The Securities and Exchange Commission, on November 24, 2020, proposed changes to the rules and forms that are used for compensatory securities offerings by both private and public companies. If adopted, the changes should give added flexibility to companies using equity as part of their compensation programs for employees, directors and consultants. At the same time, but in a separate release, the SEC proposed to extend eligibility under these rules and forms to participants in the so-called “gig economy” for five years.

Proposed Rule 701 Changes

Rule 701 provides an exemption for offers and sales of securities by a private company under a written compensatory benefit plan or written compensation contract for employees, directors and consultants, among others. Use of the rule is subject to volume limits and information requirements, including a requirement to provide financial statements if more than $10 million is sold in any 12-month period. The changes proposed by the SEC would:

• Require disclosure of the additional financial and other information mandated by Rule 701(e) only with respect to those sales that exceed the rule’s $10 million threshold in a 12-month period. The current rule requires this information to be provided with respect to all sales during the 12-month period if the threshold is exceeded, which requires issuers to anticipate whether they will exceed the threshold or risk losing the exemption entirely.
• Conform the requirements for the age of financial statements to those in Part F/S of Form 1-A under Regulation A. If financial statements are required, the current rule requires them to be prepared quarterly for offers to be made on an uninterrupted basis. The change would permit financial statements of both US and non-US companies to be prepared instead on a semi-annual basis.
• Permit non-US issuers that are exempt from SEC reporting under Rule 12g3-2(b), by virtue of being listed on an overseas exchange, to provide financial statements prepared in accordance with home country standards without reconciliation, if financial statements prepared under US GAAP or international accounting standards (IFRS) are not otherwise available.
• Allow issuers to provide, in lieu of financial statements, an independent report on the fair market value of the offered securities prepared for purposes of Section 409A of the Internal Revenue Code. The report would need to present a valuation within six months of the date of sale. Non-US issuers using the Rule 12g3-2(b) exemption could simply disclose the fair market value of the stock on the trading day preceding the sale.
• Permit companies to delay any required grant date financial statement disclosures to 14 days after hire for new employees. The change would alleviate concerns over sharing confidential information prior to the start of a person’s employment. It will not affect the grant of stock options, where any required information must be provided a reasonable time prior to exercise rather than prior to grant.
• Clarify the application of the Rule 701 volume limits to options or other derivative securities adopted by the acquirer in a merger transaction.
• Increase the amount of securities that may be sold under Rule 701 during any consecutive 12-month period to the greater of $2 million (increased from $1 million), 25% of the total assets of the issuer (increased from 15%), or 15% of the outstanding amount of the class of securities being offered or sold (unchanged).
• Permit entities to receive Rule 701 securities as a consultant or adviser, if substantially all of the activities of the entity involve the performance of services, and substantially all of the ownership interests of the entity are held directly by not more than 25 natural persons, of whom at least 50% perform such services for the issuer through the entity. Under the current rule, entities can receive grants under Rule 701 only if they are the wholly-owned “alter ego” of the service provider.
• Extend Rule 701’s availability to cover former employees receiving post-termination grants as compensation for services rendered within 12 months preceding the termination, and to cover terminated employees of an acquired entity where the securities are issued in exchange for securities of the acquired entity issued as compensation during the person’s employment with the acquired entity.
• Expand eligibility to subsidiaries, not just majority-owned subsidiaries, of the issuer or the issuer’s parent.

While the rule changes will provide welcome flexibility to private companies who use equity as an element of their compensation programs, the SEC notably did not take the opportunity to address one area of existing uncertainty under Rule 701, which is the appropriate valuation of “profits interests” issued by pass-through entities such as limited liability companies or partnerships under the rule’s volume limits. Profits interests are frequently used for management or other employees of LLCs or limited partnerships as a rough analog to stock options in a corporation, by offering participation in future growth of the company. Subject to certain conditions, the IRS treats qualifying profits interests as having zero value at grant, under IRS Revenue Procedures 93-27 and 2001-43. The SEC has never clarified whether the IRS method could be applied, or whether some other valuation method should be used. The proposed changes do not address the issue, but it would be helpful if the SEC does so.

