The Public Company Handbook is a practical guide for directors and executives of public companies.
A public company is a corporation, limited liability company or partnership subject to the regulations and disclosure requirements of the Securities Exchange Act of 1934 (1934 Act). Usually, this applies to entities that have completed an initial public offering (IPO) registered with the Securities and Exchange Commission (SEC) under the Securities Act of 1933 (1933 Act).
The 1934 Act requires companies with a widely traded class of equity securities to register those securities with the SEC. Registration under the 1934 Act is a one-time registration of an entire class of securities. By contrast, registration under the 1933 Act, such as an IPO, registers a certain number of securities for a particular public distribution. Two events trigger 1934 Act registration: listing on a national securities exchange or meeting certain size thresholds.
To list any securities for trading on a national securities exchange, a company must register the class of securities with the SEC under Section 12(b) of the 1934 Act. The company will also have to file a listing application and other materials with the exchange.
Alternatively, a company may trigger 1934 Act registration requirements simply by reaching a certain size. A company with total assets in excess of $10 million and a class of equity securities held of record by 2,000 or more persons – or 500 or more persons who are not accredited investors – must register the class of securities under Section 12(g) of the 1934 Act. A shareholder qualifies as an accredited investor by meeting criteria specified in rules under the 1933 Act, which generally involve individuals with high levels of income or net worth or entities with significant total assets. Securities issued pursuant to employee compensation plans are excluded from the definition of securities held of record for purposes of calculating the Section 12(g) threshold. This exemption generally covers stock options and other equity awards, as well as shares issued under these awards, held by employees and former employees of the company. A company must register within 120 days after the last day of the fiscal year in which it meets both the shareholder and total asset size thresholds.
Typically, a company will register its securities under the 1934 Act simultaneously with its IPO. This allows the company to list the securities offered in the IPO on a national securities exchange. Form 8-A makes 1934 Act registration relatively simple for a company concurrently registering an IPO. Form 8-A is a shortened registration statement that requires disclosure of general characteristics of the company’s securities, including dividend rights, voting rights and any antitakeover provisions in the company’s certificate or articles of incorporation and bylaws. This information is typically incorporated by reference from the company’s IPO registration statement.
Among other things, 2020 will be remembered as a year that saw a boom in the use of special purpose acquisition companies (SPACs) as a robust alternative to a traditional IPO. A SPAC is a company formed to raise capital in an IPO, with the offering proceeds serving as a blind pool of funds held in trust to finance the acquisition of one or several unidentified targets. As SPAC IPOs surged in 2020 and 2021, many companies and investors evaluated and undertook transactions with SPACs – referred to as “de-SPAC” transactions – as an alternative to traditional IPOs or merger and acquisition liquidity events. A de-SPAC transaction consists of a merger between a private operating company and a publicly traded SPAC, with the shareholders of the private company receiving shares of the SPAC and/or cash as consideration. The SPAC is already a public company, having completed an IPO and a simultaneous 1934 Act registration to list its shares on a national securities exchange. As a result of the de-SPAC transaction, the private company becomes a public company, with a shareholder base comprising the rollover private company shareholders, the SPAC sponsor, the SPAC’s public investors, and any private investors that participate in the deal through private investment in public equity.
company with securities registered under Section 12(b) (exchange listing) or 12(g) (companies of a certain size) of the 1934 Act must file periodic reports with the SEC. As we describe in this Handbook, a public company files annual, quarterly and current reports with the SEC.
In addition to periodic reporting, 1934 Act registrants and their directors, executive officers and significant shareholders are subject to the following requirements:
A company that has issued equity or debt securities to the public in an offering registered under the 1933 Act must file annual, quarterly and current reports with the SEC under Section 15(d) of the 1934 Act. This reporting requirement applies even though the company does not list the securities on a national securities exchange or market and the company has not crossed the size thresholds triggering 1934 Act registration. Companies subject to periodic reporting only by reason of Section 15(d) are free from a host of other 1934 Act requirements, including regulation of proxy solicitations and third-party tender offers, beneficial ownership reporting and short-swing profit liability.
In recent years, an array of public company stakeholders have pushed corporations to reevaluate their traditional focus on maximizing monetary returns for shareholders in favor of a more holistic approach that considers the interests of all stakeholders. Rising consumer, employee and government scrutiny and engagement have encouraged companies to change their business practices and policies. Consumers expect ethical and eco-friendly behavior; employees seek equitable pay, good working conditions and a diverse and inclusive workforce; and governments incentivize companies that invest in the communities where they operate.
In addition, a growing number of shareholders consider social and environmental factors in their investment strategies. In fact, U.S. assets held by institutional investors and money managers applying sustainable investing criteria accounted for $12 trillion in 2018 – about 25% of all professionally managed U.S. assets. Socially conscious investors look to environmental, social and governance (ESG) factors in making investment decisions, with some of the largest institutional investors leading the way. For example, massive worldwide fund manager BlackRock has developed a focus on sustainable investment offerings and plans to exit investments with high environmental risks. Investor attitudes toward ESG issues are also reflected by trends in shareholder activism. A large number of public company shareholder resolutions – a tool used by shareholders to drive change – concern political spending, climate change, pay equity, diversity, human rights and other ESG matters.
This evolving and more expansive view of the role and responsibility of corporations in society is an important backdrop against which your company will engage in public company life, crafting required and mandatory SEC disclosure and reporting obligations, guiding directors and senior management through the proxy statement and annual meeting processes, and striving to comply with the myriad corporate governance and fiduciary requirements of securities exchanges and state corporate laws. Through all this, your company will need to understand and address ESG and other matters at the forefront in the minds of stakeholders to ensure continued support, investment and opportunities for growth in the future.
The Board of Directors bears ultimate responsibility for the oversight of a company’s business and affairs. The Board establishes significant policies; makes fundamental decisions about strategic focus and direction of the company, including evaluation of key opportunities and risks; and approves the hiring, firing, succession planning and compensation of the executive officers who manage the company’s day-to-day business operations. Directors oversee risk management, including internal controls and compliance with laws, and monitor financial reporting and public disclosure. The Board also manages shareholder relations and engagement and sets the tone for ethical business conduct. This chapter describes how members of a Board, and its Audit, Compensation and Nominating & Governance Committees, can best fulfill these duties.
Although our discussion uses concepts from Delaware law, similar principles apply in other states.
Directors face a sometimes bewildering array of corporate governance requirements. Where do they come from?
In short, many of yesterday’s “best practices” have become today’s baseline requirements. New best practices continue to evolve as companies, regulators, institutional investors and corporate governance commentators debate the many new governance rules and standards that apply to public companies.
This chapter reviews best practices of corporate governance at the time this Handbook went to press in 2021. In Chapters 9 and 10, we describe in detail the governance standards of the NYSE and Nasdaq. We also make suggestions that may help your Board stay abreast of best practices of corporate governance that are sure to evolve in the years to come.
State statutes, court decisions and, increasingly, federal laws and regulations define the duties of directors. Yet even after the implementation of many new regulations, the basic duties of directors remain unchanged. Although there are nuances in the duties imposed by various states, most hold directors to general fiduciary duties of care and loyalty. Some courts have imposed the additional duty of candor.
Directors owe the company and its shareholders a duty to exercise the care that an ordinarily prudent person in a comparable position would exercise under similar circumstances. A director is not presumed to have special management skills, but is expected to exercise common sense and apply the skills he or she possesses. The time needed to fulfill the duty of care will increase with the importance and complexity of the proposed corporate action. The following decisions, for example, require substantial investigation and consideration:
Due care requires directors to apprise themselves of all reasonably available material information prior to making a business decision. Directors can best assess each proposal’s strengths and weaknesses by taking these steps:
You may want to use this image to illustrate the duty of care for your Board:
“Directors get in trouble for speeding, not for running the car off the road!”
In other words, the Board should act in good faith to make its best thoughtful, considered and informed decisions. If no conflicts of interest exist and the Board follows an appropriate process, courts usually will not second-guess the directors even when, in hindsight, the Board makes a wrong choice, takes a wrong turn or causes the company to suffer a loss.
In making decisions, a director may generally rely on information and reports from the company’s officers and employees; legal, financial and other advisors; and Board committees. Reliance, however, must be “eyes open” and prudent. Each director should assess the qualifications of the parties providing information and advice, and then examine the work product. A director may not rely on information or advice if the director has knowledge that would make reliance unreasonable. In reviewing material, the three best rules of thumb are simply:
A director owes the company and its shareholders a duty of loyalty to give higher priority to corporate interests than to his or her personal interests in making business decisions. If a director has a personal interest in a matter, he or she must fully disclose the interest to the Board and will often abstain from voting on or participating in discussion of the matter. Similarly, directors should not pursue, other than through the company, business opportunities that relate to the company’s existing or contemplated business unless disinterested members of the Board, after full disclosure, have decided that the company will pass on the opportunity.
Conflicts of Interest. Conflicts of interest and corporate opportunities arise regularly in the day-to-day conduct of a Board’s business.
A director may, for example, have a corporate opportunity or conflict of interest as a result of:
The frequency of conflicts of interest has given rise to a host of mechanisms for conflict management. Using them should permit a Board to act responsibly. Ways to manage conflicts of interest include:
In unusual situations, such as where all or virtually all directors have a conflict, and where shareholder approval is impractical or the shareholders themselves have conflicts of interest, the Board may take an action that it believes to be “entirely fair” to the company. Public companies rarely act on this basis. Shareholders have the right to challenge a transaction in which the directors have a conflict and the transaction is nonetheless approved by the Board. A court will uphold the action if it establishes that the action was fair to the company at the time the Board approved it.
The interests of the company and its shareholders, while primary, are not the sole consideration of the Board. Some states have adopted constituency statutes that permit directors to consider the interests of other constituents, including employees, customers, suppliers and communities, when making business decisions. Even in a state without a permissive constituency statute, such as Delaware, directors may take into account – in the absence of a sale of control transaction – various stakeholder interests in a manner consistent with their fiduciary duties as they consider long-term value creation for the company and its shareholders. The Business Roundtable’s 2019 Statement on the Purpose of a Corporation, highlighting the corporate signatories’ commitment to all their stakeholders, garnered significant attention. The Statement has led to conversations among governance professionals and in the boardroom about balancing the interests of various constituents while fulfilling the Board’s duties in a manner consistent with application of the business judgment rule. Chapter 3 discusses company engagement with shareholders and other stakeholders.
In addition, other statutory provisions may mandate the consideration of stakeholders other than a company’s shareholders. When a company becomes or is likely to become insolvent, for example, a director’s duty of loyalty may shift to include the company’s creditors.
Delaware and several other states have adopted laws permitting the creation of public benefit corporations. These hybrid corporations balance shareholders’ financial interest with the best interests of other stakeholders materially affected by the company’s business activities, while creating an overall public benefit. Few companies have adopted the public benefit corporation model, and we would not expect many public companies to utilize this hybrid approach.
Delaware judicial decisions have articulated a duty of candor or disclosure. This additional responsibility derives from both the duty of care and the duty of loyalty. The duty of candor calls on directors to disclose to their fellow directors and the company’s shareholders all material information known to them that is relevant to the decision under consideration. In judging whether a director has satisfied his or her duty of candor, courts will examine the materiality of all undisclosed or underdisclosed information.
Courts apply the business judgment rule in reviewing most decisions made by directors. Under the business judgment rule, courts defer to the decisions of disinterested directors absent evidence that the directors did not act in good faith or were not reasonably informed about the decision or that there is no rational business purpose for the decision that promotes the interests of the company or its shareholders.
Courts in Delaware and other states apply a more stringent enhanced scrutiny standard when examining transactions involving the adoption of antitakeover measures, implementation of deal-protection mechanisms such as lock-up options, a change of control or a breakup of the company.
When applied in assessing the appropriateness of antitakeover or deal-protection measures, this standard is known as the Unocal standard. In defending its adoption of company deal-protection measures, a Board must show that:
If a Board can establish both elements, the action should receive the protection of the business judgment rule.
When a Board elects to pursue a change of control or breakup of the company, the Board has a separate enhanced responsibility: to obtain the highest value reasonably available for shareholders. This standard is commonly referred to as the Revlon standard. A “change of control” in the Revlon context involves a cash merger, a merger in which more than 50% of the consideration is cash or a merger in which a controlling shareholder will result. If, however, a proposed merger will not result in a sale of control, such as in a stock-for-stock merger between two noncontrolled companies, the ordinary business judgment rule applies to the Board’s decision to enter into a merger agreement, as held by the Delaware Supreme Court in Paramount Communications, Inc. v. Time Inc. (commonly known as the Time-Warner case).
Courts give special deference to Boards that seek truly independent third-party advice, such as that of an investment bank, valuation consultant or law firm, to assist disinterested directors in assessing a transaction. An opinion from a reputable third-party financial advisor that a transaction is fair to the company and its shareholders from a financial point of view may substantially reduce the risk of a successful challenge to the Board’s decision under any standard of review. A fairness opinion can also help independent directors make an informed decision.
Without a fairness opinion, you may find yourself in the same unfortunate position as the directors of Trans Union Corporation. In the 1980s, Trans Union’s Board approved a sale of the company. In the case Smith v. Van Gorkom, a Delaware court held that the Board breached its fiduciary duties by acting without adequate information or independent third-party advice. The court concluded that the Board’s decision to accept a market premium without first determining the intrinsic value of Trans Union’s shares left the directors vulnerable to personal liability to the company’s shareholders to the extent a fair price exceeded the sale price.
By contrast, in the 2005 Disney case, a Delaware court placed weight on the Disney Compensation Committee’s reliance on an independent compensation expert. The Committee was entitled to rely on the expert even though his analysis may have been incomplete or flawed. The Committee had selected the expert with reasonable care, the analysis was within his professional competence, and the directors had no reason to question his conclusions. (See “Trap for the Unwary: The Compensation Committee After Disney” later in this chapter.)
Directors should remember, however, that a fairness opinion is only one item in a Board’s toolbox for satisfying directors’ fiduciary duties in a sale-of-the-company transaction, and is not an automatic defense to a fiduciary duty claim. Directors should closely review the supporting analyses for the fairness opinion and make sure they understand the various inputs. In any case, the Board’s reliance upon a fairness opinion must be reasonable.
Entire fairness, the most demanding judicial standard of review, applies when independent directors have not approved or cannot approve a transaction, and the approving directors have a financial interest in, or other conflict with respect to, a transaction. Transactions are also reviewed for entire fairness when a court finds that a breach of the duty of care occurred or that the Board failed to meet an enhanced scrutiny standard. Under the entire fairness standard, courts conduct a broad substantive inquiry into whether the transaction is fair to the company and its shareholders in light of all the relevant facts and circumstances that existed at the time of the transaction.
As Smith v. Van Gorkom and Disney show, a director has traditionally been able to demonstrate good faith and due care by relying on reports prepared by expert advisors to the company, such as bankers and accountants, regardless of the director’s personal qualifications. There are limits, however, to the safe harbor for a director who “should have known better.”
In the 2004 Emerging Communications case, a Delaware court determined that an outside director who, as an investment banker, possessed special expertise had no right to rely on a fairness opinion of the company’s independent investment banker. The court found that the director violated his duties of loyalty and/or good faith in approving a transaction because, given his background, he should have known that the transaction was unfair to minority shareholders.
The key takeaway: Although as a director you may generally rely on a report prepared by a third-party advisor, if you possess special knowledge or skill, you may not “leave it at the door” of the Boardroom! In your area of expertise, you may be held to a higher standard than your peers.
The composition, size and structure of a public company Board varies considerably with each company’s circumstances. The Board of an established Fortune 500 company differs from that of a younger, founder-led technology company. And both of these Boards differ from that of a family-dominated company. Board composition is a strategic asset and should be reviewed in light of a company’s strategic direction.
A well-assembled Board is diverse. It includes individuals who bring complementary skills relevant to the company’s business and objectives. In selecting director nominees, the Nominating & Governance Committee (or the independent directors responsible for nominations) should consider the candidates’ financial and business understanding, their industry backgrounds, public company experience, leadership skills and reputation. The Committee should also monitor and consider diversity in geography, race, gender, age and skills.
Recently, some states and other regulatory bodies have sought to address diversity on public company Boards. Legislative efforts in the last several years have ranged from aspirational, to specified minimums (requiring either compliance or explanation), to mandatory minimums (establishing penalties for noncompliance). California, for example, passed a law in 2018 requiring public companies with securities listed on a major U.S. stock exchange and headquartered in California to have women on their Boards, and a subsequent law enacted in 2020 requires the same companies to have at least one director from an underrepresented community on the Board, in each case with specific targets based on Board size and passage of time. A 2020 Washington corporate law requires gender diversity on the Boards of public companies incorporated in Washington, while a 2019 Illinois law requires public companies headquartered in Illinois to disclose certain information about racial, ethnic and gender diversity of their Boards in state filings. Numerous other states have passed similar legislation and we anticipate additional states will consider such legislation in the coming years. Even The Nasdaq Stock Market received SEC approval of a listing rule effective 2022 that generally requires Nasdaq-listed companies to provide statistical information relating to directors’ self-identified gender, race and LGBTQ+ status and satisfy an objective to include diverse directors on the Board, or explain why they have not. The new Nasdaq listing rule is discussed in greater detail in Chapter 10.
Every year, a Nominating & Governance Committee (or other independent body) assesses the existing Board’s effectiveness in light of evolving company needs and recommends appropriate nominees to address new circumstances. “Board refreshment” has increasingly been in the spotlight as institutional investors and other constituents put pressure on Boards to critically assess director independence, including a focus on director tenure, and to satisfy gender and other diversity goals or legal requirements.
Each annual proxy statement describes which experience, qualifications, attributes or skills of each director led the Board to nominate that person as a director for the company. The proxy statement also describes how the Board or the Nominating & Governance Committee considered diversity. If the Board has a diversity policy, the proxy statement describes how the Board implements the policy and includes an assessment of the policy’s effectiveness.
Set expectations for your Board members from the outset. Candidates should be ready to devote ample time to learn and give guidance to company officers, while knowing when to stop short of usurping management. An effective director will:
In short, “noses in, fingers out.”
Most public company Boards include both inside and outside (or independent) directors. An independent director is an individual who can exercise judgment as a director independent of the influence of company management. An independent director will be free from business, family or personal relationships that might interfere with the director’s independence. The NYSE and Nasdaq each require that a majority of directors be independent. Each exchange has its own definition of an independent director, and we discuss these definitions in Chapters 9 and 10. Many institutional investors expect that a “substantial” majority of a company’s directors will be independent.
The three core committees – Audit, Compensation and Nominating & Governance – generally consist exclusively of independent directors. Independence standards for Audit and Compensation Committee members are more stringent than those for membership on a Board or other Board committees. The Dodd-Frank Act and the Sarbanes-Oxley Act generally delegate to the NYSE and Nasdaq the rules defining independence. (We provide more information about the Dodd-Frank Act and the Sarbanes-Oxley Act in Chapter 4.) And the NYSE and Nasdaq largely leave to Boards the responsibility to determine whether a director is independent under NYSE and Nasdaq standards.
The size of a public company’s Board averages 11 directors but may range from as few as 5 directors to as many as 15 or more, depending on the size and complexity of the company. A company’s charter documents may set the size of the Board or allow the Board to set the size, usually within a permitted range.
Larger Boards can provide increased diversity, better continuity and greater flexibility in staffing Board committees with independent directors. But larger Boards have a cost. A group larger than 10 or 12 can prove administratively unwieldy and may reduce each director’s opportunity for active and meaningful involvement. Board committees can bridge this gap and increase the effectiveness of a larger Board.
The corporate laws of most states permit Boards to be divided into two or more classes of directors. Directors serving on an unclassified Board serve for one-year terms and stand for election at each annual shareholders’ meeting. Directors serving on a classified or staggered Board – one with multiple classes of directors – serve term lengths equal in years to the number of classes of directors.
A company with a staggered Board will divide the number of directors assigned to each class as equally as possible. Staggered Boards typically are composed of three classes (the maximum permitted by the NYSE rules and most state corporate statutes), with shareholders annually electing directors of one of the classes to serve three-year terms. This results in staggered termination dates for the director classes, enhancing Board continuity.
Institutional investors generally dislike staggered Boards. Classes reduce flexibility in changing Board membership annually because directors on a staggered Board typically may be removed only for cause and stand for election only every two or three years. Yet reviewing each class of directors with care every two or three years is a reasonable approach and, as we discuss in Chapter 11, staggered Boards may provide some protection against a hostile proxy contest. More than 90% of the S&P 500 companies now have unclassified Boards.
Institutional investors and their advisors, like the proxy advisory firm Institutional Shareholder Services, have encouraged companies to vote to elect all directors annually, and to require majority rather than plurality voting for directors. Critics contend that annual elections for all directors, together with majority voting, hold directors more accountable every year. In addition, some investors and shareholder activists argue that staggered Boards can limit a target company’s stock value in the takeover bidding process. Largely as a result of this pressure, staggered Boards at large public companies have nearly disappeared, and shareholder activists have expanded their efforts to target staggered Boards at mid-and small-cap companies. In addition, approximately 90% of the S&P 500 companies have either adopted majority voting for director elections or adopted corporate governance guidelines that implement a plurality plus policy requiring a nominee to tender his or her resignation if the nominee fails to receive a majority vote. Although Boards do, from time to time, choose not to accept resignations offered by directors who fail to receive a majority vote, this is a controversial decision that a Board should make only after careful thought.
The NYSE has not historically allowed discretionary voting by NYSE member brokers in contested elections of directors. Since 2010, the NYSE has also prohibited discretionary voting by brokers in uncontested director elections at shareholders’ meetings. Now, NYSE member brokers may vote only those shares with instructions from the beneficial owner of the shares at any company, regardless of the exchange on which the company’s stock is listed. Brokers have typically voted in favor of incumbent directors. The prohibition on discretionary voting in uncontested director elections increases the risk that director nominees at companies that have adopted majority voting and plurality plus policies will not receive the needed votes for election.
Some companies have adopted term limits or age restrictions for their directors. Term or age limits can serve as a simple mechanism to bring greater age diversity to a Board and, at times, to remove a noncontributing director. Age limits, however, can cause a qualified director who is making valuable contributions to “age out” just when he or she has the time to devote to serving on the Board and its core committees. Implementing term or age restrictions as nonbinding guidelines, rather than as charter document provisions, can provide greater flexibility. Despite the recent focus by shareholder activists on director term limits, only 5% of S&P 500 companies have adopted them, although more than 70% of S&P 500 companies have established a mandatory retirement age for directors.
Board leadership rests primarily with the chair and a lead independent director. Increasingly, Boards designate an independent director as chair, or ask an independent director to share Board leadership with an internal chair, usually the CEO. This shared role may be titled lead director or presiding director (presiding over meetings and executive sessions of independent directors). In recent years, both the number of companies separating the roles of CEO and chair and the number of companies appointing independent chairs have increased. In 2019, approximately 75% of S&P 500 companies had a lead or presiding director, and nearly 35% had an independent chair.
Under the SEC’s proxy rules, a company describes its Board leadership structure in its proxy statement and explains why it believes its structure is appropriate given the company’s specific characteristics or circumstances. Issuers must describe whether and why the company combines or separates the Board chair and CEO positions. If the Board chair and CEO positions are combined, then the proxy statement explains whether and, if so, why the company has a lead independent director and the specific role the lead independent director plays in the company’s leadership. The proxy also explains why the company believes its structure is the most appropriate.
Typical duties of a chair include:
An independent chair’s role also includes:
When the CEO or an inside director serves as the Board chair, many companies designate an independent lead (or presiding) director to coordinate the activities of the independent directors and to:
It takes a director many hours to adequately prepare for and attend just one company’s Board and committee meetings. Even talented directors can find themselves overboarded if they sit on more Boards than they can properly serve at one time. Nearly a quarter of S&P 500 companies have adopted policies limiting the number of outside Boards on which their CEOs may serve, often setting a limit of one or two public Boards. Even without formal policies, however, an increasing number of S&P 500 CEOs serve on no outside Boards – nearly 60% in 2019, up from 51% 10 years ago. Also, nearly 65% of S&P 500 companies place some restriction on other corporate directorships for their directors, often limiting the number of outside Boards on which their directors may serve to three or four public Boards. Although approximately 10% of directors serve on four or more Boards, the average S&P 500 independent director has two outside corporate Board affiliations, which number has remained relatively constant in recent years.
In prior years, institutional investors and shareholder activists focused much of their reform efforts on corporate governance matters – staggered Boards, majority voting and poison pills, among others. As the “best practices” of yesterday have become today’s standard practices, the corporate governance focus of shareholder activists is shifting to more nuanced debates, such as Board diversity and “refreshment” and the Board’s role in overseeing risk management. Given the current governance climate, shareholder activists are also more likely to engage with management and the Board on matters of economic significance to drive financial gains, such as share buybacks, spin-offs, divestitures and corporate transactions.
In addition, activists’ focus has expanded in recent years to matters beyond the traditional governance and economic focus, with growing attention to environmental and social policies. To minimize vulnerability to unwelcome engagement, Boards should remain focused on overseeing the strategic direction of the company and proactively communicating that direction and company initiatives to shareholders. See Chapter 3 for a discussion of how shareholder activism is increasing and evolving, as well as how companies are engaging with investors and other stakeholders.
With these shifts has come an evolution in Board- shareholder engagement. Today, management, Boards, institutional investors and other shareholder activists are engaging in a more regular and direct dialogue than in prior years. Directors are being asked to devote time and attention to engagement with shareholders regarding corporate governance and other matters. Chapter 3 further discusses shareholder activists and how they may seek to engage a company or its Board, including in the company’s proxy process.
Directors may meet in person or, when appropriate, by telephone or videoconference. When no further material discussion is required, a Board may also act by unanimous written consent in lieu of a meeting. A director’s failure to attend at least 75% of the Board meetings (and meetings of any committee on which the director serves) held within a fiscal year will trigger annual proxy statement disclosure – and often, negative votes.
Directors can learn some of their most important information in less formal Board gatherings, such as site visits, retreats with senior management to review company strategy, or other efforts to familiarize themselves with the company, its management and corporate governance practices.
The format and frequency of Board meetings depends on the nature of the company and the powers and duties that the Board delegates to Board committees.
By and large, people will make better decisions as part of a group – so convening a group of intelligent individuals to address tough issues should be an asset of corporate Boards. However, the failures in Board decision-making in Enron, WorldCom and other corporate governance scandals appeared to arise, in significant part, through flawed group decision-making.
Boards can help decision-making by understanding that each director will make decisions differently when serving as part of a group than when acting individually. For example, studies show that responsible and capable people take less responsibility in group settings, in effect becoming “bystanders,” than they would individually. Stress from time constraints or the importance of a decision can accentuate human factors that lead to flawed group decision-making. Here are some practical steps Boards can take to avoid the potential pitfalls of group decision-making:
Most Boards schedule 4 to 12 regular meetings a year to review and discuss company activities and to consider various proposals made by Board committees and management. At regular meetings, a Board may:
Unlike some more costly aspects of Sarbanes-Oxley (which we discuss in Chapter 4), executive sessions of independent directors, as a group or as a committee, serve a vital governance function at virtually no cost. In light of the NYSE and Nasdaq mandates requiring executive sessions of non-management and independent directors, companies should adopt a practice of routinely holding executive sessions of independent directors at each Board meeting. The NYSE and Nasdaq have few specific requirements as to the timing, format and substance of executive sessions of non-management directors. An ideal format is to schedule an executive session as the final agenda item at each regularly scheduled Board meeting. Some Boards, however, prefer to break out executive sessions as separate meetings entirely.
The lead director and fellow non-management directors set the tone for these meetings. Before each session, the lead director will develop an agenda based on matters up for consideration at the regular Board meeting or current pressing concerns. While directors usually do not have authority to make decisions while in executive session, they can reach a consensus and carry the discussion back into the formal Board meeting. A good chair or lead director will work with both management and fellow directors to use executive sessions to address critical Board issues over the course of the year.
Executive session proceedings can be informal, sometimes without an agenda. Minutes, if taken at all, generally reflect only the attendees and time of the meeting.
A Board will also call special meetings to act on important matters such as possible mergers, acquisitions or divestitures, joint ventures or securities offerings, or other significant financings.
A strong committee system will allow a Board to function effectively. Sarbanes-Oxley, the NYSE and Nasdaq standards, and SEC rules prescribe the existence, composition and many of the activities of the three core committees.
The three core committees are Audit, Compensation, and the committee variously known as Nominating, Corporate Governance or Nominating & Governance. All public companies will have an Audit Committee. The NYSE requires, and Nasdaq suggests, an independent director Compensation Committee. The NYSE requires a Nominating & Governance Committee, while Nasdaq requires either a Nominating & Governance Committee or that independent directors meet in executive session to deal with director nominations. (We discuss committee requirements of the NYSE and Nasdaq in detail in Chapters 9 and 10.) Many Boards have more than the three core committees - commonly, an additional committee may be an executive committee, finance committee or risk management committee.
Purpose and Authority. The Audit Committee fulfills the Board’s oversight responsibilities related to the company’s internal controls, financial reporting and audit functions. The Committee is directly responsible for the appointment, compensation and oversight of the company’s outside auditor and may engage independent counsel and other advisors as it deems necessary.
Duties. An Audit Committee has six areas of responsibility:
Other responsibilities of the Audit Committee include an annual self-evaluation and preparation of an annual report for the company’s proxy statement.
Charter. The Audit Committee defines its duties in a publicly available charter. The Board should approve the charter, and the Committee should annually review and reassess it. The company then files a copy of its Audit Committee charter with its annual proxy statement at least every three years or makes the charter available on its website.
Composition. The NYSE and Nasdaq require that Audit Committees consist of at least three members. With a few exceptions, all members of the Committee must be independent and financially literate. At least one member should qualify as an Audit Committee financial expert. (We discuss the Audit Committee financial expert later in this chapter.)
Independence. Audit Committee members must meet two overlapping independence standards, one established by Sarbanes-Oxley, the other by the NYSE or Nasdaq. The overlapping standards have one critical requirement: no Audit Committee member may be a party to any relationship that would interfere with the exercise of his or her independent judgment in carrying out the responsibilities of a director. (We discuss the NYSE and Nasdaq Audit Committee independence requirements in Chapters 9 and 10.)
Sarbanes-Oxley and implementing SEC rules have only two criteria for Audit Committee independence:
Financial Literacy. Audit Committee members must be able to read and understand fundamental financial statements, including balance sheets and income and cash flow statements.
Audit Committee Financial Expert. SEC rules implementing Sarbanes-Oxley require that companies disclose in their Form 10-Ks (or in a proxy statement incorporated by reference into Form 10-K) the names of one or more members of the Audit Committee who qualify as Audit Committee financial experts. If the Committee does not have at least one Audit Committee financial expert, the company must explain why in the Form 10-K or the proxy statement incorporated by reference.
The SEC has adopted a pragmatic definition of Audit Committee financial expert. Investment bankers, venture capital investors, stock analysts and others may qualify, along with finance professionals. An Audit Committee financial expert is a person who has all five of the following attributes:
The Board must determine that an Audit Committee financial expert has developed the five attributes through any combination of:
Limitation on Multiple Audit Committee Service. NYSE rules generally encourage Boards to limit their directors to serving on an aggregate of three public company Audit Committees – that is, the company’s plus two others. If an NYSE company does not limit Audit Committee members to serving on three or fewer Audit Committees, the Board must make an annual determination that the simultaneous service will not impair the director’s ability to serve effectively on the Audit Committee. Although Nasdaq imposes no similar limitation, as a practical matter, a limit of three is an excellent rule of thumb.
