October 09, 2013

Securities Update - September 2013

SEC Finally Proposes Pay Ratio Disclosure Rule

By Troy M. Calkins and Rachel M. Krol

Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which was enacted on July 21, 2010, requires the Securities and Exchange Commission to amend Item 402 of Regulation S-K to require disclosure of the median of the total annual compensation of all employees of an issuer (excluding the chief executive officer), the annual total compensation of that issuer’s chief executive officer and the ratio of the median of the total annual compensation of all employees of an issuer (excluding the chief executive officer) to the annual total compensation of that issuer’s chief executive officer. This provision of the Dodd-Frank Act has caused great anxiety for many public companies over the last three years. Companies have expressed much concern that the rule required by Section 953(b) would be extremely burdensome, imposing difficult and expensive recordkeeping and analysis requirements with respect to a company’s entire employee population. On the other hand, many shareholders and investor advocates have spoken out in support of Section 953(b). High passions on both sides of this issue resulted in the SEC receiving, prior to the issuance of the proposed rule, over 22,000 comment letters and a petition with nearly 85,000 signatures.

The strongly divergent views expressed on the idea of a pay ratio disclosure rule may explain why the Commission took over three years to finally propose, on September 18, 2013, the revisions to Item 402 of Regulation S-K required to implement Section 953(b). Some observers have also suggested that the delay was attributable in part to the fact that the Commission and its staff did not share Congress’s enthusiasm for this new disclosure requirement.

The Commission appears to have worked hard in drafting its rulemaking proposal to provide issuers with flexibility in how to approach the required pay ratio calculations. Nonetheless, we expect the proposal to receive a high volume of comments from issuers who continue to feel that the rule will impose an undue burden on issuers and will result in disclosure that is not meaningful to investors. Comments on the rulemaking proposal are due on December 2, 2013, which means that Commission adoption of final rules cannot be expected until sometime in 2014. Given this timeline and the fact that the proposed rules state that a company would be required to report the pay ratio with respect to compensation for its first fiscal year commencing on or after the effective date of the final rule, calendar-year companies will not be required to provide the pay ratio disclosure until they file their proxy statement or Form 10-K in early 2016.

Summary of Proposed Rule 402(u)

The Commission’s pay ratio proposal would add a new paragraph (u) to Item 402 that would require registrants to disclose:

(i) the median of the annual total compensation of all employees of the registrant, except the principal executive officer (PEO) of the registrant;

(ii) the annual total compensation of the PEO of the registrant; and

(iii) the ratio of the amount in (i) to the amount in (ii), presented as a ratio in which the amount in (i) equals one or, alternatively, expressed narratively in terms of the multiple that the amount in (ii) bears to the amount in (i).

Disclosure of the ratio in (iii) could take any of the following forms:

  • “PEO pay is X times the median employee pay.”
  • “The PEO’s annual total compensation is X times that of the median of the annual total compensation of all employees.”
  • “The pay ratio is 1 to X.”

The rule proposal goes on to define certain terms used above and to require disclosures around the calculation of the ratio.


The Commission’s proposal states that the rule is intended to be flexible, therefore it does not prescribe a specific methodology for identifying the median. Approaches that could be used by registrants include, for example:

  • Using reasonable estimates to determine the value of various elements of total compensation in order to identify the median employee. The SEC recognizes that using estimates may be necessary for valuing types of compensation for which the company may not have complete information, such as union pension plan benefits, or personal benefits such as housing or government-mandated pension plans for non-U.S. employees.
  • Using statistical sampling to identify a “median employee” by taking a random sample of employees and determining either the exact compensation of the employees in the sample, or to identify employees as above or below the median, in order to find the employee in the middle of the pay spectrum.

The registrant must briefly disclose the methodology and any material assumptions, adjustments or estimates used to identify the median and must describe any changes in methodology year-to-year and the reasons for the changes, and provide an estimate of the impact of the changes on the median and the ratio. Any discussion should be limited to a brief overview; the registrant does not need to provide technical analyses or formulas.

If the registrant uses estimated compensation figures to determine the median, the disclosure would need to clearly identify any estimated amounts and include a brief description of the methods used. If the registrant uses statistical sampling, the disclosure should state the size of the sample and the estimated whole population, which sampling method was used and how the method accounts for separate business or geographic segments. While a small sample size may be appropriate in certain situations, for a larger business, the sample, and any assumptions or inferences used in the calculations, must draw upon observations from each business or geographical unit. Any sample can, however, exclude employees on the high and low extremes of the sample.