Proposed Form S-8 Changes

Public companies are ineligible to use Rule 701, but instead can register the offer and sale of compensatory equity awards on a streamlined registration statement on Form S-8. The SEC’s proposed changes to that form would:

• Clarify that under existing rules, issuers may add additional plans to an existing Form S-8 through an automatically effective post-effective amendment where the additional plan does not require the registration of additional securities for offer and sale.
• Clarify that issuers are not required to allocate registered securities among compensatory plans and may use a single Form S-8 for multiple plans, effectively allowing issuers to register a pool of registered shares that may be used under various plans.
• Amend Rule 413 to permit issuers to add securities to an existing Form S-8 by filing an automatically effective post-effective amendment. Under current rules, an issuer needs to file a new Form S-8 to register the offer and sale of additional securities under a new or existing plan.
• Require issuers to pay registration fees for shares sold under defined contribution plans on an annual basis in arrears, based on the aggregate offering price of securities sold. Current rules result in issuers estimating the potential number of future sales based on employee elections and historical usage, and require payment of the filing fee at the time of filing, which can result in the over- or under-estimation of shares to be sold.
• Conform Form S-8 eligibility rules to the proposed changes to Rule 701 described above, including those relating to former employees and to consultants and advisers that organize as entities.
• Make changes to the exhibit requirements and undertakings for ERISA-qualified plans in light of changed IRS practices in issuing determination letters.
• Remove requirements in Form S-8 to disclose the tax effects, if any, on the issuer in the plan prospectus to be delivered to participants.

Proposed Temporary Inclusion of Gig Economy Workers

In its July 2018 concept release, the SEC requested comment on how its rules and forms relating to the compensatory use of equity for a company’s employees might address the changing nature of employment relationships, and in particular the new types of relationships between companies and individuals in the so-called “gig economy” that encompasses ride-sharing, food delivery, home repair, tech support, dog-walking and other services. The SEC has now proposed to include these workers, who do not have a traditional employment relationship with a company, within an expanded group of persons to whom offers and sales may be made under Rule 701 and Form S-8. To allay concerns that the expansion will lead to the use of the rule for capital-raising purposes or other abuses, and to give the SEC time to evaluate the changing nature of the workforce, the proposed rule change would be temporary, expiring after five years.

The temporary rule would permit issuers to offer compensatory securities to “platform workers,” meaning workers otherwise unaffiliated with the issuer who provide bona fide services through or by means of the issuer’s internet-based or other widespread, technology-based marketplace platform. To use the rule:

• The issuer must operate and control the platform, including having the ability to provide access to the platform, to establish the terms of use and payment, and to accept and remove platform workers using the platform.
• The issuance of securities to platform workers must be pursuant to a written compensation plan, contract or agreement, and not for capital-raising services.
• No more than 15% of the compensation received by a platform worker during a 12-month period, and no more than $75,000 during a 36-month period, may consist of securities.
• The amount and terms of securities issued to a platform worker may not be subject to individual bargaining or a worker’s option to choose between securities and cash.
• For private companies using Rule 701, the issuer must take steps to prohibit the transfer of the offered securities other than by operation of law. As proposed, these transfer restrictions would last indefinitely, although under Rule 701(g)(3) the securities could be resold 90 days after an issuer becomes an SEC reporting company.

The rule would be limited to workers who provide services over qualifying platforms, and would not be available to platforms used for the sale of goods. Issuers using these rules would be required to furnish information to the SEC at six-month intervals to help it assess the utility of the rules and whether to extend the changes past their initial expiration. Rule 12g5-1 would be amended so that platform workers who are issued securities by non-reporting companies under these temporary rules would be excluded from the definition of “holders of record” for the purpose of determining whether a company is required to register its equity securities under Section 12(g) of the Securities Exchange Act, similar to that rule’s current exclusion of securities issued under employee compensation plans.

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These proposed changes are open to public comment for 60 days after publication in the Federal Register, and so remain subject to change. Several SEC commissioners indicated that they would favor broader coverage by the temporary rule for platform workers.

If you have any questions about the proposed changes or related topics, your regular Locke Lord contact or any of the authors can discuss these matters with you.

On December 8, 2020, the Delaware Court of Chancery in Stream TV Networks, Inc. v. SeeCubic, Inc.^[1] upheld a unique structure established by secured lenders to protect their interests and in doing so the Court addressed a number of corporate law issues.

