During 2019, the Securities and Exchange Commission (SEC) proposed and/or adopted new rules and regulations, and provided important new guidance that will impact public companies in 2020 and beyond, both in terms of their reporting and disclosure obligations and the financing opportunities available to them. All directors, officers and key personnel of companies that file reports under the Securities Exchange Act of 1934 - and their advisors - should be aware of these updates as they prepare their annual reports and proxy statements, and seek to raise capital during 2020. We summarize five key items below.
New Rules on Hedging Disclosure
In December 2018, the SEC amended Item 407 of Regulation S-K to require public companies to describe any practices or policies (whether written or not) that they have adopted regarding the ability of their employees (including officers) or directors to purchase financial instruments, or otherwise engage in transactions, that hedge or offset, or are designed to hedge or offset, any decrease in the market value of equity securities granted as compensation, or held directly or indirectly by the employee or director. The summary must be fair and accurate, and must include the categories of persons covered. The new rule does not direct companies to have practices or policies regarding hedging, or dictate the content of any such practice or policy. However, if a company does not have any such practices or policies, it must disclose that fact or state that hedging transactions are generally permitted.
The new hedging disclosures are required in proxy or information statements relating to an election of directors starting in fiscal years beginning on or after July 1, 2019 for companies that do not qualify as smaller reporting companies or emerging growth companies, with compliance by smaller reporting companies and emerging growth companies beginning in fiscal years beginning on or after July 1, 2020. Issuers should consider the need to adopt or update policies regarding hedging activities, in light of the need to publicly describe such policies either in the 2020 or 2021 proxy season.
Disclosure Update and Simplification Amendments
During the summer of 2018, the SEC adopted amendments to update and simplify reporting requirements that the SEC considered to be redundant, outdated or superseded by other disclosure requirements or the modern information environment in general. These amendments, which include (i) the elimination of the requirement to provide segment or geographic-based financial information in the description of the issuer's business; (ii) the inclusion of changes in financial condition and results of operations based on geographic area in the MD&A section of the Form 10-K; and (iii) the elimination of the requirement to provide the high and low sale price for the issuer's common stock over the last two fiscal years, as well as the amount and frequency of cash dividends, became effective in November 2018, and thus applied to filings made during the 2019 filing season.
Subsequent to these amendments, the SEC, as part of the disclosure simplification initiatives mandated by the Fixing America's Surface Transportation Act, adopted additional amendments to modernize and simplify certain disclosure requirements, which became effective in May 2019. As per these additional amendments, among other things:
- Issuers are no longer required to include a year-to-year comparison in the MD&A section of the Form 10-K, but rather are allowed to use any presentation that, in the issuer's judgment, enhances a reader's understanding of the issuer's financial condition, changes in financial condition and results of operations. Issuers are also permitted to exclude the discussion in the MD&A of the earliest of the three years included in the financial statements, where applicable, if such discussion was included in the issuer's prior filings and the current filing identifies where such discussion may be found.
- Issuers are only required to provide disclosure of principal physical properties to the extent material to the issuer.
- Issuers are required to provide an additional exhibit to Form 10-K that contains a description required by Item 202(a) through (d) and (f) of Reg. S-K for each class of securities that is registered under Section 12 of the Exchange Act.
- The process for maintaining the confidentiality of certain sensitive information contained in material contracts that are filed as exhibits to SEC filings was substantially streamlined.
- The requirement to file as an exhibit to the Form 10-K material contracts that were entered into during the two year period prior to the filing but that are fully performed was eliminated.
- Issuers are be to include the trading symbol for each class of securities that is registered under Section 12(b) of the Exchange Act on the cover page of the Form 10-K.
- Issuers are being encouraged not to include disclosure under Item 405 of Reg. S-K unless disclosure is being made of late reports filed under Section 16(a) of the Exchange Act, and the heading of the proxy section where such disclosures would be contained has been changed from "Section 16(a) Beneficial Ownership Reporting Compliance" to "Delinquent Section 16(a) Reports". Consistent with the foregoing, the checkbox on the cover page of Form 10-K relating to late Section 16 filing disclosure has been eliminated.
Issuers should keep these changes in mind as they prepare their disclosure documents, and should be particularly mindful that certain of the eliminated disclosure items may now be required in other parts of the 10-K and/or proxy statement, such as the financial statements or the MD&A.
Critical Audit Matters
Beginning for fiscal years ending on or after June 30, 2019, auditors will be required to either include a discussion of "critical audit matters" (CAMs) in their audit reports that are included in the Form 10-K, or state that the auditor determined there were no CAMs for the applicable fiscal year.
The Public Company Accounting Oversight Board (PCAOB) has defined a CAM as any matter arising from the audit that was communicated or required to be communicated to the audit committee that: (1) relates to accounts or disclosures that are material to the financial statements; and (2) involved especially challenging, subjective, or complex auditor judgment.
The determination of whether a particular matter is a CAM will be a principles-based inquiry. When determining whether a particular matter is a CAM, auditors are encouraged by the PCAOB to take a nonexclusive list of factors into consideration, including the auditor's assessment of the risks of material a misstatement, the degree of auditor judgment related to areas in the financial statements that involved the application of significant judgment or estimation by management, and the degree of auditor subjectivity in applying audit procedures to address the matter.