Whatever method the registrant uses to identify the median, it must be consistently applied. For example, the registrant could use total direct compensation (i.e., annual salary, hourly wages and any other performance-based pay) or cash compensation to identify a median employee, so long as the method is identified and used consistently throughout the calculations.

“annual total compensation”

Once the median employee is identified, the registrant must calculate annual total compensation and disclose the information required under Item 402(c)(2)(x) as it relates to the median employee (replacing references to “named executive officer” with “employee” and, where necessary, references to “base salary” and “salary with “wages plus overtime”). The registrant must also briefly disclose and consistently apply the methodology and any material assumptions, adjustments or estimates used to calculate the total compensation or any elements of compensation.

Total annual compensation must be calculated for the last completed fiscal year period. Proposed instructions to the rule would permit registrant to use the same annual period already used in payroll, tax or other records for determining the median employee, but the annual compensation amount must be calculated for the last completed fiscal year.

When determining the median, the registrant may annualize the compensation for all permanent employees who were employed for less than the full fiscal year, and are employed on the calculation date described above. In some cases it may be appropriate for the registrant to annualize a permanent part-time employee’s compensation (i.e., a permanent employee works three days a week and takes a leave of absence during the year). However, the proposed rule does not permit adjustments for temporary or seasonal employees or cost-of-living adjustments for non-U.S. workers.

“all employees…except the PEO”

The principal executive officer, or PEO, is the same individual already defined in Item 402(a)(3). “All employees” is intended to include any full-time, part-time, seasonal or temporary worker employed by the registrant or any of its subsidiaries, which is consistent with Item 402(a)(2) and Instruction 2 to Item 402(a)(3), and includes U.S. and non-U.S. employees. “All employees” does not include independent contractors, “leased” workers, or temporary workers employed by a third party, but does include officers other than the principal executive officer.

The calculation date for determining who is an employee is the last day of the registrant’s last completed fiscal year, the same date used in Item 402(a)(3)(iii) for determining the identity of the three most highly compensated executive officers.

How and When to File:

Under the proposed rule, issuers would be required to include the pay ratio disclosure in filings, such as the Form 10-K and proxy statements, that already require Item 402 disclosures. The rule would only apply to issuers that are required to provide the summary compensation table pursuant to Item 402(c) and would not apply to emerging growth companies, smaller reporting companies, foreign private issuers or multijurisdictional disclosure system filers. The pay ratio disclosure will be considered “filed” rather than “furnished” for purposes of the Securities Act and Exchange Act.

The pay ratio disclosure would not be required to be updated either (i) until the registrant files its proxy statement for its annual meeting of shareholders; or (ii) no later than 120 days after the end of the registrant’s fiscal year (as provided in General Instruction G(3) of Form 10-K). Any filing made after the end of the fiscal year but before the filing of the Form 10-K or proxy statement, must include or incorporate by reference the registrant’s most recent pay ratio disclosure.

If a registrant relies on Instruction 1 to Item 402(c)(2)(iii) and (iv) to omit disclosure of the salary or bonus of a named executive officer if it is not calculable, the registrant can also omit the pay ratio disclosure (with the appropriate footnote disclosing the omission and providing the date that the compensation will be determined). The registrant would then need to include its pay ratio disclosure in the Form 8-K that included the omitted salary or bonus information pursuant to Instruction 1 described above.

Penalty for Head of Investor Relations – $50,000 Penalty for Company – $0 Regulation FD Compliance Program – Priceless

By Troy M. Calkins

The latest Regulation FD enforcement case brought by the Securities and Exchange Commission demonstrates the value to a public company of maintaining a rigorous Regulation FD compliance program. Regulation FD was adopted by the SEC in August 2000 to address concerns about the selective disclosure of information by public companies. The SEC has summarized Regulation FD as follows: when an issuer discloses material nonpublic information to certain individuals or entities — generally, securities market professionals, such as stock analysts, or holders of the issuer's securities who may well trade on the basis of the information — the issuer must make full public disclosure of that information.

