In today’s market, public companies face a variety of challenges and risks—from shifting trends in shareholder activism to new SEC reporting requirements and disclosure changes. This alert will highlight key issues every public company should be thinking about as 2018 approaches.
Form 10-K disclosure highlights
- Form updates and exhibits. Several technical rule changes that became effective in 2017 will affect upcoming Form 10-K filings for all public companies. Issuers are reminded to (1) update the Form 10-K cover page to include additional required language and check boxes regarding filing status and other emerging growth company matters, (2) present the exhibit index before the required signatures in the report and (3) include active hyperlinks to all exhibits that are filed as part of the report or are incorporated by reference to prior filings. We recommend that issuers review and refine their list of potential Form 10-K exhibits well in advance of target filing date to scrub the exhibit list and remove any exhibits that are no longer relevant and/or required under SEC rules and to ensure that all required exhibits will have a properly functioning hyperlink. Issuers are also reminded that their disclosure controls and procedures should be updated to properly address these requirements, as well as any other new or revised disclosure requirements (such as, for example, those relating to pay ratio and non-GAAP financial measure disclosures).
- Risk factors. We recommend that issuers begin evaluating risk factors early in the Form 10-K drafting process to allow sufficient time to identify and evaluate the significant risks facing the company and to gather the type of industry- and company-specific information needed for risk factor disclosure that clearly describes to investors the particular risks that may significantly impact the company and its securities and avoids boilerplate descriptions of generic risks that could be applicable to any issuer. Any risk factors included in the company’s most recent Form 10-K, or subsequent interim reports that remain relevant and will be included in the upcoming Form 10-K, should be updated to reflect the current environment and underlying facts. While each issuer should present its own tailored set of risk factors, potential risks that may be worthy of consideration for discussion in upcoming Form 10-K filings include risks associated with Brexit or changes in U.S. or foreign government regulatory policies, cybersecurity risks, risks related to climate change or other sustainability issues, risks associated with shareholder activism and risks associated with terrorism and other geopolitical issues.
- MD&A. Item 303 of Regulation S-K requires issuers to disclose, among other things, material known risks, trends and uncertainties. Recent enforcement cases have underscored the importance of this requirement. Issuers should critically review and challenge their Form 10-K MD&A disclosures to assess whether there are any additional known risks, trends or uncertainties that should be discussed. Issuers should also take steps in the review process to ensure that disclosures throughout the Form 10-K (for example, in the Business, Legal Proceedings, Risk Factors and MD&A sections, as well as in the notes to the financial statements) are not internally inconsistent. The draft Form 10-K disclosures should also be reviewed in conjunction with the company’s other public statements so that any discrepancies or inconsistencies can be appropriately addressed. The Form 10-K discussion of critical accounting policies should also be refreshed to ensure that it addresses the material uncertainties associated with the assumptions underlying each critical accounting policy.
- Non-GAAP financial measures. Issuers should continue to be mindful of recent SEC guidance when using non-GAAP financial measures in their periodic report and other filings, as well as in other public disclosures such as earnings calls and related presentations. Audit committees should also be actively involved in oversight of the company’s use of non-GAAP financial measures. Since issuing updated guidance in May 2016, the staff of the SEC (“Staff”) Division of Corporation Finance has issued numerous comment letters to issuers relating to compliance with the requirements of Regulation G and Item 10(e) of Regulation S-K as interpreted by the Staff. Although the pace of comments on these issues has abated, we expect that non-GAAP compliance will continue to be an area of Staff focus. Issuers should endeavor to use non-GAAP financial measures and other key performance indicators consistently, both over time and across the company’s filings and other public communications.
- New accounting standards. The new GAAP revenue recognition standard goes into effect starting with fiscal years beginning after December 15, 2017. Issuers that are required to apply the new standard in fiscal 2018 (including calendar-year reporting companies) should be discussing the anticipated effects of the new standard with their accountants and audit committees and preparing to include robust transition disclosures in their 2017 Annual Report on Form 10-K that will enable investors to understand the anticipated effects of the adoption of the new standard. To the extent significant changes are made to internal controls in connection with implementation of the new standard, relevant disclosure requirements should also be addressed. We recommend that issuers who may need to file a new Form S-3 shelf registration statement in 2018 plan ahead, as the transition to the new revenue recognition standard may have implications for that filing. Additionally, new lease accounting standards will go into effect on January 1, 2019 for calendar-year public companies and may require significant internal coordination adoption and ongoing compliance support. New accounting standards for financial instruments also will phase in soon. As has been the case with the approach to adoption of the new revenue recognition standard, accounting policy disclosures should be periodically updated to include discussion of the implementation status and expected impact and should become progressively more detailed as the time for adoption of the new standard approaches.