Sarbanes-Oxley and SEC rules allow a company, if it chooses, to disclose that its Audit Committee does not have an Audit Committee financial expert. However, NYSE and Nasdaq rules require that the Committee have a member with accounting and financial management expertise (NYSE) or employment experience or other comparable experience resulting in financial sophistication (Nasdaq). A director who meets the Audit Committee financial expert requirements under SEC rules is presumed to satisfy the NYSE and Nasdaq requirements.
Meetings. Many Audit Committees will meet eight or more times per year. For example, a Committee may schedule one in-person meeting every quarter to review the company’s proposed earnings release and draft financial statements. The Committee may then follow with a second telephonic meeting in the same quarter to review and comment on the Form 10-Q prior to its filing. Many Committees hold another longer meeting or retreat at least once per year, at a time when there is no pressure to review financial statements, to consider:
The Audit Committee’s own “annual meeting” is the one at which the Committee approves the Audit Committee’s report for the proxy statement and the audited financial statements that will be part of the Form 10-K. At the meeting, the Committee will consider:
Often, a Board will face a situation requiring action by its independent directors. For example, only disinterested directors should approve a transaction between the company and a director. In fact, both Nasdaq and the NYSE require that the Audit Committee or another committee of independent directors approve related party transactions. Rather than form a Special Committee of disinterested directors for each situation, the Board may ask the Audit Committee (or another existing independent committee) to review interested director transactions.
Purpose and Authority. A company’s Compensation Committee develops criteria and goals for, and then reviews and approves the compensation of, the company’s senior management. The Committee also develops and establishes equity and other benefit plans, and may review and establish director compensation. Its charter should provide the Committee sole authority to retain, compensate and terminate consultants and advisors to assist the Committee in fulfilling its responsibilities.
Duties. The Compensation Committee will:
Charter. The Compensation Committee should adopt and periodically review a charter that describes its duties.
Independence. The Compensation Committee should consist of independent directors. The NYSE requires a committee of all independent directors (at least three), and Nasdaq requires either a committee composed exclusively of independent directors (with a limited exception) or that a majority of independent directors on the Board meet in executive session to perform Committee duties. Pursuant to the Dodd-Frank Act, NYSE and Nasdaq have their own rules defining independence for Compensation Committee members. These standards, like those for the Audit Committee, are more stringent than those for membership on the Board or other Board committees. (We discuss the NYSE and Nasdaq Compensation Committee independence requirements in Chapters 9 and 10.) To preserve independence, companies will want to avoid interlocking Compensation Committee memberships. An interlock occurs when an executive officer of one company:
Interlocks can create an appearance of inappropriate influence and must be disclosed in a company’s proxy statement and Form 10-K.
Independence of Compensation Committee members plays a critical role in federal income tax deductibility as well. Although 2018 amendments to Internal Revenue Code Section 162(m) mean that companies can generally no longer deduct executive compensation over $1 million per year, transition relief provides that certain compensation paid pursuant to a written binding contract in effect on November 2, 2017, will be grandfathered and not subject to the amended rules (so long as the contract is not materially modified on or after that date). For a company seeking to take advantage of the grandfathering relief, the Compensation Committee must consist entirely of two or more “outside” directors to allow the company to maintain deductibility of executive compensation under Section 162(m). An all-independent Compensation Committee of “nonemployee” directors also allows the Committee’s approval of option grants to executive officers and directors to qualify as exempt purchases under Rule 16b-3 under the 1934 Act.
Compensation Discussion and Analysis (CD&A). In the company’s annual proxy statement and Form 10-K, the Compensation Committee submits an annual discussion that analyzes and describes the bases for the compensation paid to the CEO and other executive officers. Developing the CD&A is an annual part of the Committee’s duties. (We discuss practical tips for drafting the CD&A in Chapter 7.) Smaller reporting companies are not required to provide a CD&A.
Compensation Committee Report. In the company’s annual proxy statement and Form 10-K, the Compensation Committee submits an “annual report.” In it, the Committee confirms that it has reviewed and discussed the CD&A with management. Based on that, it recommends that the Board include the CD&A in the company’s proxy statement and Form 10-K.
Risk Management and Compensation Policies and Practices. The SEC’s proxy rules require companies to assess whether their compensation policies and practices create risks that are reasonably likely to have a material adverse effect on the company. If so, then the proxy statement will need to discuss the relationship between risk management and the compensation policies and practices for all employees, including non-executive officers. (This requirement does not apply to smaller reporting companies.)
Meetings. The Compensation Committee will generally meet at least quarterly. Its “annual” meeting will be held when fiscal year-end results are available to assess how the company’s executive officers performed against corporate and personal goals and objectives for that year and to set new goals and objectives for the new year. The Committee will also meet as needed to establish or recommend changes to compensation plans.
Compensation Consultants: Disclosing Fees and Conflicts. A prudent Compensation Committee will retain outside compensation consultants to evaluate compensation for executive officers. The proxy statement will disclose fees paid to compensation consultants, including if a compensation consultant engaged by the Board or Committee provides other services to the company (e.g., benefits or human resources consulting), if the fees for those additional services exceed $120,000 during the company’s fiscal year.
The proxy statement will not need this disclosure, however, if the Board or Committee used different compensation consultants, or when the other services performed by the consultant are limited to providing certain survey data or consulting on broad-based plans for all salaried employees that do not discriminate in favor of executive officers or directors.
The NYSE and Nasdaq provide that a Compensation Committee must consider specified independence-related criteria when selecting a compensation advisor, as discussed in Chapters 9 and 10. The Dodd-Frank Act requires Compensation Committees selecting advisors to consider factors that may affect the advisors’ independence, including:
As long as the Board takes the appropriate factors into consideration, the Board may choose to engage non-independent advisors. Companies, however, will disclose in their annual proxy statements when the Compensation Committee receives advice from a compensation consultant, whether the work of the compensation consultant raised any conflict of interest and, if so, the nature of the conflict and how it was resolved. The NYSE and Nasdaq exempt smaller reporting companies from these provisions.
In 2005, the Delaware Court of Chancery absolved directors of liability for the 1995-96 hiring and firing of former Disney president Michael Ovitz. The Board had approved a severance package for Mr. Ovitz of approximately $140 million for his 14-month tenure. While not finding Disney’s directors personally liable, the court sharply criticized their action (and inaction) as falling short of best corporate governance practices. Many lessons of what not to do, wrote the court, could be learned from the Disney Board’s conduct.
The Nominating & Governance Committee, third in the triumvirate of “core” Board committees, monitors the Board itself.
Purpose and Authority. The Nominating & Governance Committee takes the lead in selecting directors, committee members and chairs or lead directors. The Committee may also develop corporate governance principles and policies and recommend them to the Board. The Committee should have the ability to retain, compensate and terminate its own advisors, including any search firm used to identify director candidates.
Duties. The Nominating & Governance Committee will:
Either the Compensation Committee or the Nominating & Governance Committee will:
The Nominating & Governance Committee may assist the Audit Committee in monitoring ethical codes. Sarbanes-Oxley provides for a code of ethics for the CEO and senior financial officers, and both the NYSE and Nasdaq mandate a code of business conduct for employees, officers and directors.
Charter. The Board should approve, and the Nominating & Governance Committee should annually review, a written charter describing the Committee’s duties.
Composition. Like the Audit and Compensation Committees, the Nominating & Governance Committee should be composed of independent directors. The NYSE requires a Committee of all independent directors (at least three). Nasdaq mandates either a Committee composed exclusively of independent directors (with a limited exception) or that a majority of independent directors on the Board make director nominations.
Director Qualifications and Board Diversity. Companies must disclose in their annual proxy statements a description of each director’s or nominee’s experience, qualifications or skills that qualify that person to serve as a director. These qualifications may include any specific past experience that would be useful to the company, the director’s or nominee’s particular area of expertise, and why the director’s or nominee’s service as director would benefit the company. Diversity policies are also part of proxy statement disclosures, if the Nominating & Governance Committee (or Board) has a policy to consider diversity when identifying nominees. The proxy statement will disclose how the Board implements the diversity policy, and how the Nominating & Governance Committee (or Board) assesses the effectiveness of its policy.
As described in “Board Composition” earlier in this chapter, numerous state statutes establish diversity goals or mandatory minimums for the Boards of public companies incorporated and/ or headquartered in those states. Nasdaq has a listing rule related to Board diversity, and Board diversity is an area of increasing focus for institutional investors, shareholder activists and proxy advisory firms. Even investment banks are weighing in on the topic, as shown by the recent Goldman Sachs policy decision to underwrite IPOs in the United States and Europe only if the issuer has at least two (as of 2021) diverse directors on its Board.
Meetings. The Nominating & Governance Committee will meet periodically to discuss and set governance procedures, to evaluate or select the nominees for election as directors at the annual shareholders’ meeting, and to recommend members to the Board. There is no set recommended number of meetings for the Committee.
Evaluating the Board and its core committees (Audit, Compensation and Nominating & Governance) on an annual basis has rapidly become a “best practice” for public companies. The NYSE’s listing standards require annual self- evaluations in corporate governance guidelines and committee charters, and many Nasdaq companies conduct evaluations as part of a healthy corporate regimen. No single method has emerged as the “best” evaluation practice, yet these five practical tips have emerged as consistent guidelines:
More than 70% of S&P 500 companies have more than the three core committees. Other common Board committees include:
In recent years, high-profile breaches have catapulted the issue of cybersecurity, as well as victim companies and their Boards, into the spotlight. The Board’s critical roles in overseeing both risk management and crisis management mean that the full Board should be informed and engaged on cybersecurity-risk issues, even if a committee is primarily responsible for risk oversight.
The Board should make sure that the company is regularly assessing cybersecurity vulnerabilities, which could include an outside consultant’s cybersecurity-risk audit, and directors should be educated about the possible consequences of a breach. Management and the Board may work together to create an incident response plan. The Board should consider the SEC’s disclosure guidance specific to cybersecurity and should carefully review the company’s existing disclosures regarding cybersecurity risk, updating them as necessary.
Public companies compensate independent directors for Board and committee service with a combination of cash and securities. Some companies also permit their nonemployee directors to participate in company-deferred compensation or other benefit plans. Outside director compensation varies considerably from company to company. Employee directors generally receive limited or no additional compensation for Board service.
In the current environment, with directors serving on fewer Boards and dedicating more time and care to each Board on which they serve, companies have continued to increase director compensation. Directors who assume the highest levels of responsibility, including independent chairs or lead directors, committee chairs and committee members, earn more in proportion to their responsibilities. The Board or the Nominating & Governance Committee should periodically evaluate the company’s director compensation package against peer companies to ask: “Are we competitive? Do we appropriately match rewards to Board effort, risk and results?”
Most companies pay their directors an annual cash retainer for Board and committee service. Cash retainers for Board service generally range from about $50,000 to $200,000 or more per year. Directors may receive additional compensation for committee service, service as a committee chair or lead director and, sometimes, for meetings. In recent years, the annual cash retainer amount for Board service has increased while the number of companies compensating Board members for meeting attendance has declined.
Most public companies make initial stock grants to directors upon commencement of Board service. Directors then often earn additional grants as part of an annual compensation package. Many public companies pay annual retainers exclusively with equity grants, rather than cash. It is common for initial restricted stock grants to be larger and have longer vesting periods (e.g., two to four years), and for annual grants to be smaller and have shorter vesting periods (e.g., one year or immediate vesting). Although some companies continue to grant options to directors, the composition of equity awards for Board service has largely shifted to restricted stock awards.
Does equity or cash compensation provide better incentive to directors without encouraging excessive risk?
While some companies believe equity-based compensation may encourage directors to act in ways that could increase the short-term value of their equity stakes at the expense of the company’s long-term interest, most companies believe that equity can better align the interests of directors with those of shareholders.
These companies may:
Directors who exercise options for or otherwise purchase large amounts of company stock (in 2020, stock with a value in excess of $94 million) should be aware of individual filing obligations created by the Hart-Scott- Rodino Antitrust Improvements Act of 1976. Fluctuations in the trading price of a company’s common stock could cause the value of a director’s holdings to surpass thresholds obligating the director to make a filing with the Department of Justice and the Federal Trade Commission. Failure to make required filings could result in substantial monetary penalties for the individual director and company disclosure obligations.
A public company’s directors and officers may be subject to personal liability under statutes relating to employee benefits, tax, antitrust, foreign trade, environmental and securities matters. As discussed previously, directors are also liable for breaches of their duties of care, loyalty and candor. To encourage individuals to serve as directors and officers, state laws permit companies to limit director liability and indemnify their directors and officers against some of this exposure.
Delaware and states that follow the Model Business Corporation Act permit charter documents to include exculpation or raincoat provisions that eliminate the personal liability of a director to the company or its shareholders for monetary damages for some breaches of director duties. However, corporations cannot limit directors’ liability in situations that involve:
Even the most robust charter provisions limiting director liability are subject to limitations, particularly in today’s dynamic legal and business environment. The most effective ways for you as a director to reduce your exposure to fiduciary claims are to:
Actively inquire into and be informed about the corporate decisions that the Board will consider. Use the questions that we suggest in this Handbook. Comply with the duty of loyalty to the company. Create a robust record that demonstrates that you and your fellow directors have met your respective duties of care and loyalty. Do these things, and the business judgment rule will generally protect you from personal liability.
The corporate laws of nearly all states provide for both mandatory and permissive indemnification of directors and officers, and related rights.
Mandatory Indemnification. A company typically must indemnify every director or officer who successfully on the merits defends an action or claim brought as a result of his or her status as a director or officer. Some states require the director or officer to be wholly successful on the merits, while other states, including Delaware, provide for mandatory partial indemnification to the extent of the individual’s successful defense.
Permissive Indemnification. The corporate laws of most states permit a company to indemnify its directors and officers against expenses incurred in specified actions if they acted in good faith and in a manner that they reasonably believed to be in, or not opposed to, the company’s best interests. Directors and officers may receive indemnification in a criminal action or proceeding if they had no reasonable basis to believe that their conduct was unlawful. However, indemnification usually is not available for actions by the company for amounts paid in settling derivative actions or when the directors or officers are found to be liable to the company.
Advancement of Expenses. Most states also permit a company to advance defense costs to its directors and officers. State law typically provides that the company may require the director or officer to sign an agreement (an undertaking) to repay any advanced amounts if it is ultimately determined that the individual’s conduct did not meet the applicable standard of conduct to entitle the individual to indemnification.
Protection Against Subsequent Amendment to Rights. A Delaware corporation may not eliminate or impair a right to indemnification or to advancement of expenses arising under a provision of its certificate of incorporation or its bylaws by amending the provision after the act or omission occurs. The one exception to this is that the provision in effect at the time of the act or omission may explicitly authorize the elimination or impairment after the action or omission has occurred.
It is becoming increasingly common for companies to enter into indemnification agreements with their directors and, less frequently, their officers. To the extent a company’s charter documents provide for broad indemnification rights and specifically state that these rights are contractual, indemnification agreements may not seem to provide substantial additional protection. But in reality, an agreement may provide great comfort to directors and officers. It adds clarity and provides protection against future alterations of charter documents. If any contractual rights are broader than those provided by statute, courts may subject the contract rights to review on public policy or reasonableness grounds.
Most public companies purchase insurance to cover liabilities arising from their directors’ and officers’ actions on behalf of the company, known as D&O insurance. This insurance provides a potential source of reimbursement to the company for indemnification payments it makes to its directors and officers. D&O insurance may also motivate individuals to serve as directors and officers by reducing their exposure to personal liability from potential gaps in the availability of indemnification and, in situations such as insolvency, where the company cannot adequately indemnify its directors and officers. Most D&O insurance policies include entity coverage, which also insures the company directly for its liability on certain defined claims without diluting available coverage for directors and officers.
D&O insurance coverage is subject to exclusions similar to those that apply under state law to corporate indemnification obligations, including:
An insurance broker can provide detailed information and recommendations regarding appropriate D&O insurance coverage. Insurance counsel or other experts can also analyze your company’s D&O insurance needs. Liability counsel can advise your company on the terms of D&O insurance coverage, particularly terms relating to retentions and exclusions. The Board should periodically evaluate the coverage to ensure that it continues to meet the evolving needs of your company.
In addition to D&O insurance policies that concurrently cover directors, officers and the company, many companies also purchase supplemental “Side A” coverage that covers only directors and officers. This avoids a claim in a bankruptcy context that D&O insurance proceeds of the general policy are assets of the debtor’s estate and are not available to indemnify directors and officers. We provide a visual guide to D&O insurance in Appendix 3.
To help ensure that your company has taken the necessary steps to reduce its own exposure to liability as well as that of its directors and officers, ask your company’s general counsel these six questions annually:
Would you suggest any changes to our certificate or articles of incorporation and bylaws to provide the maximum liability limitations and indemnification permitted by law?
Public companies engage with their investors, as well as other stakeholders, in myriad ways. Chapters 4 and 5 discuss SEC rules pertaining to required and voluntary disclosures that companies make. This chapter addresses when and how companies engage with investors outside of SEC filings.
Many public companies have in recent years increasingly focused on efforts to engage with other key stakeholders in addition to investors. The Business Roundtable’s Statement on the Purpose of a Corporation (https://opportunity.businessroundtable.org/ourcommitment), originally published in August 2019, exemplifies the growing awareness by public companies that consideration of these other stakeholders holds great importance to their long-term success. CEOs signing the Business Roundtable’s Statement committed their companies to serve and deliver value to all stakeholders including customers, employees, suppliers, communities in which the company works, and shareholders. This chapter also addresses the growing importance placed on these engagements, and how companies are reporting on these engagements to their investors.
Public companies use a combination of channels and strategies to engage with investors. SEC filings provide periodic updates on management’s view of the company’s business, industry and competitive landscape, financial results, and known trends affecting the business. Outside these filings, common forms of company-led investor engagement are generally of two types: engagement with management regarding financial results and business developments, and engagement that might include certain directors in addition to members of management on corporate governance and related topics.
Public companies typically schedule quarterly management earnings calls to supplement their SEC filing disclosures regarding financial results and business developments. Management also discusses strategy and results in industry- focused conferences and other investor presentations. As we discuss in Chapter 5, companies must take care to provide appropriate notice of and access to such presentations when necessary to comply with Regulation FD. Management also frequently follows these broadly accessible earnings calls and investor presentations with separate, Regulation FD–compliant engagements with significant investors or investment analysts on a one-on-one basis.
For matters outside financial results, business developments and strategy, the primary vehicle for public company disclosure has long been the annual proxy statement. As discussed in Chapter 7, an annual meeting proxy statement calls for disclosures regarding directors and nominees, corporate governance matters, and executive compensation.
Companies might also provide investor-focused disclosures on environmental, social and governance (ESG) topics in separate reports, often called sustainability reports or corporate responsibility reports. These disclosures may be formatted as stand-alone reports or interactive websites. A trend that is currently emerging and may grow to become common practice in the next several years is to include disclosure on ESG topics and metrics that are material to a company in periodic reports and proxy statements. For example, the SEC adopted rule changes in 2020 requiring disclosure of material information about a company’s human capital management in the annual report on Form 10-K and certain other filings, and has indicated that additional rule changes calling for disclosure on other ESG topics may follow.
A company drafting a sustainability or corporate responsibility report for the first time will need to decide what topics to address. Topics can range from the environmental impact of the company’s operations to community relationships to pay equality.
To identify topics for disclosure in an investor-facing sustainability report, a company can start by working with its internal stakeholders and then refine and expand on that analysis with information obtained from other resources. Investor engagement meetings, discussed below, are a great opportunity for a company to get feedback on potential disclosure topics. Existing internal reporting to senior management and the Board can also help guide what metrics to include in a sustainability report. A company may also want to review any previous public statements and company policies to confirm that its approach and disclosures are consistent across channels.
There are also several standard-setting bodies that provide frameworks for and guidance on sustainability reporting. Some of the prominent and widely used standards and frameworks are identified below.
These different standards and frameworks serve different purposes, and therefore may not be consistent. While the SASB standards and TCFD framework both seek to elucidate material disclosures that are suitable for traditional corporate reports like SEC filings, the GRI standards have a wider range and encourage companies to disclose more information, whether or not it is material to the company and its investors.
A company’s sustainability report is likely to be distinctive from any other, including reports by other companies in the same industry. But by making the most of existing knowledge and reporting within the company, along with insight from investors and existing disclosure standards, no company need start from scratch.
Outside of disclosure through proxy statements and sustainability reports, companies may engage proactively with large shareholders on ESG topics in the months after the company’s annual meeting of shareholders. This timing allows companies to have interactive discussions with investors without having to file discussion-related matter as proxy soliciting materials. (We address proxy solicitation and related filing requirements in Chapter 7.)
This engagement also helps a company prepare for its next proxy and annual meeting season. The company learns what ESG issues are important to shareholders, and can consider making governance changes or preparing additional disclosures to address these concerns and to avoid potential public activism by shareholders. Companies that have engaged on ESG topics with their large shareholders and have responded to raised concerns are also well-positioned to seek the support of these large shareholders in case of shareholder activism in the form of shareholder proposals or proxy fights.
Engagement with stakeholders other than investors is not a primary focus of this Handbook, but we mention it here in light of investors’ growing interest in sustainability and ESG-related disclosures. Investors focused on a company’s long-term prospects and sustainability want to understand the ways in which the company engages with other stakeholders and addresses their concerns.
Stakeholder groups a company might engage with or consider the viewpoints of include:
Companies will have different approaches to engaging with these various stakeholders, and the relative importance of, and level of effort involved in, these engagements will vary. For many companies, engaging with and understanding the perspectives of different stakeholder groups is already an important part of the company’s culture and operations. For others, such engagement may be practiced in less formal or operationalized ways. In either case, there is a growing trend for public companies to inform investors – through their proxy statements or stand-alone sustainability or corporate responsibility reports – about how they engage with stakeholders and how they have considered the input received from stakeholders.
As discussed in Chapter 13, companies can be subject to securities law liability for materially misleading statements, even when those statements are not included in SEC filings. For this reason it is important to bring a critical eye to disclosures that are investor-facing, such as sustainability or corporate responsibility reports, to ensure that statements about topics like stakeholder engagements are accurate and not misleading. As investors focus more attention on ESG-related topics, companies should ensure that the disclosures are thoroughly vetted and based on repeatable and verifiable data-gathering processes, particularly where quantifiable metrics are provided.
Investors, including activist funds, pension funds, unions and institutional shareholders, may seek to engage with companies in a more public manner than ordinary-course investor meetings discussed above. This engagement comes in various forms, ranging from shareholder proposals for consideration at an annual meeting, discussed in Chapter 7, to “vote no” campaigns urging shareholders to vote against a director or management proposal. An investor’s most potent tool is to bring a proxy contest.
A proxy contest typically involves a challenge to existing management by a third-party acquirer or shareholder group seeking control of the company. The challenge may also be posed by a shareholder activist seeking to influence the direction of the company. Often, the challenger has obtained a significant ownership position in the company and seeks to either control the company through the election of a majority of the directors or propose a merger or tender offer for shares. (Although a detailed discussion of takeover transactions and defenses is beyond the scope of this Handbook, we summarize corporate structural defenses in Chapter 11.)
Shareholder activism has increased in recent years, and generally is targeted to affect share price, bring about governance changes or advance a social agenda. A wide variety of activists have emerged, including small and large players as well as those focused on single or multiple strategies, issues or sectors. The style and approach of activists also varies, from contentious and aggressive to constructive and cooperative.
Company size and industry no longer matter in terms of companies that are targeted by shareholder activists. In the current climate, several characteristics can make a company vulnerable to activist interest, including:
Activists engage with companies in many different ways:
In the event your company is contacted by a shareholder activist, we suggest you consider the following in formulating your response plan.
Know Who Your Shareholders Are. Your investor relations team can proactively monitor any changes in positions of your company’s known shareholders. Investor calls and interactions with analysts are a good normal-course method for taking the pulse of the investment community. Also review and monitor Schedules 13D and 13G filings both proactively and after any engagement begins.
Response and Monitoring Depend on Activist Approach. Consider keeping your response team small to lower distraction within the company and the risk of leaks. Generally, a response team will include the CEO, CFO, general counsel, investor relations, the Board (usually the chairperson or lead independent director), financial advisors, outside counsel, and possibly an investor relations/public relations firm and proxy solicitor.
Communication Is Critical. In the event of engagement, whether proactive or reactive, establish a dialogue so that each side understands what the other wants to accomplish. Open lines of communication with the CEO and rapport with the Board are critical.
Also, consider these tips about best practices for activist engagement:
Directors, executive officers and significant shareholders of a public company are subject to a number of reporting obligations and trading limitations relating to their ownership of and transactions in the company’s securities. Compliance with these rules requires strong procedures for both the company and its insiders. This chapter gives an overview of these reporting requirements and trading limitations and suggests ways in which a public company and its insiders can best comply with them.
Corporate failures, starting in the late 1990s and early 2000s, focused public attention on the integrity and quality of disclosures in companies’ annual, quarterly and current reports. Reforms to periodic reporting and corporate governance have been instituted through NYSE, Nasdaq and SEC implementation of the Sarbanes-Oxley Act of 2002 (Sarbanes-Oxley) and the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act). These initiatives have thrust the most basic of public company obligations – periodic reporting – into the forefront of directors’ and officers’ attention, and challenge even the most organized companies to keep track of what must be disclosed in reports filed with the SEC.
In Appendix 1, we provide companies with a model Annual 1934 Act Reporting Calendar, which we discuss in greater detail in this and later chapters. We urge you to use this model to create a comparable checklist for your company. Preparing your company’s 1934 Act reports will require extensive input from your Disclosure Practices Committee, discussed later in this chapter, and finance and legal departments, as well as review by outside auditors and lawyers. To ensure that your working group remains on schedule and to allow adequate review time, circulate your 1934 Act reporting calendar to the members of the working group well in advance of each reporting cycle.
Public company CEOs and CFOs must certify each annual report on Form 10-K and each quarterly report on Form 10-Q. To ensure that a disclosure system is in place to backstop these certifications, each company must also maintain disclosure controls and procedures and internal control over financial reporting.
In each Form 10-Q and 10-K, a company’s CEO and CFO are each required to provide two separate certifications, a “Section 302” certification and a “Section 906” certification. In a Section 302 certification, the CEO and CFO make statements in two areas:
In a Section 906 certification, the CEO and CFO make two basic statements that overlap with their Section 302 certifications:
Unlike the Section 302 certification, the Section 906 certification may take the form of a single statement signed by both the CEO and CFO, and may be “furnished” rather than “filed” with the related report. (We discuss the difference between “furnishing” and “filing” later in this chapter.) Section 302 and Section 906 certifications are submitted as exhibits to Forms 10-K and 10-Q, and need not accompany reports on Form 8-K or 11-K.
To back up the certifications, companies maintain a system of disclosure controls and procedures designed to ensure that the company records, processes, summarizes and discloses on a timely basis information required to be disclosed in 1934 Act filings. Companies also need to evaluate on a quarterly basis the effectiveness of their disclosure controls and procedures. The phrase “disclosure controls and procedures” is broad in scope and extends beyond financial matters to cover all controls and procedures relating to required disclosure, including interactive data. (We discuss interactive data filing requirements later in this chapter.)
The most costly and controversial aspect of Sarbanes-Oxley is the internal control requirement of Section 404. Section 404 and related rules require each public company to include in its Form 10-K a management report on the effectiveness of the company’s internal control over financial reporting, beginning with the company’s second annual report on Form 10-K after becoming a reporting company. If the company, other than an emerging growth company, is an accelerated or large accelerated filer (generally companies with market capitalizations of more than $75 million and, for smaller reporting companies, annual revenues of $100 million or more), the company’s independent auditor is required, in a separate audit-like analysis, to attest to, and report on, management’s assessment. (We discuss emerging growth companies later in this chapter.)
Internal control over financial reporting includes policies and procedures that:
Management needs to base its internal control evaluation on some “recognized control framework” in order to have a widely accepted standard of comparison. The SEC identified the Committee of Sponsoring Organizations of the Treadway Commission (COSO) report “Internal Control – Integrated Framework,” which framework was updated in 2013, as the evaluation framework of choice. Although the SEC does not mandate any particular framework, U.S. companies quickly adopted the COSO report as the standard, indeed as the only realistic standard readily available for domestic issuers.
Methods of conducting evaluations of internal control vary from issuer to issuer. Companies should review, among other publications, COSO’s “Guidance on Monitoring Internal Control Systems” released in 2009 (and, if applicable, COSO’s guidance on “Blockchain and Internal Control: The COSO Perspective” released in 2020). The COSO 2009 report expanded on the guidance issued in prior COSO publications, and remains relevant even after publication of the updated 2013 framework. Although the SEC does not specify the methods or procedures to be used, it has made the following observations that encourage documentation – one of the expensive side effects of internal control:
If a company identifies a material weakness, it must disclose the existence of the material weakness in its Form 10-K, and management is not permitted to conclude that the company’s internal control over financial reporting was effective for that period. The SEC defines material weakness to be a deficiency, or a combination of deficiencies, in internal control over financial reporting that creates a reasonable possibility that a material misstatement of a company’s annual or interim financial statements will not be prevented or detected on a timely basis. The SEC encourages companies to provide additional disclosure to allow investors to assess the potential impact of the material weakness. Experience has shown that analysts and investors are, with sufficient information, able to quickly assess the impact, in many cases with no negative effect on stock price or company reputation. The SEC’s three suggested topics are useful as a checklist for disclosure:
Most widely traded public companies follow an SEC recommendation to establish a non-Board “Disclosure Practices Committee.” This Committee of officers and employees develops and oversees the procedures that support the CEO’s and CFO’s Sarbanes-Oxley certifications. The Committee’s mandate is simple:
The Committee should be composed of two to ten officers or employees from the key functional areas in your company best able to gather and analyze material financial and other information. The SEC suggests including the following individuals:
The Disclosure Practices Committee should meet at least three times during each quarter to fulfill its three categories of duties:
The Committee or its chair will report its conclusions to the CEO, CFO and, possibly, the Audit Committee.
Filing deadlines for Forms 10-K and 10-Q depend on the company’s category of filer as set forth below:
Smaller reporting company status and entry into or exit from accelerated filer and large accelerated filer status is determined annually. A smaller reporting company with a public float of at least $75 million that had $100 million or more in annual revenues will qualify as an accelerated filer. For accelerated filers and large accelerated filers, once filer status is determined, subsequent determinations of filer status are based on public float. The table below summarizes how a company’s status changes based on subsequent public float determinations:
| Initial Public Float Determination | Resulting Filer Status | Subsequent Public Float Determination | Resulting Filer Status |
|---|---|---|---|
| $700 million or more | Large Accelerated Filer | $560 million or more | Large Accelerated Filer |
| Less than $560 million but $60 million or more | Accelerated Filer | ||
| Less than $60 million | Non- Accelerated Filer | ||
| Less than $700 million but $75 million or more | Accelerated Filer | Less than $700 million but $60 million or more | Accelerated Filer |
| Less than $60 million | Non- Accelerated Filer |
The table below summarizes the Forms 10-K and 10-Q filing deadlines for each category of filer:
| Category of Filer | Form 10-K Deadline | Form 10-Q Deadline |
|---|---|---|
| Large Accelerated Filer ($700+ MM) | 60 days after year-end | 40 days after quarter-end |
| Accelerated Filer (between $75 MM and $700 MM) | 75 days after year-end | 40 days after quarter-end |
| Non-Accelerated Filer (less than $75 MM) | 90 days after year-end | 45 days after quarter-end |
Regulation S-K, the SEC’s disclosure guidance “cookbook,” sets forth detailed disclosure requirements governing the content of 1934 Act periodic reports. Regulation S-K is a centralized source of disclosure requirements for periodic reports, proxy solicitations, registration statements and other filings pursuant to the 1933 and 1934 Acts.
