Securities Snapshot: 1st Quarter 2020
In this edition of KMK Law’s Securities Snapshot, we review the recent actions and guidance of the U.S. Securities and Exchange Commission (SEC) and its Division of Corporation Finance in response to COVID-19. We also examine other ongoing rulemaking of the SEC, including amendments to the definitions of "accelerated filer" and "large accelerated filer,” proposed amendments to private offering exemptions, amendments to limit the scope of financial disclosures required in certain registered debt offerings, and proposed amendments and guidance for modernizing financial disclosures in MD&A. Additionally, we note a recent decision from the Delaware Supreme Court that Delaware corporations may require claims under the Securities Act of 1933 to be heard in federal court. Although much of the discussion below focuses on COVID-19-related SEC developments, it is important to be mindful of the SEC’s continuing focus on updating its rules.
SEC Actions in Response to COVID-19
On March 25, 2020, the SEC extended its March 4 Order granting exemptions to reporting and proxy delivery requirements for public companies. As extended, the Order provides that public companies that are unable, because of COVID-19, to meet filing deadlines for SEC reports due to be filed on or before July 1, 2020, will have 45 additional days to file these reports so long as, among other things, they file reports on Form 8-K describing the reasons why the report may not be filed on a timely basis.
The extension of the March 4 Order (described in our advisory here) means that the filing of quarterly reports otherwise due May 11 (for accelerated filers and large accelerated filers) or May 15 (for non-accelerated filers), as the case may be, may be delayed by up to 45 days. The SEC’s extended Order provides that the SEC may “provide extensions to the time period for the relief, with any additional conditions it deems appropriate, or provide additional relief as circumstances warrant.”
Our reading of the extended Order concludes that only reports due under certain sections of the Exchange Act, including Sections 13(a) and 15(d), are subject to the Order. Form SD is required under Section 13(p) of the Exchange Act, which is not one of the sections enumerated in the Order. Therefore, absent additional relief or guidance from the SEC, companies are still required to file their Form SD reports by May 31, 2020.
The SEC’s Division of Corporation Finance issued Disclosure Guidance Topic No. 9 – Coronavirus (COVID-19) (linked here) on March 25, 2020. The guidance provides the staff’s current views regarding disclosure and other securities law obligations that companies should consider with respect to COVID-19 and related business and market disruptions. The guidance encourages timely reporting while recognizing that it may be difficult to assess or predict with precision the broad effects of COVID-19 on industries or individual companies. The guidance suggests that disclosure of COVID-19-related risks and COVID-19-related effects may be necessary or appropriate in management’s discussion and analysis, the business section, risk factors, legal proceedings, disclosure controls and procedures, internal control over financial reporting, and the financial statements. The guidance provides several questions companies should consider with respect to disclosure obligations. These questions are reviewed in our March 26 advisory.
The guidance reminds companies and insiders regarding the need to refrain from trading prior to dissemination of material non-public information related to COVID-19 as well as the importance of avoiding selective disclosures in respect to Regulation FD. The guidance also offers suggestions regarding non-GAAP financial measure disclosures.
The Impact of Coronavirus on SEC Disclosures and Shareholder Engagement
On March 4, the SEC advised all public companies to assess what COVID-19 means for their future operations and financial results and to make appropriate disclosures to their shareholders and other members of the investment community. While expectations regarding the severity of COVID-19 rapidly evolve, public companies should have focus on certain areas:
- Periodic reporting: Reports on Form 10-K and Form 10-Q require compliance with Regulation S-K Rule 303, which requires disclosure in MD&A of "known trends or uncertainties that have had or that the [company] reasonably expects to have a material favorable or unfavorable impact on net sales or revenues."
Companies should discern these uncertainties and their related response plans with respect to COVID-19 with a view to discussing them in their next periodic report. Companies expecting to be meaningfully impacted by COVID-19 also must disclose risk factors that address specific facts about the past and future effect of the virus. While some companies have added discussion of COVID-19 as a risk factor to reports on Form 10-K and Form 10-Q, other companies preparing for securities offerings or already engaging in continuous securities offerings or otherwise should consider whether a Form 8-K filing to report COVID-19 as a risk factor is necessary. Additionally, companies should carefully consider safe harbor disclosure in forward looking statements disclaimers and perhaps add COVID-19 as a cautionary factor.