Proxy statement disclosure highlights
- Disclosure updates. For many issuers, the inclusion of the required pay ratio disclosure (discussed below) will be the most significant change to the contents of 2018 annual meeting proxy statements. The evolution of proxy statements from compliance-driven disclosure documents to an investor relations focused communications tool continues, and we expect issuers will proceed in the upcoming proxy season to incorporate further content and design enhancements intended to improve messaging and readability. Areas of focus for potential additional or supplemental voluntary disclosures include (1) enhanced voluntary disclosures in the required audit committee report addressing the audit committee’s role in negotiating auditor fees, consideration of non-audit services when making auditor independence determinations, consideration of auditor tenure or consideration of specific factors in assessing the auditor’s quality and qualifications, (2) expanded discussion of board diversity, qualifications and tenure in the form of a skills matrix or other suitable graphic, (3) discussion of the board evaluation process and (4) discussion of the company’s approach to shareholder engagement and any actions taken in response to issues raised by shareholders, including with respect to any specific sustainability or environmental, social and governance topics known to be of interest to the company’s shareholders. We also remind issuers of the need to disclose all elements of compensation required under Item 402 of Regulation S-K accurately and completely, including the value of all perquisites.
- Design and readability. We expect issuers will continue in their efforts to implement proxy statement design changes intended to improve functionality and online navigability, highlight important information and increase ease of use for the reader. At the same time, issuers should exercise caution that the design changes do not become distractions and detract from the underlying messages that the company intends to convey.
- Pay ratio disclosure. There are many options and choices to make when determining the methodology to be utilized in identifying the median employee and calculating annual total compensation. Issuers should document this process including the rational for selecting the various methodologies, estimates and assumptions. Since the median employee only needs to be identified once every three years, carefully documenting the process now will facilitate the process in year three. In addition, the SEC has stated that use of reasonable estimates, assumptions and methodologies would not provide a basis for SEC enforcement action unless the disclosure is made or reaffirmed with no reasonable basis or provided in other than good faith. Documentation describing the effort made to comply with the rules requirements will enhance a showing of good faith. We expect most issuers will utilize the Staff’s guidance that the pay ratio may be disclosed as a reasonable “estimate.” We anticipate many issuers will engage in employee communications in connection with the pay ratio proxy statement disclosure. These communications and the issuer’s particular circumstances should be reviewed to determine whether such communications would be deemed additional solicitation materials and required to be filed with the SEC.
Current status of proposed rulemaking
Remaining Dodd-Frank mandates
SEC rules proposed in 2015 relating to pay-for-performance disclosure, compensation clawbacks and director and employee hedging disclosure continue to await final rulemaking and at this time do not appear to be a high priority for near-term action by the SEC.
Financial CHOICE Act proposals
The Financial CHOICE Act, passed by the House of Representatives in June 2017, covers a broad range of banking and other financial regulatory reforms and administrative law changes, in addition to a number of provisions relating to governance and disclosure requirements. This act represents an opening salvo by the House Republicans in the administration’s effort to repeal or modify a host of Dodd-Frank mandates. Targets for repeal or modification include, among others, pay ratio disclosure, conflict minerals reporting, say-on-pay and say-on-frequency advisory vote requirements, proposed clawback requirements, mine safety disclosures, proposed disclosures regarding director and employee hedging, proxy access and the SEC’s proposed rule regarding universal proxy requirements. The bill has been submitted to the Senate. However, at this point it seems to have stalled and we can’t predict when, if ever, it will be considered, debated or voted upon by the Senate.
FAST Act modernization and simplification of Regulation S-K proposals
This set of rule changes, as proposed by the SEC in late October 2017, largely represent incremental or technical changes intended to simplify and streamline various disclosure requirements. Among other things, the proposed amendments to Regulation S-K would eliminate MD&A requirement for certain prior period comparisons, simplify and streamline various exhibit requirements (including, for example, permitting certain redactions and omissions without requiring submission of a confidential treatment request), eliminate certain duplicative disclosure requirements and require hyperlinks to information incorporated by reference in certain filings. The comment period for these proposed rule changes ends January 2, 2018.
Treasury recommendations on capital markets
The U.S. Treasury’s report and recommendations on various capital market topics was submitted to President Trump in October 2017. The report makes recommendations on a variety of topics spanning the financial regulatory system, including numerous recommendations regarding the same topics as those addressed by the Financial CHOICE Act. The Treasury report takes a more moderate approach to many of these issues, however, and thus may be a starting point for a proposal on which both houses of Congress could agree. Included among the report’s recommendations are the repeal of certain Dodd-Frank mandates viewed as “well-intentioned” but not appropriate for regulation under the federal securities laws, including those relating to conflict minerals reporting, mine safety disclosures, payments by resource extraction issuers and pay ratio disclosure. The Treasury report does not address all of the Dodd-Frank provisions which are targeted for repeal in the Financial CHOICE Act proposals, however, and does not provide specific recommendations on, for example, say-on-pay voting requirements, compensation clawbacks, hedging disclosure or proxy access matters.