For each CAM identified, auditors must provide a description of the matter, the principal considerations that led the auditor to determine that the matter is a CAM and a description of how the matter was addressed in the audit, among other items.
The PCAOB indicated that it anticipates that CAMs will likely be identified in areas that investors have indicated would be of particular interest to them, such as significant management estimates and judgments made in preparing the financial statements, areas of high financial statement and audit risk, significant unusual transactions, and other significant changes in the financial statements.
The need for CAM disclosures in audit reports arose from the approval by the SEC in October 2017 of the PCAOB's Auditing Standard No. 3101, The Auditor's Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion, which was intended to enhance the relevance and usefulness of the auditor's report by providing additional information to investors.
The requirement to include a discussions of CAMs in the audit report will apply to audits of large accelerated filers for fiscal years ending on or after June 30, 2019, and to audits of all other companies to which the requirements apply for fiscal years ending on or after December 15, 2020. Emerging growth companies and investment companies are excluded from the CAM requirements.
Expansion of Smaller Reporting Company Eligibility
As a result of an amendment to the definition of "smaller reporting company" (SRC) that the SEC approved in June 2018, the universe of issuers eligible to utilize certain existing scaled disclosure accommodations under the federal securities laws significantly expanded in late 2018.
Although many newly-eligible issuers took advantage of the scaled disclosure rules during the 2019 10-K and proxy season, given the fact that eligibility is determined on an annual basis, all reporting companies should remember to evaluate their eligibility to utilize the scaled disclosure requirements applicable to SRCs when preparing for 2020. When doing so, issuers should remain cognizant of the fact that, if they also continue to qualify as "accelerated filers" or "large accelerated filers", the deadline for filing their Exchange Act reports with the SEC may not be changed, and they may continue to be subject to certain other disclosure requirements applicable to larger companies.
Under the prior rules, an issuer would qualify as an SRC if it had either a public float of less than $75 million, or less than $50 million of annual revenues and no public float. As a result of the new rules, an issuer can now qualify as an SRC if:
(i) it has a public float of less than $250 million; or
(ii) it has annual revenues of less than $100 million and either (A) no public float (either because it has no public common equity outstanding or no market price for its common equity exists) or (B) a public float of less than $700 million.
Public companies that now qualify as SRCs may elect to comply with either the scaled SRC disclosure requirements or the larger company disclosure requirements on an item-by-item basis for each filing as long as disclosures are provided consistently and allow investors to make period-to-period comparisons. However, if a scaled item requirement is more rigorous than the same larger company item requirement, SRCs must comply with the more rigorous disclosure.
At the same time that the SEC amended the SRC definition, it also amended the "accelerated filer" and "large accelerated filer" definitions contained in Rule 12b-2 of the Exchange Act to preserve the application of the current public float thresholds in those definitions. As a result, issuers with $75 million or more of public float that qualify as SRCs as per the amendments will remain subject to the requirements that apply to accelerated filers, including the expedited deadline to file periodic reports and the requirement that accelerated filers provide the auditor's attestation of management's assessment of internal control over financial reporting as required by Section 404(b) of the Sarbanes-Oxley Act.
More information on the expansion of SRC eligibility can be found in Pryor Cashman's Legal Update.
Proposed Expansion of Accredited Investor Definition
On December 18, 2019, the SEC proposed amendments to the definition of "accredited investor" as set forth in Rule 501(a) of the Securities Act of 1933. The proposed amendments would add new categories of natural persons that may qualify as accredited investors based on their professional knowledge, experience or certifications, and would also expand the list of entities that may qualify as "accredited investors".
The accredited investor definition is a central component of commonly used private placement exemptions from registration under the Securities Act, such as Rules 506(b) and 506(c) of Regulation D, and plays an important role in other federal and state securities law contexts.
Among other things, the proposals would:
- add new categories to the definition of "accredited investor" that would permit natural persons to qualify as accredited investors based on certain professional certifications and designations, such as a Series 7, Series 65 or Series 82 license, or other credentials issued by an accredited educational institution, that the SEC designates from time to time as meeting specified criteria;
- add a new category of "accredited investor" that would allow a "knowledgeable employee" of a private fund to purchase securities issued by the fund of which such natural person serves as a "knowledgeable employee";
- add limited liability companies that have total assets in excess of $5 million and that were not formed for the specific purpose of acquiring the securities being offered to the list of entities that qualify as "accredited investors" pursuant to Rule 501(a) of the Securities Act;
- revise Rule 501(a)(1) of the Securities Act to add registered investment advisers, as well as rural business investment companies, as "accredited investors";
- add a new category of "accredited investor" for any entity, including Indian tribes, labor unions and governmental bodies and funds, that are not specifically listed elsewhere in the definition of "accredited investor", that owns "investments" (as defined in Rule 2a-51-1(b) of the Investment Company Act) in excess of $5 million and that was not formed for the specific purpose of investing in the securities offered;
- add "family offices" with at least $5 million in assets under management and their "family clients" (each as defined in the SEC's family office rule) within the categories of "accredited investors"; provided, that the foregoing would apply only to a family office whose purchase is directed by a person who has such knowledge and experience in financial and business matters that such family office is capable of evaluating the merits and risks of the prospective investment; and
- add the term "spousal equivalent" to the accredited investor definition, so that spousal equivalents, rather than the more limiting term "spouses", may pool their finances for the purpose of qualifying as accredited investors under the existing income or net worth tests.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.