Senior members of the Division of Corporation Finance (“Corp Fin”) of the U.S. Securities and Exchange Commission (SEC) gathered with two former SEC commissioners at the Practising Law Institute’s annual “SEC Speaks” conference in Washington, D.C. last month to reflect on some of Corp Fin’s work in 2015 and to discuss priorities for 2016.
Shelley Parratt, deputy director of Corp Fin, opened the panel by noting that, in fiscal 2015, Corp Fin reviewed the periodic reports of 4,400 companies and initial public offerings (IPOs) of approximately 600 companies, issued numerous Compliance and Disclosure Interpretations (“C&DIs”), updated Corp Fin’s Financial Reporting Manual, and proposed numerous recommendations to the SEC for proposed and final rules. We have highlighted topics from the SEC Speaks conference and will cover SEC rulemaking in this post, and the 2016 proxy season and recent staff interpretations and reports in subsequent posts.
Dodd-Frank – Executive Compensation and Corporate Governance
Under the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”), signed into law on July 21, 2010, the SEC was tasked with issuing certain rulemakings related to executive compensation and corporate governance. Known colloquially as the “Four Horsemen” or “Gang of Four,” the rules prescribe disclosure related to the areas of CEO pay ratio, hedging, clawbacks and pay for performance. In 2015, the SEC adopted a final rule implementing the CEO pay ratio disclosure requirements and proposed separate rules related to hedging, clawbacks and pay for performance.
David Frederickson, Chief Counsel of Corp Fin, discussed the three pending rulemakings, noting that Corp Fin has received significant commentary on the proposed rules. He added that the SEC hopes to have final rules in place by 2017, though he did not specify whether the final rules would apply to the 2017 proxy season (or, as is the case with the pay ratio rules, the 2018 proxy season).
The proposed rule on hedging policies would require companies to disclose whether or not they allow employees and directors to purchase financial instruments designed to offset moves in underlying equity securities of the company. Frederickson stated that several commenters were concerned over the potential scope of the proposed rule, questioning, for example, whether an issuer that prohibited hedging generally, but permitted general portfolio diversification strategies (i.e., the purchase of broad-based indices), could nonetheless disclose that it prohibited all hedging transactions. He further noted that commenters have asked whether nonexecutive employees should be covered and, if so, how the policies and or disclosures might be different from those applicable to executive officers and directors.
Frederickson next addressed the proposed rule on pay for performance, which would require companies to disclose clearly the relationship between executive compensation actually paid and the financial performance of the company. Much of the debate has focused on how strict and standardized the disclosure should be. He pointed out that the statute requires “taking into account any change in the value of the shares of stock and dividends of the issuer and any distributions,” thereby implying total shareholder return (TSR), which is how the SEC drafted the proposed rule. Frederickson asserted that the Staff is aware of the significant external debate centered on the characterization of TSR and is trying to determine how the rule should work. He also stated that, notwithstanding the freedom given to companies when applying the executive compensation rules on an individualized basis, part of the driving goal behind the rule on pay for performance is to standardize the way companies report the compensation discussion and analysis.
Lastly, Frederickson addressed the proposed rule on clawbacks, which would require the SEC to direct exchanges to establish listing standards requiring issuers to adopt policies that require executive officers to pay back “incentive-based compensation” that is later shown to have been awarded erroneously. As proposed, incentive-based compensation is defined as “any compensation that is granted, earned or vested based wholly or in part upon the attainment of any financial reporting measure.” He stated that the challenge has been to determine what financial reporting measures should be included in this definition. While the Staff has proposed including TSR, it acknowledged that estimating TSR and figuring out what amount of compensation was overpaid might be difficult for companies. Frederickson stated that commenters also have questioned whether boards should have discretion with regard to how much compensation to recover, given their fiduciary duties. He pointed out that the statute states that issuers “will recover,” which offers wide latitude and a no-fault basis for recovery.
Frederickson concluded his remarks by noting that the Staff is considering all of these issues and preparing recommendations for the commissioners.
FAST Act – Related Securities Provisions
The Fixing America’s Surface Transportation Act (“FAST Act”), a $305 billion bill signed into law on December 4, 2015, to provide long-term funding certainty for surface transportation, included a number of securities-law-related provisions that had previously been the subject of individual congressional bills. Elizabeth Murphy, associate director in the Office of Rulemaking, noted that, on January 13, 2016, the SEC issued interim final rules implementing two provisions of the FAST Act.
The first set of rules permits an emerging growth company (EGC) that files an IPO registration statement (or submits a confidential draft registration statement) on Form S-1 or Form F-1 to omit Regulation S-X financial information for historical periods otherwise required as of the time of filing (or confidential submission), provided that (i) the omitted financial information relates to a historical period that the EGC reasonably believes will not be required to be included in the Form S-1 or Form F-1 at the time of the offering, and (ii) prior to the distribution of a preliminary prospectus to investors, the registration statement is amended to include all financial information required by Regulation S-X at the date of such amendment. Murphy noted that the amendments to Form S-1 and Form F-1 will permit EGCs to avoid the costs and burdens of including historical financial statements and related disclosures in their IPO registration statement that will not be part of the registration statement at the time the IPO is marketed and priced (i.e., such financial statements will be superseded by more recent financial statements).