- Earnings guidance: Management should consider whether the recent developments related to COVID-19 require revisiting their guidance as to future financial results. Some management teams may want to discuss the merits and risks of withdrawing (as opposed to merely revising) previous estimates or ranges.
- Board communications: Management teams need to be thinking about what boards should know about the possible effects of COVID-19 on their companies. Boards should be asking management about the possible effects of COVID-19 on operational issues, including employees, suppliers and customers.
- Shareholder meetings. Companies planning annual meetings of shareholders should be mindful of the opportunity, to the extent permitted by charter documents and state law, to conduct such meetings virtually. Even some companies that have already issued proxy materials may amend their proxy statements to change the meetings to virtual-only meetings. On March 13, 2020, the SEC relaxed shareholder meetings requirements, including for companies that already filed and mailed proxy statement materials. See “SEC Relaxes Shareholder Meeting Requirements in Response to COVID-19” below.
SEC Relaxes Shareholder Meeting Requirements in Response to COVID-19
On March 13, 2020, the SEC published guidance to assist public companies, investment companies, shareholders, and other market participants affected by COVID-19 with upcoming annual shareholder meetings. The guidance is designed to facilitate the ability of companies to conduct these meetings, including through the use of technology, and engage with shareholders while complying with the federal securities laws.
The guidance allows companies to change the date and location of meetings and use technologies, such as “virtual” meetings that avoid the need for in-person shareholder attendance. Specifically, a company that has already mailed and filed its definitive proxy materials can notify shareholders of a change in the date, time, or location of its annual meeting without mailing additional soliciting materials or amending its proxy materials if it:
- issues a press release announcing such change;
- files the announcement as definitive additional soliciting material on EDGAR; and
- takes all reasonable steps necessary to inform other intermediaries in the proxy process (such as any proxy service provider) and other relevant market participants (such as the appropriate national securities exchanges) of such change.
Companies that have not yet mailed and filed their definitive proxy materials should consider whether to include disclosures regarding the possibility that the date, time, or location of the annual meeting will change due to COVID-19.
Companies may announce in filings made with the SEC the changes in the meeting date or location or the use of “virtual” meetings without incurring the cost of additional physical mailing of proxy materials. The SEC’s guidance encourages companies to provide shareholder proponents with alternative means, such as by telephone, to present their proposals at the annual meetings in light of the difficulties that shareholder proponents face due to COVID-19.
Companies considering virtual meetings should be mindful of the perspectives of institutional investors and proxy advisory firms regarding these meetings. These constituencies generally require disclosure affirming that a virtual meeting will provide full opportunities for shareholders to participate, ask questions, and present shareholder proposals.
Changes to Accelerated and Large Accelerated Filer Definitions
On March 12, the SEC adopted amendments to the "accelerated filer" and "large accelerated filer" definitions in Exchange Act Rule 12b-2. Accelerated and large accelerated filers are subject to, among other things, the requirement that their outside auditors attest to, and report on, management's assessment of the effectiveness of the issuer's internal control over financial reporting (ICFR). In the Jumpstart Our Business Startups (JOBS) Act of 2012, Congress exempted many new public issuers from this requirement for up to five years after going public.
The amendments would allow smaller issuers that have been public for more than five years, but have not yet reached $100 million in revenues, to continue to benefit from the JOBS Act exemption as they build their businesses, while maintaining important investor protections. Specifically, the issuers' principal executive and financial officers must continue to certify that, among other things, they are responsible for establishing and maintaining ICFR and have evaluated and reported on the effectiveness of the company's disclosure controls and procedures. In addition, these smaller issuers will continue to be subject to a financial statement audit by an independent auditor, who is required to consider ICFR in the performance of that audit.
The amendments will:
- Exclude from the accelerated and large accelerated filer definitions an issuer that is eligible to be a smaller reporting company and had annual revenues of less than $100 million in the most recent fiscal year for which audited financial statements are available. Business development companies will be excluded in analogous circumstances.
- Increase the transition thresholds for an accelerated and a large accelerated filer becoming a non-accelerated filer from $50 million to $60 million and for exiting large accelerated filer status from $500 million to $560 million.
- Add a revenue test to the transition thresholds for exiting both accelerated and large accelerated filer status.
- Add a check box to the cover pages of annual reports on Forms 10-K, 20-F, and 40-F to indicate whether an ICFR auditor attestation is included in the filing.
The amendments go into effect on April 27, 2020.