The SEC issued an order on September 6, 2013, in its administrative proceeding against Lawrence D. Polizzotto, who had been the head of investor relations for First Solar, Inc., a company traded on NASDAQ. The order stated that Mr. Polizzotto made selective disclosures in one-on-one conversations with stock analysts regarding the fact that it appeared unlikely that First Solar would receive a previously anticipated government loan guarantee. These disclosures were material to investors, as the company had previously made public statements about management’s high level of confidence that the loan guarantee would be received.

What is particularly notable about the order in the Polizzotto matter is the fact that the Commission fined Mr. Polizzotto $50,000 personally, and issued a cease and desist order against him, but did not sanction First Solar. In the order and related press release, the SEC highlighted the following facts:

  • Mr. Polizzotto had been advised in an e-mail from First Solar’s inside counsel that he would be restricted by Regulation FD from making statements about the status of the loan guarantee to individual analysts and investors until the company issued a press release about the matter.
  • Knowing that the press release had not yet been issued, Mr. Polizzotto drafted talking points for discussions with individual analysts and investors about the loan guarantee status.
  • When other members of the company’s management learned through a news article that Mr. Polizzotto may have selectively disclosed material information about the status of the loan guarantee, the company finalized and issued its press release on the matter.
  • Prior to the selective disclosure, First Solar had cultivated an environment of compliance through the use of a disclosure committee that focused on compliance with Regulation FD.
  • First Solar promptly self-reported the selective disclosure to the SEC and cooperated with the SEC’s investigation.
  • The company took remedial measures to address the selective disclosure, including additional training on Regulation FD.

The moral of this story for public companies is that a company may not ultimately be able to prevent a rogue employee from violating Regulation FD, but the company can reduce its exposure to penalties for the violation by maintaining a strong culture of compliance and taking swift and thorough steps to remediate the violation when the company discovers it.

Merger Paying Common Shareholders $0 Found To Be Entirely Fair

By Todd C. Schiltz

On August 16, 2013, the Delaware Court of Chancery issued a post-trial opinion holding that the directors of Trados Inc. did not breach their fiduciary duties when approving a merger notwithstanding the fact that holders of common stock received nothing in the transaction.

The case concerned a typical fact pattern: Trados had issued several series of preferred stock in exchange for venture funding, the holders of the preferred stock had gained control of the Trados board, the venture capitalists were unwilling to invest more in Trados, the Trados directors approved a merger transaction that resulted in the common shareholders receiving nothing, and the holders of preferred stock, whose designees on the Trados board approved the transaction, received all of the merger consideration in partial satisfaction of the preferred stock liquidation preference.

A holder of common stock brought suit alleging that the directors breached their duties by approving a transaction that benefitted the preferred at the expense of the common. The plaintiff emphasized the interested nature of the transaction (a majority of the directors who approved the transaction were affiliated with the holders of preferred who benefitted from the transaction), the contractual nature of preferred stock, the limited fiduciary duties directors owe to holders of preferred stock, and the Delaware case law, which recognizes that, when directors can exercise discretion, they should generally prefer the interests of common stockholders to those of preferred stockholder, and argued that the directors should have continued operating Trados for the benefit of the common.

The Court began by concluding that a majority of the directors were interested in or had a conflict with respect to the transaction. In reaching this conclusion, the Court noted that venture capitalists seek to receive outsized economic returns in a compressed time frame and that the funds that had invested in Trados (and their director designees on the Trados board) were following this business model when they were looking to exit their investment. This objective can be at odds with a board member’s fiduciary duties: “the standard of conduct for directors requires that they strive in good faith and on an informed basis to maximize the value of the corporation for the benefit of its residual claimants, the ultimate beneficiaries of the firm‘s value, not for the benefit of its contractual claimants.”

Because the directors were interested in the transaction, they bore the burden of proving that the transaction was “entirely fair” to the common stockholders. Entire fairness has two basic components: fair process and fair price. Fair process concerns how the transaction was initiated, structured, negotiated and disclosed to the directors, as well as how the approvals of the directors and the stockholders were obtained. Fair price relates to the economic consideration of the transaction. Although fair process and fair price can be examined separately, entire fairness involves a unitary analysis with the court considering all aspects of the issue since the inquiry is one of entire fairness.

