST.
NYSE notes that a change in the earnings announcement date can sometimes affect the trading price of a company’s stock and/or related securities and those market participants who are in possession of this information before it is broadly disseminated may have an advantage over other market participants. Consequently, listed companies are required to promptly and broadly disseminate to the market, news of the scheduling of their earnings announcements or any change in that schedule and to avoid selective disclosure of that information prior to its broad dissemination. The purpose of these rules is to prevent insider trading or even a jump-start advantage to trading on material information.
The compliance letter also addresses the following matters:
Annual Meeting Requirements – If an annual meeting is postponed or adjourned, such as if quorum is not reached, the company will not be in compliance with Section 302 of the Manual, which requires that a company hold an annual meeting during each fiscal year.
Record Date Notification – To participate in shareholder meetings as well as receive company distributions and other important communications, investors must hold their securities on the relevant record date established by the listed company. For this reason, the NYSE disseminates record date information to the marketplace so that investors can plan their holdings accordingly. Listed companies are required to notify the NYSE at least ten calendar days in advance of all record dates set for any purpose or changes to a set date. Record dates should be set for business days. A press release or filing with the SEC cannot satisfy the notice requirements. The NYSE has no power to waive these requirements and so, if notice is not provided to NYSE as required, a record date may have to be reset.
Redemption and Conversion of Listed Securities – Advance notice must be provided to the NYSE of any call redemptions or conversions of a listed security. The NYSE tracks redemptions and conversions to ensure that any reduction in securities outstanding does not result in noncompliance with the Exchange’s distribution and market capitalization continued listing standards. Also, the NYSE relies on a listed company’s transfer agent or depositary bank to report share information. Transfer agents are required to report shares no later than the 10th day following the end of each calendar quarter.
Annual Report Website Posting Requirement – Section 203.01 of the Manual requires that a company post its annual report on its website simultaneously with the filing of the report with the SEC. A listed company that is not required to comply with the SEC proxy rules (such as foreign issuers) must also post a prominent undertaking on its website to provide all holders the ability, upon request, to receive a hard copy of the complete audited financial statements free of charge; and issue a press release that discloses that the Form 10-K, 20-F, 40-F or N-CSR has been filed with the SEC, includes the company’s website, and indicates that shareholders have the ability to receive hard copy of the complete audited financial statements free of charge upon request.
Corporate Governance Requirements – All listed companies must file an annual affirmation that it is in compliance with the corporate governance requirements. The affirmation must be filed no later than 30 days after the company’s annual meeting and if no meeting is held, 30 days after the filing of its annual report (10-K, 20-F, 40-F or N-CSR) with the SEC. In addition, a listed company must file an Interim Written Affirmation promptly (within 5 business days) after any triggering event specified on that form. Domestic companies are not required to submit an Interim Written Affirmation for changes that occur within 30 days after the annual meeting, as these can be included in the Annual Written Affirmation.
Transactions Requiring Supplemental Listing Applications – A company is required to file a Listing of Additional Securities (“LAS”) application to obtain authorization from the NYSE for a variety of corporate events, including (i) the issuance or reserve for issuance of additional shares of a listed security; (ii) the issuance or reserve for issuance of additional shares of a listed security that are issuable upon conversion of another security; (iii) change in corporate name, state of incorporation or par value; and/or (iv) the listing of a new security (such as preferred stock or warrants). No additional securities can be issued until the NYSE authorizes the LAS. Moreover, authorization is required whether the securities will be issued privately or through a registration and even if conversion is not possible until some future date. Authorization takes approximately 2 weeks.
Broker Search Cards – SEC Rule 14a-13 requires any company soliciting proxies in connection with a shareholder meeting to send a search card to any entity that the company knows is holding shares for beneficial owners. The search card must be sent: (i) at least 20 business days before the record date for the annual meeting; or (ii) such later time as permitted by the rules of the national exchange on which the securities are listed. The NYSE American does not have any rules allowing for a later search card and accordingly, all listed companies must comply with the Rule 14a-13 20-day requirement.
NYSE Rule 452, Voting by Member Organizations – The Exchange reviews all listed company proxy materials to determine whether NYSE American member organizations that hold customer securities in “street name” accounts as brokers are allowed to vote on proxy matters without having received specific client instructions. The Exchange recommends that listed companies submit their preliminary proxies for preliminary, confidential review.