Harmonizing Private Offering Exemptions
On March 4, 2020, the SEC proposed amendments to the current private offering exemptions that are intended to address gaps and complexities in the exempt offering framework. The proposal is a nod to smaller companies who are more likely to rely on these exemptions, but may find the exemptions particularly difficult to navigate given their more limited resources. The proposed amendments include the following highlights:
- Integration. The proposal provides additional clarity to the rules governing “integration” of private and public offerings, by establishing the following four non-exclusive safe harbors from integration with other offerings:
- Offerings more than 30 calendar days apart, provided that the purchasers were not solicited through a general solicitation, or had previously established a substantive relationship with the issuer.
- Offers and sales made in compliance with Rule 701, pursuant to an employee benefit plan or in compliance with Regulation S;
- Offerings for which a registration statement has been filed would not be integrated with another offering if made subsequent to: (i) a terminated or completed offering for which general solicitation is not permitted; (ii) a terminated or completed offering for which general solicitation is permitted and made only to qualified institutional buyers and institutional accredited investors; or (iii) an offering that terminated or completed more than 30 calendar days prior to the commencement of the registered offering.
- Offers and sales made in reliance on an exemption for which general solicitation is permitted would not be integrated with another offering if made subsequent to any prior terminated or completed offering.
- General Solicitation and Offering Communications. The proposal expands general solicitation exemptions, including for “demo days” and similar events. Also, the proposal includes a new “testing the waters” exemption that would permit an issuer to use a generic solicitation of interest materials for an offer of securities prior to making a determination as to the exemption under which the offering may be conducted which would, in part, allow issuers to use general solicitation to test the waters prior to conducting a Rule 506(b) offering (provided that offerees that were solicited by means of general solicitation cannot participate in the Rule 506(b) offering).
- Rule 506(c) Verification Requirement. The proposal expands the methods by which an issuer may verify accredited investor status.
- Harmonizing Disclosure Requirements. For Regulation D offerings that include non-accredited investors, the proposal would align the financial disclosure requirement with the less burdensome financial disclosure requirements of Regulation A. The proposal would also simplify Regulation A by aligning it with the rules for registered offerings regarding the redaction of confidential information in material contracts, permitting draft offering statements to be made public on EDGAR, permitting incorporation by reference on Form 1-A, and permitting the declaration of a post-qualification amendment as abandoned.
- Offering and Investment Limits. The proposal raises Tier 2 maximum offerings under Regulation A from $50 million to $75 million and, for secondary sales, from $15 million to $22.5 million. The proposal also raises the offering limit under Regulation Crowdfunding from $1.07 million to $5 million. The proposal would revise the eligibility restrictions by (i) allowing certain special purpose vehicles to be used when investing in Regulation Crowdfunding issuers and (ii) restricting the types of securities that can be offered under Regulation Crowdfunding. The SEC declined to raise the offering limits under Rule 504 of Regulation D.
The comment period for this proposal is open until June 1, 2020.
Financial Disclosures for Certain Registered Debt Offerings
On March 2, 2020, the SEC adopted amendments to Regulation S-X that significantly change the financial disclosures required in registered offerings applicable to guarantors, issuers of guaranteed securities and to affiliates whose own securities make up some or all of the collateral for the securities offered. The amendments reduce the financial disclosures required and focus on information that is material to investors given the specifics of each offering.
New Rule 13-01 - Guaranteed Securities
The amendments to Rule 3-10 and new Rule 13-01 of Regulation S-X will replace the condition that a subsidiary issuer or guarantor be 100% owned by the parent so long as it is consolidated in the parent's consolidated financial statements and certain specific financial and non-financial disclosures be included in the prospectus. Additionally, the following list of "summarized financial information" must generally be included for the issuer and guarantors for the most recent fiscal year and subsequent interim period:
- Current assets, non-current assets, current liabilities, non-current liabilities, and, when applicable, redeemable preferred stocks and non-controlling interests;
- Net sales or gross revenues, gross profit (or costs and expenses applicable to net sales or gross revenues), income or loss, and net income or loss attributable to the entity; and
- Such other financial information deemed material for investors.
The adopted rules also eliminate the requirement to provide pre-acquisition financial statements of recently acquired subsidiaries and guarantors, but will require pre-acquisition summarized financial information about recently acquired subsidiary guarantors when the recently acquired guarantors are part of a business that is "significant" and otherwise requires financial statements.