Based on the evidence presented at trial, the Court found that the directors had not engaged in fair dealing when approving the merger. The Court concluded the sale process had been initiated to obtain an exit for the preferred holders and that the board had failed to consider the interests of the common or how those interests might be protected by allocating merger proceeds in a different manner. Nevertheless, the Court determined that the transaction was entirely fair to the common shareholders and the board had not breached its fiduciary duties because the evidence showed that the economic value of the common stock at the time of the transaction was zero, exactly what the holders of common stock received in the merger. As the holders of the common received through the merger the equivalent of what they held before the merger, the merger was entirely fair to them. As explained by the Court: “the directors breached no duty to the common stock by agreeing to a Merger in which the common stock received nothing. The common stock had no economic value before the Merger, and the common stockholders received in the Merger the substantial equivalent in value of what they had before.”

The Trados case highlights the difficulties directors can face when they have conflicting duties. Resolving these conflicts and/or determining the best way to proceed can be a difficult process, and individuals and entities should consult with their counsel to navigate and attempt to minimize these difficulties.

PCAOB Proposes Changes to Audit Reports

By Elizabeth A. Diffley

The Public Company Accounting Oversight Board (PCAOB) has proposed two new auditing standards that would expand the content of audit reports as well as the auditor’s responsibility regarding information outside the financial statements. PCAOB Release No. 2013-005 (August 13, 2013) is available at: http://pcaobus.org/Rules/Rulemaking/Docket034/Release_2013-005_ARM.pdf. The proposals are designed to retain the current “pass/fail” audit report model while increasing the informational value and relevance of the report. In his remarks about the proposals, PCAOB board member Steven Harris articulated the challenge of this project to be finding “a way to balance the need for a different, more useful and communicative model of the auditor’s report with the need not to change what auditors do, but how they report on what they do.”

Audit Report

The proposed standards would keep the basic elements of the current auditor’s report, including the current “pass/fail” model, but would require the auditor to include additional information specific to the audit. Auditors would be required to communicate “critical audit matters” as determined by the auditor. Critical audit matters are generally defined to be those addressed during the current-period financial statements audit that (1) involved the most difficult, subjective or complex auditor judgments, (2) posed the most difficulty to the auditor in obtaining sufficient appropriate evidence, or (3) posed the most difficulty in forming the opinion on the financial statements.

Described informally as the types of matters that kept the auditor up at night, critical audit matters are generally of such importance that they are included in the audit completion documents that summarize the significant issues and findings, reviewed by the audit engagement quality reviewer, and communicated to the company’s audit committee. The audit report would identify critical audit matters, describe the considerations that led the auditor to determine that each matter is a critical audit matter, and refer to relevant related financial statement accounts and disclosures. In the alternative, if the auditor determines that no critical audit matters exist, the auditor would include a statement to that effect in the report.

The proposed changes to the audit report would also add a requirement to include information in the report related to auditor tenure and independence.

Other Information

The proposed standards would also expand the auditor’s responsibilities for information included in the company’s annual report other than the audited financial statements. This “Other Information” would include management’s discussion and analysis, selected financial data, exhibits, and certain information incorporated by reference. The auditor’s current requirement is to “read and consider” information, but there is no related reporting requirement. The proposed standards would instead require the auditor to “read and evaluate” the other information for a material misstatement of fact or material inconsistency with the financial statements. The auditor would not opine on this other information, but would be required to disclose in its report its responsibility for other information and the results of its evaluation. Specifically, the auditor would state either that it did not identify a material inconsistency or material misstatement of fact in the other information, or, if it had, would state that it had identified something that had not been revised and would describe that material inconsistency, material misstatement of fact, or both, found in the other information.

Reactions and Next Steps

Response to the proposals has been mixed, with some investors and audit firms expressing receptiveness to enhancing auditor reporting to be more useful to financial statement users. Other parties, however, have raised concerns not only about the increased cost and complexity of the financial reporting process, but also about auditors directly communicating with shareholders regarding a company’s accounting judgments, including the potential chilling effect on communications between the company and the auditor and additional litigation risk for both the company and the auditor.

The public comment period on these proposals ends on December 11, 2013. In the proposing release, the PCAOB also noted that it is considering holding a public roundtable in 2014 to discuss the proposed standards and comments received.

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