Stream TV Networks, Inc. (“Stream“) was a family-controlled Delaware corporation with outside investors and two secured lenders that held security interests in substantially all of Stream’s assets. Stream was in financial difficulties, having defaulted on the secured loans, missed payroll and failed to pay trade debt. Under pressure, the two controlling family members who were the directors increased the size of the board and added four independent outside directors. The outside directors then formed a committee with full authority to resolve any debt defaults. Following negotiations, the committee authorized and Stream executed a restructuring agreement providing that the secured lenders would not foreclose on Stream’s assets but instead would accept the voluntary transfer of Stream’s assets to SeeCubic, Inc. (“SeeCubic”), a new entity controlled by the secured lenders. As part of the understanding, Stream’s minority stockholders would receive shares in SeeCubic in exchange for their Stream shares and Stream itself would receive shares, benefitting its remaining stockholders, principally the controlling family. Stream also granted a power of attorney to implement the agreement and consummate the transaction. The controlling family members, unhappy with the arrangement, then sought to remove the outside directors, purportedly (but the Court found not actually) before the board committee authorized the restructuring agreement and they otherwise sought to challenge the status of the outside directors. They then filed the lawsuit to enjoin enforcement of the restructuring agreement, and SeeCubic responded by seeking to enforce the agreement.

In resolving the dispute in favor of SeeCubic’s right to enforce the restructuring agreement and exercise the power of attorney to accomplish that, the Court addressed the following issues:

Expanding board and filling vacancies.  The Court found that the board was validly expanded and the outside directors validly appointed to fill the vacancies so created because the two family members were the sole members of the two-person board. As authorized by §141(b) of the Delaware General Corporation Law (the “DGCL“), the bylaws provided for the number of directors to be set by the board and, consistent with §141(f), authorized directors to act by unanimous written consent. The Court stated that the issue would have been more complicated if the number of directors had been five, with three vacancies, because then under §223(a) the two directors, since they would not have been a quorum, could only have filled the vacancies and not increase the board to six (citing Applied Energetics, Inc. v. Farley, 239 A.3d 409 (Del. Ch. 2020)). The Court went on to explore other alternatives the two directors could have followed in this hypothetical circumstance, but one was not to act as stockholders to increase the size of the board because that authority was given solely to the directors. The Court also gave advice on how to  draft the resolutions to properly effect the increase in the size of the board and fill the vacancies.

Authority of de facto directors.  Even if the outside directors were not validly appointed and thus would not be de jure directors, in the circumstances of this case they would be de facto directors with the authority to take the actions they took, including approving the restructuring agreement. The Court cited several Delaware decisions addressing the status of de facto directors as applied to protect third parties.

Imposing director qualifications.  Although the resolution designated the outside directors as “Interim ‎Directors“ and required certain conditions to be met for their service to begin, the Court ruled that Delaware law ‎does not contemplate such a position and conditions on the ability to become and remain ‎a director would be a qualification provision that under §141(b) of the DGCL can ‎only be imposed by the certificate of incorporation or bylaws. In addition, a director qualification ‎must be reasonable, and the Court found that those being asserted were not reasonable.‎

Need for stockholder approval for sale of substantially all the assets.  Under §271 of the DGCL, stockholder approval is required for a sale of all or substantially all the assets of a corporation. The approval is not required, however, for the mortgage or pledge of the corporation’s assets, as provided in §272.  The Court noted that the exclusion of a mortgage or pledge must, as a matter of policy, encompass the ability of the creditor to realize on its security. The question for the Court was whether the transfer of Stream’s assets under the restructuring agreement in lieu of a foreclosure of the lenders’ security interest in those assets was subject to the stockholder approval requirement of §271. After reviewing the history‎ ‎of Delaware law on mergers and sales of assets, the ‎evolution of the DGCL provisions and relevant case law, the Court held that §271 does not apply to a transaction like the one under the restructuring agreement in which an insolvent corporation transfers its assets to its secured creditors in lieu of a formal foreclosure proceeding. The Court pointed to the past common law rule that, although a board of directors did not have the authority to sell all the corporation’s assets, it did have that authority to transfer the assets to creditors when the corporation was insolvent, and that the legislature’s having added the authority for the board to sell assets with stockholder approval should not be read to limit the authority that existed under common law. Moreover, the addition of the statutory exclusion for mortgages supported that conclusion.

Need for class vote for such sale.  Stream had a class of stock that required the approval of the holders of that class in order to consummate an “Asset Transfer,” which was defined in the same terms as §271 of the DGCL. Because a charter provision that tracks a statutory provision is to be given the same meaning as the statutory provision, the Court ruled that the class vote provision did not apply to Stream’s transfer to the secured creditors of the assets in which they held a security interest.

Application of business judgment rule.   The final claim was that the restructuring agreement was void because the members of the committee breached their fiduciary duties in approving it. The Court described the three tiers of judicial review of director actions and ruled that the business judgment rule, as the default rule, applied in this case. Under that rule, unless rebutted, “the court merely looks to see whether the business decision made was rational in the sense of being one logical approach to advancing the corporation’s objectives.” The Court found that no basis existed to rebut the protections of the business judgment rule and therefore it rejected the breach of fiduciary duty claim.

