March 2022 in Brief: Securities Law

Securities Regulation

SEC Proposes New Public Company Cybersecurity Disclosure Rules

By Alan J. Wilson, WilmerHale

On March 9, 2022, the Securities and Exchange Commission (“SEC”) proposed rules that are intended to enhance disclosures about cybersecurity risk management, strategy, governance, and incident reporting by public companies. If adopted as proposed, the rules will dramatically impact the way public companies, boards, and management disclose cyber incidents and matters relating to their cybersecurity oversight (including board and management expertise). The proposed rules represent a significant expansion of current SEC guidance, which dates back to 2011 and 2018, and if adopted as released, will likely lead to operational and governance changes for many businesses. For more detailed information about the proposed rules, see this post on WilmerHale’s Focus on Audit Committees, Accounting and the Law blog.

SEC Issues Climate Disclosure Proposal

By Alan J. Wilson, WilmerHale

On March 21, 2022, the Securities and Exchange Commission (“SEC”) proposed rules intended to enhance and standardize climate-related disclosure requirements for public companies. The proposal would amend non-financial and financial disclosure requirements in Regulation S-K and Regulation S-X, respectively, as well as the related SEC forms, to require mandatory disclosures on a number of climate-related metrics, including quantified disclosures of annual greenhouse gas emissions. For more information about the proposed rules, see WilmerHale’s client alert.

Assessing Materiality: Focusing on the Reasonable Investor When Evaluating Errors

By Brian E. Saleeby, Mayer Brown

On March 9, 2022, the Office of the Chief Accountant (“OCA”) released a statement regarding assessing the materiality of financial reporting errors. The OCA used this statement to rehash guidance on the concept of materiality and the correction of material errors, evaluate methods of performing an objective assessment of materiality, and state observations from recent interactions with registrants and auditors on materiality. The concept of a material fact as one that “would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available” has long been established by the Supreme Court. When an error is determined to be material to previously issued financial statements, the error can either be corrected by a reissuance or revision of the relevant financial statement in line with U.S. GAAP. The OCA noted that an objective materiality analysis combines both quantitative and qualitative considerations, taking into account all relevant facts and circumstances relating to the error and putting aside the personal bias of the registrant, auditor, or audit committee. In circumstances where a quantitatively small error could be material because of qualitative factors (and vice versa), the OCA finds that as the quantitative magnitude of the error increases, it may increasingly outweigh qualitative considerations. Nevertheless, a holistic and objective assessment from a reasonable investor’s perspective is still of the utmost importance. The OCA included some significant observations from recent interactions with registrants and auditors on materiality:

• Accounting Errors and Materiality: The fact that a misstatement may have been unintentional does not negate the possible materiality of the error. Even if an aggregate effects analysis of an individual error finds that its effect is offset by other errors, that should not serve as the basis for a conclusion that individual errors are immaterial.
• Accounting Errors and Internal Control over Financial Reporting (“ICFR”): The OCA notes that management should continue to steadfastly report any material weakness in the effectiveness of ICFR in a holistic and objective manner, noting the magnitude of the potential misstatement that could result from any control deficiencies.
• Other Auditor Considerations: Audit firms should pay special attention to having policies and procedures in place to ensure that any materiality analysis is carried out in compliance with applicable professional standards by the appropriate individuals.

New SEC C&DIs Impacting Mergers and Acquisitions

By Laura D. Richman, Mayer Brown

On March 22, 2022, the staff (“Staff”) of the Securities and Exchange Commission (“SEC”) issued six compliance and disclosure interpretations (“C&DIs”) impacting mergers and acquisitions. Two of the new C&DIs relate to Item 1.01 of Form 8-K. Three of the C&DIs interpret proxy solicitation requirements. One addresses a tender offer issue relating to special purpose acquisition companies (“SPACs”).

Form 8-K

C&DI #102.04 specifies that the amount and nature of consideration, committed financing arrangements, material terms regarding the securities ownership or management structure of the combined or surviving company, material closing conditions, and anticipated timeframes for SEC filings and closing are generally considered material and should be disclosed pursuant to Item 1.01 of Form 8-K. This C&DI also indicates that the Form 8-K must also include all other material information that is necessary to make the required disclosure, in light of the circumstances under which it is made, not misleading. This includes whether a material term of the agreement has not yet been determined by the parties and the nature of the target company’s business, including, at a minimum, whether it has existing operations or has generated revenues, as well as any information disclosed by the target company in announcing the business combination transaction.

C&DI #102.05 encourages companies, as a best practice, to file the business combination agreement as an exhibit to an Item 1.01 Form 8-K. This C&DI also specifies that, as a best practice, companies should provide an explanation in the Form 8-K if they are unable to prepare the agreement in the proper EDGAR format and file the agreement as an exhibit to the Form 8-K.