Amendment to Rule 3-16 and New Rule 13-02
Amendments to Rule 3-16 and new Rule 13-02, in part, do the following:
- Replace the requirement to provide disclosure based on the 20% "substantial portion" test with a requirement to provide financial and non-financial disclosures to the extent material.
- If materiality is established for an affiliate whose securities are pledged as collateral, the issuer must provide specific financial and non-financial disclosures, including summarized financial information about the affiliate and the collateral arrangement as a supplement to the consolidated financial statements of the registrant that issues the collateralized security.
- Require certain non-financial disclosures about the securities pledged as collateral, along with disclosure about additional facts and circumstances specific to particular affiliates that would be material to holders of the collateralized security.
Effective Date and Transition
The final amendments are effective on January 4, 2021. Voluntary compliance with the final amendments, rather than the SEC rules in effect prior to these amendments, is permitted in advance of the effective date. Generally, we expect that issuers who want to pursue registered offerings of guaranteed debt will voluntarily comply with the new rules and provide the more limited disclosures. Importantly, Rule 3-16 as currently in effect will apply to any security issued before January 4, 2021.
Proposed Amendments to Regulation S-K
On January 30, 2020, the SEC proposed more amendments to the disclosure requirements of Regulation S-K. Like other proposed and final amendments to Regulation S-K issued over the past two years, the recent proposal intends to modernize, simplify and enhance the SEC's framework for disclosures outside the financial statements. The proposed amendments would:
- Streamline the disclosure instructions to management's discussion and analysis (MD&A) (S-K Item 303) and clarify the overall objective of MD&A;
- Eliminate the requirements to disclose selected financial data (S-K Item 301) and supplementary financial data (S-K Item 302);
- Amend certain other longstanding prescriptive disclosure requirements within MD&A (e.g., disclosure of contractual obligations in a tabular format would no longer be required (S-K Item 303(a)(5));
- Clarify the existing guidance for the disclosure of critical accounting estimates and incorporate it into Regulation S-K;
- Clarify the disclosure requirements regarding the results of operations by codifying other guidance within Regulation S-K (e.g., the discussion of the reasons underlying material changes is required); and
- Promote a principles-based approach to certain disclosures within MD&A.
Appendix A includes some of the significant proposed amendments compared to the current requirements. The proposal is subject to a 60-day public comment period after its publication in the Federal Register.
Interpretive Guidance on Key Performance Indicators and Metrics in MD&A
On January 30, 2020, the SEC also released guidance on the disclosure of key performance indicators and metrics in MD&A that is effective upon its publication in the Federal Register. The guidance provides considerations and disclosures that are expected to accompany non-financial and financial metrics used to describe the performance or status of the business.
Based on a registrant's facts and circumstances, the SEC expects the following disclosures to accompany disclosures of key performance indicators and metrics:
- A clear definition of the metric and how it is calculated;
- A statement indicating the reasons why the metric provides useful information to investors; and
- A statement indicating how management uses the metric in managing or monitoring the performance of the business.
The guidance includes additional disclosure considerations for companies that change the method by which they calculate or present a metric from one period to another (e.g., differences in the metrics between periods, reasons for the changes, etc.).
Registrants should also consider:
- The extent to which an existing regulatory framework applies, such as GAAP or, for non-GAAP measures, Regulation G or Item 10 of Regulation S-K;
- Whether there are estimates or assumptions underlying the metric or its calculation, and whether disclosure of such items is necessary for the metric not to be materially misleading; and
- Additional information that may be necessary to provide adequate context for an investor to understand the metric presented.
Companies preparing their annual reports should evaluate key performance indicators presented and accompanying disclosure, including whether MD&A covers the material metrics highlighted in their earnings releases and other investor presentations. The guidance reminds registrants of the importance to maintain effective disclosure controls and procedures when disclosing material key performance indicators or metrics that are derived from the company's own information.
Delaware Corporations May Restrict 1933 Act Claims to Federal Court
The Delaware Supreme Court reversed a Chancery Court decision invalidating federal-forum provisions that require Securities Act claims to be brought in federal court. The Delaware Supreme Court held that charter provisions requiring that Securities Act claims be brought in federal court are facially valid under Delaware law (Salzberg v. Blue Apron Holdings, Inc., March 18, 2020, Valihura). Mindful of concerns that other states may not follow this decision, the court explained, "Delaware historically has [been], and should continue to be, vigilant about not stepping on the toes of our sister states or the federal government.”
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