Conclusion

The Stream decision illustrates a creative way lenders can successfully deal with a distressed borrower situation. The Court’s decision upholding the actions taken by the lenders also provides a primer on some basic corporate law rules that are worth noting.

[1] C.A. No. 2020-0310-JTL (Del. Ch. Dec. 8, 2020) here.

The Securities and Exchange Commission has continued its effort to update and streamline the disclosure requirements for filings with the SEC. In November, the SEC adopted amendments to the rules for Management’s Discussion and Analysis and related financial disclosures. [1] MD&A, because of its principles-based nature, is among the most challenging of the disclosure requirements. Within MD&A, addressing “known trends or uncertainties,” because the requirements are not only principles-based but also future oriented, can be especially challenging. In the recent amendments, the SEC, although not directly modifying its previous interpretations regarding disclosure of known trends or uncertainties that have troubled practitioners over the years, provides useful guidance that should align the specific requirements with the approaches followed in practice.

MD&A, as required by Item 303 of Regulation S-K, has long been a part of required disclosure. It is designed to provide additional meaning to the required financial information and to put that information in context “through the eyes of management.”  Part of providing that context is to disclose known trends, demands, commitments, events or uncertainties that have had or would reasonably have a material effect on the company‘s financial condition, cash flow or results of operations in a way that makes the past financial information not necessarily indicative of future condition or results.

In 1989, the SEC established a two-step test for determining whether a known trend or uncertainty required disclosure.[2] First, management must determine if the known trend or uncertainty is likely to occur – if it determines it is not likely to occur, no disclosure is required. If it cannot make that determination, it must go to the next step, which is to evaluate objectively the materiality of the known trend or uncertainty on the assumption that it will occur. Disclosure is then required unless management determines that the effect is not reasonably likely to be material. This two-step negative presumption test has caused concern for practitioners. Despite comments expressing that concern, the Commission chose to reaffirm the 1989 two-step test, asserting that the language of Item 303 as amended codified that position.  At the same time, however, the Commission provided guidance in the adopting release on how to apply the two-step test in making disclosure determinations that should align Item 303’s requirements with how it is generally applied in practice.

First, the Commission has included in Item 303(a) general concepts applicable to MD&A that previously appeared as guidance in instructions and interpretations. Although provisions of Regulation S-K items usually are applied as legal requirements, because of their generality the provisions of Item 303(a) are unlikely to be applied that way. The Commission also makes clear in the adopting release that MD&A should include a thoughtful discussion and analysis of factors specific to the particular company’s business that from management’s perspective are necessary to an understanding of the company’s financial condition, changes in financial condition and results of operations. The Commission emphasizes that materiality is the overarching principle of MD&A disclosure.

With specific reference to known trends and uncertainties, the amendments to Item 303 establish a consistent “reasonably likely” standard as opposed to a “will” or “reasonably expected” standard. The required analysis is to be based on “management’s assessment,” which must be “objectively reasonable.” The Commission then explains that in applying the two-step test in assessing whether disclosure of a known trend or uncertainty is required, the analysis is to be based on “materiality,” as commonly understood as being what would be considered important by a reasonable investor in making a voting or investment decision. In applying the two-step test under the “reasonably likely” standard, a company must first objectively consider whether it is likely to occur. If the known trend or uncertainty is not remote or if management cannot make that determination, management must then on an objective basis consider whether, if the known trend or uncertainty were to occur, it would have a material effect. If so, disclosure would be required if omission of the information would significantly alter the mix of information a reasonable investor would consider important, with the objective being to provide investors with an understanding of the material consequences of the known forward-looking trends or uncertainties. The Commission expressly rejected use in this context of the Basic probability/magnitude standard for assessing materiality.[3]

Although the two-step negative presumption test is reaffirmed, the Commission’s guidance puts it in a context that should give companies somewhat more leeway in assessing the materiality to investors of non-remote known trends or uncertainties and greater comfort in reaching good faith thoughtful disclosure decisions.