Regulation S-X is the financial information counterpart to Regulation S-K. Regulation S-X provides the centralized source of requirements for the form and content of financial information required to be included in filings under the 1933 and 1934 Acts.
For some disclosure items, Regulations S-K and S-X provide scaled disclosure requirements for smaller reporting companies. For example, smaller reporting companies are only required to provide two years of audited income statements (instead of the three years required for larger companies) and are not required to include compensation discussion and analysis (CD&A) disclosure (discussed in Chapters 2 and 7) in their Form 10-Ks or proxy statements. Smaller reporting companies may choose to comply with scaled or nonscaled financial and nonfinancial disclosure requirements on an item-by-item basis in any one filing. However, where the smaller reporting company requirement is more rigorous, the smaller reporting company must satisfy the more rigorous standard. For example, the related person transactions disclosure requirement (discussed in Chapter 7) is more stringent for smaller reporting companies, establishing a potentially lower dollar threshold and requiring a two-year lookback. Companies that meet the smaller reporting company standard should consult with counsel regarding these scaled disclosure requirements.
The JOBS Act was enacted in 2012 to spur job creation by improving access to capital for smaller companies. Among other things, the JOBS Act relaxed certain requirements relating to IPOs by creating a new category of issuers called “emerging growth companies,” and eased certain post-IPO disclosure requirements for these issuers.
An emerging growth company (EGC) is a company with less than $1.07 billion in total annual gross revenue during its most recently completed fiscal year. EGC status is determined in connection with a company’s IPO. The company can continue to have EGC status until the earliest of:
The annual gross revenue threshold is updated every five years for inflation. Among the post-IPO benefits of EGC status are exemption from the Dodd-Frank Act say-on-pay vote requirements (discussed further in Chapter 7), exemption from the requirement to include an audit of internal control assessment in its Form 10-K, and the ability to take advantage of the smaller reporting company scaled disclosure provisions for executive compensation reporting.
Data submitted in XBRL (eXtensible Business Reporting Language) format is often referred to as “interactive data.” The XBRL process requires a company to tag certain numbers and content in filings to allow easy identification, extraction and comparison by computer programs. The SEC began requiring companies to use XBRL in 2009, and, on a phased-in basis starting in 2019, began requiring the use of Inline XBRL (iXBRL). The iXBRL format allows XBRL data to be embedded directly into the filing itself, avoiding the need to create and attach a separate exhibit. This change also makes filings more interactive for users (they can hover over tagged data points for additional information) and allows computers to more easily search, gather and analyze data contained in SEC filings.
The iXBRL tagging requirements apply to financial statements and accompanying footnotes and schedules located in registration statements (other than IPO registration statements) and in Forms 10-Q, 10-K and 8-K.
Documents incorporated by reference into a filing, as well as exhibits listed in an exhibit index in a registration statement or report pursuant to Item 601 of Regulation S-K, must be hyperlinked to the incorporated document as filed on the SEC’s EDGAR website, which we discuss later in this chapter. These hyperlinking rules streamline the filing process by allowing companies to link to previously filed documents. These rules also make it easier for investors and other market participants to find and access incorporated-by-reference documents and exhibits.
Companies should be careful to identify and include the required hyperlinks for documents incorporated by reference. However, companies do not need to file an amendment to a document solely to correct an inaccurate hyperlink; they can simply correct it on the next filing. While hyperlinks are required for material that is incorporated by reference, companies should use inactive textual references for any other websites, such as reports available on the company’s investor relations website, to avoid such referenced websites being considered part of the filing.
Tagging inline interactive data accurately and consistently, and inserting hyperlinks in an EDGAR filing, adds extra steps to the filing process. Whether your company prepares filings internally using software that facilitates EDGAR filings or uses an outside service provider, be sure to build in time for the filing team to prepare and proof iXBRL tags and hyperlinks.
In particular, companies will want to consider the impact on timing in a few specific instances:
A public company must file an annual report on Form 10-K following the end of each fiscal year. The first Form 10-K is due 90 days after the end of the first fiscal year in which the issuer becomes subject to the periodic reporting requirements of the 1934 Act. (We summarize the filing deadlines for subsequent years earlier in this chapter.)
Form 10-K is the most comprehensive periodic report filed with the SEC. It includes much of the same information that is required in a registration statement filed for an IPO under the 1933 Act. Required information includes:
The following items, known as “Part III” information, are also required, but companies that file a proxy statement within 120 days after the end of the fiscal year may meet these requirements by including these items in the proxy statement and incorporating them by reference into the Form 10-K:
The company’s principal executive officer, principal financial officer and principal accounting officer, along with at least a majority of the members of the company’s Board, must sign the Form 10-K. (We discuss requirements for the use of electronic signatures later in this chapter.)
In addition, the CEO and CFO must each sign Section 302 certifications and a Section 906 certification for each Form 10-K.
The heart and soul of the Form 10-K is MD&A, management’s discussion and analysis of financial condition and results of operations. MD&A, governed by Item 303 of Regulation S-K, requires a discussion of liquidity, capital resources, results of operations and other information necessary to an understanding of the company’s financial condition, changes in financial condition and results of operations.
In December 2003, the SEC issued detailed interpretive guidance regarding disclosure in MD&A, including key concepts that continue to be extremely helpful guidelines for the drafters of MD&A. In adopting amendments to Regulation S-K Item 303 that became effective in February 2021, the SEC underscored the 2003 guidance and codified it in part through a new section outlining the objective of MD&A. The following are key concepts for consideration in preparing MD&A.
According to the 2003 SEC interpretive release, management should provide “early top-level involvement” in “identifying the key disclosure themes and items” to include in a company’s MD&A. These key themes should first appear in the “executive-level” overview. Although the content of an introduction or overview will depend on the circumstances of each particular company, the SEC suggests that a good overview will discuss:
Ask your CEO or CFO to sketch out a one-page narrative or outline addressing these factors in his or her own words, or to discuss them with the principal MD&A drafter, to provide a “through the eyes of management” starting point for the MD&A overview.
In the SEC’s continuing focus on the quality of MD&A disclosure, it has re-emphasized the need to identify and analyze material trends, demands, commitments, events and uncertainties that could impact a company’s liquidity, financial condition or operating results. This disclosure, the SEC believes, is critical to understanding a company’s reported financial information and the extent to which reported information is indicative of future results or financial condition. SEC regulations require that MD&A focus on material events and uncertainties known to management that could cause reported financial information not to be indicative of future operating results or future financial condition. A disclosure duty exists where a trend, demand, commitment, event or uncertainty is both:
The “reasonably likely” threshold is higher than “possible” but lower than “more likely than not.” The SEC indicates that it expects disclosure of an identified trend, future event or uncertainty unless management concludes that either:
The year 1989 was a profitable one for the Brazilian subsidiary of Caterpillar Inc. It accounted for 23% of the earnings of the Peoria, Illinois, maker of heavy machinery engines. A number of nonoperating gains caused by hyperinflation and currency exchange rates contributed to the strong year.
In its 1989 Form 10-K, as in years past, Caterpillar presented its financial results on a consolidated basis, melding the Brazilian subsidiary with the rest of the company. Its MD&A did not discuss the extent to which Caterpillar’s 1989 earnings were derived from the subsidiary. Moreover, neither the Form 10-K nor Caterpillar’s Form 10-Q for the first quarter of 1990 discussed what seemed to be known risks faced by the Brazilian subsidiary arising from possible economic reforms in Brazil that could have had a material adverse effect on the subsidiary’s financial performance and the overall financial performance of Caterpillar.
When, in June 1990, Caterpillar announced that new economic policies in Brazil would hurt the company’s overall earnings, its stock price plummeted by 16%.
The SEC charged Caterpillar with disclosure violations in a proceeding that centered on the MD&A section of the company’s 1989 Form 10-K and first-quarter 1990 Form 10-Q. In the SEC’s interpretive release, which it still refers to today for MD&A guidance, the SEC described Caterpillar’s MD&A disclosure as deficient in that:
Caterpillar’s experience reminds us that an MD&A that provides a view of the company “through the eyes of management” will:
Most companies’ Form 10-Ks incorporate portions of the “glossy” annual report to shareholders and the proxy statement by reference, without repeating the incorporated information. For example, companies generally incorporate by reference from the proxy statement all compensation information and related person transactions regarding directors and officers, known as “Part III” information. (We describe this information in this chapter under “Annual Report on Form 10-K.”) This is permitted even though the proxy statement is filed later than the Form 10-K.
Incorporation by reference requires that:
The Form 10-K may also incorporate by reference the “glossy” annual report to shareholders. If so, the company must file the annual report with the SEC as an exhibit to the Form 10-K. (We discuss both the glossy annual report and the proxy statement in greater detail in Chapter 7.)
Most companies are required to include disclosure of risk factors in their Form 10-Ks. Risk factor disclosure involves a discussion of material circumstances, trends or issues that may affect the company’s business, prospects, future operating results and financial condition, making an investment in the company speculative or risky. The SEC discourages including risks that could apply generically to any company, and requires companies to organize the risk factor section with headings and subcaptions. Companies are also encouraged to make risk factor disclosures concise. If the risk factors are longer than 15 pages, a summary of no more than two pages must be provided. This risk factor disclosure requirement does not extend to smaller reporting companies, although these companies will want to consider including this disclosure for the reasons discussed below.
Although the SEC discourages companies from unnecessarily repeating the risk factors in their Form 10-Qs, companies filing Form 10-Qs will need to consider on a quarterly basis whether there have been any material changes from their Form 10-Ks. If a risk factor is updated in a Form 10-Q, the updated risk factor will need to be included in each subsequent Form 10-Q until the next Form 10-K is filed.
Even if not mandated to include risk factors, many issuers include risk factors in 1934 Act reports to take advantage of the safe harbor provided by Section 21E of the 1934 Act. Section 21E provides a public company with a safe harbor defense in securities litigation challenging a forward-looking statement made by the company. To fall within the safe harbor, the forward-looking statement must be identified as a forward- looking statement and be accompanied by meaningful cautionary language that, in the case of written statements, identifies important factors that could cause actual results to differ materially from those projected in the forward-looking statement. (We discuss and provide practical tips for using these safe harbors in Chapter 5.)
Periodic reports usually include forward-looking statements, particularly in the MD&A section where the SEC encourages disclosure of forward-looking information. Risk factors accompanying these forward-looking statements will provide the meaningful cautionary language that identifies important factors that could cause actual results to differ from projected results. In addition, the company can protect oral forward-looking statements under the safe harbor provisions of Section 21E of the 1934 Act by referring to the risk factors disclosed in the most recent Forms 10-K and 10-Q.
Some of the most valuable sources of information about a public company are the exhibits to its Form 10-K. Item 601 of Regulation S-K identifies the documents to be filed as exhibits. Companies generally incorporate by reference documents that they have previously filed as exhibits to other SEC filings. As mentioned previously, a filing that incorporates an exhibit by reference must include a hyperlink to the previously filed exhibit.
The most significant category of documents that must be filed as exhibits to Form 10-K is material contracts. All material contracts made outside the ordinary course of business must be filed as exhibits. If a contract was made in the ordinary course of business, it does not have to be filed unless it is material and falls within one of the following categories:
Immaterial exhibits and schedules attached to any document required to be filed as an exhibit under Item 601 may be excluded from the exhibit filing. The document must include a list identifying the contents of the omitted exhibits and schedules. In addition, the company can redact or seek confidential treatment for certain reda under specific circumstances. (We discuss redaction and confidential treatment later in this chapter.)
Public companies file a quarterly report on Form 10-Q after the end of each of their first three fiscal quarters. (We summarize the filing deadlines earlier in this chapter.) Companies that go public during a quarter must file a Form 10-Q that covers the entire quarter in which the 1933 Act registration statement becomes effective.
Form 10-Q generally includes:
In addition, a company will disclose specific events that occurred during the quarter, including:
A duly authorized officer signs a Form 10-Q on behalf of the company, as does either its principal financial or chief accounting officer. Unlike the Form 10-K, the Form 10-Q does not require CEO or Board signatures. (We discuss requirements for the use of electronic signatures later in this chapter.)
Although the CEO does not necessarily sign the Form 10-Q, the CEO and CFO each sign Section 302 certifications and a Section 906 certification for each Form 10-Q.
Item 601 of Regulation S-K identifies the documents that must be filed as exhibits to Form 10-Q. Companies may and generally do incorporate previously filed exhibits by reference.
Form 10-Q must identify any information required to be disclosed in a Form 8-K during the quarter but not reported.
Form 8-K is a current report filed between quarterly and annual reports to provide the public with information on recent material events. Form 8-K disclosure is mandatory if specified events occur. In addition, many companies make optional filings on Form 8-K to ensure maximum public disclosure of material developments. A duly authorized officer of the company signs the Form 8-K.
Appendix 2 contains a complete list and description of the items a company is required to report on Form 8-K. These items include:
A company may elect to voluntarily report other material events under Item 8.01 of Form 8-K.
Regulation FD requires that when a public company discloses material nonpublic information to certain shareholders and investment professionals, it must also simultaneously make general public disclosure of that information. Regulation FD public disclosure requirements may be met by reporting the information under Item 8.01 or Item 7.01 of Form 8-K. (We discuss Regulation FD in detail in Chapter 5.)
Information provided under Item 7.01 (and Item 2.02) of Form 8-K is considered “furnished” rather than “filed.” As a result, this information will not be subject to liability under Section 18 of the 1934 Act and will not be incorporated by reference into shelf registration statements filed under the 1933 Act.
Companies file exhibits with Form 8-K to the extent required by Form 8-K or Item 601 of Regulation S-K.
The SEC encourages, but does not require, companies to file a copy of the reported material definitive agreement as an exhibit to the Form 8-K. A company will file any agreement not filed as a Form 8-K exhibit as an exhibit to the company’s next periodic report or registration statement.
Because the Form 8-K disclosure must contain sufficient information not to be misleading and must not contain any material misstatements or omissions, your company should take steps to ensure that it discloses all material information concerning an agreement on Form 8-K. To ensure compliance with this requirement, many companies file agreements with Form 8-K, where practicable, to ensure that the disclosure is complete. However, if you seek confidential treatment of the agreement, you must submit your request for confidential treatment of sensitive information no later than the date on which you file the Form 8-K that includes the agreement.
Companies must file mandatory Form 8-Ks generally within four business days of the reported event and “promptly” file an optional report made pursuant to Item 8.01 after the triggering event. Regulation FD establishes timelines for filing a report made to satisfy Regulation FD requirements. (We discuss Regulation FD in detail in Chapter 5.)
Limited Safe Harbor from Rule 10b-5 Liability. Because several of the Form 8-K disclosure items require management to quickly assess the materiality of an event or to determine whether a disclosure obligation has been triggered, the SEC provides a limited safe harbor from claims under Section 10(b) of the 1934 Act and Rule 10b-5 under the 1934 Act for failure to timely file a Form 8-K. (We discuss Section 10(b) and Rule 10b-5 in Chapter 13.) The safe harbor applies only to these items of Form 8-K:
The safe harbor extends only until the due date of the next 1934 Act report for the period in which the Form 8-K was not timely filed. The safe harbor does not provide protection against, and the SEC may still bring, enforcement actions against the company under other 1934 Act rules for failure to timely file Form 8-Ks.
Failure to Timely File May Affect Form S-3 Eligibility. A company that fails to timely file a mandatory Form 8-K generally will lose its eligibility for a period of 12 months to use Form S-3, which is a streamlined registration statement form. (We discuss this registration statement in Chapter 12.) However, companies that fail to file timely reports on Form 8-K required solely by the Form 8-K items for which the limited safe harbor described above applies will not lose their eligibility to use Form S-3. A company must be current in its Form 8-K reports, and have filed the disclosure required by any of these Form 8-K items, on or before the date on which it files a Form S-3.
To meet the challenges of real-time reporting on Form 8-K, management should work with your company’s Disclosure Practices Committee to monitor your company’s disclosure controls and procedures. They should consider whether to design and implement new controls and procedures to ensure that someone at your company identifies and evaluates information about events that may be reportable on Form 8-K, and does so in a timely way.
Here are some useful steps to help you assess and consider improvements to existing disclosure controls and procedures:
In 2012, the SEC adopted the Conflict Minerals Disclosure Rule pursuant to the Dodd-Frank Act. This rule applies to a reporting company that uses conflict minerals that are necessary to the functionality or production of a product it manufactures or contracts to be manufactured. A company that used conflict minerals in the most recent calendar year must file a report on Form SD by May 31 of each year.
Form SD disclosure requirements vary depending on the circumstances for the particular company and product. The basic requirement is that a company perform a “reasonable country of origin” inquiry to determine whether any of the minerals originated in the Democratic Republic of the Congo or an adjoining country. Additional disclosure requirements apply if the company determines that any of its necessary conflict minerals originated in the Democratic Republic of the Congo or an adjoining country.
The reasonable country of origin inquiry and due diligence processes relating to supply chain source and chain of custody can be time and labor intensive. A company that will be subject to the Conflict Minerals Disclosure Rule should begin the inquiry and implement a compliance program well in advance of preparing its first Form SD report.
Following litigation over the constitutionality of the Form SD requirements, the SEC’s Division of Corporation Finance announced in 2017 that it would not take enforcement action against companies that do not satisfy the requirements under paragraph 1.01(c) of Form SD, including the detailed supply chain due diligence disclosure, Conflict Minerals Report and independent private sector audit.
The 1934 Act sometimes calls for the disclosure of information that a company wants to keep confidential, because disclosure may adversely affect the company’s business and financial position or because the information is otherwise personally sensitive. The process for redacting or obtaining confidential treatment depends on the type of information and where the information is located. Potential disclosure of confidential information typically arises with respect to exhibits required to be filed under Regulation S-K Item 601.
Personal or private information, such as bank account numbers or personal home addresses, may be redacted by the company without any other action required.
If confidential information is located in a material contract being filed pursuant to Regulation S-K Item 601(b)(10), or in a plan of acquisition, reorganization, liquidation or succession being filed pursuant to Regulation S-K Item 601(b)(2), a company may redact such information without prior SEC approval if such redacted information is both customarily treated by the company as confidential and not material. The company must mark the exhibit index to indicate that certain identified information has been omitted, include a prominent statement on the first page of the redacted exhibit that certain information has been excluded for such reasons, and within the exhibit itself indicate by brackets where information is omitted.
The SEC can still request an unredacted copy of the exhibit as well as the materiality analysis conducted by the company to justify the company’s decision to redact the confidential information, and if it disagrees with the redaction, can request the company to amend its filing to include the updated exhibit. The tips that follow regarding redactions, including limiting the amount of information that is redacted and material the SEC generally does not consider to be confidential, also apply to redactions made to exhibits without prior SEC approval.
In all other cases, a company must make a confidential treatment request (CTR). The company submits a CTR application to the SEC on paper, not electronically, and includes a copy of the relevant exhibit that identifies its confidential portions. Simultaneously, the company files a redacted version of the exhibit electronically with the 1934 Act report. The SEC reviews and comments on the CTR application, sometimes requiring an amended application in response to its comments.
Steps to submitting a successful confidential treatment request include:
Sarbanes-Oxley requires the SEC to review a company’s 1934 Act reports at least once every three years. The SEC may review a company’s 1934 Act reports more frequently, however, often as part of an initiative to monitor specific companies. At other times, the SEC uses review to address specific issues (e.g., disclosure of non-GAAP financial measures, results of operations, “critical accounting policies” and liquidity in MD&A or revenue recognition). The SEC may also review 1934 Act reports in connection with its review of a company’s 1933 Act registration statements.
Any SEC review may generate a comment letter to the company. The company addresses the comments in a response letter to the SEC. Ultimately, the comment process could cause the company to amend the reviewed report.
Accelerated filers, large accelerated filers and well-known seasoned issuers (discussed in Chapter 12) must disclose in their Form 10-Ks written comments from the SEC in connection with a review of a 1934 Act report that:
The disclosure must be sufficient to convey the substance of the comments. Companies may provide additional information, including their positions regarding any unresolved comments.
The SEC publicly releases SEC comment letters and company response letters on the SEC’s EDGAR website. Letters are released by the SEC no earlier than 20 business days after the review of the disclosure filing is complete.
Although the SEC notes that comment letters reflect only the SEC staff’s position on a particular filing, do not apply to other filings and are not the official expressions of the SEC, the availability of comment and response letters can be a valuable resource to your company’s disclosure team. Prior to making a filing, you will be able to review comments made on similar filings and potentially avoid issues encountered by other companies.
But remember, your response letters will be public too! Before submitting a response letter to the SEC, consider whether your letter includes confidential information that should be protected from public disclosure. If so, work with your counsel to develop an appropriate CTR for the portion of your response letter that contains confidential information.
Amendments to Form 10-K, 10-Q and 8-K filings bear the letter “A” after the title of the form being amended (e.g., Form 10-Q/A). The amendment sets forth the complete text of the item that is being amended. For example, if Item 1 of Form 10-K (Business) is the only item that requires amendment, the filing need only include Item 1, but it must include the complete text of Item 1. Amendments are signed on behalf of the company by a duly authorized representative.
Section 302 certifications are required with amendments to Forms 10-K and 10-Q. You may omit the certification paragraph regarding the accuracy of the financial statements if no financials or other financial information is included with the amendment, and you may omit the paragraphs regarding disclosure controls and procedures and the evaluation of internal control over financial reporting if the amendment does not contain or amend disclosures regarding controls and procedures.
Section 906 certifications are required with an amendment to Form 10-K or 10-Q only if the amendment contains financial statements or other financial information.
Historically, the SEC’s plain English rules applied only to prospectuses filed pursuant to the 1933 Act. However, the SEC encourages plain English drafting in all SEC filings, and has mandated it in 1934 Act risk factors and disclosures in 1934 Act reports regarding executive compensation, security ownership, related person transactions and corporate governance. As a result, many companies now use plain English throughout their 1934 Act documents. Companies should strongly consider converting their entire Form 10-K (and other periodic reports) to the plain English style.
Draft a plain English document in a clear, concise and understandable manner. Design the text to be visually inviting and easy to read. The SEC provides these guidelines:
A highly accessible SEC guide to drafting plain English documents is “A Plain English Handbook: How to Create Clear SEC Disclosure Documents,” available on the SEC’s website at https://www.sec.gov/reportspubs/investor-publications/newsextrahandbookhtm.html. The Warren Buffett preface alone is a quick, amusing and useful read.
Most documents filed with the SEC, including periodic reports on Forms 10-K, 10-Q and 8-K, must be filed electronically via the SEC’s Next-Generation EDGAR (Electronic Data Gathering, Analysis, and Retrieval) system. Documents filed via EDGAR are available promptly on the SEC’s website.
Most documents filed with the SEC, including periodic reports on Forms 10-K, 10-Q and 8-K, must be filed electronically via the SEC’s Next-Generation EDGAR (Electronic Data Gathering, Analysis, and Retrieval) system. Documents filed via EDGAR are available promptly on the SEC’s website.
Companies can obtain the SEC’s software package and submit filings directly with the SEC or use an outside service provider, such as a financial printing company, to convert SEC filings to the EDGAR format and file the documents on the EDGAR system. Prior to making filings on EDGAR, a company must apply to the SEC for a unique identification number, known as a CIK (Central Index Key) code, and a confidential password to enable the company to log into, and be identified by, the EDGAR system.
Regulation S-T contains the rules and procedures for filing via EDGAR and supersedes many requirements in other SEC regulations and forms.
Rule 302(b) of Regulation S-T and the EDGAR Filer Manual set forth rules and procedures for including signatures with electronically submitted filings. In 2020, the SEC modernized these rules by allowing electronic signatures on the signature page or other document (which the SEC refers to as an “authentication document”) that adopts the signature appearing in typed form within the electronic filing, provided that (1) the signatory has previously signed (in wet ink) a document attesting to their agreement to the use of electronic signatures, and (2) the e-signature process used by the company meets four process requirements designed to ensure verification and security, including through authentication and nonrepudiation. Companies can also continue to rely on manually signed (i.e., “wet ink”) authentication documents. The following diagram summarizes the signature process.
Public companies and their officers and directors face potential personal liability resulting from the failure to make required periodic reports or from making materially misleading statements in them. Companies and individuals can be subject to SEC enforcement actions or private civil actions, including class actions and derivative actions. (We discuss these liabilities in Chapter 13.)
Directors who join a Board shortly before the company files a 1934 Act report may be concerned about potential liability associated with the report, especially if they must sign a Form 10-K. Directors can take steps to minimize this liability and still meet their responsibilities:
Failing to comply with all securities laws requirements for periodic reporting may also cause an issuer to lose eligibility to use short-form 1933 Act registration statements. (We discuss these registration statements and their advantages in Chapter 12.)
Managing disclosures to shareholders and to the “street” – equity analysts, investment professionals and the financial press - presents CEOs, CFOs and investor relations officers (IROs) with the daily challenge of controlling the uncontrollable: human communication.
Many of an issuer’s disclosures are mandatory. The 1933 and 1934 Acts, as well as SEC and stock exchange rules, all require a variety of periodic reports and other filings. In addition, issuers make voluntary disclosures – sharing news or facts with the market as part of a financial public relations strategy. The SEC has set forth ground rules for disclosures of non-GAAP financial measures in Regulation G (GAAP), Item 10(e) of Regulation S-K and related interpretations, as well as for other voluntary statements with Regulation FD (Fair Disclosure) and Regulation M-A (Mergers and Acquisitions).
Public companies are not generally required to publicly disclose all material information at all times. But there are so many “triggers” of mandatory disclosure that it can seem like it! Mandatory disclosures must be made:
Specific SEC regulations and interpretations cover three key categories:
Virtually all other communications, both formal and informal, by a public company – such as holding earnings calls, attending analyst conferences, posting information on a company website or social media account, and discussions with analysts, investors or the press – are voluntary.
Non-GAAP financial measures are voluntary disclosures made by companies to provide investors and analysts with a better understanding of their business. Recently, Audit Analytics determined that over 97% of S&P 500 companies use at least one non-GAAP metric in their financial statements. Initially with Regulation G, and increasingly with interpretive releases in the late 2010s, the SEC has set bounds around the use and presentation of non-GAAP measures. By non-GAAP financial measures, the SEC means any numerical measure of historical or future performance, financial position or cash flow that a company creates by adjusting a comparable GAAP measure, generally by selectively eliminating or including specific metrics.
For example, non-GAAP financial measures include adjusted earnings before interest, taxes, depreciation and amortization (EBITDA), adjusted free cash flow, net debt or other similar measures. Where business or operational performance metrics – often known as key performance indicators or KPIs – are calculated on a non-GAAP basis, they are considered non-GAAP metrics for purposes of Regulation G and Item 10(e) of Regulation S-K. However, metrics that are based on operating and statistical data alone, such as same-store sales or the number of employees, will not be considered non-GAAP measures. Similarly, ratios calculated using only GAAP financial measures are not included in the definition of non-GAAP measures.
Non-GAAP financial measures have in recent years been the most frequent subject of SEC comment letters, largely due to their increased use and prominence. While non-GAAP measures can provide valuable information, the SEC has sought, through its interpretations and comment letters, to establish guardrails limiting the risk that such measures mislead investors.
In interpretive guidance, the SEC has noted that it may be necessary for issuers to disclose certain financial and operating metrics – such as KPIs – used by management in managing the business as material information, particularly as part of their management’s discussion and analysis (MD&A) in periodic reports. To the extent such metrics are presented, issuers should carefully consider including the following disclosures to avoid misleading investors, which apply even if the metric is not a non-GAAP measure:
All public releases of material information that contain a non-GAAP financial measure – whether in writing; orally; telephonically; on blogs, social media or websites; or in a webcast – must comply with Regulation G and related interpretations and rules, which require a company to:
When publicly disclosing non-GAAP information, whether in a press release, analyst call or slide show from an investor conference, provide the required reconciliation to the most directly comparable GAAP information in the disclosure. For an oral disclosure, you can do this by:
Item 10(e) of Regulation S-K, like Regulation G, requires that companies reconcile the differences between non-GAAP financial measures and the most directly comparable GAAP financial measures in any filings with the SEC. Item 10(e) of Regulation S-K, which applies only to SEC-filed documents, also requires:
And Item 10(e) of Regulation S-K prohibits:
Non-GAAP measures should be used to present investors and analysts with a more accurate understanding of the company, not merely a more favorable one, the SEC staff has stated. When presenting non-GAAP financial information, companies should be cautious that the measures they present do not mislead investors by avoiding:
Senior executives strive to maintain a dialogue with professional analysts, the financial press and major shareholders to help market professionals follow their company’s stock and to provide shareholders with access to management. Reports that equity analysts write and distribute to their customers in turn encourage investor interest. Yet private discussions with analysts and major investors can create an imbalance of information, and absent Regulation FD, detailed private discussions could provide institutional shareholders and professional analysts more in-depth information than other investors receive. Regulation FD is the SEC’s effort to create a level playing field.
Regulation FD promotes fair play by requiring issuers to widely share information that would otherwise be disclosed selectively to a mere handful of market professionals. Specifically, Regulation FD requires a company to inform the public when the company, or a person acting on its behalf, voluntarily discloses material nonpublic information to securities market professionals or to security holders when it is reasonably foreseeable that the holders will trade on the basis of that information.
The timing of the company’s required public disclosure depends on whether its voluntary selective disclosure was intentional or unintentional.
(The SEC’s 24-hour clock begins at the moment a senior official of a company learns of the unintentional disclosure and recognizes the disclosed information to be both material and nonpublic.)
In a series of public statements from February to October, Flowserve Corporation reduced its full-year earnings projections by more than 30%. During a private meeting in November, Flowserve’s CEO responded to an analyst’s question by reaffirming the October earnings projections. The CEO’s response was contrary to the company’s disclosure policy:
Although business conditions are subject to change . . . the current earnings guidance was effective at the date given and is not being updated until the company publicly announces updated guidance.
Flowserve’s IRO, present at the meeting, remained silent, and the company did not file a Form 8-K or issue a press release at that time. The day after, the stock price and trading volume increased substantially, and the SEC concluded that the CEO’s reaffirmation was material information.
Unintentional disclosures will happen. When they occur, the company should promptly distribute the disclosed material nonpublic information through a press release or appropriate website or social media disclosure. The company may also wish to include the curative press release on Form 8-K, which includes a Regulation FD item, Item 7.01, designed precisely to “furnish” rather than “file” the information. Issuers can use Item 7.01 as a “super-press release” to ensure broad dissemination of the relevant information.
Unscripted questions during an analyst or industry conference regarding the company’s performance could lead to the release of material nonpublic information. To avoid inadvertent disclosures, follow a script for the presentation, anticipating any questions that could come up, and:
Regulation FD applies only to the disclosure of material nonpublic information. Although Regulation FD does not itself define what constitutes material information, the U.S. Supreme Court and the SEC provide guidance. Information is material to an investor making an investment decision if there is a “substantial likelihood that a reasonable shareholder would consider the information important in making an investment decision” or if the information “would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.” The Supreme Court has rejected any bright-line test for determining materiality. Materiality with respect to contingent events depends on balancing the probability that the event will occur with the magnitude of the expected event in light of the company’s other activities.