Shareholder Approval and Voting Rights Requirements – Sections 303A.08 and 312.03 of the Manual outline the Exchange’s shareholder approval requirements including the 20% rules. Listed companies are strongly encouraged to consult the Exchange prior to entering into a transaction that may require shareholder approval including, but not limited to, the issuance of securities: (i) with anti-dilution price protection features; (ii) that may result in a change of control; (iii) to a related party; (iv) in excess of 19.9% of the pre-transaction shares outstanding; and (v) in an underwritten public offering in which a significant percentage of the shares sold may be to a single investor or to a small number of investors (as this may be deemed a private offering requiring approval).
Listed companies are also encouraged to consult the Exchange prior to entering into a transaction that may adversely impact the voting rights of existing shareholders of the listed class of common stock, as such transactions may violate the Exchange’s voting rights. Examples of transactions which adversely affect the voting rights of shareholders of the listed common stock include transactions which result in a particular shareholder having: (i) board representation that is out of proportion to that shareholder’s investment in the company; or (ii) special rights pertaining to items that normally are subject to shareholder approval under either state or federal securities laws, such as the right to block mergers, acquisitions, disposition of assets, voluntary liquidation, or certain amendments to the company’s organizational/governing documents.
Voting Requirements for Proposals at Shareholder Meetings – Section 312.07 of the Manual provides that, where shareholder approval is required under NYSE rules, the minimum vote that constitutes approval for such purposes is approval by a majority of votes cast (i.e., the number of votes cast in favor of the proposal exceeds the aggregate of votes cast against the proposal plus abstentions).
Nasdaq has long been a proponent of environmental, social and governance (ESG) disclosures and initiatives, having published a guide for listed companies on the subject over six years ago (see HERE). In December 2020, Nasdaq took it a step further and proposed a rule which would require listed companies to have at least one woman on their boards, in addition to a director who is a racial minority or one who self-identifies as lesbian, gay, bisexual, transgender or queer. Companies that don’t meet the standard would be required to justify their decision to remain listed on Nasdaq. To help facilitate the proposed rule, Nasdaq has also proposed to offer a complimentary board recruiting solution. A final decision on the proposals is expected this summer.
The SEC recently extended the consideration period and will either approve or disapprove the proposal by August 8, 2021. The newest Regulatory Flex Agenda which was published last week and will be a topic of a future blog, included the subject in proposed rule making stage with action slated by October 2021. Its anyone’s call where this will land. The current SEC regime is more likely to pass a rule than previous administrations but there is still significant pushback. The SEC could also kick the can down the road and ask Nasdaq to strengthen the data backing its proposal.
Nasdaq Proposed Board Diversity Rule
Nasdaq proposes to adopt Rule 5605(f) to the corporate governance requirements for listing and continued listing which would require Nasdaq listed companies, subject to certain exceptions, to: (i) to have at least one director who self identifies as a female, and (ii) have at least one director who self-identifies as Black or African American, Hispanic or Latinx, Asian, Native American or Alaska Native, Native Hawaiian or Pacific Islander, two or more races or ethnicities, or as LGBTQ+, or (iii) explain why the company does not have at least two directors on its board who self-identify in the categories listed above.
Nasdaq also proposed to add to its list of services for listed companies to provide a complimentary board recruiting solution to help advance diversity on company boards. The service would provide companies that have not yet achieved a certain level of diversity with one-year complimentary access for two users to a board recruiting solution, which will provide access to a network of board-ready diverse candidates, allowing companies to identify and evaluate diverse board candidates, and a tool to support board benchmarking. To access the service a listed company must make a request on or before December 1, 2022.
The rule would also require Nasdaq listed companies to disclose statistical information regarding its board’s diversity. Statistical information will be required in an annual report or proxy statement, or on the company’s website. Although not required, the proposed rule encourages disclosure of other diverse attributes such as nationality, disability or veteran status. It could be that a company’s reasoning for not having board members that specifically fit the diverse attributes in the rule, is that it has otherwise a diverse board composition based on other considerations. Under the proposed rule Nasdaq will not assess the substance of an explanation but would just verify that the company has provided one.
Foreign issuers will be required to disclose the gender of board members; voluntary disclosure of LGBTQ+ status; and information regarding underrepresented groups in their home jurisdiction. Also, foreign issuers will be required to have at least two diverse directors including at least one female. Both foreign issuers and smaller reporting companies may satisfy the two diverse director requirements by having two female directors.