Other Changes

The following is a summary of some of the other changes made by the SEC:

• Item 301 requiring a five-year selected financial data table is eliminated in recognition that the financial information appears in other filings.
• Item 302 calling for tabular quarterly financial information for the prior two fiscal years and any subsequent quarterly period, which applies to an annual report on Form 10-K and certain registration statements on Form S-1, is modified to require disclosure only when prior changes to the income statement during those periods have been material, thus substituting a principles-based approach for a technical requirement that replicates information largely available in other filings.
• In addition to adding a new Item 303(a) called “Objective,” the requirements for analysis and discussion of liquidity and capital resources and results of operations in Item 303(b)(1) and (2) for the full fiscal years and for material changes in financial condition and results of operations for interim periods were revised to “modernize, enhance and clarify” and, in some cases, streamline the disclosure requirements. They largely call, however, for the same primarily principles-based substantive information as has been required. In the case of interim period information, the SEC has added flexibility to allow companies to tailor their disclosure to their own situation by choosing the year-over-year traditional comparison or a sequential quarter comparison. If a company changes the approach, it must explain the reason and provide both comparisons in the first changed filing.
• Instead of a separate provision for off-balance sheet arrangements, an instruction to discuss material commitments and obligations arising from those off-balance sheet arrangements in the context of the MD&A discussion is substituted.
• The requirement to include a table of contractual obligations is eliminated in favor of expanded disclosure regarding liquidity and capital commitments of material cash commitments from obligations, including contractual obligations.
• New Item 303(b)(3) is added to codify the SEC’s guidance on critical accounting estimates to make clear that the discussion should not repeat the financial statement note on significant accounting policies. Instead, the discussion should provide qualitative and quantitative information necessary for an investor to understand the uncertainty of those accounting estimates reflected in the financial statements that involve significant uncertainty and are likely to have a material impact on financial condition or results of operation.
• Conforming changes are made to the requirements for smaller reporting companies and foreign private issuers, along with other changes in rules and forms to reflect the amendments.

Effective Date and Transition.

The amendments become effective 30 days after publication in the Federal Register but the changes only apply to filings beginning the first fiscal year ending on or after 210 days following publication in the Federal Register (for calendar year companies that will be the fiscal year ending December 31, 2021). Companies may choose to use the new rules any time after they become effective so long as they comply with an item (such as Item 303) in its entirety.

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If you have any questions about these amendments or related topics, your regular Locke Lord contact or any of the authors can discuss these matters with you.

[1] Management’s Discussion and Analysis, Selected Financial Data and Supplementary ‎Financial Information, Release No. 33-10890 (Nov. 19, 2020).‎

[2] Management’s Discussion and Analysis of Financial Condition and Results of ‎Operations; Certain Investment Company Disclosures, Release No. 33-6835 (May 18, 1989).‎

[3] Basic, Inc. v. Levinson, 485 U. S. 224 (1988).‎

The Delaware Court of Chancery,  in The Williams Companies Stockholder Litigation, 2021 WL 754593 (Del. Ch. Feb. 26, 2021), struck down a shareholder rights plan (commonly known as a “poison pill”) adopted by The Williams Companies, Inc. at the outset of the pandemic that depressed the energy industry in order to forestall possible activist attacks. By invalidating the Williams rights plan, the Court reminds companies that, while a recognized defensive measure to be appropriately employed, shareholder rights plans interfere with the ability of shareholders to fully exercise their fundamental rights and, therefore, the provisions of the plan must pass muster as reasonably related to the threat to the company and the process followed and record made in adopting it must establish that reasonableness.

Background. Williams is a publicly-held energy company in the natural gas industry. In early 2020, after the COVID-19 pandemic was declared a national public health emergency, the Williams stock price fell sharply. After international oil prices dropped following an OPEC price war, the Williams stock price fell further. This stock price decline caused concern at Williams that it could be a target for activist actions. Williams had prior experience dealing with activists who tried to gain a controlling influence and pursue a short-term agenda.  To combat the threat of new activist attacks, the Williams board, with input from outside advisers, acted quickly to adopt a shareholder rights plan aimed at preventing such attacks. The plan, which had a one-year term, had several aggressive features as described below.

Adoption of the rights plan received negative market and stockholder reaction, and lawsuits were filed to enjoin the plan based on claims of breach of fiduciary duty by the Williams directors in adopting the plan. In reaching its decision, the Delaware Court of Chancery applied the two-part Unocal standard, looking first at whether the board “had reasonable grounds for concluding that a threat to the corporate enterprise existed,” and then at whether the defensive measures were “reasonable in relation to the threat posed.” The Court determined that this standard was not met in this situation and invalidated the rights plan and enjoined its continued operation.

Substantive Provisions. The Williams rights plan had several substantive provisions that troubled the Court, which characterized the plan as “unprecedented” in having “a more extreme combination of features than any pill previously evaluated by this court.” First, the plan established an aggressive 5% beneficial ownership trigger threshold. This threshold was lower than the 10% to 15% thresholds typically used (apart from plans designed to protect net operating losses as tax  assets) and lower than any general rights plan approved by the Delaware courts. The Court expressed concern over use of this low a trigger threshold absent clear circumstances justifying it.