The SEC has provided a list of seven categories of information that a company should review carefully when determining materiality:
The most sensitive category is earnings estimates. The SEC’s other principal statement on materiality is Staff Accounting Bulletin No. 99 – Materiality (SAB 99). In SAB 99, the SEC sought to put to rest the practice of using certain dollar or percentage thresholds to judge nonmateriality. SAB 99 asked:
[M]ay a registrant or the auditor . . . assume the immateriality of items that fall below a percentage threshold . . . to determine whether amounts and items are material .
The SEC answered with a resounding “No.” Why? Qualitative factors can cause misstatements of even small amounts to be material.
In SAB 99, the SEC gave these examples of issues that might cause information to be material regardless of the dollar amount involved:
In SAB 99, the SEC acknowledges that some issuers and accountants may use a “rule of thumb” test such as 5%. But measures like this should be used only as a starting point. Any percentage threshold can be only a first step toward answering the question:
Is there a substantial likelihood that a reasonable person would consider this to be important?
SAB 99 notes that stock price volatility may be an indicator of materiality. SEC enforcement actions demonstrate that the SEC will assess materiality in hindsight by looking at a company’s stock price and trading volume in the period immediately following a selective disclosure of nonpublic information.
Quarterly earnings calls are the best example of the voluntary disclosures for which the SEC designed Regulation FD and non-GAAP disclosure requirements. Prior to each earnings call, your company should do the following:
Disclosing material information on your company’s website or social media accounts can fulfill the requirements of Regulation FD “public disclosure” if the company’s web or social media presence is prominent enough to constitute broad, nonexclusive distribution to the public. The SEC has offered three tests to determine whether the release of information on a company’s website or social media is public for Regulation FD purposes:
Companies should caution employees and directors that posting material information on a personal social media account may violate Regulation FD if the company has not laid the appropriate groundwork to prepare investors. For example, when the SEC investigated Netflix for a post by the CEO on his personal Facebook page containing material performance metrics (without any other disclosure from Netflix), the SEC questioned not the use of social media generally but whether investors knew to monitor the CEO’s personal account for new material information.
Before relying on a company website or social media account to communicate with the marketplace, make sure that these outlets have become recognized channels for distribution. Do this by including a cautionary legend in your Form 10-K or 10-Q filings that describes the company’s intent to disclose material information by website or social media, as well as which social media channels the company intends to use.
On August 7, 2018, the founder and CEO of Tesla, Inc., Elon Musk, announced on Twitter: “Am considering taking Tesla private at $420. Funding secured.” The implication that Mr. Musk had secured funding for a go-private deal at a significant premium to the then-current trading price of Tesla stock created volatility in the company’s stock for weeks. On August 24, 2018, Mr. Musk sent another tweet stating that the company would stay public, and he included a link to a blog post on the company’s website with more explanation.
On September 27, 2018, the SEC alleged that Mr. Musk had engaged in securities fraud, stating that the initial tweet was “materially false and misleading.” As part of the announcement of a settlement agreement, the SEC noted that while the company had informed investors that it would use Musk’s social media as a channel for releasing material information, the company failed to put in place any disclosure controls to determine whether Mr. Musk’s social media posts contained information that required further disclosure in SEC filings or to determine whether the information in Mr. Musk’s social media posts was accurate and complete.
On September 29, 2018, the SEC announced a settlement with Mr. Musk and Tesla where Mr. Musk agreed to pay $20 million and step down as chair of Tesla’s Board for three years. Tesla further agreed to appoint two independent directors and pay a $20 million fine. Finally, Tesla agreed to establish a committee of independent directors and put in place additional disclosure controls on Musk’s communication.
Regulation FD applies only to certain communications. Communications exempt from Regulation FD include:
Disclosures made to nationally recognized statistical rating organizations (NRSROs), such as Moody’s and Standard & Poor’s, are not subject to Regulation FD. While rating agencies are no longer explicitly exempt from Regulation FD, NRSROs have regulatory obligations that prevent them from using the information to trade or to advise others on trading, and so are not “covered persons.” A cautious issuer may wish to ask a smaller non-NRSRO to sign a nondisclosure agreement prior to sharing confidential information as part of the rating review process.
To prevent Regulation FD from having a chilling effect on issuers’ communications to the public, the SEC has limited Regulation FD liability:
Regulation FD is not an antifraud rule – an issuer may be liable only for knowing and reckless conduct (not for good faith mistakes in making materiality judgments); and
While not a separate antifraud rule, Regulation FD compliance is actively monitored by the SEC. The SEC closely follows corporate disclosure and continues to bring enforcement actions in the challenging area of one-on-one discussions of earnings guidance with analysts.
Providing required disclosures under Regulation FD or non-GAAP financial information often relates to future events, creating a level of uncertainty. Thankfully, Section 21E of the 1934 Act, Section 27A of the 1933 Act (both part of the Private Securities Litigation Reform Act of 1995) and Rule 175 under the 1933 Act give companies guidelines for disclosing forward-looking statements to the investing community. Forward-looking statements are projections, plans, objectives, forecasts and other discussions – whether oral or written – of future operations. These guidelines provide a safe harbor defense to securities litigation challenging forward-looking statements that fail to predict the future accurately.
Sections 21E and 27A incorporate a caselaw concept known as the “bespeaks caution” doctrine, which provides that a reader or listener needs to take any forward-looking statement in context. If the context provides fair warning of future uncertainties, the reader cannot fairly ignore them. To fall within the safe harbor, the forward-looking statements must be accompanied by:
The risks that companies face can evolve quickly. Risk factors and other cautionary statements from last year’s or last quarter’s Form 10-K or 10-Q (or even from an earlier press release) may be inadequate for the report you are filing today.
When preparing to file a new periodic report or press release:
For oral forward-looking statements, meaningful cautionary language must include a declaration that additional information concerning factors that could cause actual results to vary materially is contained in a readily available written document, such as a recent Form 10-K or 10-Q. As with written forward- looking statements, boilerplate disclaimers are insufficient.
A company in the midst of a business combination transaction – such as a stock-for-stock merger, cash merger or tender offer – will need to file with the SEC many communications that relate to the transaction.
Regulation M-A is a series of rules that fashion safe harbors permitting companies to communicate freely about planned business combination transactions (both before and after a registration statement is filed) so long as the company files its written communications with the SEC.
What communications must a company file with the SEC? It must file any written communication made in connection with, or that relates to, a business combination transaction that is provided to the public or to persons not a party to the transaction (e.g., written information about the transaction that is provided to a company’s employees generally).
In contrast, a company does not need to file:
Regulation M-A’s filing requirement begins from the first public announcement of the transaction and continues until the transaction closes. During that period, information subject to Regulation M-A must be filed with the SEC on or before the “date of first use.” Each Regulation M-A written communication must include a prominently displayed legend that advises investors to read the relevant registration statement, proxy statement or tender offer statement and that directs investors to the SEC’s website for copies of the relevant documents.
In business combination transactions, financial forecasts are often used by financial advisors and disclosed as part of the M&A disclosure documents to stockholders. The SEC has issued guidance that clarifies that such forecasts do not trigger Regulation G or Item 10(e) of Regulation S-K, and therefore do not need to be reconciled to GAAP, so long as the measures are:
Similarly, where a company provides forecasts to bidders and includes these forecasts in the M&A disclosure documents (for purposes of antifraud concerns and to ensure that other disclosures are not misleading), the forecasts are excluded from the definition of non-GAAP financial measures under Regulation G. However, the SEC guidance states that if the same non-GAAP financial measures are disclosed in a registration statement or proxy statement, Regulation G and Item 10(e) of Regulation S-K will apply.
Regulations M-A and FD have overlapping, but slightly different, timing and disclosure requirements. Regulation M-A requires filing of a written public communication on the “date of first use.” In contrast, Regulation FD requires public disclosure of all material nonpublic communications simultaneously with (and, as a practical matter, prior to) any selective disclosure of the information. When both Regulations M-A and FD apply, use a format that satisfies Regulation M-A, but for timing, comply with Regulation FD by making a prior or simultaneous filing.
Most public companies will want to adopt a corporate disclosure policy and investor relations practices that comply with rules and regulations around non-GAAP measures, with Regulations FD and M-A, and that take full advantage of the safe harbor for forward-looking disclosures. A compliant disclosure policy will include some variation of the following elements:
Non-GAAP Measures. When disclosing non-GAAP measures, make sure that the presentation is not misleading and that all non-GAAP measures are reconciled to the most directly comparable GAAP measure.
Because many of the most effective corporate structural defenses, such as a dual-class common stock structure or a staggered Board, require shareholder approval, the best time to institute these measures is prior to going public. Advantages of pre-IPO adoption include:
However, there are other factors that cause companies to hold off from pre-IPO adoption:
After the IPO, some institutional investors and their advisors may believe that these defenses should be maintained only if the defenses have been approved by public shareholders. Such investors may mount a “withhold vote” campaign against one or more directors to pressure the Board to seek such approval.
Directors, executive officers and significant shareholders of a public company are subject to a number of reporting obligations and trading limitations relating to their ownership of and transactions in the company’s securities. Compliance with these rules requires strong procedures for both the company and its insiders. This chapter gives an overview of these reporting requirements and trading limitations and suggests ways in which a public company and its insiders can best comply with them.
Directors and Officers. Section 16(a) of the 1934 Act requires directors and specified officers of a public company to report their beneficial ownership of and transactions in the company’s securities to the SEC and the public. An officer for this reporting purpose generally includes the company’s “executive officers,” as that term is used in the rules governing proxy statements and other SEC disclosure documents, and covers:
Trap for the Unwary: More Than “Executive Officers”
The definition of Section 16 officers is nearly identical to the general 1934 Act definition of executive officers, except in one important respect that often leads to filing errors. For purposes of Section 16, if the principal financial officer is not also designated as the principal or chief accounting officer (CAO), the CAO must be a Section 16 filer, even if not considered an executive officer by the company. If a company does not designate a CAO, then the controller must be a Section 16 filer.
More Than 10% Beneficial Shareholders. In addition to directors and officers, persons, including entities, who beneficially own more than 10% of a class of a company’s registered securities are subject to Section 16(a) reporting obligations. In determining who is a more than 10% holder, Section 16(a) uses the concept of beneficial ownership rather than legal or record ownership. A person’s voting or investment power over a security is a key factor in determining beneficial ownership. For example, a person with sole or shared voting or investment power over securities will usually beneficially own the securities for Section 16(a) 10% ownership purposes. This is the same test used for determining 5% beneficial ownership for purposes of Schedules 13D and 13G.
Equity Securities. Section 16 applies only to equity securities of the company, including the right to acquire equity securities. It does not apply to non-equity securities, such as pure debt securities.
What Do Section 16(a) Insiders Report?
Beneficially Owned Shares. For Section 16(a) insiders, the SEC uses a second beneficial ownership test to determine which holdings and transactions the insider must report. Beneficial ownership for purposes of reporting holdings and transactions to the SEC (and for short-swing profit liability) is based on the insider’s direct or indirect pecuniary interest in the securities. This test is based on an insider’s ability to profit from purchases or sales of securities.
Shares Held by Household Members. An insider is considered to have indirect beneficial ownership of securities held by members of the insider’s immediate family sharing the same household. These immediate family household members include grandparents, grandchildren, siblings and in-laws, as well as the insider’s spouse, children and parents.
Trust Shares. An insider is considered a beneficial owner of shares in a trust for Section 16 purposes if the insider has or shares investment control over the trust securities and the insider is a:
Partnership or Corporation Shares. An insider who has control or a controlling influence over a partnership or corporation will generally have beneficial ownership of the securities held by that partnership or corporation.
Derivative Securities. Section 16(a) applies not only to a company’s common stock but also to derivative securities. Derivative securities include stock options, stock appreciation rights, warrants, convertible securities or similar rights with an exercise or conversion privilege at a price related to an equity security. Derivative securities also include third-party contracts: puts, calls, options or other rights to acquire the company’s securities that an insider enters into with a person other than the company.
Initial Report – Form 3. Upon becoming an insider, an insider initially files a Form 3 with the SEC listing all the insider’s holdings of the company’s securities, including derivative securities such as stock options. The insider must file a Form 3 within ten calendar days of the triggering event, for example, within ten days after becoming an officer, director or more than 10% shareholder of a public company. The insider must file a Form 3 even if the insider does not beneficially own any securities of the company at the time of the filing. Insiders of a newly public company file a Form 3 on the date the company becomes a reporting company under the 1934 Act.
Current Report – Form 4. Generally, any change in an insider’s beneficial ownership of the company’s securities is reported on a Form 4. Insiders usually must file a Form 4 within two business days after a change in beneficial ownership. This two-day reporting period begins when a transaction is executed, not when it settles.
If an executive vice president places an order with a broker to purchase or sell company securities on a Monday morning in Los Angeles, she must file the Form 4 with the SEC no later than 10 p.m. Eastern time (7 p.m. Pacific time) on Wednesday. The Form 4 must indicate the officer’s total direct and indirect ownership in the company’s securities after the reported transaction. In accordance with company compliance procedures discussed later in this chapter, the officer should notify the company compliance officer before placing the order to enable the company to begin preparing a Form 4 on the officer’s behalf.
The Form 4 two-day filing deadline also applies to any transaction between an insider and the company, including transactions that are exempt from short-swing profit recovery under Rule 16b-3 under the 1934 Act, such as the grant, exercise or conversion of stock options or other derivative securities or the withholding of shares for tax purposes (such as upon vesting of restricted stock units).
Three transactions are exempt from the two-day filing deadline:
The insider must report these transactions at the end of the company’s fiscal year on a Form 5 annual report if they were not voluntarily reported earlier on a Form 4.
Officers often receive option grants or other awards at the time of hire as do directors at the time of election to the Board. The Form 3 filed upon becoming an insider should report only securities owned immediately prior to becoming an insider. Report the awards granted as a result of becoming an insider on Form 4. In this situation, the Form 4 would be due before the Form 3, so the better practice is to file the Form 3 and the Form 4 at the same time (within two business days after the grant), even though the Form 3 would not technically be due until ten calendar days after the triggering event.
Insiders are not required to report on Form 4 or 5 transactions that effect only a mere change in the form of the insider’s beneficial ownership of securities without changing the insider’s pecuniary interest in the securities. For example, a distribution to the insider of securities previously beneficially owned by the insider through an employee benefit plan merely changes the form of the insider’s beneficial ownership (from indirect to direct) and is exempt from Forms 4 and 5 reporting requirements. Likewise, a pro rata distribution of securities from a general partnership to its general partners is a mere change in the form of ownership and exempt from Forms 4 and 5 reporting requirements. This change in form exemption does not apply to:
Even though a mere change in the form of an insider’s beneficial ownership does not in itself trigger a Form 4 or 5 reporting obligation, the insider must reflect the resulting changed ownership in the total direct and indirect beneficial ownership column on the next Form 4 or 5 the insider files.
Acquisitions of company securities in ongoing, tax-conditioned employee benefit plans (e.g., broad-based employee stock purchase plans or 401(k) plans) generally are also exempt from Section 16(a) reporting obligations. But the insider needs to reflect the changes to her current holdings as a result of those acquisitions in the total beneficial ownership column on all subsequent Forms 4 and 5. By contrast, dispositions of securities acquired under employee benefit plans must be reported on Form 4. Transfers into and out of company stock funds in employee benefit plans generally must be reported on Form 4 but, in specific circumstances, the insider may be provided additional time to report.
Annual Report – Form 5. Insiders must file any required Form 5 within 45 calendar days after the end of the company’s fiscal year. Any person who was an insider at any time during the fiscal year must file a Form 5 unless the insider had no reportable transactions during the year or had already filed one or more Forms 4 during the year covering all transactions required to be reported on a Form 4 or 5. A Form 5 must include all reportable transactions that were exempt from Form 4 reporting requirements and not reported earlier and all holdings or transactions that should have been reported on Form 3 or 4 during the fiscal year but were not.
Civil Penalties. Failure to timely file a Form 3, 4 or 5 can result in substantial penalties to the insider. The SEC can seek fines in judicial enforcement actions of up to $9,753 for each violation by an individual and up to $97,523 for each violation by a corporation or other entity. If the violation includes fraud, deceit or deliberate disregard of a regulatory requirement, the fine can be as much as $195,047 for an individual and $975,230 for a corporation. (These amounts are subject to adjustment for inflation.) The SEC can also issue cease-and-desist orders in administrative proceedings against future violations. Failure to file reports also prevents the two-year statute of limitations from running on suits against insiders to recover any profits due to the company under the short-swing profit rules in Section 16(b).
SEC Enforcement. Aided by sophisticated computer algorithms and quantitative data sources, the SEC has made clear that it has the tools and the intention to vigorously investigate and enforce Section 16 reporting violations. In a major enforcement initiative in 2014 specifically targeting Section 16 reporting violations, the SEC recovered significant monetary penalties from individual insiders and companies. More recently the SEC has focused enforcement attention on cases in which an insider committed other, more serious violations of the federal securities laws, but could initiate another sweep based solely on Section 16(a) violations at any time. A company’s agreement to make filings on behalf of insiders is not a valid defense against individual director and officer liability since insiders bear the ultimate responsibility for Section 16 filings.
Proxy Statement Disclosure. A public company must disclose by name in its proxy statement any insiders who reported transactions late or failed to file required reports during the fiscal year. In 2019 the SEC adopted amendments changing the caption for proxy statement disclosure from “Section 16(a) Beneficial Ownership Compliance” to “Delinquent Section 16(a) Reports” and encouraged companies to exclude this disclosure and heading if there are no delinquencies to disclose. At the same time, the SEC eliminated the requirement that a company note by checkbox on the cover of its Form 10-K if there is proxy statement disclosure of late Section 16 reports.
Electronic Filing. Insiders must file Section 16 reports electronically. The reports are due by 10 p.m. Eastern time on the filing deadline. Although insiders can file reports directly through the SEC’s online filing system (located at www.onlineforms.edgarfiling.sec.gov), it is far more common for companies or third-party service providers to submit Section 16 reports on behalf of insiders, although the insiders remain legally responsible for their individual electronic filing obligations.
Electronic Signatures. Effective December 4, 2020, insiders can elect to sign Section 16 reports electronically by using existing platforms such as DocuSign and Adobe Sign. Previously, people who filed Section 16(a) reports for insiders were required to have in hand a manually signed paper copy with ink signature before submitting the filing. Before utilizing the electronic signature process, the filer must manually sign an attestation agreeing that the filer’s electronic signature will constitute the legal equivalent of a manual signature. The attestation must be furnished to the SEC on request and retained by the company for at least seven years from the date it was last used in connection with an electronically signed filing.
To file electronically, insiders must apply for EDGAR access codes. It can take up to five days to receive the codes, so do not delay in submitting an application until the last minute. Since only one set of codes is permitted for an insider, companies obtaining codes on an insider’s behalf should verify that the insider does not already have assigned codes (e.g., if an insider is or was also a director or officer of another reporting company). Please visit the SEC’s website to generate access codes.
Website Posting. Section 16 rules mandate that companies post on their corporate websites all Forms 3, 4 and 5 filed by their insiders and 10% beneficial owners by the end of the business day after the date of filing. Companies must keep the reports posted for at least 12 months. Although companies may post the reports directly, most post by linking to third-party service providers or to the EDGAR database. The link must be directly to the forms or a list of the forms, and the link caption must clearly indicate access to insider Section 16 reports.
To easily and efficiently satisfy the website posting requirements, link to the EDGAR database on the SEC’s website. The advantage is that the EDGAR link will not require an update each time you file a new Section 16 report and will capture reports of 10% beneficial owners that your company might not otherwise notice.
As a best practice for compliance with Section 16(a) reporting obligations, we suggest that your company implement the following procedures:
Section 16(b) of the 1934 Act imposes liability on insiders for profits realized on short-swing trades, that is, for any profits an insider receives from the purchase and sale (or sale and purchase) of registered securities of the company within a period of less than six months in nonexempt transactions. In other words, the insider must be sure that no “matchable” transactions occurred in the six months prior to the planned nonexempt transaction and must avoid any matchable transactions in the following six months. The insider is liable for profits realized in either cash or noncash form (such as securities). Under Section 16(b), the company or a shareholder acting on behalf of the company may bring an action against the insider for disgorgement of the realized profits. Section 16(b) applies to all Section 16(a) insiders (i.e., directors, executive officers and more than 10% beneficial shareholders).
The test for Section 16(b) liability is purely objective: an insider who purchases and sells (or sells and purchases) registered securities in nonexempt transactions within a period of less than six months is liable for the profits received as a result of the transactions. It does not matter whether the insider was aware of confidential information, whether the confidential information was material, whether the insider relied on the information in making the transaction or whether the insider acted in good faith.
Insiders can be liable under Section 16(b) for nonexempt transactions in shares that they hold indirectly as well as directly – particularly for shares held by household members.
An insider is presumed to have indirect beneficial ownership of securities held by members of the insider’s immediate family sharing the same household, including the insider’s spouse, children, parents, grandparents, grandchildren, siblings and in-laws. As a result, if an insider’s spouse or a relative living with the insider sells the company’s stock, and the insider then purchases lower- priced shares within six months of the sale, the insider is liable for short-swing profits.
This is true even if the insider was not aware that the insider’s spouse or household-sharing relative had sold the shares. Liability follows from the presumption that the insider has beneficial ownership of the shares held by the spouse or relative. This is a rebuttable presumption, and the insider may disclaim beneficial ownership of the spouse’s or relative’s securities in the insider’s Section 16 filings.
Transactions Between the Company and Its Officers or Directors. Transactions between the company and its officers or directors may be exempt from Section 16(b) short-swing liability. For example, a grant of stock options to a director or officer will not be treated as a purchase under Rule 16b-3 if the company’s Board, a committee of nonemployee directors or the shareholders approve the grant or if the director or officer holds the stock options or shares acquired upon exercise of the stock options for at least six months from the stock option grant date. The exercise by the director or officer of the stock options will also be exempt. Similarly, a sale or disposition of securities by the director or officer back to the company generally will not be treated as a sale for purposes of Section 16(b) if the Board or a committee of nonemployee directors pre-approves the sale or disposition.
Stock Options and Other Derivative Securities: Purchase Occurs at Time of Grant. Shares subject to stock options and other types of derivative securities are deemed to be purchased for Section 16(b) purposes upon the grant of the stock option or other acquisition of the derivative security rather than upon exercise or conversion. This is because a derivative security is treated as the functional equivalent of the underlying security into which it can be exercised or converted. For example, the grant of an option to purchase common stock is treated as the functional equivalent of the insider’s purchase of the common stock. The exercise, conversion or vesting of a derivative security is generally exempt from Section 16(b) liability.
Although exempt from Section 16(b) liability, insiders must report separately the grant and the exercise or conversion of an option or other derivative security on Form 4 within two business days after each transaction.
When applying Section 16(b) to a single purchase and single sale of securities within a six-month period, the profit calculation is straightforward: the aggregate purchase price of the securities is subtracted from the aggregate sale price.
For multiple sales and purchases within a six-month period, the profit realized is calculated under the lowest-in, highest-out method. The following example illustrates the application of the rule:
Assume that Director Bertrand Brass purchases 100 shares of his company’s common stock in January for $40 a share, purchases an additional 100 shares in February for $45 a share, sells 100 shares in March for $60 a share, purchases 100 shares in April for $50 a share, sells 100 shares in May for $55 a share and sells 100 shares in June for $80 a share. Under the lowest-in, highest-out approach, the January purchase ($40 per share) would be matched with the June sale ($80 per share), the February purchase ($45 per share) would be matched with the March sale ($60 per share) and the April purchase ($50 per share) would be matched with the May sale ($55 per share). Mr. Brass would be liable for $6,000 in realized profits.
Former directors and officers continue to have Section 16(a) reporting obligations (and Section 16(b) short- swing profit liability) for nonexempt trades that they make after termination if the trade occurs within six months of a nonexempt opposite-way transaction (e.g., open market purchase vs. sale) that the insider effected before termination. The former insider must report these post- termination, opposite-way transactions on a Form 4 (indicating a short-swing violation) and will be liable for any short-swing profits resulting from the transactions.
Former directors or officers who did not engage in any transactions during their last six months in office have no Form 4 reporting obligations after termination of service. However, no later than 45 days after the end of the fiscal year in which a director or officer ceased service, she is required to report on Form 5 any exempt transactions (such as gifts) that occurred while she was still an insider and that were not reported earlier. It is a “best practice” for companies to obtain from a departing director or officer who has no Form 5 reportable transactions a representation at the time of departure that no Form 5 is due. On any Form 4 or 5 filed after termination of service, former directors and officers must check the “exit” box indicating that their insider status has terminated.
Entirely apart from any Section 16(a) reporting obligations they may have, shareholders who beneficially own more than 5% of a public company’s stock must report their stock ownership to the SEC on Schedule 13D or 13G filed on EDGAR. Shareholders who through shared control or other similar relationship have agreed to act together with respect to a public company’s stock become a group, and if together they beneficially own in excess of 5% of a public company’s stock, they must report the group’s ownership on Schedule 13D or 13G.
Within 45 days following the end of the calendar year in which a company completes its IPO, every person (including directors and officers) that beneficially owned more than 5% of the company’s stock at the time of the IPO and as of the last day of the calendar year must report that ownership to the SEC on a short-form Schedule 13G. The term person includes entities. These initial 5% shareholders are referred to as exempt shareholders because their shares were acquired prior to the company’s IPO.
After a company is public, any exempt shareholder who acquires more than 2% of the company’s stock in a 12-month period, or any other shareholder who acquires more than 5% of the company’s stock (following its IPO), may be required to file a Schedule 13D, which is more lengthy than Schedule 13G. Shareholders who are passive investors can initially file or continue to file reports on Schedule 13G, avoiding the more burdensome Schedule 13D. A passive investor is a shareholder who beneficially owns less than 20% of the company’s stock, provided the investor did not acquire the securities for the purpose, or with the effect, of changing or influencing control of the company. A person in a control position – such as a director or executive officer – does not qualify as a passive investor.
In general, an investor must amend Schedule 13G annually to report any changes in the information previously reported, including any change in beneficial ownership. Whenever a passive investor acquires more than 10% of the company’s stock, the investor must amend the Schedule 13G “promptly” after the date of the acquisition. From then on, the passive investor must file an amended Schedule 13G promptly after the date on which its beneficial ownership increases or decreases by more than 5%, until the passive investor has reported beneficial ownership below 10% again. A nonpassive investor must amend its more detailed Schedule 13D promptly to report any material change in the information previously reported, which includes any change of 1% or more in its beneficial ownership.
A passive investor loses Schedule 13G eligibility – and must file a Schedule 13D – if the investor acquires 20% or more of a class of securities or no longer holds the shares with no purpose, or effect, of changing or influencing control of the company. In either case, the investor must file a Schedule 13D within ten days of the acquisition or change in passive investor status. In addition, the investor may not vote its shares or acquire more shares during the period that begins at the time of the acquisition of 20% or more of the company’s shares or loss of passive investor status and ends ten days after the investor files Schedule 13D.
Individuals and entities who fail to file timely and accurate Schedules 13D and 13G can be subject to significant monetary penalties and cease-and-desist orders. The SEC’s enforcement initiative targeting Section 16 beneficial ownership reporting violations (discussed above in the section on Section 16 reporting) has also been directed against Schedule 13D and 13G filers.
New Schedules 13D and 13G filers who don’t already have EDGAR access codes must obtain their EDGAR access codes before the applicable due date. It can take up to five days to receive the codes, so do not delay in submitting an application until the last minute. Please visit the SEC’s website to generate access codes.
Under the SEC’s Large Trader Identification System, individuals or entities who, for their own account or for an account for which they exercise investment discretion, effect certain large transactions in exchange-listed securities must file Form 13H identifying themselves as a Large Trader. Transactions aggregating two million shares or $20 million in value on any day, or 20 million shares or $200 million in value in any calendar month, trigger the filing requirement. Form 13H filers must update filings annually. Although Form 13H filers must submit the filings on EDGAR, only the SEC can access the filings, which cannot be viewed by the public. The SEC assigns each Form 13H filer a Large Trader Identification Number, which the filer must provide to the filer’s brokers. To avoid an inadvertent failure to make a required Form 13H filing, or to avoid inadvertently exceeding the applicable size-of-transaction threshold, companies should advise their officers and directors to consider the Form 13H filing requirements in advance of any anticipated large transactions, including exercising expiring stock options.
The 1933 Act requires that any sale of a security must be registered with the SEC, unless the security or transaction qualifies for an exemption. Rule 144 under the 1933 Act provides the most frequently used exemption for the public resale of restricted and control securities.
Although brokerage firms generally play the primary role in assisting their clients with Rule 144 compliance, as a best practice companies should educate insiders who are subject to Rule 144 regarding the applicable resale limitations and assist with Rule 144 compliance. (See our Practical Tip later in this chapter, which includes our suggestions for compliance with Rule 144.)
Rule 144 covers two types of securities: restricted securities and control securities.
Under Rule 144, a company’s affiliates generally include its directors, executive officers and significant shareholders that can influence the company either individually or in concert with others, as well as:
Determining which persons may be affiliates for purposes of Rule 144 requires a fact-specific inquiry.
Three additional requirements of Rule 144 apply only to affiliates:
Although affiliate status generally ceases upon termination of a director’s or officer’s employment or service relationship with a company, brokers may require that a former affiliate continue to sell under Rule 144 until 90 days after the date affiliate status terminates.
Generally, sellers may not rely on Rule 144 for the resale of securities initially issued by current or certain former shell companies, other than a business combination–related shell company.
During six-month holding period:
During six-month holding period:
After six-month holding period:
After six-month holding period and until one year:
After one-year holding period:
Officers or directors with significant holdings may trigger a Hart-Scott-Rodino (HSR) filing obligation by acquiring even one additional share of their company’s stock, including through the exercise of stock options or the vesting of restricted stock units (RSUs). Although the value of the stock acquired through the exercise of stock options or vesting of RSUs typically falls well below the size-of-transaction threshold that would trigger an HSR filing ($92 million in 2021, and adjusted annually), that value must be aggregated with the value of the officer’s or director’s existing holdings when determining whether an HSR filing is necessary. Failure to make a required filing could result in substantial monetary penalties for the individual officer or director, as well as company disclosure obligations. To avoid an inadvertent failure to make a required HSR filing, companies should implement an HSR warning system that reminds the company and its officers and directors to confer with counsel about potential HSR implications well in advance of the anticipated date of any stock option exercise or RSU vesting.
The antifraud provisions contained in Rule 10b-5 under the 1934 Act prohibit directors, officers, employees and others who are aware of material nonpublic information from trading while aware of that information. Disclosing material nonpublic information to others who then trade while aware of that information is also a violation of Rule 10b-5, and both the person who discloses the information and the person who trades while aware of the information are liable. These illegal activities are commonly referred to as insider trading. In the context of insider trading, the term insider covers all employees and certain others who are aware of the material nonpublic information, such as consultants, in addition to Section 16 insiders.
Insider Liability: For Trading. Potential penalties for insider trading violations include imprisonment for up to 20 years, civil fines of up to three times the profit gained or loss avoided by the insider trading and criminal fines of up to $5 million.