We expect to see additional rulemaking proposals in 2018 from the SEC directed at modernizing, simplifying and streamlining Regulation S-K disclosure requirements. Cybersecurity disclosure, initial coin offerings regulation and capital formation initiatives may also be areas of focus for SEC rulemaking. We also expect that investors and interest groups will continue to be active in pressing for reforms and in lobbying efforts to influence the rulemaking process. The outlook for significant legislative reforms, however, remains uncertain.
Changes in Auditor’s Report (AS 3101)
The PCAOB’s proposed expanded audit report was approved by the SEC in October 2017. Certain changes to the audit reports of all issuers took effect immediately (for fiscal years ending on or after 12/15/17). Immediate changes for all issuers, for fiscal years ending on or after December 15, 2017, include various procedural and form changes to the audit report and required disclosure regarding auditor tenure and independence. Issuers who haven’t previously disclosed auditor tenure and whose auditor has served a long term may want to consider adding disclosure to the audit report to explain how the company benefits from the long-standing auditor relationship and also ensures the auditor’s independence.
Changes with delayed effectiveness
Beginning with fiscal years ending on or after June 15, 2019, for large accelerated filers and December 15, 2020, for all other issuers, the audit report will be required to include disclosures relating to critical audit matters, or CAMs, which are matters arising in the audit which (1) are required to be or actually are communicated to the audit committee, (2) are related to accounts or disclosures material to the financial statements and (3) involve especially challenging, subjective or complex auditor judgment. The CAM disclosure requirement does not apply to emerging growth companies, investment companies or business development companies. Issuers and audit committees should be discussing the CAM disclosure requirements with their auditor now and should begin reviewing with their auditor how the audit firm expects to apply the new standard and what types of CAM disclosures might be included in the report. Issuers will also want to understand of the implications of the expanded disclosures from a timing and process perspective. Issuers may also want to consider with their auditors engaging in periodic trail runs to ensure that internal and external processes are appropriately coordinated before CAM disclosure reporting becomes effective.
Shareholder activism and engagement
Expect continued intense activism
We anticipate that shareholder activism will continue to focus on director diversity and qualifications; environmental, social and governance matters and political contributions and lobbying disclosure. 2018 will likely see addition pressure on proxy access for issuers that are perceived to be late in adopting it or to have adopted it with nonstandard terms; disapproval of multiclass capital structures involving nonvoting shares; a push for shareholder authorization requirements for certain share issuances and buybacks; and a focus on cybersecurity. Groups such as the Investor Stewardship Group, the NYC Comptroller Boardroom Accountability Project 2.0, state AGs and others will likely take a more organized approach to their efforts. Engagement with all shareholders on a year-round basis will grow in importance.
Proxy advisor recommendations
We expect that ISS and Glass Lewis will continue to exert their influence in director diversity and qualifications and environmental, social and governance matters. The ISS 2018 Proxy Voting Guidelines, released on November 16, 2017, are important reading for most issuers. The changes to the guidelines address topics including board accountability, independence, responsiveness and composition; pay-for-performance; and shareholder proposals on climate change risk and gender pay gap, among others.
The rise of “active passive” investors
We believe that 2018 will be an important year for the involvement of passive index investors, such as Vanguard, Blackrock and State Street Global Advisors (SSGA). Each has noted that as investors who are essentially prohibited from selling the securities of index component issuers, they must take a long-term view of corporate governance and will assert themselves more forcefully with respect to both traditional corporate governance issues and emerging topics. With nearly half of U.S. market capitalization now managed on a passive basis, this could represent a major sea change in activism, with long-term investors challenging the efforts of traditional activists whose holding periods are decidedly short-term.
The recently issued Staff Legal Bulletin 14I (SLB 14I) indicates that the SEC’s staff may be more amenable to concurring in the exclusion of shareholder proposals that relate to ordinary business operations, even if they involve a matter of widespread public debate or societal importance, so long as the issuer can demonstrate having undertaken a thoughtful analysis of how the issuer’s business is affected by the matter. We also believe that the “economic relevance” grounds for excluding a shareholder proposal, which has fallen into disuse, may again become useful in light of the SEC’s comments in SLB 14I.
Virtual shareholder meetings
We expect more issuers to adopt virtual meetings, or hybrid live/virtual meetings, in 2018. Until key shareholders and proxy advisory firms take firm positions on virtual meetings, there appears to be a window of opportunity to adopt the practice in a way that fosters shareholder participation and engagement.
The foregoing has been prepared for the general information of clients and friends of the firm. It is not meant to provide legal advice with respect to any specific matter and should not be acted upon without professional counsel. If you have any questions or require any further information regarding these or other related matters, please contact your regular Nixon Peabody LLP representative. This material may be considered advertising under certain rules of professional conduct.