Next, the plan included an expansive concept of “acting in concert” to aggregate stockholders as a “group” designed to prevent activist “wolfpacks,” but which the Court found could have swept in stockholders exercising their normal rights as stockholders without even collaborating with those targeted by the plan. Relatedly, the “passive investor” exclusion was so narrow, even more limited than the “passive investor” exclusion under Section 13(d) of the Securities Exchange Act of 1934, that it would not have excluded these types of ordinary stockholders from being subject to the severe consequences of triggering the rights plan.

The Court found that, taken together, the Williams rights plan exceeded what is permissible in the absence of a strong showing that the plan was reasonably related to addressing an actual threat, which Williams failed to show.

Procedural Considerations. In addition to concerns over the substantive provisions of the rights plan, the Court found the process followed in adopting it to be deficient. Despite various procedural steps taken by the Williams board, the Court questioned their adequacy. For example, the Court noted that the board never discussed the plan’s key features and, while the minutes recited the usual justifications for typical rights plans, they failed to address this specific unique situation and the actual motivations behind adoption of the plan.

These deficiencies gave the Court leeway to determine the true motivations and whether they represented actual threats justifying adoption of the Williams plan. The Court identified the board’s generalized concerns over activist threats and short-termism, but was not willing to go so far as to recognize these “hypothetical” threats as justification for adoption of a rights plan. The Court also identified the board’s concern over filling the gap left under the federal disclosure regime under Section 13(d) of the Securities Exchange Act by blocking undetected rapid stock accumulations. However, without determining whether that could be a sufficient justification, it found that the Williams board “failed to show that this extreme, unprecedented collection of features bears a reasonable relationship to their stated corporate objective” and therefore that the rights plan was invalid.

Lessons to be Learned.

• Triggering thresholds in shareholder rights plans commonly used and previously upheld by courts are more likely to be sustained. To the extent a more aggressive approach is taken, the justification for it will need to be greater.
• Aggregation provisions, such as “group” and “acting in concert” concepts, have been upheld, but they and related exclusions need to be drafted with care to avoid being broader than justified and sweeping in stockholders who are not part of the targeted group.
• Process continues to be important, which includes establishing a good official record, and shareholder rights plans should not be treated as routine. The more aggressive the plan, the more effort should be made to justify its provisions and to establish a record of careful consideration, including the threats being addressed and the reasons for particular provisions to address those threats.
• Most importantly, the Williams decision does not undermine the valid use of shareholder rights plans, but, in recognizing them as an available defensive measure, emphasizes the importance of their being done carefully and correctly. If anything, the decision underscores the benefit of companies having a carefully considered rights plans “on-the-shelf,” ready to be implemented if and when needed, and reviewing it regularly so that it is kept current.

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Your regular Locke Lord contact or any of the authors can help you address matters relating to a stockholder rights plan or other corporate governance issues.

In a settled enforcement action against Under Armour Inc. announced on May 3, 2021 the SEC reminded companies that managing earnings, even if accounted for correctly, can have MD&A implications triggering disclosure obligations.  According to the SEC order, Under Armour, in order to meet analyst projections and sustain its 20% quarter over quarter revenue growth record, pressured customers to move purchases forward into the current quarter, and did this for a number of consecutive quarters. There was no finding that Under Armour’s accounting for these sales as revenues was improper since the sales were actually made.  However, Under Armour gave the same reasons for revenue growth as it had before in earnings releases and its MD&A, without indicating that it was pulling revenues forward to maintain its growth and that this was an unsustainable practice, especially since doing so made it harder to sustain the rate of growth as a result of increasing the prior year’s base and taking revenues from the later year.

The SEC charged Under Armour with misleading investors by failing to disclose a key reason for its revenue growth and to identify the significant uncertainty as to whether it would meet its revenue guidance in the future, characterizing this as a “known uncertainty“ that indicated that reported results were not indicative of future results and thus had to be disclosed in the MD&A.

The SEC’s action against Under Armour underscores the importance of conveying an accurate picture of the drivers of a company’s financial results and disclosing known uncertainties concerning its business that could be material to investors.

If you have any questions about these or related topics, your regular Locke Lord contact or any of the authors can discuss these matters with you.