Issuer Liability: For Inaction. The company, as well as directors and officers, may be subject to controlling-person liability under federal securities laws. Controlling-person liability may apply if the company or the director or officer knew, or recklessly disregarded, that a person directly or indirectly under the company’s or the responsible person’s control was likely to engage in insider trading and the company or person failed to take appropriate steps to prevent the trading. The penalty for inaction is a civil fine of up to the greater of $2,166,279 (subject to adjustment for inflation) or three times the profit gained or the loss avoided as a result of the insider trading and criminal fines of up to $25 million.
The best way to protect a company and its insiders from potential liability under the insider trading laws is to adopt and enforce a clear policy that defines insider trading and prohibits trading while aware of material nonpublic information. The insider trading policy should apply to all directors, officers, employees and consultants of the company.
Establish Blackout Periods. The insider trading policy should establish trading blackout periods. A trading blackout period is a time period during which the company prohibits Section 16 insiders and other employees and consultants who have access to material nonpublic information about the company from buying and selling the company’s securities. Blackout periods generally begin two to four weeks before the end of the quarter and end after the first or second full business day following the company’s earnings release for that quarter. If a material event occurs (or material information is known) outside a blackout period, the company generally will impose an event-specific blackout period for applicable insiders while the event (or information) remains material and nonpublic.
Require Preclearance. Section 16 insiders and certain other employees and consultants with access to material nonpublic information should be required to notify and seek approval from a company compliance officer for any transactions in company stock by them or their family members at least two business days before the contemplated transaction.
Rule 10b5-1 provides an affirmative defense for insiders who sell securities pursuant to a previously established Rule 10b5-1 trading plan, even if the insider is aware of material nonpublic information at the time of the actual trade. (We discuss Rule 10b5-1 trading plans in detail later in this chapter.) A company’s insider trading policy will generally permit an insider to adopt a Rule 10b5-1 trading plan during a period of time outside a blackout period and when the insider is not aware of material nonpublic information, but only if the trading plan is precleared by a compliance officer. The insider trading policy should exclude trades under appropriately established Rule 10b5-1 trading plans from the preclearance policy and blackout periods.
Under the SEC’s Regulation Blackout Trading Restriction (Regulation BTR), executive officers and directors may not, during any pension plan blackout period, directly or indirectly (including through a family member) acquire, sell or transfer any company equity securities that the director or executive officer acquired in connection with employment or service as a director or executive officer.
A Regulation BTR blackout period means any period of more than three consecutive business days during which pension plan participants cannot trade in securities held in their individual accounts, but only if this suspension affects at least 50% of the participants in all of the company’s “individual account plans.” A Regulation BTR blackout period does not include:
A variety of transactions over which directors and executive officers have no control fall outside Regulation BTR. For example, transactions under Rule 10b5-1 trading plans, changes that result from a stock split or dividend and compensatory grants and awards under plans that clearly set out the amount, price and timing of awards or include a formula for determining these items are all exempt.
To satisfy Regulation BTR and notify the directors, executive officers and the public, companies must, within specific time frames:
In addition to implementing an insider trading policy and Section 16(a) and Rule 144 compliance procedures, providing your insiders with a Trading Compliance Checklist similar to the following will serve as a basic reminder of trading prohibitions and SEC filing requirements:
1. Comply with the Company’s Insider Trading Policy
Any time you engage in a transaction involving company securities, you must comply with the company’s insider trading policy and applicable insider trading laws. The company’s insider trading policy requires that transactions by insiders be precleared with the company’s compliance officer and that insiders trade only during periods that are not blackout periods. Before effecting any transaction in company securities, you should ask:
2. Short-Swing Profit-Matching Liability Under Section 16(b) and Reporting Under Section 16(a)
Any nonexempt trade you make that effects a purchase within six months before or after a sale or a sale within six months before or after a purchase results in a violation of Section 16(b). The profit will be determined by matching the highest-priced sale with the lowest-priced purchase within six months of the sale. Even if you do not realize this profit in an economic sense, the company or any shareholder acting on behalf of the company may recover this profit from you. It makes no difference how long you held the shares, that you were not aware of inside information, that you had no harmful intent or that one of the two matchable transactions occurred after you were no longer an insider. Before effecting any transaction in company securities, you should ask:
For Sales:
For Purchases:
Before Any Transaction in Company Securities:
3. Compliance with Rule 144
To comply with Rule 144, certain limitations on sales of company securities must be met, and generally, insiders must file Form 144s. Before effecting any transaction in company securities, an insider should ask:
One cost of inside knowledge for a public company director or executive officer is illiquidity. The insider cannot sell shares during a trading blackout period or when the insider is aware of material nonpublic information. For many insiders, this may leave little or no time in which to trade. The SEC, by adopting Rule 10b5-1, opened a path that can bring transparency and order to insider selling, and so both eases this liquidity squeeze and helps ensure compliance with the antifraud provisions of Rule 10b-5.
Rule 10b5-1 begins by clearly stating that anyone trading in a company’s securities while aware of material nonpublic information is engaging in unlawful insider trading. The rule then provides a limited safe harbor (technically, an affirmative defense) that, when closely followed, creates a shield from liability. Rule 10b5-1 allows insiders to adopt, at a time when the insider is not aware of material nonpublic information, a written trading plan that will permit future sales, even when those future sales may occur at times that the insider is aware of material nonpublic information. Rule 10b5-1 trading plans are relatively easy to understand, establish and administer, and court cases have demonstrated the usefulness of properly structured trading plans in defending against charges of insider trading. However, perceived abuses of Rule 10b5-1 trading plans have led to scrutiny in academic studies and by the SEC and the courts. In early 2021 the SEC chair asked the SEC staff to make recommendations to “freshen up” Rule 10b5-1 to incorporate and expand upon best practices.
In addition to helping establish protection from liability, written Rule 10b5-1 trading plans can:
A successful Rule 10b5-1 trading plan stands on three legs. First, the trading plan must be established when the insider is not aware of material nonpublic information. SEC guidance clarifies that the affirmative defense of a trading plan is not available if an insider establishes the plan while aware of material nonpublic information, even if the plan is structured so that transactions will not begin until after that material information is made public.
Second, the trading plan must be in writing and must:
Third, each trade should comply with the trading plan. The insider must not alter or deviate from the trading plan (by changing the amount, price or timing of the trade) or enter into or alter a corresponding or hedging transaction or position with respect to the securities. SEC guidance clarifies that the cancellation of one or more plan transactions represents an alteration of or deviation from the trading plan that may affect the availability of the affirmative defense.
In addition to these three legs, the insider must enter into the trading plan in good faith and not as part of a scheme to evade the prohibitions of Rule 10b5-1. SEC guidance clarifies that in creating a new trading plan after cancelling a prior trading plan, all surrounding facts and circumstances, including the period of time between the cancellation of the old plan and the creation of the new plan, must be evaluated in determining the insider’s good faith intent.
The legal or compliance department of the insider’s broker usually will take the lead in drafting the insider’s Rule 10b5-1 trading plan. The insider and the company must then closely review and tailor the draft trading plan to ensure that it fits their requirements. The trading plan should first establish the amount, price and dates of the trades, or a method to determine the amount, price and dates. Next, a Rule 10b5-1 trading plan will state explicitly in writing that:
A company’s insider trading policy should require insiders to submit Rule 10b5-1 trading plans to the company’s compliance officer for preclearance before adoption. The purpose of preclearance is not for company “approval” of the terms of the trading plan, but to permit the compliance officer to determine that the plan is being adopted outside a trading blackout period and otherwise complies with the company’s insider trading policy. To assist with this review, companies should consider adopting written Rule 10b5-1 guidelines that all insiders must follow in adopting a Rule 10b5-1 trading plan.
If the Rule 10b5-1 trading plan relates to a senior executive and a material number of shares, the company should consider disclosing the establishment of the executive’s trading plan to maximize transparency, preempt market reaction and alleviate shareholder concerns. A company can make the public disclosure through one or some combination of a Form 8-K, Form 10-Q, press release or website posting.
Companies should implement procedures to ensure that insiders timely report Rule 10b5-1 trading plan transactions on Forms 4, 5 and 144 and, as required, on Schedule 13D or 13G. When reporting transactions on Form 144 (initially filed when the first trade under the trading plan is executed or a sell order is placed), the insider must sign the form and indicate in the space provided below the signature line the date on which the insider adopted the trading plan, which actions serve as the insider’s representation that the insider was not aware of material nonpublic information as of the date the plan was adopted (rather than the date the Form 144 was signed). Sales under a trading plan that will occur over a period of more than three months will require multiple filings of Form 144. In the Form 4, filed to report the transaction, insiders should also note that the trade was pursuant to a Rule 10b5-1 trading plan to minimize speculation that the transaction reflected the insider’s current perception of the status of the company.
Insiders should be cautioned that a Rule 10b5-1 trading plan, even one that meets all the requirements of Rule 10b5-1, only provides an affirmative defense in an enforcement action or lawsuit alleging unlawful insider trading. It does not prohibit someone from bringing the enforcement action or lawsuit. It is possible to strengthen this affirmative defense by following the six steps suggested below.
Prior to each shareholders’ meeting, a public company solicits a proxy from each of its shareholders by providing a proxy statement and a proxy card (or voting instructions). A proxy is a power of attorney allowing the company’s management (or another designee) to vote the shares owned by a shareholder as directed by the shareholder or at the designee’s discretion. The proxy solicitation process allows shareholders to exercise their voting rights without being physically present at the shareholders’ meeting. The proxy statement informs shareholders about the items of business to be voted on at a shareholders’ meeting, provides certain other SEC-required disclosures and solicits a proxy from each shareholder entitled to vote at the meeting.
In connection with a public company’s annual meeting of shareholders, a public company provides its shareholders with a proxy statement and an annual report to shareholders, which together play a critical role:
Typical annual meeting matters include director elections, say-on-pay proposals and ratification of independent auditors. Other matters to be voted on may include approval of equity incentive plans and qualified shareholder proposals.
A public company may also hold a special meeting of shareholders for a variety of reasons, including seeking shareholder approval for a sale of the company or certain other major transactions involving the company. In connection with these special meetings, a company provides its shareholders with a proxy statement containing, among other things, information regarding the matter to be voted on at the meeting.
Regulation 14A of the 1934 Act governs any communication by a public company reasonably calculated to cause a shareholder to grant, withhold or revoke a proxy. Regulation 14A requires a public company to disclose relevant material information and prohibits fraud in connection with a proxy solicitation. State corporate law, as well as the provisions of each company’s certificate or articles of incorporation and bylaws, also govern aspects of the proxy solicitation process.
With the increasing influence of shareholder activists and proxy advisory firms (such as Institutional Shareholder Services Inc. (ISS) and Glass, Lewis & Co. LLC (Glass Lewis)), the proxy statement has evolved from a pure SEC disclosure document to become a solicitation tool that savvy companies use to connect with shareholders to tell their companies’ story. In addition to the required disclosures, many companies focus on making their proxy statements clearer and more user-friendly through the use of executive summaries, graphics and other techniques. See the “Proxy Statement Usability” Practical Tip later in this chapter for our suggestions about using your proxy statement to tell a compelling story.
Schedule 14A outlines the information that a public company must include in a proxy statement. Companies typically include, for example, many Form 10-K-required disclosures in the proxy statement and incorporate them by reference into the Form 10-K. (Form 10-K permits this so long as the company files its proxy statement within 120 days after its fiscal year-end.) Mandatory Schedule 14A disclosures include:
The Dodd-Frank Act, which became law in 2010, has significantly impacted annual shareholders’ meetings and proxy statement disclosures, including say-on-pay and say-on-frequency votes, CEO pay ratio disclosure, company policies on hedging of company securities by directors and employees, and disclosures regarding Compensation Committee independence and the use of compensation advisors. As of the time this Handbook went to press in 2021, the SEC had proposed but not yet adopted rules to implement two other provisions under the Dodd-Frank Act that will impact proxy statement disclosures: the relationship between executive pay and company performance, and mandatory clawbacks for some executive incentives, which will then require further NYSE and Nasdaq rulemaking.
Compensation Discussion and Analysis (CD&A). The CD&A is principles-based, similar to the MD&A in the Form 10-K, and must discuss the material information necessary to understand the objectives of a company’s compensation for its named executive officers for the last completed fiscal year. This means that each company must determine, in light of its particular facts and circumstances, what elements of the company’s compensation policies and decisions are material to investors’ understanding. In addition, the proxy statement CD&A must answer these questions:
The SEC rules also provide a nonexclusive list of topics a company should address in the CD&A for the last completed fiscal year if material and necessary to an understanding of the company’s policies and decisions for compensation of its named executive officers. Compensation actions or decisions taken before or after the last completed fiscal year should also be addressed, if necessary, to present a “fair understanding” of the named executive officers’ compensation for the last completed fiscal year.
Due to proxy advisory firm and investor focus on executive compensation, the CD&A also often includes disclosures that go well beyond SEC requirements and the above-listed items. Such disclosures are typically aimed at more clearly explaining the executive compensation program’s link to company financial and market performance with an eye toward soliciting support for the say-on-pay proposal.
Compensation Committee Report. A Compensation Committee Report, which accompanies the CD&A and is followed by the name of each member of the Committee, confirms that the Committee has reviewed and discussed the CD&A with management and recommended to the Board that the CD&A be included in the proxy statement.
Your company must generally disclose company and individual performance targets for incentive compensation in the year covered by the CD&A as well as the actual achievement levels matched against the targets. You must include these targets if they are material elements of your company’s compensation policies and decisions, unless you can demonstrate that the disclosure would result in competitive harm to the company. The SEC, through comment letters, imposes a stringent standard of review on omitted performance goals. It rarely accepts “competitive harm” arguments for corporate-level financial performance targets for completed fiscal periods. If your company omits performance targets, you must discuss in your CD&A with meaningful specificity how difficult it will be to achieve the undisclosed targets. In addition, proxy advisory firms are often critical of companies that fail to clearly disclose executive compensation performance targets.
Executive Compensation Tables and Related Narrative Disclosures. A series of required tables and supplemental narrative disclosures follow the CD&A, showing compensation of named executive officers in three categories:
Narrative disclosure provides the context for the compensation tables. By contrast, the narrative in the CD&A focuses on the broader “how” and “why” issues behind the company’s compensation policies and programs.
Companies must specifically discuss and analyze employee compensation policies and practices to the extent that the policies or practices create risks that are reasonably likely to have a material adverse effect on the company.
The proxy disclosure rules do not require you to affirmatively state that your company has determined that the risks arising from your compensation policies and practices are not reasonably likely to have a material adverse effect on your company. However, consider this: affirm both your risk analysis conclusion and the process by which you arrived at that conclusion. If you do this, discuss the policies or practices (such as clawbacks or minimum stock ownership guidelines) that mitigate those risks that your incentive compensation programs create. If you discuss these risk-mitigation elements, set them off under a separate, identifiable heading to make it clear that you are not including these elements in the executive compensation covered by the say-on-pay vote. You should also consider including details regarding the consideration of risk for named executive officer compensation policies and practices within the CD&A.
Public companies holding a shareholders’ meeting to elect directors also conduct nonbinding advisory votes on both the compensation paid to named executive officers (the say-on-pay vote) and, at least once every six years, whether the say-on-pay vote should be held every one, two or three calendar years (the say-on-frequency vote).
Say-on-Pay Vote. The say-on-pay vote seeks approval of executive compensation as disclosed in the proxy statement.
Although SEC rules require no specific language or form of resolution, generally a company must:
Say-on-Frequency Vote. The purpose of the say-on-frequency vote is to ask, at least every six years, how often shareholders would prefer future say-on-pay votes to occur. The proxy card should give shareholders four alternatives: every one, two or three years or abstain. Companies must disclose that they are providing a separate say-on-frequency vote pursuant to the SEC’s proxy rules and explain the nonbinding nature of the vote. Although a company’s Board may include a recommendation on how shareholders should vote, the proxy statement should be clear that shareholders are not voting to approve or disapprove the Board’s recommendation.
When drafting your proxy card, you can carefully preserve your ability to vote uninstructed proxy cards in accordance with management’s recommendation for the say-on-frequency vote if you:
Form 8-K Disclosure. Companies disclose the voting results for the say-on-pay and say-on-frequency votes under Item 5.07 of Form 8-K within four business days following the date of the shareholders’ meeting. This may include the Board’s decision on how frequently to hold future say-on-pay votes, although this decision can also wait until an amendment to the Form 8-K is filed within 150 days of the shareholders’ meeting or, if earlier, 60 calendar days before the deadline for the submission of shareholder proposals under Rule 14a-8 under the 1934 Act for the next annual meeting.
U.S. public companies are required to disclose the annual compensation of their median employee, the annual total compensation of their CEO, and the ratio of these two amounts. Emerging growth companies and smaller reporting companies are exempt from this disclosure.
To identify the median employee, companies may select a methodology based on their own facts and circumstances. For example, a company could use its total employee population, a statistical sampling of that population or other reasonable methods. In performing its pay ratio calculation, subject to limited exceptions, a company is required to include all personnel – U.S. and non-U.S., full-time, part-time, temporary and seasonal – employed by the company and any of its consolidated subsidiaries on any date of the company’s choosing within the last three months of its last completed fiscal year.
In identifying the median employee, a company may rely on a compensation measure that uses the same rules that apply to the CEO’s compensation, or any other compensation measure that is consistently applied to all employees included in the calculation, such as information from its tax or payroll records. Once the median employee has been identified, however, a company must calculate the annual total compensation for that employee using the same rules that apply to the CEO’s compensation as disclosed in the summary compensation table.
A company is permitted to identify its median employee once every three years, unless there has been a change in its employee population or employee compensation arrangements such that the company reasonably believes would result in a significant change to its pay ratio disclosure. A brief description of the methodology used to identify the median employee, and any material assumptions, adjustments or estimates used to identify the median employee or to determine annual total compensation, must be provided.
U.S. public companies are required to disclose in proxy statements any practices or policies they have adopted regarding the ability of any company employee, officer or director to engage in any transaction to hedge or offset any decrease in the market value of company equity securities granted to the individual as compensation or held by the individual directly or indirectly.
Companies must provide a “fair and accurate” summary of the practices or policies (whether written or unwritten) or disclose the practices and policies in full. Any disclosure must include the categories of persons covered and the categories of hedging transactions that are specifically permitted or disallowed. If the company does not have any hedging policies or practices, it must disclose that fact and state, if accurate, that hedging transactions are generally permitted.
Drafting your proxy statement with “usability” in mind allows it to serve as your company’s voice in presenting your executive compensation and governance story to investors and proxy advisory firms. It also allows you to keep up with your peers in the ever-evolving world of shareholder engagement efforts. We suggest the following as ways to enhance proxy statement usability:
Most “leaders” in proxy statement disclosures have evolved over time. Starting from scratch on proxy statement usability requires a long lead time and can be cost-intensive. An alternative approach is to consider a few items to improve each year with an eye toward gradual and achievable long-term improvements.
SEC disclosure requirements for annual reports and proxy statements highlight the composition and role of the Board and corporate governance generally. Key governance disclosures include:
Stakeholder focus on environmental, social and governance (ESG) topics continues to influence companies of all sizes across industries. Many companies provide ESG disclosure in separate reports, often called sustainability reports or corporate responsibility reports, but include limited disclosures in their SEC filings. While the required SEC proxy statement disclosures address many governance items, given that the proxy statement is a main form of stakeholder engagement, companies should consider highlighting their environmental and social efforts by adding such disclosure to the proxy statement. At a minimum, proxy advisors expect S&P 500 companies to explicitly disclose the Board’s role in overseeing environmental and social issues, and many other ESG-related disclosures regarding human resources, compensation and the Board may fit naturally in the proxy statement. See Chapter 3 for more information about stakeholder engagement on ESG topics.
Director Nominations. A detailed description of the director nomination processes in the proxy statement, to give shareholders an understanding of Board operations, includes:
Communications with the Board. A company must describe whether and how shareholders (and for NYSE companies, other interested parties) can send communications to the Board or to specific individual directors (and for NYSE companies, to the non-management directors as a group).
Director Compensation. Finally, a company must disclose in a specified tabular format all compensation that it has paid to directors or that they have earned in the most recently completed fiscal year, and provide narrative disclosure of any material factors necessary to understand the information in the table.
The Audit Committee publishes its own report in the proxy statement. This report includes disclosure that the Committee reviewed and discussed with management the audited financial statements, reviewed and discussed with the independent auditors written disclosures regarding the auditors’ independence, and other matters required by applicable auditing standards. At the heart of this report is the Committee’s recommendation to the Board to include the audited financial statements in the company’s annual report. A company must also disclose in detail in its proxy statement and Form 10-K the fees paid to the independent auditors and a description of any preapproval policies and procedures.
A company also discloses in the proxy statement whether representatives of the auditors will attend the annual meeting and whether they will have the opportunity to make a statement or respond to questions.
The SEC’s e-proxy rules require each public company to post proxy materials on a publicly available “cookie-free” website. The posted materials include the proxy statement, proxy card, annual report to shareholders, notice of shareholders’ meeting, other soliciting materials and any amendments to these materials.
There are two alternatives available to companies to satisfy additional e-proxy requirements related to distribution of proxy materials:
Companies use a variety of ways to satisfy this mandate, many distributing proxy materials using a stratified or bifurcated approach, employing different methods for different shareholder groups based on status as a retail versus institutional holder or registered versus street name holder.
Companies that use the notice-only method of distribution file a form of the Notice of Internet Availability on EDGAR as additional soliciting materials no later than the date the company first sends the notice to its shareholders.
Most annual meeting proxy materials relate only to routine matters such as the election of directors, say-on-pay and say-on-frequency proposals, approval of an equity compensation plan or ratification of the independent auditor. A company may file a routine proxy statement with the SEC in final form either prior to or concurrently with distributing the proxy materials to shareholders.
When the proxy materials relate to nonroutine matters (such as authorizing additional shares or otherwise materially amending the charter or approving a merger), a company must file them in preliminary form at least ten days prior to distributing them to shareholders. These preliminary proxy materials are subject to review and comment by the SEC. The SEC will promptly advise a company if it intends to review the preliminary proxy materials. If the SEC advises that it will not review the materials, the company may distribute the definitive proxy materials to its shareholders and concurrently file them with the SEC. If the SEC comments on the preliminary proxy materials, the company needs to file amended proxy materials for SEC review.
State corporate law in the company’s jurisdiction of incorporation and a company’s governing documents establish the time period for delivery of notice of an annual or special shareholders’ meeting under most state laws. The notice period is generally no less than ten days (20 days for business combinations) and no more than 60 days prior to the shareholders’ meeting date. The notice is usually included as part of a company’s proxy statement. In practice, well-organized companies distribute proxy materials as far in advance of the shareholders’ meeting as permitted by applicable notice requirements. Early distribution allows sufficient time for proxy materials to reach beneficial owners, helps ensure the presence of a quorum at the meeting and gives the company time to follow up with shareholders regarding voting.
With the implementation of the e-proxy rules, a company is required to post its proxy materials on the e-proxy website no later than the date the company first sends the Notice of Internet Availability to shareholders. As a result, any website hosting company or other service provider involved in implementing the e-proxy website will need to receive finalized proxy materials in sufficient time to have the e-proxy website operational prior to that date. In addition, if companies utilize the notice-only method of distribution, the Notice of Internet Availability must be sent to shareholders at least 40 days before the shareholders’ meeting. This means that companies must actually finalize proxy materials prior to the 40-day deadline and coordinate with various intermediaries to ensure timely mailing. With the full-set delivery method, this 40-day deadline does not apply.
A shareholder can appoint a proxy by completing the proxy card that accompanies the proxy statement. Rule 14a-4 under the 1934 Act sets forth the specific form and content requirements for the proxy card.
If a company uses the notice-only method, it will need to hold off on mailing the proxy card until at least ten calendar days after mailing the Notice of Internet Availability to shareholders. This gives the shareholders time to access and review the proxy statement. Alternatively, rather than waiting ten days, the company could mail the proxy card if accompanied or preceded by a copy of the proxy statement and annual report.
Trap for the Unwary: Remember Your Optionees and 401(k) Plan Participants
Option Holders and 401(k) Plan Participants. Although the primary purpose of a proxy statement is to solicit votes from shareholders, you will also need to get your proxy statement and annual report, as well as other communications distributed to shareholders generally, to holders of stock options and some participants in 401(k) plans with employer stock funds. Hidden in Rule 428(b) under the 1933 Act is an easy-to-overlook requirement identifying the information you need to deliver to optionees and other employee benefit plan participants, which includes delivery of proxy materials no later than when the materials are sent to the company’s shareholders.
Electronic Delivery. If you adopt the notice-only option or use a stratified approach, pay special attention to ERISA plans with individual accounts invested in your company’s stock, such as 401(k) plans and employee stock ownership plans. Rules adopted by the Department of Labor in May 2020 create a notice and access safe harbor for electronic delivery of proxy materials. To rely on the safe harbor, companies must first provide participants an initial notice of availability in paper form tailored to provide the participant’s electronic address and stating that the proxy materials will be provided electronically unless the participant opts to receive only paper versions. The rules then provide detailed instructions about the content and manner of delivery of the electronic documents for individuals who have not opted out of electronic delivery.
We suggest approaching electronic delivery involving participants in equity and ERISA plans with extra care to address compliance with both SEC and ERISA rules.
Under certain conditions described in Rule 14a-8 under the 1934 Act, a public company must include in its proxy materials a qualifying proposal from a shareholder at no expense to that shareholder. These rules provide a means for shareholders to seek shareholder consideration of actions not otherwise proposed by the Board. If the proposal does not meet the procedural and substantive requirements outlined in Rule 14a-8, the company may exclude the proposal from its proxy materials. If the Board does not favor a qualifying proposal, the company may include a statement in opposition to the proposal.
In September 2020 the SEC adopted amendments to Rule 14a-8 increasing and tightening eligibility requirements for submitting and resubmitting shareholder proposals. The amendments will first apply to any shareholder proposal submitted for an annual or special meeting held on or after January 1, 2022.
Prior to the amendments, to be eligible to have a proposal included in a company’s proxy statement, a shareholder proponent was required to have held at least
$2,000 of a company’s securities continuously for at least one year. The amendments eliminated the alternative 1% threshold and adopted a tiered approach based on a combination of the amount of securities a shareholder proponent holds and the length of time the securities have been held. Under the amended rules, shareholder proponents must satisfy one of three alternative tests:
Under a temporary phase-in period, a shareholder that has continuously held at least $2,000 of a company’s securities for at least one year as of the effective date, and continuously maintains at least $2,000 of such securities through the date it submits a proposal, will be eligible to submit a proposal without satisfying the new ownership thresholds for an annual or special meeting to be held prior to January 1, 2023.
The amended rules also raise the threshold levels of shareholder support a proposal must receive to be eligible for resubmission at future shareholders’ meetings. Previously, shareholder proposals could be excluded if they addressed substantially the same subject matter as a proposal or proposals formerly included in the company’s proxy materials within the past five years if the most recent vote occurred within the preceding three years and the resulting vote in favor of the proposal was below 3% if submitted once, 6% if submitted twice and 10% if submitted three times. The new thresholds under the amended rules are 5%, 15% and 25%, respectively.
The new rules also require specified documentation when a proposal is submitted by a representative on behalf of a shareholder proponent and require shareholder proponents to identify specific dates and times they can be available to engage with the company to discuss the proposal.
A shareholder must satisfy four procedural steps to be eligible to include a proposal in a company’s proxy materials:
If a shareholder fails to satisfy any of these requirements, the company may exclude the proposal on procedural grounds – but only if it notifies the shareholder of any defects within 14 calendar days of receiving the proposal and permits the shareholder an opportunity to cure the defects. The company need not provide a shareholder notice of a defect if the defect cannot be remedied, such as if the shareholder failed to submit a proposal by the company’s properly determined deadline.
If the shareholder, or a representative of the shareholder, does not personally appear at the meeting to present the proposal, the company may exclude any proposals submitted by that shareholder from its proxy materials for the following two years unless the shareholder can demonstrate good cause for failing to attend.
Rule 14a-8 also includes several substantive bases on which a company may seek to exclude a shareholder proposal:
If a company intends to exclude a shareholder proposal from its proxy materials on procedural or substantive grounds, it generally must submit its reasons for doing so to the SEC, with a copy sent simultaneously to the shareholder proponent. This submission is referred to as a no-action letter request and must be submitted to the SEC no later than 80 calendar days prior to filing the company’s definitive proxy statement. Whether the company is ultimately able to exclude the proposal from its proxy statement will depend on the SEC’s response to the no-action letter request. The SEC now accepts no-action letter requests and correspondence related to Rule 14a-8 shareholder proposals via e-mail at shareholderproposals@sec.gov.
The SEC staff may respond to no-action requests informally instead of by letter on well-settled matters. These responses are posted on the SEC website in a chart tracking the staff’s no-action positions. The chart lists the company name, the proponent, date of the company’s initial submission, bases asserted by the company for exclusion, whether the staff granted, denied or declined to state a view – and provides the basis for a decision granting no-action relief.
If a company intends to make a statement in the proxy statement in opposition to a shareholder proposal, the company must provide a copy of the statement to the proponent at least 30 days before filing the definitive proxy statement. If the SEC’s no-action letter request response requires the shareholder proponent to revise a proposal, the company must provide a copy of the statement in opposition no later than five calendar days after the company receives a copy of the revised proposal.
The proxy statement must either include the shareholder proponent’s name, address and share ownership or indicate that the company will provide this information upon request. Although in the past most companies did not identify shareholder proponents, many companies now include this identifying information in their proxy statements.
Under certain conditions a shareholder may submit a proposal for consideration at a shareholders’ meeting even though the proposal does not meet the procedural requirements for inclusion in the company’s proxy statement. The requirements for such submissions are described in the company’s bylaws or, in the absence of applicable bylaw provisions, in Rule 14a-4(c). Companies should be aware of the deadlines for these types of shareholder proposals, which are usually provided for in the company’s advance notice bylaw provisions, and the applicable deadlines should be disclosed in the company’s proxy statement. In addition, a company can generally retain discretion to vote proxies it has received on this type of shareholder proposal if it includes in its proxy statement advice on the nature of the proposal and how it intends to exercise its voting discretion.
As with shareholder proposals, there are various ways that management may appropriately anticipate and manage proxy contests with shareholder groups. A proxy contest typically involves a challenge to existing management by a third-party acquirer or shareholder group seeking control of the company or by a shareholder activist seeking to influence the direction of the company. Often, the challenger has obtained a significant ownership position in the company and seeks to either control the company through the election of a majority of the directors or propose a merger or tender offer for shares. (Although a detailed discussion of takeover transactions and defenses is beyond the scope of this Handbook, we summarize corporate structural defenses in Chapter 11.)
Proxy access is a method for shareholders to gain representation on the Boards of public companies. Unlike waging a proxy contest, utilizing proxy access does not require shareholders to bear the cost of preparing and distributing their own proxy materials. Market standard terms for proxy access have developed over the past several years, to require the nominating shareholder (or a group of up to 20 shareholders) to hold at least 3% of the company’s shares for at least three years to nominate up to 20% of the Board or at least two directors, with a nominating group size of 20 shareholders. While proxy access bylaws now have been adopted by over 70% of S&P 500 companies and over half of the companies in the Russell 1000, as of the date of this Handbook, proxy access has been used only once to include a director nominee in the proxy materials of a company pursuant to a proxy access right.