The following types of companies would be exempt from the requirements: (i) SPACs; (ii) asset backed issuers; (iii) cooperatives; (iv) limited partnerships; (v) management investment companies; (vi) issuers of non-voting preferred securities, debt securities or derivative securities; and (vii) ETFs and similar funds.
If adopted, the Rule would provide each company with one calendar year from adoption to comply with the Rule’s requirement to provide statistical information disclosures. A company that goes public via a business combination with a SPAC, an IPO, a direct listing, a transfer from another exchange or an uplisting from the OTC Markets would have one year to comply with the disclosure requirements. Failure to provide the disclosure would result in a listing deficiency with the ability to submit a plan for cure and to cure within 180 days. Ultimate non-compliance could result in delisting.
A company would have two calendar years to have, or explain why it does not have, at least one diverse director. A Nasdaq Global Select or Global Market listed company would then have four calendar years to either have, or explain why it does not have, at least two diverse directors and a Nasdaq Capital Markets listed company would have five calendar years.
Purpose of the Proposed Rule
Simply put, Nasdaq is of the view that diversity in the board room equates to good corporate governance. They believe that increased diversity brings fresh perspectives, improved decision making and oversight and strengthened internal controls. Further, Nasdaq asserts that the increased focus on diversity by companies, investors, legislators and corporate governance organizations provides evidence that investor confidence is enhanced by greater board diversity. In conducting an internal study on diversity amongst listed companies, Nasdaq found they fell short and that a regulatory impetus would help.
Nasdaq’s rule proposal indicates it conducted extensive research including reviewing a substantial body of third-party research and conducting interviews. Among the questions it sought to answer were (i) whether there is empirical evidence to support the proposition that board diversity increases shareholder value, investor protections and board decision-making; (ii) investors interest in board diversity information; (iii) the current state of board diversity and disclosure; (iv) causes of underrepresentation; (v) various approaches to encourage board diversity; and (vi) the success of approaches taken by other groups, both domestic and foreign.
Clearly Nasdaq is confident that the answers to these questions support not only the value of board diversity and related disclosure, but the value of regulations requiring same. In addition to the results of its studies, Nasdaq cites the increasing call for diversity by large institutional investors such as Vanguard and BlackRock in their corporate engagement and proxy guidelines. Nasdaq also believes that the SEC disclosure regime supports disclosure requirements in this context.
The 127-page Nasdaq proposed rule release contains an in-depth discussion of Nasdaq’s research, findings, and conclusions. Nasdaq also presents counter-information. There is a lack of studies or information of the association between LGBTQ+ diversity and board representation, stock or other financial performance. Many studies support a correlation between women on the board and increased earnings and other financial metric performance, but some also show a lack of correlation between the two. Studies which include other factors, such as strong shareholder rights, show a decreasing impact of diversity to performance.
Interestingly, I believe it is the non-financial aspects, including investor protections (through increased internal controls, public disclosure and management oversight) and confidence, that are compelling Nasdaq to put forth the proposed rule. As it states in its release “[A]t a minimum, Nasdaq believes that the academic studies support the conclusion that board diversity does not have adverse effects on company financial performance.” Moreover, as most directors are chosen from the current directors and C-Suite executive’s social and business network, without a compelling reason to search elsewhere, such as regulatory compliance, a natural impediment to increased diversity will remain.
Although Nasdaq’s finding and arguments are compelling, I remain on the fence as to whether regulatory action setting quotas is appropriate. Certainly, in today’s environment, there is a strong faction of support for the rule and for improvement in diversity in business as a whole. As a woman, I of course support diversity in business and the boardroom. Where I am on the fence regarding the quota issue, I support the disclosure aspects of the proposed rule. Transparency and disclosure on the topic will only provide better information to make sound decisions moving forward.
Board Diversity – Beyond Nasdaq
Putting aside Nasdaq’s rule publication, a lot of groups and thought leaders have been tackling the question of whether board diversity is a benefit or detriment to corporations with thorough arguments to support both sides of the fence. Board composition is consistently one of the most important topics on the agenda for shareholder engagement, and voting.
Harvard Law Professor Jesse Fried has publicly questioned the empirical value of Nasdaq’s board diversity proposal. Also, University of MN Law Professor and former chief White House ethics lawyer Richard Painter wrote a thorough rebuttal to Nasdaq’s findings. That rebuttal was met with its own rebuttal’s pointing out the lack of, and age, of the data presented. It seems one of the best sources of information is California which imposed a board diversity obligation on corporations domiciled in the state two years ago. Since enactment of the statute there has been a significant increase of women on the boards of California entities, though other minorities, including women of color, continue to lag.