The SEC’s Division of Enforcement announced on April 29, 2021 settled enforcement actions against eight companies for failure to adequately disclose the reasons for their inability to timely file their Form 10-Ks or Form 10-Qs when filing a Form 12b-25 (commonly known as “Form NT”) to extend the time to file those reports. (The SEC’s press release is available here.) In particular, the SEC noted that these companies failed to disclose anticipated restatements and corrections subsequently reflected in the filed financial statements as the reason for the inability to file on time. The SEC also noted the need to disclose any significant change in quarterly income or revenue anticipated by management.

SEC reporting companies sometimes need to avail themselves of the additional time to file their periodic reports, typically because of the inability to complete their financial statements, by filing a Form 12b-25.  It is important that companies treat the form as a disclosure document and not just as an automatic extension, and that they adequately disclose the reasons for the inability to file on time and any anticipated changes in quarterly results.

If you have any questions about these or related topics, your regular Locke Lord contact or any of the authors can discuss these matters with you.

Please see our updated post here.

The SEC, together with the PCAOB, recently updated guidance to reporting companies on issues arising from the coronavirus (COVID-19) outbreak. On February 19, 2020, SEC Chairman Clayton, PCAOB Chairman William Duhnke, and senior members of the SEC staff advised that, while specific analysis of the impact of the coronavirus may not be feasible, information about a company’s plan and response to its outbreak could be material and may need to be disclosed. That advice referred to the effect of the outbreak on the audit process and financial reporting. The SEC also updated its guidance to companies for evaluating general disclosure and reporting requirements in light of the quickly developing coronavirus situation.

U.S. listed companies with significant operations in China and other affected areas, whether based in those areas or not, may be affected by the continued spread of the coronavirus. The SEC observed that companies that do not themselves have operations in affected areas, but who depend on suppliers, distributors, and/or customers in those areas, may suffer financial and operational impacts. The reactions of other countries to the spread of the coronavirus, including potential travel bans, can have adverse impacts on companies. The coronavirus can affect the availability, timeliness and accuracy of financial information necessary for financial disclosures. This could then affect the quality of any financial audit.

Practical Takeaways:

• Companies should consider including disclosures in upcoming filings to the extent relevant to their industries and operations. These disclosures should be targeted to the company’s particular circumstances and may be made, for example, in the Risk Factors section or in relation to known trends and uncertainties in the MD&A.
• Management may want to develop contingency plans, including employee safety protocols, to respond to the threats posed by the coronavirus to the extent material to operations or financial results. Audit committees can provide oversight of the contingency planning and any effect the outbreak might have on the preparation and audit of the financial statements.
• Companies should have discussions with their independent auditors to ensure the quality or timing of an audit is not compromised due to a lack of access caused by the coronavirus. If the quality or timing of an audit poses a concern to a company, it should contact the SEC to request appropriate relief.
• Companies may want to review the force majeure clauses in material contracts and their business interruption plans and insurance.

Your regular Locke Lord contact and any of the authors would be happy to assist you with these matters.

Visit our COVID-19 Resource Center often for up-to-date information to help you stay informed of the legal issues related to COVID-19.

The SEC issued new guidance yesterday supplementing its previously-announced COVID-19 order that gives relief from Exchange Act filing deadlines (see our blog post about the COVID-19 order here).  The guidance details how the order applies to companies that omitted from their annual report on Form 10-K the information required under Part III of Form 10-K.  It is a common practice to omit that information and provide instead that it will be incorporated into the Form 10-K from the company’s proxy statement, provided that the proxy statement is filed within 120 days of the company’s fiscal year end. Part III information includes disclosure about directors and executive officers, executive compensation, corporate governance, stock ownership, related party transactions, audit fees and similar matters.

The SEC’s new guidance (in CD&Is – Exchange Act Forms Question 104.18, available here) confirms that the SEC’s COVID-19 order also applies to Part III information.  Specifically, to take advantage of the relief:

• A company that timely filed its annual report without relying on the COVID-19 order should furnish a current report on Form 8-K by the 120 day deadline, or April 29, 2020 for calendar year companies. The Form 8-K should meet the requirements of the COVID-19 order by disclosing that the company is relying on the order; describing the reasons why the company could not file the information on a timely basis; estimating the date on which the information will be filed; outlining a company-specific risk factor; and providing any third-party statements required under the order. The company will then need to provide the Part III information, either in a Form 10-K/A or in a definitive proxy statement, within 45 days after the 120-day deadline.
• A non-calendar year company using the COVID-19 order to extend its Form 10-K deadline may use a single Form 8-K filed by the original deadline of the annual report. That Form 8-K should indicate that the company will incorporate Part III information by reference and disclose an estimated date by which the Part III information will be filed. The Part III information will then need to be filed no later than 45 days after the 120-day deadline. The original Form 10-K filing deadline has already passed for calendar year companies.
• Many companies already furnished a Form 8-K to extend their original Form 10-K filing deadline but were silent on Part III information. Those companies may either (a) file the Part III information in their Form 10-K or proxy statement within 45 days after the original deadline, or (b) furnish a second Form 8-K by the 120-day deadline that includes the disclosures required by the COVID-19 order, and file the Part III information no later than 45 days after that 120-day deadline.