The second set of rules also revised Form S-1 to permit smaller reporting companies (SRCs) to automatically update information in a Form S-1 prospectus by forward incorporation of reports filed with the SEC after the registration statement is declared effective. Eligibility for this forward incorporation by reference depends on eligibility for historical incorporation by reference.
Murphy stated that registrants can immediately rely on the interim final rules, which became effective on January 19, 2016. Murphy noted that the request for comments on the interim rules closed on February 18, 2016, and that many commenters, not surprisingly, had asked the SEC to extend the rule accommodations to all companies, not just EGCs and SRCs. She said the Staff was working to convert the interim final rules to final rules and noted that any additional rulemakings stemming from comments would be published for notice and comment. Finally, Murphy stated that other FAST Act rulemakings, which are mandated by June 1, 2016, are forthcoming, including rules allowing a company to include a summary page in its Form 10-K, provided that each item includes a hyperlinked cross-reference to the more detailed item later in the filing.
Rules 147 and 504
Rule 147 of the Securities Act of 1933 (the “Securities Act”), adopted in 1974, is a safe harbor based on Securities Act Section 3(a)(11), the “intrastate exemption,” which exempts from registration offers and sales of securities to residents of the same state or territory in which the issuer resides or does business. Rule 147 has become more prominent in the last few years as more states have developed intrastate crowdfunding provisions. Another exemption, Rule 504 of the Securities Act, adopted in 1982 as part of Regulation D and often referred to as the “seed capital exemption,” exempts from registration offers and sales of up to $1 million of securities over a 12-month period.
In October 2015, the SEC proposed amendments to both Rule 147 and Rule 504 to assist small companies with capital formation. The impetus behind the proposed amendments was not a congressional mandate, but rather a widely perceived need to modernize the exemptions. Sebastian Gomez Abero, chief of the Office of Small Business Policy, stated that the SEC considered the observations and recommendations of a number of disparate market participants, including the North American Securities Administrators Association (NASAA) and the SEC’s Advisory Committee on Small and Emerging Companies, as to the general utility of the exemptions and the areas in which they could be updated.
With respect to Rule 147, Gomez Abero noted that the rule has not been substantively revised since 1974 and that some commenters have complained that it has not kept pace with the changing business environment and current technology. He acknowledged that existing limitations under the rule have hindered its usefulness in the electronic age, noting that, because the Internet knows no territorial boundaries, compliance with the in-state residency requirement has become exceedingly difficult. Based on the Staff’s recommendations, the SEC proposed amendments to the exemption that would help facilitate capital formation by:
- eliminating the restrictions on offers so that an offer could be made to anyone, not just in-state residents
- continuing to require, however, that all purchasers be residents of the same state as the issuer
- easing issuer eligibility requirements
- limiting the exemption to offerings of up to $5 million of securities over a 12-month period, together with an investment limitation on investors.
With respect to Rule 504, Gomez Abero noted that the $1 million limit on the exemption has not changed since it was raised from $500,000 in 1988. Based on the Staff’s recommendations, the SEC proposed amendments to raise the limit on offerings to $5 million of securities and to add bad-actor disqualifications similar to those found in Rules 505 and 506.
In closing, Gomez Abero stated that the proposed amendments would facilitate smaller companies’ ability to raise capital and give state regulators greater flexibility to implement coordinated review programs to promote regional offerings. He added that the comment period on the rule amendments closed on January 12, 2016, and that the Staff had received 26 comments, which were generally supportive of both proposed rules.
Crowdfunding, a relatively new and evolving form of alternative finance, is the practice of funding a project or venture by raising monetary contributions from a large number of investors. Often conducted via the Internet, an entity or individual raising funds through crowdfunding typically solicits small contributions from individuals interested in the crowdfunding campaign (i.e., members of the “crowd”). Such members may share information about the project, cause, idea or business with each other and use the information to decide whether to fund the campaign based on the collective “wisdom of the crowd.”
On October 30, 2015, the SEC adopted Regulation Crowdfunding, pursuant to the mandate under Title III of the Jumpstart Our Business Startups Act (the “JOBS Act”). Title III added new Securities Act Section 4(a)(6), which provides an exemption from registration for certain crowdfunding transactions. Regulation Crowdfunding prescribes rules governing the offer and sale of securities under new Section 4(a)(6) and also provides a framework for the regulation of registered funding portals and broker-dealers that issuers are required to use as intermediaries in the offer and sale of securities in reliance on Section 4(a)(6). Per Regulation Crowdfunding, issuers engaged in crowdfunding activities will be required to file on “Form C” detailed information about:
- the issuer and its business, capital structure and material debt
- the use of offering proceeds
- the offering itself, including how the securities were valued and target offering amounts and deadlines
- securities transfer restrictions
- intermediary compensation and ownership interest in the issuer
- a narrative discussion of the issuer’s financial condition
- other information related to the issuer.
As permitted, crowdfunding portals have been registering with the SEC since late January 2016. While the rules for issuers will not go into effect until May 16, 2016, issuers have been able to submit a test filing on Form C since December. Per Gomez Abero, the benefits of test filings are twofold: first, the Staff is able to solicit feedback on the new electronic form, and, second, issuers can become familiar with the mechanics of the filing process in advance of the rules going into effect. In closing, Gomez Abero reminded issuers that the Staff had a press release on the Corp Fin website with instructions for conducting a test filing and that testing of Form C would remain open until the end of February 2016.