Getting ahead of this year’s proxy season, Glass Lewis published an in-depth report on Board Gender Diversity with an overview of where things stand in the U.S. and internationally, investor and state efforts to promote balance in the boardroom, and academic research on the benefits of diversity. Glass Lewis recognizes the complexity of the issue and the recruiting involved to find uniquely qualified directors who bring a breadth of experience and insight to the board table. Simply adding women to the board for diversity’s sake and without careful consideration of qualifications and experience is unlikely to automatically effect any positive corporate change. With that said, the report also concludes that bringing women and diverse board members will add to the overall viewpoints and knowledge base of a board thereby improving corporate performance.
Many companies are not waiting for a rule to increase diversity disclosure. To help stakeholders compare disclosure practices, KPMG recently launched a free new web-based tool that tracks disclosure about board diversity. The software compares disclosure practices by sector, index (Russell 3000 and S&P 500) and company size. There are several comparative publications as well with one by Deloitte and the Alliance for Board Diversity including information through 2020.
The voluntary increase in disclosure comes, at least partially, from pressure by institutional investors which have been vocal on the subject. In 2020 many of those entities promised to put their views to action by increasing diversity in their own house. The data is not in yet as to whether specific vocal proponents of diversity have made significant internal changes, but some are putting on a better show than others. The Carlyle Group announced a new policy calling for at least one candidate who is Black, Latino, Pacific Islander or Native American to be interviewed for every new position and that at least 30% of its portfolio companies will have ethnic diversity on the board of directors.
Besides investor financial incentives, D&O insurers have started to include diversity practices among the many considerations in granting and pricing liability policies.
As required by the Dodd-Frank Act, in December 2020, the SEC adopted final rules requiring require resource extraction companies to disclose payments made to foreign governments or the U.S. federal government for the commercial development of oil, natural gas, or minerals. The last version of the proposed rules were published in December 2019 (see HERE )The rules have an interesting history. In 2012 the SEC adopted similar disclosure rules that were ultimately vacated by the U.S. District Court. In 2016 the SEC adopted new rules which were disapproved by a joint resolution of Congress. In December 2019, the SEC took its third pass at the rules that were ultimately adopted.
The final rules require resource extraction companies that are required to file reports under Section 13 or 15(d) of the Securities Exchange Act of 1934 (“Exchange Act”) to disclose payments made by it or any of its subsidiaries or controlled entities, to the U.S. federal government or foreign governments for the commercial development of oil, natural gas, or minerals.
The Dodd-Frank Act added Section 13(q) to the Exchange Act directing the SEC to issue final rules requiring each resource extraction issuer to include in an annual report information relating to any payments made, either directly or through a subsidiary or affiliate, to a foreign government or the federal government for the purpose of the commercial development of oil, natural gas, or minerals. The information must include: (i) the type and total amount of the payments made for each project of the resource extraction issuer relating to the commercial development of oil, natural gas, or minerals, and (ii) the type and total amount of the payments made to each government.
As noted above, the first two passes at the rules by the SEC were rejected. The 2016 Rules provided for issuer-specific, public disclosure of payment information broadly in line with the standards adopted under other international transparency promotion regimes. In early 2017, the President asked Congress to take action to terminate the rules stemming from a concern on the potential adverse economic effects. In particular, the rules were thought to impose undue compliance costs on companies, undermine job growth, and impose competitive harm to U.S. companies relative to foreign competitors. The rules were also thought to exceed the SEC authority.
The final rules make many significant changes to the rejected 2016 rules. In particular, the final rules: (i) revise the definition of project to require disclosure at the national and major subnational political jurisdiction as opposed to the contract level; (ii) amend the definition of “not de minimis” to mean any payment or series of related payments that equals or exceeds $100,000; (iii) add two new conditional exemptions for situations in which a foreign law or a pre-existing contract prohibits the required disclosure; (iv) add an exemption for smaller reporting companies and emerging growth companies; (v) revise the definition of “control” to exclude entities or operations in which an issuer has a proportionate interest; (vi) limit disclosure liability by deeming the information to be furnished and not filed with the SEC; (vii) permit an issuer to aggregate payments by payment type made but require disclosure of aggregated amounts for each subnational government payee and identify each subnational government payee; (viii) add relief for companies that recently completed a U.S. IPO; and (ix) extend the deadline for furnishing the payment disclosures.