A company’s proxy statement, Form 10-K and annual report to shareholders provides a variety of detailed information about its directors and officers, including employment history, compensation, security ownership in the company, related transactions with the company and Section 16 reporting compliance history. Even if a company believes it already knows all the relevant information, the company should ask its directors and officers each year to complete a D&O questionnaire to elicit or confirm the required information. Companies will want to review and update their D&O questionnaires annually (as necessary) to incorporate changes to applicable SEC requirements and NYSE and Nasdaq rules. Companies should provide the D&O questionnaires to directors and officers sufficiently in advance to allow adequate time for responses to be incorporated into the proxy statement, Form 10-K and annual report. A helpful approach is to include a copy of relevant portions of the prior year’s proxy statement, Form 10-K or annual report with the D&O questionnaire and request that the directors and officers update and edit the information as needed.
In the annual report to shareholders, senior executives have an opportunity to communicate directly with the company’s shareholders. Unlike the corporate governance focus of the annual proxy statement, the annual report conveys information regarding the company’s business, management and operational and financial status.
The “glossy” annual report to shareholders has similar content requirements to Form 10-K, but serves a different purpose designed to communicate directly with shareholders. Rules 14a-3 and 14c-3 under the 1934 Act specify the minimum content requirements for an annual report. These include:
Companies are free to include information in the annual report that goes beyond the minimum content requirements. Companies generally include a letter from the president or chair of the Board summarizing the company’s operations, strategy, projected performance, key personnel changes and other highlights for the year. Because the annual report is furnished to the SEC and generally made publicly available, any information included in the annual report, even if not required, may be the source of legal liability if found to be materially misleading.
Format requirements for the annual report are minimal. The SEC permits virtually any format, but innovative presentation, including the use of tables, graphs, charts, schedules and other illustrations, can be useful in presenting operational and financial information in an easily understandable manner. Some of the financial information included in the body of the annual report must be presented in tabular form.
Companies are increasingly using a Form 10-K wrap annual report to shareholders. This consists of up to a few pages of company message materials, usually including a president’s or chair’s letter, that simply wrap around the Form 10-K. This avoids duplication between the annual report and the Form 10-K, while reducing costs and environmental impact. A similar cost-saving approach is to send shareholders a combined document that includes both the proxy statement and the annual report.
Timing of the Annual Report to Shareholders
The SEC requires an annual report to shareholders to accompany or precede a company’s proxy statement for any annual meeting at which shareholders will elect directors. Unlike the other proxy materials, a company’s annual report to shareholders need not be filed with the SEC on EDGAR.
For the first several months of each fiscal year, a public company’s senior management and professional advisors will spend significant energy preparing for the company’s annual meeting of shareholders. An important component in conducting a successful annual meeting is early and consistent preparation. Agreeing to a pre-meeting timetable can bring order to this process and help ensure timely completion, as many of the tasks require significant lead time.
The Annual 1934 Act Reporting Calendar in Appendix 1 can help you plan your annual meeting process. Your calendar or time and responsibility (T&R) schedule should identify the group or individual in charge of each task and set a due date for accomplishing the task. One person should take responsibility for updating and recirculating the T&R schedule on a regular basis during the planning period to reflect the current status or completion of the necessary tasks.
Tailor your company’s T&R schedule to the rules and regulations that govern the annual meeting process, which are derived from: (1) federal securities laws; (2) exchange rules and regulations; (3) the company’s governing documents (i.e., certificate or articles of incorporation, bylaws, Board guidelines and policies, and committee charters); and (4) state corporate law. Care should also be taken to ensure that the company’s T&R schedule incorporates lessons learned from the prior year’s annual meeting and any changes to applicable rules and regulations.
The calendar for each company will be different, and its preparation will require some judgment. Given the requirements under state law, the company’s charter, the company’s bylaws, SEC rules and exchange rules, each company should work with its counsel to identify and comply with the most restrictive applicable requirements.
Companies should consider the following when setting the annual meeting date:
Some state corporate laws set forth a time frame during which companies must hold an annual meeting. Failure to hold an annual meeting during the specified time frame generally gives shareholders the right to demand that a meeting be held. For example, if a Delaware company fails to hold an annual meeting within 30 days after the date designated for the company’s annual meeting or, if a date is not designated, 13 months after its previous annual meeting, a shareholder or director can bring an action to force the company to hold its annual meeting. In addition, companies listed on the NYSE and Nasdaq are generally required to hold an annual meeting during each fiscal year.
Keep in mind that a change in the annual meeting date by more than 30 days before or after the anniversary of the prior year’s annual meeting will also affect the date by which shareholder proposals or director nominations need to be received by the company pursuant to SEC regulations and the company’s advance notice provisions in its governing documents. In such case, the company is generally required to publicly disclose the annual meeting date and the date on which any shareholder proposals or director nominations are required to be received by the company.
As early as a year in advance, individuals with responsibility for annual meeting logistics should anticipate the number of shareholders who will attend the meeting and reserve an adequate facility. State corporate laws generally permit annual meetings to be held within or outside the state of jurisdiction (including, in the case of many jurisdictions, such as Delaware, a virtual annual meeting on the Internet), in accordance with the company’s articles or certificate of incorporation and bylaws.
Many companies hold their annual meetings at the same location each year, either in their corporate offices or in conference facilities nearby. Holding the annual meeting at a corporate office can result in great price savings, and allows the company to be on familiar ground with everything from audiovisual equipment to security. An annual meeting at the company’s offices also provides shareholders the opportunity, during or after the meeting, to see new product demonstrations or to take a facility tour. Some larger companies with an extensive shareholder base rotate their annual meeting from year to year among cities where they have facilities or high shareholder density. In addition, some state corporate laws permit companies to supplement their annual meetings with virtual components or virtual shareholder participation at in-person meetings, such as broadcasting their meetings on the Internet.
In recent years, an increasing number of jurisdictions, including Delaware, have adopted laws allowing companies to hold an entirely virtual annual meeting in lieu of a physical meeting if the company’s governing documents so provide. There are, of course, legal, procedural, technical and administrative issues that need to be thoroughly considered before holding a virtual annual meeting.
Virtual annual meetings gained rapid momentum in 2020 due to health and safety concerns surrounding the COVID-19 pandemic, despite historical objections from some shareholder groups. Prior to the pandemic, Glass Lewis recommended a vote against Nominating & Governance Committee members when a company held a virtual annual meeting without providing disclosure in its proxy statement to assure shareholders that they would be afforded the same participation rights and opportunities as at an in-person meeting. Glass Lewis suspended this policy through June 2020, and it is unclear how the company will apply the policy going forward, including whether it will amend the policy as a result of the COVID-19 pandemic.
Virtual annual meetings present the following potential benefits:
Opponents of virtual annual meetings claim that shareholders lose the valuable ability to confront management in person, that companies could manipulate virtual question-and-answer sessions, and that voting “surprises” or technology glitches could occur. In 2020, as a result of the COVID-19 pandemic, many companies opted to hold virtual annual meetings for health and safety reasons. It is currently unclear whether this trend will continue beyond the end of the pandemic.
If your company contemplates holding a virtual annual meeting, consider some or all of the following tips and best practices:
Only shareholders of record on the record date for the annual meeting are entitled to receive notice of, and to cast votes during, the meeting. Therefore, shareholders that acquire a company’s stock after the record date have no voting or notice rights with respect to the annual meeting. State corporate laws set the maximum and minimum number of days between the record date and the annual meeting date. In Delaware, for example, the record date may not be more than 60 days nor less than 10 days before the annual meeting. A company’s Board generally sets the record date for the annual meeting; however, some companies’ bylaws set further limits on the record date.
Subject to the limitations described above, companies generally should set a record date far enough in advance to allow adequate time for the solicitation of proxies prior to the annual meeting.
State corporate law requires a company to notify its shareholders in writing of the annual meeting date, time and place. Notice periods vary from state to state. In Delaware, for example, the notice period is at least 10 days and no more than 60 days prior to the annual meeting, and unless notice is waived, a company’s failure to adhere to that state’s notice requirements voids any action taken at the annual meeting. Each company should also comply with any notice provisions in its governing documents. In addition, companies taking advantage of the “notice and access” option for distributing proxy materials are subject to additional notice requirements under the e-proxy rules, including providing the notice at least 40 calendar days prior to the annual meeting.
The exchange on which a company lists its shares may also require notice of an annual meeting. For example, companies listed on the NYSE must provide the exchange with notice at least 10 days prior to the record date established for the annual meeting, and must indicate the date of the meeting and the record date. Nasdaq does not require advance notice of the record date by its listed companies.
Because many owners of public company stock hold their shares in street name (i.e., by having a brokerage firm, bank or other nominee hold the shares in its name for the benefit of the actual investor), a public company cannot contact its shareholders directly by simply using its transfer agent’s list of record holders. To facilitate this contact, the SEC, the exchanges and the nominees themselves have developed rules, practices and procedures to make sure the materials will eventually be delivered to the investors (beneficial owners) that have economic ownership of shares held in street name.
Per SEC rules and exchange requirements, companies must send a sufficient amount of shareholder materials to the nominees for them to distribute to beneficial owners.
Under Rule 14a-13(a)(3) of the 1934 Act, companies must contact institutional nominees (through their transfer agent or other third-party service provider) at least 20 business days before the record date to learn the number of copies of the proxy and other soliciting materials needed for distribution to beneficial owners, which essentially imposes a 20-business-day advance notice requirement for setting a record date.
Shareholders intending to solicit proxies in opposition to a proposed action at an annual meeting have the right to access information regarding beneficial ownership. Delaware courts have ruled that soliciting shareholders are entitled, in addition to a list of record holders, to other information readily obtainable by the company that identifies beneficial owners, provided they take the necessary steps in time to obtain the information.
Most annual meetings have few to no outside shareholders in attendance, but some large companies draw very large crowds of shareholders.
Additionally, senior management and some or all members of the Board typically attend the annual meeting. Their attendance provides shareholders an opportunity to meet and provide feedback to the Board and management team. A company must disclose in its proxy statement any policy regarding director attendance at the annual meeting and how many directors attended the prior year’s annual meeting.
If your company wishes to present a general business update that may include material nonpublic information at its annual meeting, you should make arrangements to webcast the meeting to ensure compliance with Regulation FD. To webcast your annual meeting:
See Chapter 5 for a full discussion of webcasts and shareholder or analyst calls and furnishing nonpublic earnings information.
Inspector of Elections. The company should arrange for an inspector of elections to tabulate votes and certify results. Sometimes the inspector is a company employee. More often, the inspector is a representative of the company’s transfer agent, independent auditors or other third-party service provider. Ideally, the inspector is truly independent and unrelated to the company or its regular service providers. The company should be familiar with the inspector’s qualifications and be prepared to answer shareholder questions regarding the inspector. In cases of close voting, a well-prepared, well-qualified and independent inspector will provide support for a company if a shareholder later challenges the voting results.
Form 8-K, Item 5.07, requires disclosure of shareholder voting results within four business days of the annual meeting. If your final voting results are not available to meet that deadline, you must file a Form 8-K with preliminary voting results, and amend it within four business days of the date on which you know the final voting results. In addition, remember to disclose your Board’s say-on-frequency vote decision, if applicable, in the original Form 8-K to report the voting results or an amendment to the Form 8-K. This amendment must be filed no later than 150 calendar days after the date of the annual meeting and in no event later than 60 calendar days prior to the deadline for the submission of shareholder proposals under Rule 14a-8 for the next annual meeting.
Counsel and Auditors. Representatives from the company’s legal counsel and independent auditors usually attend the annual meeting. The independent auditors can field questions regarding the company’s financial statements. Legal counsel attend to address any voting, agenda or procedural issues that may arise.
Three to four months prior to the annual meeting, a company’s Board should:
At the same time, the Audit Committee should indicate what firm it has selected as the company’s auditors, if it has not done so already. The Audit Committee may also recommend that its appointment of the auditors be submitted to the shareholders for ratification.
Most companies hold a meeting of the Board either just prior to the annual meeting, to discuss matters that may be presented at the annual meeting, or just after the annual meeting, when the officers will not be distracted by preparation for the annual meeting. Holding a Board meeting on the annual meeting date helps ensure Board member attendance at the annual meeting, which attendance is required to be disclosed in the proxy statement.
Most companies prepare a script, agenda and rules of conduct for the annual meeting. A well-organized script and agenda as well as clear and understandable rules of conduct are essential elements to conducting a successful annual meeting. It is good practice to distribute the agenda and rules of conduct to attending shareholders as they arrive.
Script and Agenda. The script should cover all items on the agenda and all statements that the scheduled speakers will make during the annual meeting, as well as provide draft answers to any questions that management can anticipate. An agenda and script typically include the following:
Follow the Script! Regulation FD. The script plays a critical part in complying with Regulation FD by anticipating questions that may call for answers potentially revealing material nonpublic information. The company’s investor relations officer should carefully review these areas and either:
Speakers will benefit from rehearsing the script before the annual meeting and should pay particular attention to warnings on disclosure of material nonpublic information.
Rules of Conduct. Rules of conduct typically limit shareholders’ time to ask questions and address the annual meeting, describe how the company will handle unscheduled proposals, address how to handle unruly shareholders and restrict shareholders’ ability to use video or other recording devices during the meeting.
While shareholders have an opportunity to be heard at an annual meeting, a company should take measures to prevent a shareholder from monopolizing other shareholders’ time and impeding the meeting’s progress. Management can best prepare to calm a contentious shareholder with clear rules of conduct and thorough planning. Rules of conduct should be handed out to the shareholders as they check in to the annual meeting and address basic procedural matters such as recognition by the chairperson before speaking, time limits for each question, etc. The chairperson of the annual meeting should warn a disorderly shareholder whose actions are out of order. If preliminary steps do not restore order, the chairperson should follow a planned course of action to remove the shareholder and, if necessary, adjourn the annual meeting or call for a recess. Companies who typically have high attendance and/or protestors at their annual meetings should consider additional steps, such as hiring outside security personnel.
Most companies have an admissions desk staffed with friendly company representatives and materials for the annual meeting attendees. Each attendee will receive the annual meeting agenda and rules of conduct. The company should also have available extra copies of its proxy materials, annual report and Form 10-K for distribution at the request of any attendee. Additionally, the corporate laws of most states require that companies make available to their shareholders a list of shareholders entitled to vote at the annual meeting and that such list be available at the meeting.
A shareholder with voting power may vote at the annual meeting by attending in person and casting a ballot or by designating a proxy to act on the shareholder’s behalf. In general, a proxy holder has broad discretion to vote the shares covered by the proxy.
Under Delaware corporate law, for example, a proxy generally allows the proxy holder to vote shares in the proxy holder’s discretion on any issue that is properly raised at an annual meeting, unless the proxy specifically limits the holder’s authority.
Before shareholders can conduct business at an annual meeting, a quorum must be present. Quorum requirements generally are governed by state corporate law and the company’s articles or certificate of incorporation and bylaws. Usually, a quorum consists of a majority of the shares entitled to vote at the annual meeting. Shares count for quorum purposes if present at the annual meeting either in person or by proxy.
When a beneficial owner fails to instruct the company or the beneficial owner’s nominee how to vote on certain matters deemed to be “routine,” the nominee may vote the shares for or against the proposal in its discretion. Matters on which a nominee may vote a beneficial owner’s shares in its discretion are known as discretionary matters.
Each nominee ultimately sends a proxy to the company containing the cumulative result of beneficial owners’ instructions and the nominee’s votes on those discretionary matters for which it did not receive instructions. Typically, the only matter that is considered to be “routine” and discretionary is the proposal to ratify the company’s independent auditors.
National stock exchanges prohibit brokers and other nominees from voting shares they do not beneficially own with respect to the election of directors, executive compensation proposals and certain other nondiscretionary matters unless they receive specific voting instructions from the beneficial owners. Instead, a beneficial owner must give specific instructions to the nominee to vote on the nondiscretionary matter, or else the shares cannot be voted and a broker non-vote occurs. Broker non-votes are votes that a broker cannot cast with respect to the particular nondiscretionary matter.
Since most matters up for vote at the annual meeting are nondiscretionary, companies should consider including at least one annual meeting agenda item that qualifies as “routine” – such as the ratification of the company’s independent auditors – to help achieve a quorum.
A person with voting power (whether as a beneficial owner of shares, a designated proxy holder or a broker with discretionary authority to vote shares) who is present in person or by proxy at an annual meeting has the discretion to abstain from voting.
Each company’s proxy statement relating to an annual meeting must describe how abstentions and broker non-votes count toward the tabulation of each proposal presented at the meeting.
Quorum. Delaware and jurisdictions that follow the Model Business Corporation Act (MBCA) count both abstentions and broker non-votes as “present” for the purpose of establishing a quorum.
Voting. The effect of abstentions and broker non-votes on the outcome of a shareholder vote varies based on:
Vote Required: Fixed Percentage of Shares Present and Entitled to Vote. Under Delaware corporate law, unless otherwise provided in the company’s governing documents, most routine shareholder actions, other than the election of directors, require the affirmative vote of a fixed percentage of the voting shares that are present, either in person or by proxy, and entitled to vote on the matter presented at the annual meeting. Because abstentions are present and entitled to vote on the matter presented at the annual meeting, they have the effect of counting as votes against the proposal – they add to the pool of votable shares without contributing to the affirmative votes required to approve the shareholder action. Broker non-votes, however, while present for purposes of a quorum, are not entitled to vote on the matter presented at the annual meeting. Broker non-votes, therefore, are excluded from the pool of votable shares and have no effect on the outcome of the shareholder vote.
It is important to refer to the corporate law of a company’s state of incorporation for its treatment of abstentions and broker non-votes. For example, under New York corporate law, abstentions are treated differently than under Delaware law. In New York, unless the company’s shareholders have adopted a bylaw or provided otherwise in the certificate of incorporation, abstentions have no effect on the approval of a proposal other than the election of directors.
Vote Required: Fixed Percentage of Outstanding Shares. Approval of some shareholder actions requires the affirmative vote of a fixed percentage of the company’s outstanding voting shares, whether or not such shares are present at the annual meeting. Under Delaware corporate law, mergers, sales of substantially all the company’s assets, amendments to the company’s certificate of incorporation and dissolutions all require the affirmative vote of a majority of the outstanding voting shares. For these proposals, abstentions and broker non-votes are the same as votes against the proposal because both are included in the pool of the company’s overall voting shares, although they do not count toward the affirmative vote needed to approve the shareholder action. Stock exchanges may also have requirements regarding shareholder votes on certain matters mandated to be approved by shareholders.
Default Vote Required for Election of Directors: Plurality of Votes Cast at a Meeting. The corporate laws of Delaware and the jurisdictions that follow the MBCA require only the affirmative vote of a plurality of votes actually cast at the annual meeting to elect directors and, in jurisdictions following the MBCA, to approve most other shareholder matters, unless a company’s governing documents provide otherwise. This means that more votes must be cast in favor of the action than votes cast for any other alternative, whether or not the approving votes constitute a majority or other fixed percentage. Abstentions and broker non-votes do not affect the vote’s outcome because they are neither votes cast for nor votes cast against the action.
Majority Voting in Election of Directors. Many larger public companies have moved away from plurality voting and adopted a form of majority voting standard for the election of directors. The majority voting standard for director elections typically requires that, to be elected, a nominee must receive more votes “for” than “against,” which may include any votes withheld, depending on the definition of majority. One approach for implementing a majority voting standard is through an amendment to a company’s bylaws. As a result, there have been changes to Delaware corporate law and the MBCA to accommodate majority voting bylaw amendments and related matters.
For example, Delaware bylaws may even prohibit directors from unilaterally amending shareholder-approved bylaw provisions implementing majority voting. Delaware law also includes a provision that permits irrevocable director resignations that are effective upon the occurrence of a future event, which could include a director’s failure to be elected by a majority vote.
In some states, shareholders may act by written consent in lieu of an annual meeting. Although technically permitted, action by written consent in lieu of an annual meeting has little practical value for most public companies, and many public companies have provisions in their governing documents prohibiting or severely limiting the ability of shareholders to act by written consent. Under Delaware corporate law, for example, shareholders may act by written consent to elect directors in lieu of an annual meeting, but only if the consent is unanimous or, if not unanimous, if all directorships to which directors could be elected at an annual meeting held at the written consent’s effective time are vacant (by way of resignation or removal) and filled by such written consent. In addition, Section 14(a) of the 1934 Act extends the proxy rules to solicitations of written consents, and exchange rules may also apply.
When a company agrees to list its securities on the New York Stock Exchange (NYSE), it agrees to comply with exchange listing standards and rules designed to achieve a high standard of corporate governance and disclosure. While some of these requirements mirror those imposed by the SEC, these requirements are in fact independent obligations with separate ramifications if not met. An NYSE company and its counsel must ensure that the company satisfies both SEC and NYSE requirements.
This chapter reviews listing standards and rules applicable to companies listed on the NYSE, including:
The NYSE requires its listed companies to meet quantitative and qualitative standards on a continuing basis to remain listed on the exchange. Quantitative standards consist of objective financial and share distribution criteria. Qualitative standards relate to companies’ corporate governance and ongoing status.
These quantitative and qualitative continued listing standards are set forth in Appendix 4. A company’s failure to maintain these standards often triggers NYSE action, which can include initiation of suspension and delisting procedures that may ultimately result in the removal of the company’s securities from listing and trading on the NYSE. See the end of this chapter for more information relating to a listed company’s failure to comply with listing standards and other requirements.
The NYSE has established corporate governance standards for its listed companies. These governance standards are designed to bolster public confidence in listed companies, promote prompt public disclosure of material events and enhance corporate ethics and democracy. Compliance with these corporate governance standards is an ongoing condition to listing.
The NYSE requires a majority of Board members of a listed company to be independent directors. For a director to qualify as independent under NYSE standards, a company’s Board must affirmatively determine that the director has no material relationship with the listed company (including any parent or subsidiary in a consolidated group). The Board must consider the materiality of the director’s direct and indirect relationships as a partner, shareholder or officer of any organization with links to the company (including with its senior management). A material relationship can come in many forms, including commercial, industry-related, banking, consulting, legal, accounting, charitable, private or familial.
Listed companies must report determinations of director independence in their annual meeting proxy statements, together with a description of any direct and indirect transactions, relationships and arrangements between directors and the company considered by the Board in making its independence determinations. Some companies use various general categories of relationships to help determine director independence, and they disclose in the proxy statement whether a director had a relationship that fell into one of the categories without going into much additional detail. We discuss general categories of relationships relating to director independence in Chapter 2.
Does an individual, group or another company hold more than 50% of the voting power for the election of your directors? If so, your company may be a controlled company and you may choose to be exempted from various NYSE standards relating to director independence and the existence, composition and duties of your Compensation and Nominating & Governance Committees.
If you opt to use the controlled company exemption, you will need to include in appropriate SEC filings a description of your controlled company status and a statement that you are relying on the controlled company exemption. A controlled company must continue to comply with NYSE’s other corporate governance standards, including the requirements relating to an independent Audit Committee and regular executive sessions of non-management (or independent, as the case may be) directors.
If a company ceases to qualify as a controlled company, it must meet the standard listing requirements within specified periods following its change of status.
A director who has any of the following relationships is not independent under NYSE standards:
Boards must evaluate contributions to charitable organizations as part of the director independence determination process. In addition, a listed company must publicly disclose contributions the company made to any charitable organization in which an independent director serves as an executive officer if, within the past three years, contributions in any single fiscal year exceeded the greater of $1 million or 2% of the charitable organization’s consolidated gross revenues. Some companies adopt a general category of relationships relating to director independence establishing that charitable contributions below a certain dollar amount do not constitute a material relationship for director independence purposes.
Listed companies are required to schedule “regular” executive sessions in which non- management directors meet without management participation. Non-management directors exclude company executive officers, but include other directors who may not be independent because of a material relationship or other reason. A listed company may satisfy this requirement by holding regular executive sessions of only its independent directors. However, if a company regularly holds meetings of all non- management directors (and if that group includes any non-independent directors), then it should also hold an executive session of only independent directors at least once a year. We provide practical tips for organizing executive director sessions in Chapter 2.
The non-management (or independent, as the case may be) directors should either appoint a single presiding director for all executive sessions or rotate the presiding director position following a set procedure. Listed companies that have either an independent chair or a lead independent director usually name this person as the presiding director. Companies are required to publicly disclose the presiding director’s name or the procedure used to select the presiding director for executive sessions, as well as a method for all interested parties (not just shareholders) to communicate directly with the presiding director or with the non-management (or independent) directors as a group.
Composition and Independence. NYSE listing standards generally require that listed companies have an Audit Committee that consists of at least three independent directors and meets SEC requirements. All Audit Committee members must meet two somewhat overlapping independence standards, one established by Sarbanes-Oxley and the other by the NYSE:
Financial Literacy and Expertise. Each member of the Audit Committee must be, or within a reasonable period of time following appointment must become, financially literate. In addition, at least one member must have accounting or related financial management expertise. The NYSE does not provide detailed definitions for these concepts; a listed company’s Board is expected to use its business judgment in interpreting these requirements. For example, the Board can presume that a person who meets the SEC’s Audit Committee financial expert standard has the requisite financial expertise to meet this NYSE standard. (We discuss the SEC’s Audit Committee financial expert standard in Chapter 2.)
Effectiveness Evaluation of Director’s Service on Multiple Audit Committees. Does an Audit Committee member serve on more than three public company Audit Committees? If so, the Board must decide whether these commitments impair the director’s ability to serve as an effective Audit Committee member, and the listed company must publicly disclose the determination. (Many companies’ corporate governance guidelines specifically restrict a director from simultaneously serving on more than three public company Audit Committees.)
As described above, the NYSE requires a company to have at least three qualified independent directors on the Audit Committee. Consider whether it makes sense for your company’s Audit Committee to have a fourth independent member so that your company remains compliant with this NYSE listing standard even when a member unexpectedly resigns, no longer qualifies or is removed, without having to scramble to appoint a new member on short notice.
Audit Committee Charter. The NYSE requires a listed company to have a written Audit Committee charter that addresses:
To comply with NYSE listing standards and governance expectations generally, the Audit Committee must review and discuss a relatively advanced draft of the MD&A to be included in a listed company’s SEC filing, instead of simply discussing the MD&A disclosure in general. Accordingly, Audit Committee meetings should be scheduled to allow review of the MD&A disclosure in a form that is almost final. Meetings can be telephonic or in person.
Internal Audit Function. The NYSE requires each listed company to have an internal audit function. A company may outsource this function to a third party other than its independent auditor. The Audit Committee is generally responsible for oversight of the internal auditor.
Composition and Independence. NYSE listing standards generally require that listed companies have a Compensation Committee composed entirely of independent directors, but do not prescribe a minimum number of members. In addition, when determining the independence of a director who will serve on the Compensation Committee, the Board must specifically consider all relevant factors regarding whether the director has a relationship to the listed company that is material to the director’s ability to be independent from management with regard to Compensation Committee service, including:
Compensation Committee Charter. The NYSE requires a listed company to have a written Compensation Committee charter that addresses:
NYSE listing standards generally require that listed companies have a Nominating & Governance Committee composed entirely of independent directors. A minimum number of members is not prescribed. The Nominating & Governance Committee must have a written charter that addresses:
The corporate governance guidelines required of each listed company allow the Board and senior management to publicly set out the key tenets of their company’s governance values.
Accessible on the corporate governance page of an NYSE company’s website, the guidelines should address:
The NYSE calls for website posting of a listed company’s corporate governance guidelines, code of business conduct and ethics and core committee charters. A listed company must disclose the availability of these materials and the website on which the materials are located in its annual proxy statement (and other SEC filings). Companies use website postings both as a way to publicly communicate the “tone at the top” from the CEO and the Board and as a ready reference for employees, directors and shareholders.
Paired with the corporate governance guidelines is the NYSE-required code of business conduct and ethics – a practical set of ethical requirements for a listed company’s officers, directors and employees. Only the Board or a committee can waive violations of the code by directors or executive officers, and the company must disclose any of these waivers to its shareholders within four business days of the waiver.
An NYSE-compliant code of business conduct and ethics will address, at a minimum:
In reviewing a code of business conduct and ethics, the Board should consider whether the code provides for sufficiently practical and general compliance standards and procedures, so that the Board or a committee is not put in a position of regularly considering waivers.
A listed company’s CEO must annually certify to the NYSE that he or she is unaware of any (not only material) violation of the NYSE’s corporate governance standards, or detail any known violation. On an ongoing basis, the CEO must promptly notify the NYSE in writing if any executive officer of the company becomes aware of any noncompliance with the NYSE’s corporate governance standards, even if the noncompliance is not material. In addition, a listed company must file a separate annual written affirmation regarding ongoing NYSE obligations, and may have to provide interim affirmations if various triggering events occur.
The NYSE may issue a public reprimand letter to a listed company that it determines has violated any NYSE listing standard. For companies that repeatedly or flagrantly violate NYSE standards, the reprimand could lead to trading suspension or delisting.
Listed companies are required to have and maintain a publicly accessible website. To the extent that the NYSE requires a listed company to make documents available on or through its website, such website must clearly indicate in the English language the location of such documents on the website. Any such documents must be available in printable versions in the English language.
The NYSE believes that good business practice calls for a listed company’s management to consider submitting to shareholders those matters that may be important to shareholders, even if submission is not necessarily required by law or by governing documents. If a listed company has questions about submitting a matter to its shareholders, the NYSE urges the company to reach out and discuss the matter with its NYSE representative as appropriate. For the following key corporate actions, however, the NYSE specifically requires shareholder approval:
Shareholders must approve any new equity compensation plan (or arrangement), whether or not officers and directors can participate in the plan. Shareholders must also approve any material revision to an existing plan.
For purposes of the NYSE requirements, an equity- compensation plan is a plan or other arrangement that may provide equity securities (newly issued or treasury) of the listed company to any employee, director or other service provider as compensation for services.
The NYSE’s definition of material revision is general, but specifically includes:
Limited exemptions from the NYSE’s shareholder approval requirements regarding plan approval include dividend reinvestment or other plans offered to all shareholders, some issuances in connection with mergers and acquisitions, 401(k) and stock purchase plans or similar tax-qualified and parallel nonqualified plans, and equity grants made as a material inducement to a person being newly hired.
If a grant, plan or amendment is exempt from the NYSE’s shareholder approval requirements, the Compensation Committee (or a majority of the independent directors) must approve the grant, plan or amendment. In addition, the company must notify the NYSE in writing of the use of an exemption and, for any hiring inducement grant, issue a press release to disclose the material terms of the grant.
It is good practice to file an application with the NYSE for listing of reserved, unissued shares in connection with a stock option, stock repurchase or other remuneration plan prior to securities under those plans being issued.
In most cases, shareholders must approve a listed company’s new issuance of common stock (or securities convertible into, or exercisable for, common stock) in any transaction (or series of related transactions) that could equal or exceed 20% of the outstanding common stock or 20% of the outstanding voting power before the new issuance. However, a public offering for cash (even if over these 20% limits) generally does not require shareholder approval, nor does a private sale of common stock for cash at a price at or above the common stock’s minimum price unless the sale is related to the acquisition of the stock or assets of another company and the related issuance of common stock (and any other issuances of common stock relating to the acquisition) could exceed the 20% limits. The NYSE defines “minimum price” as the lower of (1) the official closing price of the listed company’s common stock immediately prior to the signing of the binding agreement to issue the additional common stock; or (2) the average official closing price of the listed company’s common stock for the five trading days immediately prior to the signing of the binding agreement.
