March 02, 2020

MONTH-IN-BRIEF: Securities Law

Alan J. Wilson, Rani Doyle

SECURITIES REGULATION

SEC Chair Jay Clayton and Others Issue Statement on Continued Dialogue with Audit Firm Representatives on Audit Quality on China and Other Emerging Markets; Coronavirus—Reporting Considerations and Potential Relief

By Rani Doyle, EY*

On February 19, 2020, SEC Chair Jay Clayton, Division of Corporate Finance Director Bill Hinman, Chief Accountant Segar Teotia and PCAOB Chair William D. Duhnke III (collectively, the “SEC and PCAOB representatives”) issued a statement about recent meetings with senior representatives of the four largest U.S. audit firms, including certain of their network representatives, to discuss audit quality across their global networks and certain of the challenges faced in auditing public companies with operations in emerging markets, including China.  

The SEC and PCAOB representatives expect to have similar meetings with other U.S. audit firms that, through use of their own networks or otherwise, audit U.S.-listed companies with significant operations in emerging markets, including China.

The statement also addressed effects of the coronavirus on financial reporting, noting that the actual effects of the coronavirus may be difficult to assess or predict with meaningful precision both generally and on an industry- and issuer-specific bases.

The statement reports that in the meetings referenced above, the SEC and PCAOB representatives  emphasized:  “(1) the need to consider potential disclosure of subsequent events in the notes to the financial statements in accordance with guidance included in Accounting Standards Codification 855, Subsequent Events and (2) our general policy to grant appropriate relief from filing deadlines in situations where, in light of circumstances beyond the control of the issuer, filings cannot be completed on time with appropriate review and attention.  In addition, if issuers have questions regarding the reporting of matters related to the potential effects of the coronavirus, including potential subsequent event disclosure, we welcome engagement on these matters.”

The statement encourages issuers and their advisors to contact SEC staff regarding any need for relief or guidance.  Based on these communications and its continuing monitoring of the situation, the staff will determine whether to provide additional guidance and relief as appropriate for affected parties.  Relief may be made available on a case-by-case or broader basis as circumstances merit. 

SEC Proposes Amendments to Modernize and Enhance Financial Disclosures

By Andrew Galtieri, K&L Gates LLP 

On January 30, 2020, the SEC proposed amendments to “modernize, simplify, and enhance” MD&A and other disclosure requirements of Regulation S-K. The proposed rule would eliminate Item 301 (Selected financial data) and Item 302 (Supplementary financial data), and amend Item 303 (Management’s discussion and analysis).The proposal is part of the SEC’s Disclosure Effectiveness Initiative, a product of Section 108 of the JOBS Act and the SEC’s subsequent Report on Review of Disclosure Requirements in Regulation S-K.

In a press release, SEC Chair Jay Clayton stated that the proposed guidance would “improve the quality and accessibility of registrants’ presentation of financial results and performance metrics” and enable investors to “make better capital allocation decisions while reducing compliance burdens and costs without in any way adversely affecting investor protection.”

In addition to removing Items 301 and 302 from Regulation S-K, the proposed revisions include:

  • adding a new Item 303(a) (Objective) to state the principal objectives of MD&A and streamline its instructions,
  • amending current Item 303(a) (Full fiscal years) to modernize clarify and streamline its items, including:
    • revising current Item 303(a)(2) (Capital resources) to account for capital expenditures that are not necessarily capital investments;
    • revising current Item 303(a)(3) (Results of operations) by modifying disclosure thresholds, codifying existing SEC guidance, and encouraging registrants to focus on material information that is tailored to its businesses, facts and circumstances;
    • replacing current Item 303(a)(4) (Off-balance sheet arrangements) with a new instruction regarding the need to integrate disclosure of such arrangements in the context MD&A; and
    • eliminating current Item 303(a)(5) so that a contractual obligations table would no longer be required.
  • revising current Item 303(b) (Interim periods) to permit registrants to allow flexibility in the comparison of interim periods and to clarify and codify SEC guidance; and
  • eliminating current Item 303(c) (Safe harbor) and 303(d) (Smaller reporting companies) in light of the proposed changes to Items 303(a)(3), (4) and (5).

The proposal also contains corresponding amendments that would apply to foreign private issuers providing disclosure on Forms 20-F or 40-F, along with conforming amendments affecting (i) roll-up transactions and Item 914 of Regulation S-K, (ii) asset-backed securities and Regulation AB, (iii) summary prospectuses in Forms S-1 and F-1, (iv) business combinations and Form S-4, F-4 and Schedule 14A and (v) standardized options and Form S-20.

SEC Issues Guidance on Disclosure of Metrics in MD&A

By Rani Doyle, EY*

In a January 30, 2020 interpretive release, the SEC provided guidance on key performance indicators and metrics in MD&A. When disclosing metrics in MD&A, companies should consider whether (1) they are US GAAP measures and the US GAAP disclosure framework applies to them, or (2) they are non-GAAP measures and Regulation G or Item 10(e) of Regulation S-K applies to them. If the metrics are not subject to an existing framework, companies should then consider what additional information is needed to provide adequate context. The SEC said that it would generally expect, based on the facts and circumstances, the following additional disclosures:

  • A clear definition of the metric and a description of how it is calculated
  • A statement indicating the reasons why the metric provides useful information to investors
  • A statement indicating how management uses the metric in managing or monitoring the performance of the business

If estimates or assumptions underlie the metric or its calculation, companies should evaluate whether disclosing them is necessary for the disclosure of the metric not to be misleading.