The rules add a new Exchange Act Rule 13q-1 and amend Form SD to implement Section 13(q). Under the rules, a “resource extraction issuer” is defined as a company that is required to file an annual report with the SEC on Forms 10-K, 20-F or 40-F. Accordingly, Regulation A reporting companies and those required to file an annual report following a Regulation Crowdfunding offering are not covered. Moreover, smaller reporting companies and emerging growth companies are exempted. However, if the SRC or EGC is subject to disclosure requirements by an alternative reporting regime will have to report on a scaled basis.
The rules define “commercial development of oil, natural gas, or minerals” as exploration, extraction, processing, and export of oil, natural gas, or minerals, or the acquisition of a license for any such activity. The definition of “commercial development” captures only those activities that are directly related to the commercial development of oil, natural gas, or minerals, and not activities ancillary or preparatory to such commercial development. The definition of “commercial development” captures only those activities that are directly related to the commercial development of oil, natural gas, or minerals, and not activities ancillary or preparatory to such commercial development. The SEC intends to keep the definition narrow to reduce compliance costs and negative economic impact.
Likewise, the definitions of “extraction” and “processing” are narrowly defined and do not include downstream activities such as refining or smelting. “Export” is defined as the transportation of a resource from its country of origin to another country by an issuer with an ownership interest in the resource. Companies that provide transportation services, without an ownership interest in the resource, are not covered.
Under Section 13(q) a “payment” is one that: (i) is made to further the commercial development of oil, natural gas or minerals; (ii) is not de minimis; and (iii) includes taxes, royalties, fees, production entitlements, bonuses, and other material benefits. The rules define payments to include the specific types of payments identified in the statute, as well as community and social responsibility payments that are required by law or contract, payments of certain dividends, and payments for infrastructure. Furthermore, an anti-evasion provision is included such that the rules require disclosure with respect to an activity or payment that, although not within the categories included in the rules, is part of a plan or scheme to evade the disclosure required under Section 13(q).
A “project” is defined using three criteria: (i) the type of resource being commercially developed; (ii) the method of extraction; and (iii) the major subnational political jurisdiction where the commercial development of the resource is taking place. A resource extraction issuer will have to disclose whether the project relates to the commercial development of oil, natural gas, or a specified type of mineral. The disclosure would be at the broad level without the need to drill down further on the type of resource. The second prong requires a resource extraction issuer to identify whether the resource is being extracted through the use of a well, an open pit, or underground mining. Again, additional details are not required. The third prong requires an issuer to disclose only two levels of jurisdiction: (1) the country; and (2) the state, province, territory or other major subnational jurisdiction in which the resource extraction activities are occurring.
Under the rules, a “foreign government” is defined as a foreign government, a department, agency, or instrumentality of a foreign government, or a company at least majority owned by a foreign government. The term “foreign government” includes a foreign national government as well as a foreign subnational government, such as the government of a state, province, county, district, municipality, or territory under a foreign national government. On the other hand, “federal government” refers to the government of the U.S. and does not include subnational governments such as states or municipalities.
The annual report on Form SD must disclose: (i) the total amounts of the payments by category; (ii) the currency used to make the payments; (iii) the financial period in which the payments were made; (iv) the business segment of the resource extraction company that made the payments; (v) the government that received the payments and the country in which it is located; and (vi) the project of the resource extraction business to which the payments relate. Under the rules, Form SD expressly states that the payment disclosure must be made on a cash basis instead of an accrual basis and need not be audited. The report covers the company’s fiscal year and needs to be filed no later than nine months following the fiscal year-end. The Form SD must include XBRL tagging.
As noted above, the rule includes two exemptions where disclosure is prohibited by foreign law or pre-existing contracts. In addition, the rules contain a targeted exemption for payment related to exploratory activities. Under this targeted exemption, companies will not be required to report payments related to exploratory activities in the Form SD for the fiscal year in which payments are made, but rather could delay reporting until the following year. The SEC adopted the delayed approach based on a belief that the likelihood of competitive harm from the disclosure of payment information related to exploratory activities diminishes over time.
Finally, the rule allows a similar delayed reporting for companies that are acquired and for companies that complete their first U.S. IPO. When a company is acquired, payment information related to that acquired entity does not need to be disclosed until the following year. Similarly, companies that complete an IPO do not have to comply with the Section 13(q) rules until the first fiscal year following the fiscal year in which it completed the IPO.