In a non-cash transaction or in a cash transaction at a price less than the minimum price (see above), the NYSE generally requires shareholder approval prior to the issuance of common stock (or securities convertible into, or exercisable for, common stock) of over 1% of the outstanding preissuance common stock or voting power to directors, officers or substantial securities holders. In addition, prior shareholder approval is required if the common stock issuance is related to an acquisition of a company or assets where a related party has a 5% or greater (or related parties collectively have a 10% or greater) direct or indirect interest in the company or assets or the consideration to be paid in the acquisition, and the related issuance of common stock (and any other issuances of common stock relating to the acquisition) could exceed 5% of the outstanding preissuance common stock or voting power.
The NYSE generally requires shareholder approval prior to an issuance of securities that would result in a change of control of the listed company.
In general, the voting rights of an NYSE company’s current common shareholders cannot be disproportionately reduced or restricted through any corporate action or issuance, such as through capped or time-phased voting plans, issuance of super-voting stock or exchange of common stock for common stock with fewer voting rights per share. It is important to note, however, with regard to issuance of super-voting stock, that this restriction is primarily intended to apply to issuance of new classes of stock, so companies with existing dual-class capital structures generally are permitted to continue to issue any existing super-voting stock without conflict.
That said, an NYSE company (whether dual-class or not) wishing to enter into an arrangement that may disproportionately affect the voting rights of its current common shareholders (through stock issuance or otherwise) should carefully consider consulting with its NYSE representative early in the proposed transaction process, because even shareholder approval of the proposed transaction does not make it permissible without a prior “green light” from the NYSE.
The NYSE considers related party transactions as those types of transactions potentially required to be disclosed in a company’s proxy statement (and some other public filings).
The NYSE requires advance review and oversight of related party transactions for potential conflicts of interest by the Audit Committee or another independent body of the Board. For a related party transaction, the Audit Committee or other independent body of the Board must prohibit the transaction unless it determines that the transaction is not inconsistent with the interests of the company and its shareholders.
With this advance review requirement, a company must carefully implement procedures to identify potential related party transactions and approve them before they occur.
The NYSE reviews proxy statements and other public filings disclosing related party transactions, and where such situations continue for several years, the NYSE may remind the listed company of its obligation, on a continuing basis, to evaluate each related party transaction and determine whether it should be permitted to continue.
Other critical NYSE standards include:
Under the Dodd-Frank Act, the SEC must adopt rules to direct the NYSE and other national securities exchanges to establish rules requiring “clawback” policies. These policies, to be adopted and implemented by listed companies, must be designed to recover certain incentive-based compensation paid to current and former executives in the three years preceding a financial restatement that was made due to material noncompliance with financial reporting requirements. The clawback would apply even in the absence of misconduct on the part of the executive. As of the time this Handbook went to press in 2021, the SEC had proposed but not taken final action regarding adoption of these rules. The NYSE would be required to adopt related rules within a specific period of time following final SEC action.
A listed company’s IRO or corporate secretary office should maintain close contact with the company’s NYSE representative. At a minimum, the company will need to notify and provide supporting documentation to the NYSE prior to, or at the time of, a number of corporate actions, including (in addition to those already mentioned) the following:
In making the disclosure decisions discussed in Chapter 5, a listed company must consider the NYSE’s requirement calling for prompt release to the public of any material news that might affect the market for the company’s securities. This obligation exists side by side with requirements imposed by securities laws and the SEC, and results in an affirmative disclosure obligation for NYSE companies that may not otherwise exist.
Material news consists of news or information that might reasonably be expected to have a material effect – favorable or unfavorable – on the market of a listed company’s securities, including information that might affect the value of the company’s securities or influence an investor’s decision to trade in the company’s securities. Events such as earnings announcements, dividend declarations, mergers and acquisitions, tender offers, major management changes, and significant new products or contracts may all qualify as material news.
Chapter 5 provides a more detailed list of factors that will help in deciding when news or information merits public release.
The NYSE permits a listed company to refrain from publicly announcing even material news, if necessary, as long as the company can maintain its confidentiality while still keeping all investors on equal footing and allowing no unfair information advantage. However, a company must take extreme care to keep the information confidential and to remind persons who possess the knowledge of their obligation to refrain from trading on insider information.
If a decision is made not to disclose material news, a listed company’s IRO and general counsel’s office should closely monitor the price and trading patterns in the company’s securities and be prepared to make a public announcement if it becomes clear that the information has leaked to outsiders. If the NYSE detects unusual or suspicious trading activity in a company’s securities, the NYSE may contact the company, require that the company make the information public immediately or possibly halt trading in the company’s securities until the public has time to absorb the information.
Perhaps the greatest threat to the confidentiality of material news is a rumor that indicates the market is aware of the confidential information. In the event of unusual market activity or rumors indicating that investors already know about impending company events – for example, a possible acquisition – your company may be required to make a clear public announcement regarding the state of negotiations or the development of corporate plans relating to the rumored information. This may be required even if the Board has not yet considered the matter.
If rumors do arise, you should first seek to confirm that they did not originate from within the company and, subject to conversations with the NYSE and if considered appropriate, issue the sort of release that we discuss in Chapter 5 (i.e., a release stating that the company’s policy is not to comment on transactional rumors). If the rumors are untrue, you may need to issue a press release publicly denying or clarifying the falsehoods or inaccuracies. It is critical, of course, that you not deny negotiations that are in fact occurring and that the statement be otherwise truthful and in compliance with antifraud laws.
The NYSE outlines the following steps a listed company should take when publicly releasing material news (including responding to rumors):
The NYSE requires advance notice of potentially material news in part to determine whether the news would justify a trading halt or delay in the listed company’s securities. Companies generally may avoid temporary trading halts or delays related to the release of new material news by fully disseminating the information to the public well before trading begins. If the company believes that it may request a trading halt in connection with the announcement of material news, the company should coordinate closely with the NYSE. Whenever the NYSE decides to halt or delay trading due to pending material news, it will make an announcement to the market to that effect. Once the company releases the material news, the NYSE will monitor the situation and commence trading pursuant to its normal trading procedures. If the pending material news is not released within a reasonable time after the halt, the NYSE will monitor the situation and may reopen trading (often within 30 minutes of the trading halt or delay) and signal that material news is still pending. In addition, when the NYSE believes it is necessary to request from a company information relating to material news, the NYSE may halt trading until it has received and evaluated the information.
The NYSE outlines the following potential consequences for a listed company in the event of noncompliance with its standards and rules:
When a company receives notice from the NYSE of any of the circumstances described above, a Form 8-K filing may be required. Companies in these circumstances should discuss with counsel how to best engage with the NYSE to avoid penalties, including potential trading suspension and securities delisting.
Deciding to list on The Nasdaq Stock Market (Nasdaq) brings with it the agreement to follow listing rules designed to achieve a strong standard of corporate governance, but one that is generally more flexible and accommodating to the needs of less mature companies than that of the NYSE. For example, Nasdaq provides an exceptional and limited circumstances exception permitting a non-independent director to serve on the Audit, Compensation or Nominating & Governance Committee. Larger or more mature Nasdaq companies will still want to be familiar with, and consider generally following, any additional requirements of the NYSE governance standards, as well as the expectations of ISS and other monitors of governance standards.
This chapter presents an overview of Nasdaq’s listing and corporate governance standards. Nasdaq’s requirements often mirror those imposed by the SEC, but are in fact independent obligations with separate ramifications if not met. Nasdaq companies need to satisfy both sets of requirements.
Nasdaq requires its listed companies to meet quantitative and qualitative standards on a continuing basis to remain listed on the exchange. Quantitative standards consist of objective financial and liquidity criteria. Qualitative standards relate to companies’ corporate governance and ongoing status.
A company that lists its securities with Nasdaq is indexed according to a three-tier classification system: The Nasdaq Global Select Market®, The Nasdaq Global Market® and The Nasdaq Capital Market®. The continued listing standards are the same for The Nasdaq Global Select Market and The Nasdaq Global Market and are slightly less burdensome for The Nasdaq Capital Market; these standards are set out in Appendix 5. A company’s failure to meet its listing standards over a specified period of time often triggers Nasdaq action, which can include a Nasdaq delisting procedure and the removal of a company’s securities from its Nasdaq market or require its move to a different Nasdaq market. See the end of this chapter for more information relating to a listed company’s failure to comply with listing standards and rules.
Is your company transferring to Nasdaq from another exchange? If so, you may have a grace period before being subject to some of Nasdaq’s corporate governance standards. For a company transferring from another exchange or market (e.g., from the NYSE to Nasdaq), Nasdaq has special rules governing the phase-in period of its corporate governance requirements. Generally, if the exchange or market from which a company is transferring did not have the same requirements as Nasdaq, the transferring company has one year from the date of transfer in which to comply with the applicable Nasdaq requirements. If the exchange or market from which the company is transferring had substantially similar requirements, the company is afforded the balance of any grace period provided by the other exchange or market (other than for Audit Committee requirements, unless a transition period is available under Rule 10A-3 of the 1934 Act).
Nasdaq corporate governance standards parallel NYSE standards in many respects, but provide greater flexibility for a less mature company. However, Nasdaq companies find that institutional investors still expect a high standard of corporate governance, sometimes looking with disfavor on companies that, for example, use the exceptional and limited circumstances exception to include a non-independent director on an otherwise independent Compensation Committee.
A majority of the Board members of a Nasdaq company must be independent. The Board itself annually determines independence – specifically, that directors do not have a relationship with the company that would interfere with their exercise of independent judgment in carrying out their director responsibilities. A company lists the independent directors in its annual proxy statement. A Nasdaq director is not independent if the director has one or more of the following relationships:
Nasdaq provides a cure period for a listed company’s failure to comply with the independent majority requirement if one director ceases to be independent for reasons beyond the director’s reasonable control or in the case of a single Board vacancy. The cure period ends on the earlier of the company’s next annual shareholders’ meeting or the first anniversary of the event that caused the noncompliance. However, if the next annual shareholders’ meeting is less than 180 days after the event that caused the noncompliance, the company will instead have 180 days to regain compliance. The company must notify Nasdaq immediately upon learning of the noncompliance.
Does an individual, group or other entity own more than 50% of the voting power of your company’s securities? If so, your company may be a controlled company that does not need to have:
A controlled company must continue to comply with Nasdaq’s requirement for an independent Audit Committee and other Audit Committee rules. And the independent directors must hold regular executive sessions. Otherwise, Nasdaq’s corporate governance burdens are reduced. A controlled company must disclose its controlled company status in its annual proxy statement, as well as explain the basis for its status.
If a company ceases to qualify as a controlled company, it will need to phase-in its independent Compensation Committee, Nominating & Governance Committee (if a company has such a committee) and majority independent Board in the following manner:
Independent directors must meet “regularly” in executive sessions, without management or other directors present. Nasdaq contemplates that listed companies will hold at least two executive sessions each year. (We discuss executive sessions in further detail in Chapter 2.)
In August 2021, the SEC approved Nasdaq’s proposed board diversity rule. Generally, listed companies are required to have their Board meet two diversity objectives: (1) at least one director must self-identify as female; and (2) at least one director must self-identify as an underrepresented minority or LGBTQ+. Both diversity objectives cannot be met by only one director.
There are a few exceptions to this requirement, including the following:
Nasdaq defines underrepresented minority as an individual who self-identifies in one or more of the following groups: Black or African American, Hispanic or Latinx, Asian, Native American or Alaska Native, Native Hawaiian or Pacific Islander, or two or more races or ethnicities.
Listed companies will have a transition period to meet the diversity objectives or explain their reasons for not doing so. The timeframe is based on a company’s Nasdaq listing tier:
If a listed company does not meet its applicable diversity objectives described above, it will need to provide an explanation (in a proxy statement, information statement, Form 10-K or on the company’s website) for not doing so, which could include a description of a different approach taken by the company on diversity. Nasdaq will verify that the company has provided an explanation but will not assess the merits of the explanation.
Listed companies subject to the board diversity rule are also required to annually disclose (in a proxy statement, information statement, Form 10-K or on the company’s website, depending on timing) the voluntary self-identified gender and racial characteristics and LGBTQ+ status of the Board. This information should be presented in an aggregated matrix format that is the same or substantially similar to the format provided by Nasdaq. Listed companies must disclose the initial matrix in 2022, as follows:
Composition and Independence. Each Nasdaq company must have an Audit Committee consisting of at least three directors, all of whom must be independent. All Audit Committee members must be financially literate and at least one member must be financially sophisticated. (We discuss these requirements later in this chapter.) Directors who have participated in the preparation of the financial statements of the company or any current subsidiary of the company during the past three years cannot serve on the Audit Committee.
Heightened Independence Requirements for Audit Committee Members. In addition to Nasdaq’s general independence requirements discussed above, Audit Committee members must satisfy the Sarbanes-Oxley Audit Committee independence requirements under Rule 10A-3 of the 1934 Act. These requirements provide that Audit Committee members cannot:
Exceptional and Limited Circumstances Exception to Audit Committee Independence Requirements. A director who does not satisfy Nasdaq’s general independence standards for directors but who does satisfy the Sarbanes-Oxley Audit Committee independence requirements and is not a current executive officer or employee, or an immediate family member of a current executive officer of the company, can serve on the Audit Committee for up to two years.
The company must disclose in the company’s annual proxy statement the nature of the director’s relationship and the reasons for the Board’s determination that the director’s service on the Audit Committee is in the best interests of the company and its shareholders. Only one director may be appointed under this exception at one time and, if so appointed, may not serve as the Audit Committee chair. The company may rely on this exception without obtaining Nasdaq approval.
Trap for the Unwary: Use Exceptional and Limited Circumstances Exception from Independence with Great Care
Nasdaq permits a director who is not independent under Nasdaq criteria to serve on an Audit, Compensation or Nominating & Governance Committee for up to two years under its exceptional and limited circumstances exception, but Boards should be aware of important limits to this exception’s usefulness.
First, take the temperature of your shareholders before using this exception. Many institutional investors look with great disfavor on non-independent core committee members, particularly for the Audit and Compensation Committees. These investors may let you know that they will vote against those directors or against an entire Board slate that uses the exception without a very good reason (or at least one they do not agree with).
Second, separate and apart from Nasdaq, various regulations may make it cumbersome to use this exception. For example, Sarbanes-Oxley requires all public company Audit Committee members to be independent under the Sarbanes-Oxley definition. As we detail in Chapter 2, Sarbanes-Oxley has only two criteria for independence (but they do cover many potential relationships): no compensation from the company whatsoever other than for Board or committee service and no affiliate status, that is, a director who controls, is controlled by, or is under common control with the listed company (or an officer or director of another company that is an affiliate of the listed company). Also, regarding the Compensation Committee, the usual desire under the Internal Revenue Code and the 1934 Act to have “outside directors” and “nonemployee directors” approve certain compensation arrangements and option and share grants makes a fully independent Compensation Committee far more practical than having an appropriate subset of the Compensation Committee act on compensation. Further, as we discuss in Chapter 7, a fully independent Compensation Committee gives shareholders additional comfort regarding a company’s compensation practices and may help a company avoid an unfavorable say-on-pay shareholder vote on executive compensation.
Companies Can “Cure” Inadvertent Noncompliance with Nasdaq’s Audit Committee Composition Requirements. Nasdaq provides a cure period if a company fails to comply with the Audit Committee composition requirements because one director ceases to be independent for reasons beyond the director’s reasonable control or because of a single Board vacancy. If reasons beyond the director’s reasonable control cause the failure to comply, the cure period ends on the earlier of the company’s next annual shareholders’ meeting or the first anniversary of the event that caused the noncompliance. If a single Board vacancy causes the failure to comply, then the cure period also ends on the earlier of the company’s next annual shareholders’ meeting or the first anniversary of the event that caused the noncompliance, except that if the next annual shareholders’ meeting is less than 180 days after the event that caused the noncompliance, the company will instead have 180 days to regain compliance. The company must notify Nasdaq immediately upon learning of noncompliance. Nasdaq will excuse only a single noncomplying Audit Committee member from meeting the Nasdaq independence requirements, and the director must at all times meet Sarbanes-Oxley’s Audit Committee independence requirements.
Financial Literacy and Sophistication. Audit Committee members must be financially literate, meaning they are able to read and understand fundamental financial statements, including balance sheets and income and cash flow statements, at the time of their appointments. In addition, at least one member of the Audit Committee must have financial sophistication. Past employment experience in finance or accounting, requisite professional certification in accounting or other comparable experience or background, including being or having been a CEO, CFO or other senior official with financial oversight responsibilities, may result in financial sophistication. Although Nasdaq did not expressly adopt the SEC’s Audit Committee financial expert standard, any director who meets that standard will meet Nasdaq’s financial sophistication standard. (We discuss the SEC’s Audit Committee financial expert standard in Chapter 2.)
Audit Committee Charter. A Nasdaq-compliant written charter must detail the membership, structure, processes, responsibilities and authority of the Audit Committee, including those elements established in Rule 10A-3 of the 1934 Act. Nasdaq rules, in conjunction with SEC rules, call for a charter that requires the Audit Committee to:
We discuss other common duties of the Audit Committee in Chapter 2.
A Nasdaq company’s Audit Committee (or a comparable body of independent directors) must review and oversee all related party transactions for potential conflicts of interest on an ongoing basis. To be consistent with SEC disclosure requirements, Nasdaq defines related party transactions as those described in Item 404 of Regulation S-K (which covers the SEC’s definition of related person transactions). These transactions include those in which the company is a participant that involve over $120,000 and in which any director or nominee, executive officer or 5% or more shareholder, or any immediate family member of the foregoing, has a direct or indirect material interest. (We discuss related person transactions in more detail in Chapter 7.)
Composition and Independence. Each Nasdaq company must have a Compensation Committee composed of at least two directors, generally all of whom must be independent. In addition, when determining the independence of a director who will serve on the Compensation Committee, the Board must specifically consider all relevant factors regarding whether the director has a relationship to the listed company that is material to the director’s ability to be independent from management with regard to Compensation Committee service, including:
In some circumstances, however, a Nasdaq company may avail itself of the exceptional and limited circumstances exception to this independence requirement if the Compensation Committee has three or more members.
Compensation Committee Charter. Nasdaq requires a listed company to have a written Compensation Committee charter that addresses:
Independence Requirements. A director who does not satisfy Nasdaq’s general independence standards for directors but who is not a current executive officer or employee, or an immediate family member of a current executive officer of the company, can serve on the Compensation Committee for up to two years, as long as the Committee is composed of at least three members (not the usual minimum of two members).
The company must disclose in the company’s annual proxy statement or on the company’s website that it is relying on this exemption and explain the basis for the company’s conclusion that this exemption is applicable. A director appointed under this exception may not serve longer than two years. The company may rely on this exception without obtaining Nasdaq approval.
Companies Can “Cure” Inadvertent Noncompliance with Nasdaq’s Compensation Committee Composition Requirements. Nasdaq provides a cure period if a company fails to comply with the Compensation Committee composition requirements because one director ceases to be independent for reasons beyond the director’s reasonable control or because of one vacancy. In either case, the cure period ends on the earlier of the company’s next annual shareholders’ meeting or the first anniversary of the event that caused the noncompliance, except that if the next annual shareholders’ meeting is less than 180 days after the event that caused the noncompliance, the company will instead have 180 days to regain compliance. The company must notify Nasdaq immediately upon learning of the noncompliance.
Limited Requirements for Smaller Reporting Companies. For a company that qualifies as a “Smaller Reporting Company” for SEC filing purposes, Nasdaq provides relief from some of the Compensation Committee requirements. A Smaller Reporting Company must certify that it has, and will continue to have, a Compensation Committee meeting the composition requirement of at least two independent members, as well as a written charter or a Board resolution addressing the Committee’s scope of responsibilities generally, the determination of CEO and other executive officers pay, and that the CEO and other executive officers may not be present during voting or deliberations on their executive compensation. Smaller Reporting Companies may rely on the independence cure period and the independence exception described above.
A company exiting Smaller Reporting Company status is given a grace period before being subject to the remaining Compensation Committee requirements from which it was previously exempt. Within six months after ceasing to qualify for Smaller Reporting Company status, the company must certify to Nasdaq that it has adopted a formal written Compensation Committee charter that complies with all Nasdaq requirements and it has complied, or will comply based on the following phase-in schedule, with all Compensation Committee composition requirements.
The company is permitted to phase-in compliance with the composition requirements related to director’s compensation and affiliation (but not the requirements related to Compensation Committee size or independence), based on the following schedule:
The third core independent Board committee of a Nasdaq company is the independent Nominating & Governance Committee. The Board may forgo the Nominating & Governance Committee and choose instead to act on director nominations by a majority of independent directors (through a vote in which only independent directors participate). The Nominating & Governance Committee (or an appropriate majority of independent directors) will select, or recommend to the Board for selection, all director nominations, except for those Board “seats” where a third party has a contractual or other right to nominate a director. The Board may use the exceptional and limited circumstances exception for service by one non-independent director on the Nominating & Governance Committee.
The Board of a Nasdaq company with a Nominating & Governance Committee will need to adopt a formal written charter covering at least the nomination process. If, instead, the Board acts by having an appropriate majority of independent directors make nomination decisions, then a comparable Board resolution should address the nomination process.
Exceptional and Limited Circumstances Exception to Nominating & Governance Committee Independence Requirements. A director who does not satisfy Nasdaq’s general independence standards for directors but who is not a current executive officer or employee, or an immediate family member of a current executive officer of the company, can serve on the Nominating & Governance Committee for up to two years, as long as the Committee is composed of at least three members.
The company must disclose in the company’s annual proxy statement or on the company’s website that it is relying on this exemption and explain the basis for the company’s conclusion that this exemption is applicable. A director appointed under this exception may not serve longer than two years. The company may rely on this exception without obtaining Nasdaq approval.
A core component of a Nasdaq company’s good governance framework is adoption and public availability of a code of conduct that covers all its directors, officers and employees. Nasdaq requires that the code of conduct comply with the code of ethics mandated by Sarbanes-Oxley. Item 406 of Regulation S-K defines this code of ethics as written standards reasonably designed to deter wrongdoing and to promote honest and ethical conduct and fair and full disclosure. The code of conduct must include enforcement mechanics, and the Board must approve any waivers from the code of conduct for directors or executive officers. Waivers must be disclosed to shareholders within four business days.
A Nasdaq company must promptly notify Nasdaq if an executive officer of the company becomes aware of any cany nomponcompliance with Nasdaq’s corporate governance standards (whether there is an automatic cure period or not).
Nasdaq requires shareholders to approve specified key corporate actions including those below.
Nasdaq generally requires that shareholders approve both new equity-based compensation plans or arrangements, whether or not officers and directors can participate, and material amendments to those types of existing plans or arrangements.
Nasdaq defines a material amendment to include:
There are a variety of special-purpose exemptions to these shareholder approval requirements. These include exemptions for warrants or rights offered generally to all shareholders (poison pills), stock purchase plans available on equal terms to all shareholders (dividend reinvestment plans), some types of awards made in connection with mergers and acquisitions, tax-qualified nondiscriminatory employee benefit plans and parallel nonqualified plans (like 401(k) plans or other ERISA plans), and grants of equity awards made as a material inducement to a person’s initial employment with the company. Even when a plan or an arrangement is exempt from shareholder approval requirements, Nasdaq generally still requires that the Compensation Committee (or a majority of independent directors) approve inducement grants and tax-qualified nondiscriminatory employee benefit and parallel nonqualified plans. In addition, the company must promptly disclose in a press release the material terms of inducement grants made in reliance on the shareholder approval exception.
Shareholders of Nasdaq companies have long been required to approve major additional issuances of common stock (or convertible securities). These are the provisions that generally trigger a shareholder vote and proxy solicitation on significant transactions, including stock-for-stock mergers.
20% Rule. Shareholders must approve any securities issuance (other than in a public offering) that may exceed 20% of the outstanding common stock or the outstanding voting power outstanding before the issuance, if the issuance is priced below the minimum price (sales by officers, directors and 5% shareholders will be combined with the company’s securities issuance in determining whether the 20% threshold has been met). Nasdaq defines “minimum price” as the lesser of (1) the official closing price of the listed company’s common stock immediately preceding the signing of the binding agreement to issue the additional common stock; or (2) the average official closing price for the five trading days immediately preceding the signing of the binding agreement to issue the additional common stock. Nasdaq also requires shareholder approval for any acquisition that results in the issuance of common stock (or convertible securities) of 20% or more of the outstanding common stock or the outstanding voting power outstanding before the issuance (and this acquisition-related approval triggers a shareholder vote regardless of the price of the Nasdaq purchaser’s common stock).
5% Affiliate Acquisition Rule. A Nasdaq acquirer must also seek shareholder approval of an acquisition where a related issuance of securities could result in an increase of over 5% (by number of shares or voting power) of outstanding common stock or voting power, if a director, executive officer or 5% shareholder of the acquirer has a 5% interest (or those insiders together have a 10% interest) in the target company.
Nasdaq requires shareholder approval for issuances or potential issuances of securities resulting in a change of control of the company.
Trap for the Unwary: Shareholder Voting Rights – Keep It Proportional (Usually, Anyway)!
In general, the voting rights of a Nasdaq company’s current common shareholders cannot be disproportionately reduced or restricted through any corporate action or issuance, such as through capped or time-phased voting plans, issuance of super-voting stock or exchange of common stock for common stock with fewer voting rights per share. It is important to note, however, with regard to issuance of supervoting stock, that this restriction is primarily intended to apply to issuance of new classes of stock, so companies with existing dual-class capital structures generally are permitted to continue to issue any existing super-voting stock without conflict.
That said, a Nasdaq company (whether dual-class or not) that wishes to enter into an arrangement that may disproportionately affect the voting rights of its current common shareholders (through stock issuance or otherwise) should carefully consider consulting with its Nasdaq representative early in the proposed transaction process, because even shareholder approval of the proposed transaction does not necessarily make it permissible without a prior “green light” from Nasdaq.
Nasdaq companies must comply with a number of additional corporate governance standards. Four critical ones are:
Under the Dodd-Frank Act, the SEC must adopt rules requiring Nasdaq and other national securities exchanges to establish rules requiring “clawback” policies. These policies, to be adopted and implemented by listed companies, must be designed to recover certain incentive-based compensation paid to current and former executives in the three years preceding a financial restatement that was made due to material noncompliance with financial reporting requirements. The clawback would apply even in the absence of misconduct on the part of the executive. As of the time this Handbook went to press in 2021, the SEC had proposed but not taken final action regarding adoption of these rules. Nasdaq would be required to adopt related rules within a specific period following final SEC action.
Nasdaq requires listed companies to notify, and provide supporting documentation to, Nasdaq and, in some cases, file a Listing of Additional Shares form or other relevant form, at, prior to or within specified periods following many corporate actions, including (in addition to those already mentioned) the following:
At its discretion, Nasdaq may request any additional documentation, public or nonpublic, it finds necessary to consider a company’s continued listing.
Nasdaq, like the NYSE, generally requires a listed company to promptly and publicly disclose any material news or information that might affect the market for the company’s securities. This obligation exists side by side with securities law and SEC obligations, and results in an affirmative company disclosure obligation (with a variety of exceptions as discussed below).
Material news includes information that would reasonably be expected to affect the value of a company’s securities or influence an investor’s decision to trade in the company’s securities. Categories of material news are very broad; generally, all significant events affecting the company, including its business, products, management, securities and finances, presumably merit prompt public disclosure consideration.
Nasdaq provides examples of material news, similar to the SEC’s list of possible material information that we set out in Chapter 5, that serve as a useful guide for determining whether news merits public disclosure. Nasdaq companies must notify Nasdaq’s MarketWatch Department between 7:00 a.m. and 8:00 p.m. Eastern time (4:00 a.m. and 5:00 p.m. Pacific time) (and outside that period, prior to 6:50 a.m. Eastern time/3:50 a.m. Pacific time) at least ten minutes prior to the release of the following types of material information:
The exceptions to Nasdaq’s disclosure requirements soften the general mandate to always promptly publicly disclose material news. A listed company may delay announcement of material news if it is possible for the company to maintain confidentiality and immediate public disclosure would prejudice the company’s ability to pursue legitimate corporate objectives – the delay must not, however, give any investor an unfair information advantage. To take advantage of this exception, a company must keep the information confidential and remind those who possess the information of their obligation to refrain from trading on insider information.
The investor relations department and other responsible officers of a listed company will need to closely monitor the trading of its securities for unusual price or volume movements, and be prepared to make a public announcement if it becomes clear that confidential information has leaked. If Nasdaq detects unusual or suspicious trading activity in a company’s securities, Nasdaq’s MarketWatch Department may contact the company and require that it promptly and publicly disclose the information. In this case, Nasdaq may require a trading halt in the company’s securities until the public has time to absorb the information.
A Nasdaq company needs to carefully guard confidential information to prevent circulation of rumors that originate from company sources. Nasdaq specifies that if unusual market activity or rumors indicate that investors are aware of current actions or impending events, your company may be required to make a clear public announcement regarding the state of negotiations or the development of corporate plans in the rumored area. This disclosure may be required even if your Board has not yet taken up the matter for consideration.
If the rumors are untrue, your company may need to issue a press release publicly denying or clarifying the false or inaccurate information. This statement must obviously be truthful and not omit material information necessary to prevent the disclosure from being misleading.
Because a premature public announcement, including one triggered by rumors, can jeopardize proposed plans, careful monitoring of confidential information, and of rumors, can protect a critical corporate initiative.
Nasdaq permits its listed companies to disclose material information through any, or any combination of, Regulation FD– compliant methods. These methods include a broadly disseminated press release or a Form 8-K, as well as a conference call, press conference or webcast, provided that the public is given adequate prior notice (generally by press release) and access. In addition, with appropriate prior notice and disclosure regarding company public disclosure methods, a company’s websites and social media channels may also be adequate tools for public disclosure – although company website and social media disclosures are often coupled with more standard disclosure methods, particularly regarding very significant news. (We provide practical tips for making Regulation FD–compliant disclosures in Chapter 5.)
Nasdaq requires a listed company to notify Nasdaq’s MarketWatch Department usually at least ten minutes prior to the release of material information. (See the “What Is Material News?” Practical Tip earlier in this chapter for details on timing and material events.) For material disclosure not in written form (e.g., in a press release, Form 8-K or appropriate company website or social media disclosure), companies should provide prior notice to Nasdaq of the press release announcing the logistics of the future disclosure and a descriptive summary of the information to be announced.
Nasdaq encourages companies to provide prior notice of material news disclosures, even if not mandated, whenever the company believes, based on its knowledge of the significance of the information, that a temporary halt in trading may be appropriate. Nasdaq’s MarketWatch Department is required to keep nonpublic information confidential and use it only for regulatory purposes.
Nasdaq requires advance notice of disclosures in part to help determine whether the material news justifies a trading halt in a company’s securities. A listed company can generally avoid a trading halt by broadly issuing the disclosure to the public with an adequate amount of time before market open.
When an issuer makes a significant announcement during trading hours, the exchange may require a trading halt to allow investors to gain equal access to information, fully digest the material news and consider its impact. A trading halt also alerts the market that material news has been released. Nasdaq determines when a trading halt is necessary and how long it should last, usually permitting trading to resume within 30 minutes after news is fully disseminated.
Nasdaq rules require listed companies to publicly disclose (in a proxy statement, information statement, Form 10-K, Form 8-K, press release or on the company’s website, depending on timing circumstances) the material terms of compensation or other payment arrangements provided by third parties to directors or director nominees (e.g., shareholder director representatives being paid additional director fees or equity by a shareholder). Noncompliance with this disclosure requirement may be excused if a company has undertaken “reasonable efforts” to identify all relevant golden-leash arrangements and initially found none, but then later discovered and promptly disclosed such arrangements.