Proxy solicitations

C&DI #101.02 provides that a target company that does not plan to solicit its own shareholders could be engaged in a solicitation of the acquiror’s shareholders if its public communications promote the proposed transaction or may be reasonably expected to influence the voting decisions of the acquiror’s shareholders. This would subject the target company to liability under, and filing and information requirements of, the Securities Exchange Act of 1934 (“Exchange Act”).

C&DI #132.01 indicates that the Staff will not object if a target company that is not soliciting its own shareholders relies on Exchange Act Rule 14a-12 to communicate publicly about the proposed business combination transaction if conditions specified in this C&DI are met.

C&DI #132.02 permits an acquiror to make public communications regarding a proposed business combination transaction in reliance on Exchange Act Rule 14a-12 where the acquiror will not file a definitive proxy statement for the transaction but the target company will, as long as conditions specified in this C&DI are met.

Tender Offers

C&DI #166.01 states that to the extent that a SPAC redemption offer constitutes a tender offer, the Exchange Act Rule 14e-5 prohibition of purchases outside of a tender offer applies to the purchases of SPAC securities by the SPAC sponsor or its affiliates outside of the redemption offer. However, the Staff will not object to purchases by the SPAC sponsor or its affiliates outside of the redemption offer as long as conditions are specified in this C&DI are satisfied.

SEC Proposes to Exorcise the Investment Grade Rating Exemption from Regulation M

By Bradley Berman, Mayer Brown

On March 23, 2022, the Securities and Exchange Commission (“SEC”) proposed amendments that would remove the investment grade rating exemptions from Rules 101(c)(2) and 102(d)(2) of Regulation M. The Dodd-Frank Wall Street Reform and Consumer Protection Act called for the SEC to review its rules that used credit ratings as an assessment of creditworthiness and to replace those references with other appropriate standards. The SEC has done so, with Regulation M being the last such rule to retain references to credit ratings.

Rule 101(c)(2) and Rule 102(d)(2) of Regulation M currently except nonconvertible debt securities, nonconvertible preferred securities, and asset-backed securities that are rated investment grade by at least one nationally recognized statistical rating organization. Rule 101 applies to distribution participants and their affiliated purchasers, and Rule 102 applies to issuers, selling security holders, and their affiliated purchasers. In place of the investment grade rating requirement, under Rule 101, the SEC is proposing to except (1) nonconvertible debt securities and nonconvertible preferred securities of issuers having a probability of default of less than 0.055%, as measured over certain period of time and as determined and documented using a “structural credit risk model,” as defined in the rule, and (2) asset-backed securities that are offered pursuant to an effective shelf registration statement filed on the SEC’s Form SF-3. The SEC is proposing to eliminate from Rule 102 the existing exception for investment grade nonconvertible debt securities, nonconvertible preferred securities, and asset-backed securities.

The comment period is open for 60 days following the publication of the proposing release on the SEC’s website, which occurred on March 23, 2022.

PCAOB Reports on Audit Committee Communications

By Thomas W. White, Retired Partner, WilmerHale

The Public Company Accounting Oversight Board follows a practice of engagement with the audit committee chairs of companies whose audits it inspects. In 2021, the Board’s inspection staff had “conversations” with over 240 audit committee chairs. Recently, the Board published a report presenting high-level observations and takeaways from those conversations. The report highlighted the following topics:

• Required communications between auditor and audit committee—Accounting matters, including goodwill and impairments, revenue recognition, and credit losses were the required communications that generated the most discussion with auditors.
• Discussion outside required communications—Audit committee chairs looked to auditors for perspective on management/tone at the top, big picture business trends, and regulatory state of play in financial reporting and standard setting.
• Auditor strengths and areas for improvement—Discussing auditor strengths, many chairs cited comprehensive, timely, and focused communications, while those critiquing auditors flagged poor communication, work left to the last minute, and turnover on the audit team.
• Review/discussion of PCAOB inspection reports—Seventy percent of chairs who answered the question definitively said that they either review the auditor’s PCAOB inspection report or discuss it with the auditors.
• Quality control systems at audit firms—Most chairs expressed satisfaction with their audit firms’ approach to quality control.
• Auditor’s use of technology—Many chairs continued to see “transformative potential” in the use of technology, although some also highlighted potential challenges.
• Information outside the financial statements—Of the chairs who discussed information outside the financial statements with the auditors, roughly 70% cited ESG as a key area of discussion.

This report is probably most relevant to auditors, as it provides some insight into what the PCAOB is hearing about auditors from audit committees, especially since that information may feed into how the PCAOB approaches its regulatory activities. The report may also be useful to audit committees (and their advisers) insofar as it provides information about other committees’ experiences with their companies’ auditors.