The ESG debate continues, including within the SEC and amongst other regulators and industry participants. Firmly in support of ESG disclosures, and especially climate change matters, is SEC Chair Gary Gensler and Commissioner Allison Herren Lee, while opposing additional regulation is Commissioners Eliad L. Roisman and Hester M. Peirce. Regardless of whether new regulations are enacted (I firmly believe they are forthcoming), like all SEC disclosure items, the extent of disclosure will depend upon materiality.
The U.S. Supreme Court’s definition of materiality is that information should be deemed material if there exists a substantial likelihood that it would have been viewed by the reasonable investor as having significantly altered the total mix of information available to the public [TSC Industries, Inc. v. Northway, Inc.]. The concept of materiality represents the dividing line between information reasonably likely to influence investment decisions and everything else.
Rule 405 of the Securities Act defines “material” as “[T]he term material, when used to qualify a requirement for the furnishing of information as to any subject, limits the information required to those matters to which there is a substantial likelihood that a reasonable investor would attach importance in determining whether to purchase the security registered.”
Despite the case law and statutory definition, the concept remains fact-driven and difficult to apply. There are no numeric thresholds to establish materiality, and market reaction is inconsistent and not always available. Ultimately professionals and company management must consider all facts and circumstances available to them on any given day to determine the materiality of a given disclosure. The SEC has been consistent in its description of materiality for purposes of disclosure in all of its guidance, commentary and rule releases. Information is material if there is a substantial likelihood that a reasonable investor would consider it important in deciding how to vote or make an investment decision, or put another way, if the information would alter the total mix of available information.
In its recent request for public comment on climate change disclosure, the SEC sought input on, among other items, what disclosure would be material to an investment or voting decision. Likewise, the SEC’s 2010 Climate Disclosure Guidance seeks disclosure of material information. Although some environmental disclosures are prescriptively required by Regulation S-K or S-X, climate matters would be disclosable if they fell under the general materiality bucket of information (i.e., such further material information, if any, as may be necessary to make the required statements, in light of the circumstances under which they are made, not misleading) (see for more information on the request for comment and 2010 guidance HERE.
In determining materiality, practitioners need to consider Regulation FD, which prohibits the selective disclosure of material information. Regulation FD requires that if material information is to be disclosed, it must be disclosed to the entire market, either through a press release or Form 8-K or both, and not selectively, such as to certain analysts or market professionals.
In May 2021 Commissioner Allison Herren Lee gave a speech on ESG disclosures expressing her well known support for disclosure. As the concept of materiality has arisen as a gating question in the need for ESG disclosure, Ms. Lee focused on that concept in her speech. Beginning with the inarguable position that materiality is based on “information that is important to reasonable investors,” she posits that management, lawyers and accountants often get it wrong. Rather, she believes that a “disclosure system that lacks sufficient specificity and relies too heavily on a broad-based concept of materiality will fall short of eliciting information material to reasonable investors.”
Ms. Lee continues that despite this concept of materiality, she does not believe that the disclosure rules are, or should be, constrained by materiality. She points to many prescriptive disclosure requirements that are not guided by materiality, such as related party transactions, share repurchases and executive compensation – which leads to ESG disclosures. Commissioner Lee believes that ESG is material in and of itself and thus disclosure is required. She continues that “investors, the arbiters of materiality, have been overwhelmingly clear in their views that climate risk and other ESG matters are material to their investment and voting decisions.”
This is where I put the brakes on. SEC disclosures are not meant to provide specific factions of, or for that matter any faction of, investors with particular disclosures. Rather, the standard is well settled that disclosures are meant to provide a “reasonable investor” with information useful in making decisions (investment, voting, etc.). The test is objective. The SEC should not be catering to particular factions on investors, especially on a clearly partisan political subject. That doesn’t mean that I am opposed to climate change disclosures, but rather, that I don’t agree the rulemaking on such disclosures should deviate from the long-standing objective principals of materiality.
More on ESG and Climate Change Disclosures
The SEC request for public comment has been met with an enthusiastic response on both sides of the fence. However, as many great thinkers are pointing out, although the view that climate change will impact society is fairly accepted, the view that it will impact specific economic sectors, is far less so. For a financial regulator like the SEC, that discrepancy between societal costs and costs to public companies and markets creates a potential disconnect.