Notice of Deficiency. When Nasdaq has determined that a company does not meet a listing standard, it will notify the company of the deficiency. Based on the type of deficiency, the company may be (1) entitled to an automatic cure or compliance period, (2) entitled to submit a compliance plan for Nasdaq to review or (3) immediately suspended, delisted or transferred to a different Nasdaq market (a Staff Delisting Determination, described later in this chapter).
Automatic Cure or Compliance Period. As described earlier in this chapter, Nasdaq provides a cure period for a listed company’s failure to comply with some of its standards, such as various corporate governance standards related to the composition of the Board or its committees.
Deficiencies for Which a Company May Submit a Plan of Compliance. With some exceptions, Nasdaq may accept and review a plan to regain compliance when there is one or more of the following deficiencies:
A deficient company must provide the compliance plan generally within 45 calendar days, except for compliance plans with respect to failures to file periodic financial reports required by the SEC, which must be provided generally within 60 calendar days. There are notable exceptions to these time periods regarding compliance plans, including for a company’s deficiencies relating to bid price, market makers and market value.
Staff Delisting Determinations and Public Reprimand Letters. Specific types of deficiencies will immediately result in a Staff Delisting Determination, such as failure by a company to timely solicit proxies or if Nasdaq believes continued listing raises a public concern. When Nasdaq determines that a Staff Delisting Determination is an inappropriate sanction for a company that has violated a Nasdaq corporate governance or notification listing standard, it may instead issue a Public Reprimand Letter. This will depend on factors such as whether the violation was inadvertent, whether the violation materially adversely affected shareholders’ interests, whether the violation has been cured, whether the company reasonably relied on an independent advisor and whether the company has demonstrated a pattern of violations.
Nasdaq may issue a Staff Delisting Determination or a Public Reprimand Letter at its discretion after a cure or compliance period has expired, after Nasdaq reviews a compliance plan submitted by the company, or if a company does not regain compliance within the time period provided by Nasdaq.
Public Announcement of Notice. A company that receives a notification of deficiency, Staff Delisting Determination or Public Reprimand Letter is required to disclose that notice in a public announcement by (1) filing a Form 8-K (where required by SEC rules), (2) issuing a press release or (3) sometimes both, depending on the deficiency. Both actions are required if the deficiency is due to a failure to file periodic financial reports required by the SEC. The company should make the public announcement promptly and not more than four business days following receipt of the notification. If the company fails to timely make the required announcement, Nasdaq will halt trading of the company’s securities generally at least until the required information has been made public.
Appeals Process. Upon receiving a Staff Delisting Determination or a Public Reprimand Letter, a company may request in writing that the Hearings Panel review the matter in a written or an oral hearing. The Hearings Panel is an independent panel generally made up of two or more persons who have been authorized by the Nasdaq Board of Directors and who are not employees or otherwise affiliated with Nasdaq or its affiliates. After the Hearings Panel has issued a decision, the company may further appeal to the Nasdaq Listing and Hearing Review Council.
Many private companies aspire to go public. The benefits of going public include the acquisition of capital for growth and the provision of liquidity to shareholders. At the same time, third parties may seize opportunities presented by public capital markets to acquire control of public companies. Vulnerability to unsolicited and sometimes hostile takeover attempts, as well as attempts to influence corporate decision-making, can jeopardize achievement of the company’s long-term strategic goals.
Potential acquirers employ a range of techniques to take over public companies. Friendly negotiated acquisitions or hostile takeover attempts can result in a change of control. Some of these techniques essentially coerce shareholders of the target company into accepting the takeover proposal. Hostile takeovers, whether or not accompanied by coercive tactics, result in enormous stress for the target companies and their shareholders.
Although a public company can defeat a takeover attempt after it has begun, a Board should prepare for unsolicited takeover efforts well before these situations arise. Courts have upheld the adoption of takeover defenses that meet the following tests: the Board had reasonable grounds for believing that a hostile action or takeover attempt constituted a danger to the company’s corporate policy and effectiveness, and antitakeover protections adopted by the Board was a reasonable and proportionate response to a legitimate corporate threat.
The Board oversees the development and implementation of the company’s business goals and strategies. By equipping the company with tools to withstand hostile takeover efforts, the Board enhances the ability of the company to accomplish its strategic objectives. In particular, the Board may implement appropriate corporate structural defenses by amending the company’s certificate or articles of incorporation or bylaws, or by adopting a shareholder rights plan. Although standard takeover defenses will not prevent a well-financed takeover that is in the best interests of shareholders, these defenses will generally provide a target company’s Board with sufficient time and negotiating leverage to allow it to:
While our discussion uses concepts from Delaware law, similar defenses are permitted by most other states.
Your Board should consider corporate structural takeover defenses well before the company confronts a takeover attempt. It is important for the Board to consider corporate structural defenses in a reasoned fashion, rather than in the heat of a takeover battle. Implementing some defenses will require shareholder approval, which requires lead time and, as we discuss later in this chapter, may be difficult to obtain after a company has public shareholders. Corporate structural defenses such as a shareholder rights plan that can be put in place after the IPO and even after a takeover attempt has been initiated will, if challenged in court, receive significantly closer judicial scrutiny than defenses established prior to a takeover attempt, although a court reviewing a Board’s response to a takeover proposal will consider the impact of all the target’s defenses in the aggregate.
Institutional shareholders often object to corporate structural defenses because they view these defenses as entrenching existing management and denying shareholders the benefit of potentially valuable offers for corporate control. Proxy advisory firms such as ISS and other institutions have identified the following provisions that increase the concerns of governance-related risk:
Dual-class common stock structures are designed to create a new class of super-voting common stock that preserves control in the hands of pre-IPO shareholders – typically founders, executive officers and venture capital investors – for a significant period. Dual-class structures have become more common over the last ten years, particularly among technology companies. Ideally, the bulk of the super-voting shares will be held by founders and executives who are closely involved with the management of the company, allowing the company to focus on remaining innovative and creating value for the long-term, with less concern for short-term market pressures. However, the concentrated control is also a deterrent to hostile takeover attempts as it requires the potential acquirer to negotiate with the controlling group.
A dual-class common stock structure is created through a restructuring, usually prior to or concurrent with an IPO. The restructuring converts the common shares of pre-IPO shareholders into Class B shares with ten votes per share, and creates Class A shares with one vote per share that will be sold in the IPO and used for equity compensation, capital raising and acquisition purposes after the IPO.
Post-IPO, the interests of holders of Class B shares may diverge. If founders, the Board and executives begin to divest their Class B shares to achieve liquidity, control may shift to one or more pre-IPO investors who are not actively involved in the company’s business and whose interests may not align with those of other shareholders. The Board should carefully analyze the pre-IPO shareholder base and the respective liquidity needs and interests of different groups of the company’s shareholders before adopting a dual-class structure.
A staggered Board, which is discussed in Chapter 2, may impede some takeover attempts. Under Delaware law, shareholders may remove directors of a company with a staggered Board only for cause. If a company has three classes of directors, then, in the absence of cause, shareholders can replace no more than one-third of the directors in any one year.
Staggered Board terms prevent hostile acquirers from taking control of the company by replacing the entire Board at one time. This structure may deter certain types of takeover tactics, including proxy fights and tender offers for less than all of a company’s shares. A staggered Board alone will not usually deter an any-and-all cash tender offer – an offer made to all the shareholders to buy all their shares at the same price – because most Board members will not oppose an offeror that has acquired a majority of the company’s shares.
If a company declines to implement a staggered Board, it may otherwise limit shareholders’ ability to remove Board members. For example, the company may amend its certificate or articles of incorporation to stipulate that a director may be removed only for cause and/or to increase the percentage vote of the shareholders required for removal of a director from a simple majority to 75% or 80%.
Because many of the most effective corporate structural defenses, such as a dual-class common stock structure or a staggered Board, require shareholder approval, the best time to institute these measures is prior to going public. Advantages of pre-IPO adoption include:
However, there are other factors that cause companies to hold off from pre-IPO adoption:
After the IPO, some institutional investors and their advisors may believe that these defenses should be maintained only if the defenses have been approved by public shareholders. Such investors may mount a “withhold vote” campaign against one or more directors to pressure the Board to seek such approval.
A shareholder rights plan, or poison pill, can be a powerful takeover defense that encourages acquirers to negotiate with the Board so the Board can either seek to obtain the best value for shareholders in the event of an acquisition or choose to reject an inadequate offer in order to pursue the company’s long-term strategic objectives. A rights plan operates by substantially diluting the stock ownership position of a would-be acquirer who buys shares in excess of a set threshold, thereby substantially increasing the cost of a potential takeover.
A standard shareholder rights plan results from a Board’s declaration of a special dividend of one right per share of common stock. While differences among plans exist, most shareholder rights plans contain the following common principal features:
A company can adopt a shareholder rights plan through Board action at any time if sufficient authorized, unissued preferred stock shares or common stock shares are available under the certificate or articles of incorporation for issuance pursuant to the rights plan. To implement a preferred stock shareholder rights plan, the certificate or articles of incorporation of the company must authorize blank check preferred stock.
Shareholder rights plans are proven and effective tools in defending against takeover attempts and inadequate acquisition offers. However, they are not designed to, and will not, deter all hostile takeover attempts. Specifically, a shareholder rights plan will not prevent a successful proxy contest for control of a company’s Board, nor can it override the fiduciary obligations of the Board to consider a fairly priced, any-and-all cash tender offer for the company’s shares. A shareholder rights plan will, however, encourage a potential acquirer to negotiate with the company’s Board as an alternative to triggering the rights and thereby diluting the interest of the bidder in the target company.
The Delaware Court of Chancery has reaffirmed the validity of shareholder rights plans as a permissible defensive measure for a Delaware corporation faced with a takeover proposal its Board finds inadequate. In Air Products & Chemicals, Inc. v. Airgas, Inc., the court confirmed that while a Board cannot “just say never” to a hostile tender offer, the Board can utilize a rights plan to reject a hostile offer and adhere to its existing strategic plan if the Board is acting in good faith with a reasonable factual basis for its decision.
Net operating losses (NOLs) have become significant assets for many companies. If a company experiences an ownership change, Section 382 of the Internal Revenue Code generally limits the company’s ability to use its pre-ownership change NOL carryovers to offset taxable income. Under Section 382, an ownership change occurs if one or more 5% shareholders of the company increase their ownership by more than 50 percentage points in the aggregate over the lowest percentage of the company’s stock owned by those shareholders at any time during the preceding three-year period. Public companies with significant NOLs have increasingly chosen to protect their NOL assets by adopting NOL shareholder rights plans. A NOL rights plan operates similarly to a traditional shareholder rights plan, but with lower triggering thresholds, typically 4.9% of the outstanding shares, versus 10% to 20% for a traditional shareholder rights plan.
In Selectica, Inc. v. Versata Enterprises, Inc., Trilogy and its subsidiary, Versata, had offered to acquire some or all of Selectica’s business, and were rejected. Trilogy began acquiring Selectica stock, and Selectica then lowered the trigger on its rights plan to 4.99%, allowing existing 5% or more shareholders to acquire up to an additional 0.5% without triggering the rights plan. Trilogy then bought more Selectica shares, exceeding the 4.99% trigger.
The Delaware Supreme Court held that the Selectica Board acted reasonably in determining that the NOL represented a significant business asset worth protecting, and found that the implementation of a NOL rights plan with a 4.99% trigger constituted an appropriate defensive response to the threats represented by Trilogy’s actions.
In Third Point LLC v. Ruprecht, the Delaware Court of Chancery found that the possibility of “creeping control” and “negative control” from activist investors posed objectively reasonable threats to justify the adoption by Sotheby’s of a two-tiered shareholder rights plan that allowed passive institutional investors (those reporting ownership pursuant to Schedule 13G) to acquire up to a 20% interest in Sotheby’s, while permitting all other shareholders to acquire only up to a 10% interest, without triggering the rights plan. In an era of increasing shareholder activism, the court recognized the legitimate concerns of Sotheby’s Board that hedge funds would form a group to acquire a control block of Sotheby’s or that a single hedge fund would exercise disproportionate and negative control through a 20% ownership interest, without paying a control premium. Under the circumstances, the court concluded that the adoption of Sotheby’s rights plan was a reasonable response to a cognizable threat.
Like virtually every other state, Delaware, the most common domicile of public companies, has adopted an antitakeover statute. State antitakeover statutes are generally based on a control share, business combination or fair price model.
Section 203 of the Delaware General Corporation Law is a business combination statute. Section 203 limits any investor that acquires 15% or more of a company’s voting stock (thereby becoming an interested shareholder) from engaging in certain business combinations with the issuer for a period of three years following the date on which the investor becomes an interested shareholder, unless:
Section 203 defines a business combination broadly to include:
A Delaware company may opt out of Section 203:
In a friendly acquisition, a buyer may request that a company’s Board waive the application of any state antitakeover statutes that could prevent or delay the transaction, while leaving it in place with respect to other bidders. To satisfy their duty of care, directors should take the following actions before granting a waiver:
A company should maintain sufficient amounts of common stock and blank check preferred stock to retain maximum business and governance flexibility, including in employing corporate structural defenses.
As a general matter, a public company should ensure that it always has an adequate number of authorized shares of common stock, taking into account both outstanding shares and the number of shares issuable upon conversion or exercise of outstanding or anticipated preferred stock, stock options and warrants. The company should maintain sufficient authorized, but unissued and unreserved, shares of common stock for:
The company’s certificate or articles of incorporation may authorize blank check preferred stock – a specified number of shares of authorized but undesignated preferred stock. Authorizing blank check preferred stock gives the Board the authority, without having to seek prior shareholder approval, to designate one or more series of preferred stock out of the undesignated shares and to establish the rights, preferences and privileges of each series.
Taken together, blank check preferred stock and a reserve of authorized but unissued shares of common stock provide target companies the flexibility to:
Even if a company has authorized sufficient common stock or blank check preferred stock, NYSE or Nasdaq rules may require shareholder approval of certain large stock issuances. For example, Nasdaq requires shareholder approval of the issuance of common stock (or securities convertible into common stock) equal to 20% of the outstanding common stock or 20% of the voting power prior to the issuance for less than book or market value of the stock. (We discuss this and the NYSE’s similar requirement in detail in Chapters 9 and 10.)
Limitations on shareholders’ meetings and other shareholder action can slow the efforts of an acquirer to appeal directly to shareholders without negotiating with a target company’s Board. For example, if shareholders can act only at annual meetings, an unfriendly third party would be unable to acquire control of the company by soliciting written consents to remove directors and elect a new Board.
A company may defend against coercive takeover attempts by appropriately limiting the power of shareholders to call special shareholders’ meetings. Delaware law provides that only the Board and persons authorized in the company’s certificate of incorporation or bylaws may call a special meeting of shareholders.
Thus, absent authorizing language in a company’s certificate of incorporation or bylaws to the contrary, a Delaware company may entirely eliminate the right of shareholders to call a special shareholders’ meeting. In other states, however, a certain percentage of shareholders may have a statutory right to call a special shareholders’ meeting. A company incorporated outside Delaware may still increase the default percentage of shareholders required for shareholders’ meetings and, in some cases, entirely eliminate this right. Limiting the right of shareholders to call special meetings can ensure additional time to negotiate by preventing a would-be acquirer from electing a class of directors or gaining control of the Board until the company’s next annual shareholders’ meeting.
Advance notice bylaw provisions provide that shareholders seeking to bring business before, or to nominate directors for election at, any shareholders’ meeting must provide written notice of such action within a specified number of days (usually from 60 to 90 or 90 to 120) in advance of the meeting. Because only business contained in the meeting notice may be conducted at special shareholders’ meetings, these bylaw provisions can delay the efforts of coercive acquirers and prevent surprises at shareholders’ meetings
Delaware courts have upheld advance notice bylaw provisions as appropriate mechanisms to give shareholders an opportunity to evaluate shareholder proposals and to give the Board adequate time to make informed recommendations. However, advance notice bylaw provisions may not unduly restrict shareholder rights and must be implemented fairly.
In JANA Master Fund, Ltd. v. CNET Networks, Inc. and Levitt Corp. v. Office Depot, Inc., decided by the Delaware Court of Chancery, and in Hill International v. Opportunity Partners, decided by the Delaware Supreme Court, the courts narrowly interpreted advance notice bylaw provisions in favor of shareholder activists. In Hill International, the court agreed with the activists’ reading of the company’s bylaws and found that the activists had complied with the advance notice provisions. Although these cases were decided by the Delaware courts, they may influence courts in other jurisdictions interpreting advance notice bylaw provisions.
These decisions highlight the need for public companies to carefully review and, if necessary, clarify and expand the advance notice provisions of their bylaws to eliminate ambiguities and establish procedures shareholders must follow and information they must supply. Among other things, you may wish to:
Under Delaware law, unless otherwise provided in a company’s certificate of incorporation, any action required or permitted to be taken by shareholders may be taken by written consent, without a meeting or shareholder vote. A valid written consent sets forth the action to be taken and is signed by the holders of outstanding stock having the requisite number of votes necessary to authorize the action at a shareholders’ meeting. The certificate of incorporation may prohibit shareholder action by written consent. Such a prohibition has the effect of confining shareholder consideration of proposed actions to shareholders’ meetings. As a result, the holder or holders of a majority of the voting stock of a company may not take preemptive, unilateral action by written consent, and may act only within the framework of a shareholders’ meeting.
Delaware law requires shareholder approval for any merger or sale of substantially all the assets of a company. A Delaware company’s certificate of incorporation or bylaws may include a supermajority provision requiring more than a simple majority (generally companies choose a percentage between 60% and 80%). A typical provision requires the affirmative vote of 66-2/3% of the voting shares for any merger or sale of substantially all the company’s assets if, at the time of the vote, the company has a controlling shareholder (i.e., a shareholder holding a substantial block of stock, such as 10%). A supermajority provision often requires a potential acquirer to obtain a greater number of shares in order to complete the acquisition.
In deciding whether to adopt a supermajority requirement for a merger or sale of substantially all of a company’s assets, it is important for a Board to consider the following:
The default rule under Delaware law provides that a simple majority of a company’s voting securities must approve any amendments to a company’s certificate of incorporation. A company’s certificate of incorporation or bylaws, however, may include so-called lock-in provisions that require supermajority voting on specified amendments to a company’s charter documents. Lock-in provisions force a hostile acquirer to control a greater number of shares in order to eliminate a company’s corporate structural defense provisions by amending the certificate of incorporation or bylaws. However, supermajority voting requirements reduce a company’s flexibility to make other desirable changes to its certificate of incorporation or bylaws. As a result, a company may choose to retain a majority approval requirement for amendments to most of the provisions of its certificate of incorporation and bylaws, and to establish a supermajority approval requirement only for amendments to those particular provisions that provide takeover protection, such as provisions dealing with:
A company may also retain flexibility by providing that the supermajority approval is not required if the amendment is approved by a majority of directors serving before a controlling shareholder acquired its controlling stake in the company.
Every time a public company solicits shareholder approval of amendments to its certificate or articles of incorporation (e.g., to increase the authorized number of shares), it must describe its corporate structural defense provisions in a proxy statement for the shareholders’ meeting. The existence of extremely formidable corporate structural defense measures may suggest to shareholders and prospective investors that the company adamantly opposes a change of control. Institutional investors may prefer the short-term returns engendered by hostile takeovers, and are likely to vote against many corporate structural defense provisions. For this reason, public companies should:
Change-of-control, or golden parachute, agreements are not structural defenses to takeovers, but instead help to incentivize key employees to remain with the company and assist the Board in evaluating an unsolicited acquisition proposal at a time when they might otherwise be concerned about the impact of a takeover on their employment prospects. Nonetheless, ISS and other advisors are often critical of change-of-control agreements, especially if they are adopted in the heat of a takeover contest.
Change-of-control agreements can be stand-alone agreements or severance provisions included in employment agreements. They typically trigger a cash payment (or the automatic vesting of stock options, restricted stock or other noncash benefits) on the occurrence of a change-of-control event, including a merger, sale of assets or stock, or a change of the constituency of the Board. Single trigger agreements result in a severance payment becoming due on the occurrence of a change of control alone. The more common double trigger agreements result in a severance payment only if the triggering event is coupled with a significant change in job status or compensation (e.g., termination of employment or decrease in salary or responsibilities).
Corporate structural defenses are not absolute deterrents to takeover attempts. Instead, they are designed to give directors and management time to consider the merits of an offer as well as leverage to negotiate that offer and counteract the coercive tactics that sometimes characterize takeover contests.
Some of the strongest protections against an unfriendly takeover are not special provisions in a company’s charter documents, but are, in this order:
Even with these elements in place, in order to keep pace with changes in applicable law, as well as the increasingly refined approach of shareholder activists and institutional shareholders, a Board should also protect the company through its overall efforts to prepare for an unsolicited acquisition proposal. To that end, a Board should periodically (at least annually) review:
In advance of any unsolicited acquisition proposal, a Board should also:
This advance preparation will put the Board in the strongest position to respond to an unsolicited acquisition proposal in a manner that will serve the best interests of the company’s shareholders.
An issuer must register each offering of securities to the public on a 1933 Act registration statement unless an exemption from registration is available. Shelf registrations can ease the burden associated with the registration process by allowing one registration statement to register a variety of securities in advance of one or more transactions.
The SEC has adopted a variety of 1933 Act registration forms that require differing levels of disclosure depending on the type of transaction to be registered and the 1934 Act reporting history of the registrant. The most commonly used forms are:
We discuss each of these forms in more detail in this chapter.
Sales under a registration statement may be made only after the registration statement becomes effective. Generally, registration statements on Form S-3 filed by well-known seasoned issuers (WKSIs) and all registration statements on Form S-8 become automatically effective when they are filed. (We discuss WKSIs later in this chapter.)
In most other cases, the SEC has the opportunity to review and comment on a registration statement before effectiveness. In these cases, the SEC takes administrative action, upon a company’s written request, to declare a registration statement effective, either when the company is informed that the SEC staff does not intend to review the filing or after the SEC staff is satisfied that the registration statement, as may be amended, adequately addresses the SEC staff’s comments. The SEC will post a notice of effectiveness on the company’s EDGAR filings index page that indicates the date and time the registration statement was declared effective.
Historically, most companies have first gained access to the public capital markets through the IPO process. More recently, however, some companies have also been going public through a direct listing on a securities exchange or through a merger transaction using a special type of acquisition vehicle called a special purpose acquisition company (the vehicle, a SPAC; the related merger transaction, a de-SPAC transaction). (See Chapter 1 for further discussion regarding SPACs.)
After a company goes public, it may continue to raise capital through additional public offerings of debt or equity securities. These additional public offerings are sometimes referred to as follow-on offerings, as they follow a company initially going public. Follow-on offerings of securities by the company itself, as well as IPOs, are referred to as primary offerings to distinguish them from registered offerings of securities on behalf of selling shareholders, which are referred to as secondary offerings.
In a secondary offering, selling shareholders, not the company, receive the proceeds from the offering. These offerings provide liquidity to the selling shareholders. For example, shareholders may hold restricted shares purchased from the company in a private financing transaction that cannot be easily or quickly resold except through a registered public offering. In connection with a private financing transaction, a company may agree to register securities for resale and enter into a registration rights agreement for the benefit of the security holders. Another example of a secondary offering is when a company and a shareholder holding a large number of shares choose an underwritten public secondary offering as an orderly and efficient means of liquidating all or part of the shareholder’s position.
On occasion, registered offerings involve both primary and secondary offerings.
A shelf registration allows a company to register the offer and sale of securities on a delayed basis (for future use) or on a continuous basis. Often public companies register securities for offer and sale to the public at undetermined future dates to be able to take advantage of favorable market conditions when they occur, although a portion of the securities registered may be offered immediately after effectiveness of the registration statement. Public companies may also use shelf registrations to permit security holders to sell otherwise restricted securities (e.g., securities issued in a private placement) or control securities (i.e., securities held by affiliates) in the public market over a period of time.
Three common types of shelf registrations are the universal shelf, the resale shelf and the acquisition shelf.
Universal Shelf. A universal shelf is a registration statement on Form S-3 that typically registers a variety of equity and debt securities that a company may wish to sell in the future. Form S-1 is not available for this kind of registration. A universal shelf registration statement will typically include some combination of common stock, preferred stock, convertible and nonconvertible debt securities, and warrants to purchase stock (or other securities). In this type of registration statement, a company specifies the aggregate dollar amount of all the securities it intends to offer, rather than specifying the dollar amount of each type of debt security or the number of each type of equity security it is registering. (As we discuss later in this chapter, a WKSI may register securities by specific types or classes on Form S-3 without indicating any dollar amount or number of securities.) The primary advantage of a universal shelf registration statement is that, once effective, a company may offer and sell registered securities (often referred to as a “takedown off the shelf”) without the delay that might result from a review by the SEC staff.
A universal shelf registration statement includes a base prospectus, which often consists of only a section listing the 1934 Act reports and other relevant SEC filings incorporated by reference, a brief overview of the company, an outline of the plan of distribution, a short description of the intended use of the proceeds from a sale of the securities, and, generally, a high-level description of each type of security that is being registered. The 1934 Act reports and other relevant SEC filings incorporated by reference usually satisfy many of the disclosure requirements that apply to this registration statement (including requirements relating to a description of the company’s business, relevant financial statements and MD&A, management, legal proceedings and other matters). A universal shelf registration on Form S-3 also allows a company to forward incorporate future 1934 Act filings to facilitate automatic updating of information required to be included in the base prospectus. In addition to the base prospectus, the registration statement includes other information such as estimated offering expenses (although not required in automatic shelf registrations for WKSIs) and required exhibits (many of which can be incorporated by reference from other filings with the SEC).
The base prospectus does not contain pricing information or other details regarding any particular transaction. This additional information is included in a prospectus supplement, which is filed with the SEC when there is an offering of securities, and delivered with the base prospectus to investors. For instance, a prospectus supplement filed in connection with a takedown of debt securities will disclose the aggregate principal amount offered, the public offering price, any discounts and commissions, a detailed description of the terms of the debt securities (including the rate at which interest will accrue, interest payment dates and the maturity date), and more detailed descriptions of the intended use of proceeds and the plan of distribution. The prospectus supplement often includes a description of the risk factors and tax consequences related to the specific offering.
In many cases, underwriters will use a preliminary prospectus supplement (together with the base prospectus) that does not include pricing information, but does include more specificity about a particular transaction for marketing an offering to potential investors. Once an offering is priced, a type of free writing prospectus – typically a one-page pricing term sheet – is usually prepared and filed with the SEC. The underwriters then use this pricing term sheet to confirm sales. The pricing term sheet typically provides only the pricing information previously omitted from the preliminary prospectus supplement, including the public offering price of the securities, underwriting discounts and commissions, and, in the case of debt or preferred securities, items such as interest or dividend rates and, if relevant, conversion prices, redemption prices and the like. An issuer then prepares and files with the SEC a final prospectus supplement (together with the base prospectus) that includes the pricing information from the pricing term sheet and any other final changes to the prospectus supplement.
Resale Shelf. Companies typically use a resale shelf registration statement on Form S-3 to register the resale to the public, from time to time, of securities held by an affiliate of the issuer or securities that were issued in a private placement. The prospectus included in a resale shelf registration statement on Form S-3 tends to be very short (particularly when the securities registered are shares of common stock). It usually includes a section listing the company’s 1934 Act reports and other relevant SEC filings incorporated by reference, a section on risk factors, a list of the selling shareholders (including the name, address and number of securities each holder plans to sell) and descriptions of their related transactions with the company, and a section describing the manner in which the securities are expected to be distributed. Typically, the plan of distribution is drafted to provide significant flexibility relating to the types of transactions in which the registered securities may be sold. Many of the details relating to selling shareholders (including their identities and the number or amount of securities they may sell) may be omitted from an automatically effective resale shelf registration statement filed by a WKSI and, under certain circumstances, from a standard resale shelf filed by a non-WKSI issuer. The initially omitted details are later added to the registration statement by means of a prospectus supplement, post-effective amendment or 1934 Act report, depending on the circumstances.
If a company is not eligible to use Form S-3, the company could file a resale shelf registration statement on Form S-1. Keeping a resale shelf registration statement on Form S-1 updated is, however, much more time-consuming and expensive than with Form S-3. Unlike with Form S-3, Form S-1 does not allow forward incorporation by reference to a company’s 1934 Act reports. As a result, a company would have to continually update a resale registration statement on Form S-1 by filing prospectus supplements and post-effective amendments to reflect material developments and updated financial information.
An effective resale shelf registration statement typically permits selling shareholders to sell securities from time to time at their discretion. When selling shareholders have the ability to sell at any time, your company has to be particularly attuned to whether the registration statement (including the prospectus contained therein) remains up-to-date. Sales made at a time when the registration statement omits material information or includes materially inaccurate or misleading information could expose your company (and your officers and directors) to liability to purchasers of the securities under Rule 10b-5 under the 1934 Act. Accordingly, during the period in which the resale shelf registration statement is effective, ensure that an appropriate person at the company is tasked with continually monitoring and, if necessary, updating the information included or incorporated in the prospectus to keep it accurate and complete. Because a prospectus related to a shelf registration on Form S-3 is automatically updated through incorporation by reference of subsequently filed 1934 Act reports, it will typically be kept up-to-date through the filing of those reports. However, officers should maintain a heightened awareness of any nonpublic developments and, where material, disclose the developments on a Form 8-K.
Agreements to file resale shelf registration statements can form an important part of a venture or private equity fund’s exit strategy. When a fund invests in a privately held company, the company often agrees at the time of the investment to file for the fund one or more shelf registration statements after the company has completed its IPO. This arrangement provides a way for the fund to eventually obtain liquidity for its investment.
Sometimes companies also use resale shelf registrations after issuing securities in an acquisition transaction. For instance, when acquiring a privately held company, a public company may issue its shares to the shareholders of the target company in an unregistered transaction pursuant to an exemption from registration such as Rule 506 or Section 4(a)(2). Often, the shareholders of the target company will require the acquirer to register the shares received in the acquisition by filing a resale shelf registration statement on Form S-3 soon after the closing of the acquisition. This allows the shareholders to start selling the shares they received in the transaction sooner than they otherwise would under Rule 144 under the 1933 Act (which we discuss in Chapter 6) and, in the case of target company shareholders who become affiliates of the acquiring company, in amounts exceeding the volume limits under that rule.
Companies may also file resale shelf registration statements in connection with PIPE (private investment in public equity) transactions. In a PIPE transaction, a public company typically agrees to sell shares of its common stock or convertible preferred stock (and sometimes warrants) to institutional and other accredited investors in a private placement, usually at a discount to the market price, with an agreement to file a resale shelf registration statement on Form S-1 or S-3 shortly after closing. The benefit to the company of a PIPE transaction is that the company is able to obtain the proceeds from the sale much faster than if it were to instead launch a registered public offering, which would be subject to the SEC review and comment process.
Companies typically agree to keep their resale shelf registration statements effective (meaning that the prospectus will be kept up-to-date and shareholders will be allowed to sell under the registration statement) for a prescribed period of time, usually until the time at which shares become freely transferable under Rule 144. This allows holders of restricted securities to have some control over the timing of their resales. To deregister, a company would file an amendment to the resale registration statement deregistering any remaining unsold securities, which terminates the effectiveness of that registration statement.
Acquisition Shelf. An acquisition shelf provides for the issuance of equity securities as consideration in future acquisitions. An acquisition shelf registration statement is usually filed on Form S-4 and cannot be filed on Form S-3. (We discuss acquisition shelf registration statements in greater detail later in this chapter.)