If a company changes the method it uses to calculate or present the metric from one period to another, it should consider the need to disclose, if material, (1) the differences in how the metric is calculated or presented, (2) the reasons for such changes, (3) the effects of any such changes on the amounts or other information being disclosed and on amounts or other information previously reported, and (4) other differences in methodology and results that would reasonably be expected to be relevant to understanding the company’s performance or prospects. Depending on the significance of the change(s) in methodology and results, the company should consider whether it is necessary to recast previously reported metrics to conform to the current presentation to achieve comparability and avoid misunderstandings.

Examples of metrics to which this new guidance applies include operating margin, same-store sales, total customers/subscribers, average revenue per user, and data security measures (e.g., number of data breaches, number of account holders affected by data breaches). Metrics also can relate to external or macroeconomic matters, involve a combination of internal and external information, or address environmental matters.

In addition, the guidance reminds companies that they are required to maintain effective disclosure controls and procedures around metrics.

BDC Coalition Withdrawals AFFE Exemption

By Brian Hirshberg, Mayer Brown

In recent years, many industry participants have recommended that the SEC’s Division of Investment Management remove or alter the line item titled “Acquired Fund Fees and Expenses” (AFFE) that is currently required to be included in a business development company’s (BDC) prospectus fee table.  BDCs provide capital to, and invest in, small and middle-market companies in the United States.  As a result of this special investment purpose, BDCs are exempt from certain regulatory constraints imposed by the 1940 Act on traditional investment companies and generally benefit from pass through tax treatment. 

AFFE disclosure requires acquiring funds to aggregate and disclose in their prospectuses the amount of total annual acquired fund operating expenses and express the total amount as a percentage of an acquiring fund's net assets.  The calculation of AFFE typically results in an overstated expense ratio because an acquiring fund's indirect expenses are often significantly greater than the expense ratio of the BDC.  As a consequence, many index providers removed BDCs from their indices, causing a significant reduction in institutional ownership of BDCs and lowering share prices of BDCs.

On September 4, 2018, The Coalition for Business Development (Coalition), Apollo Investment Management, L.P., and Ares Capital Management LLC requested that the SEC issue an exemptive order exempting BDCs from the AFFE disclosure.  Further hope was provided to the BDC industry when on December 19, 2018, the SEC formally requested industry suggestions to improve AFFE disclosure (including with respect to BDCs).  Additionally, the House Appropriations Committee 2019 fiscal year appropriations bill contained language recommending that the SEC address the AFFE rule as it applies to BDCs.  

Unfortunately, in December 2019, the SEC determined not to move forward with any further consideration of the Coalition’s application and requested that it formally withdrawal its application.  Nonetheless, the Coalition urged the SEC to reconsider providing AFFE relief to BDCs when it updates its final fund-of-funds proposal later this year.  Incorporating the suggested revisions would have significantly benefited BDCs and indirectly benefited U.S. small and middle-market companies that are the primary beneficiaries of BDC capital.

SEC Chair Clayton Issues A Statement on Proposed Changes to the Volker Rule

By Melissa Sanders, Fox Rothschild

On January 30, the SEC and other agencies proposed amendments to the “Volcker Rule.”  The amendments focus on the portions of the Volcker Rule related to covered funds.  In his statement regarding the proposed amendments, SEC Chair Clayton stated that the proposed amendments could “facilitate capital formation” and “improve competition and market efficiency….without increasing risk to investors.” 

Of particular note for venture capital funds is the proposed exclusion for certain venture capital funds.  Banking entities would be allowed to invest in startups and smaller business through venture capital funds that qualify under the rule.  In order to qualify under the rule, the venture capital fund would be required to fall within the existing definition of a venture capital fund under 17 CFR § 275.203(l).  It would also be subject to additional requirements, including the requirements that the fund not “engage in proprietary trading” and that the banking entity investing in the fund comply with certain banking standards.    

SEC Chair Clayton noted that the proposed rules could benefit businesses in non-coastal areas where venture capital financing has traditionally been hard to obtain.  He referenced findings contained in the first annual report of the Office of the Advocate for Small Business Capital Formation.  The report contains statistics regarding the impact of financing availability on job growth and discusses the obstacles faced by small businesses without access to bank financing. 

ESG Initiatives Rapidly Advance in 2020; Institutional Investors Issue Updated Proxy Voting Policies

By Rani Doyle, EY

Leading market participants are taking stronger action on ESG issues in 2020 in ways that are intended to impact corporate priorities and disclosures. Management and boards should be aware of these and related developments:

Some of the world’s largest institutional investors have issued updated proxy voting policies or stewardship principles, which are linked here:

* Material included in this Month-In-Brief publication is for general informational purposes only and does not represent the views or advice of Ernst & Young LLP or any of its professionals as to any client or particular set of facts.

Alan J. Wilson

Senior Associate, WilmerHale

Alan J. Wilson is a Senior Associate in WilmerHale’s Transactional Department who routinely counsels public company clients on a variety of matters concerning corporate governance and compliance with federal securities laws, particularly with regards to the intersection between law and accounting.  He also advises public and private companies from a range of industries on navigating transactional and strategic matters, including securities offerings, mergers and acquisitions, joint ventures, and activist shareholder engagement.

Rani Doyle

Executive Director, EY Center for Board Matters

Rani is an executive director in the EY Center for Board Matters.  She has extensive experience working with executive management and boards at public and private companies on a wide range of corporate governance and business matters.