On June 3, 2021, Commissioner Elad L. Roisman gave a poignant speech on ESG disclosure, and its inevitable costs. Mr. Roisman is vocally against the SEC issuing prescriptive, line-item disclosure requirements on ESG matter and in particular environmental and social issues. Echoing prior speeches by former Chair Jay Clayton, Mr. Roisman states the obvious that standardization is extremely difficult. The data is imprecise and fraught with political motivations.
Commissioner Roisman is focused on the costs of disclosure. The SEC has a mandate to consider the costs of compliance with any new regulations. Certainly, companies would incur costs in obtaining and presenting the new information and liability for the adequacy of such information. To counter some of these costs, Roisman suggests (i) scaled disclosure for smaller reporting companies; (ii) flexibility in methodologies in fashioning disclosure (for example, a company’s ability to calculate Scope 3 greenhouse emissions depends on it gathering information from sources wholly outside the company’s control, both upstream and downstream from its organizational activities and can be daunting and expensive); (iii) safe harbors similar to forward looking statements disclaimers to reduce litigation risks; (iv) allow disclosures to be furnished not filed; and (v) an extended implementation period.
He also poses basic structural questions such as what standards would the SEC use; if they rely on third parties, how will those standards be monitored and supervised going forward (especially if that party changes political views); and is the SEC the best regulator to require disclosures, especially related to the external impact a company has on society/the environment (as opposed to the potential impact on the company itself).
Staying true to form, Commissioner Hester M. Peirce made a pragmatic and pointed statement on ESG disclosures. Ms. Peirce points out that “[T]he task before us is to find a way to bring about lasting, positive change to our countries on a range of issues without sacrificing in the process the very means by which so many lives have been enriched and bettered.” Ms. Peirce also takes aim at the push to follow European disclosure requirements and to create a comprehensive international disclosure regime. However, ESG factors are complex, evolving and not readily comparable across issuers and industries. Peirce notes that “[T]he European concept of ‘double materiality’ has no analogue in our regulatory scheme and the addition of specific ESG metrics, responsive to the wide-ranging interests of a broad set of ‘stakeholders,’ would mark a departure from these fundamental aspects of our disclosure framework.” Clearly, the U.S. capital markets are number one for a reason and an international homogenous disclosure system is likely to impose new costs on public companies, decrease the attractiveness of our capital markets, distort the allocation of capital, and undermine the role of shareholders in corporate governance.
Turning back to the SEC request for comments, one such comment letter response submitted by UVA law professors Paul and Julia Mahoney, argues that the movement to require disclosure is being led by institutions whose purpose is in part “to pursue public policy goals outside the normal political process,” and whose statements asserting the supposed financial value of ESG are “cheap talk that conveys no information other than that the institution wants the SEC to require the disclosures.” The article suggests that by requirement disclosure the SEC “risks eroding public trust in its capacity and willingness to serve as an apolitical, technocratic regulator of the capital markets.”
Realizing that climate change disclosures are likely forthcoming, the Securities Industry and Financial Markets Association (SIFMA) advocates for the SEC to start slowly with climate change disclosures and hold off on other ESG matters. SIFMA suggests requiring disclosures of metrics related to greenhouse gas emissions and so-called carbon footprints based on a materiality standard and principles approach.
Illustrating that the issue follows party lines, supporting disclosure is the New York Department of Financial Services; California Attorney General Rob Bonta and the Attorney Generals for Connecticut, Illinois, Maryland, Massachusetts, Michigan, Minnesota, New York, Oregon, Vermont and Wisconsin.
Congress is getting in on the act as well. On June 16, 2021, the U.S. Democratic run house narrowly passed H.R. 1187, the Corporate Governance Improvement and Investor Protection Act, which would require the SEC to issue rules within two years requiring every public company to disclose climate specific metrics in financial statements. The Act would modify Section 14 of the Exchange Act which governs the solicitations of proxies, information statements following shareholder consents, and tender offers and require specified disclosures in proxy solicitations and information statements for annual meetings. The Act also requires the SEC to create a Sustainable Finance Advisory Committee. Next the Act goes to the Senate and if passed, to the President to be signed into law or vetoed. Many Acts are passed by either the House or Senate but never go the distance. Since this Act is so narrow compared to the SEC’s much broader request for comment on climate disclosure, even if passed, I suspect the SEC rulemaking will be broader than this requires.