Your regular Locke Lord contact and any of the authors can discuss these matters with you. Please visit our COVID-19 Resource Center often for up-to-date information to help you stay informed of the legal issues related to COVID-19.

On March 25, 2020, the SEC modified its March 4th order described here, which allowed extended filing deadlines for disclosure reports due between March 1 and April 30, 2020.  The modified order covers all filings due on or before July 1, 2020.

Companies may use the 45-day extension in the order or can rely on Rule 12b-25.  If a company uses the 45-day extension, it may then use Rule 12b-25 at the end of the 45 days.

The updated order included three clarifications from the original order:

• The deadline for amendments required to be filed under the Exchange Act can be extended. This may be useful for companies who are unable to file their definitive proxy materials within 120 days of their fiscal year end, and who would otherwise be required to amend their annual reports on Form 10-K to include required executive compensation and governance information by then.
• Companies must submit a current report on Form 8-K or Form 6-K summarizing the need for relief for each filing for which it uses the extension. The current report must be submitted by the original filing deadline for filings after March 16th.
• The Form 8-K or Form 6-K must include “a company specific risk factor or factors explaining the impact, if material, of COVID-19 on its business.” The original order used softer language, only requiring a risk factor, if appropriate.

The original and updated order can be found here and here.

On March 26, 2020, the SEC extended similar relief to issuers who are subject to the reporting requirements of either Regulation Crowdfunding or Regulation A. Subject to the conditions outlined in the order, this relief offers a 45-day extension for filings otherwise due between March 26, 2020 and May 31, 2020.  That order can be found at this link.

Further Update: On March 31, 2020, the SEC released two new compliance and disclosure interpretations (C&DI’s) under the Exchange Act Rules (Questions 135.12 and 135.13, available at this link) relating to the order on Exchange Act filing deadlines. The first of these confirmed that an issuer unsure of whether it will be able to file within the extensions available in the normal course through Rule 12b-25 should instead file the Form 8-K as outlined in the order. The second confirmed that an issuer who obtains an extension under Rule 12b-25, without filing a Form 8-K under the order on the original due date of an Exchange Act report, will not be able to avail itself of the 45-day extension under the order at the end of the Rule 12b-25 extension period, because Rule 12b-25 does not extend the original due date of the report.  Conversely, issuers who file the Form 8-K and satisfy the other conditions of the order will be considered to have a due date 45 days after the original filing deadline, and so thereafter will be able to rely on Rule 12b-25 for a further extension.

Visit our COVID-19 Resource Center often for up-to-date information to help you stay informed of the legal issues related to COVID-19.

Picking up on suggestions from its Small Business Capital Formation Advisory Committee, the SEC has adopted a temporary rule to permit small businesses eligible to do a Regulation Crowdfunding offering that have been operating for at least six months to have access to capital through August more quickly by streamlining some of the crowdfunding exemption requirements as follows:

• Gauging interest. An issuer can begin its offering through its intermediary platform after filing its offering statement even though its financial statements are not available. However, it cannot accept commitments until the required financial statements are filed and provided to investors. It also must disclose that the financial statements are not available and will be provided later, that no commitments will be accepted until the financial statements are provided, and that the investor should review all the required information.
• Financial statements required. For offerings not exceeding $250,000 (but more than $107,000), the requirement for reviewed or audited financial statements is waived and instead, if those are unavailable, the financial statements and information from the issuer’s federal tax returns can be certified by its principal executive officer.
• Expedited Funding. Instead of the 21-day waiting period under existing rules, an issuer can make sales once it has received binding commitments for the target offering amount (but a commitment is not binding for 48 hours) and it can close on the offering as long as it has complied with the disclosure requirements, notified investors that the target offering amount has been met, and the amount being closed on is at least the target offering amount.

These changes, which became effective May 4, 2020 and apply to crowdfunding ‎offerings begun by August 31, 2020, provide welcome short-term relief for those companies that ‎can avail themselves of the crowdfunding alternative. ‎

Visit our COVID-19 Resource Center often for up-to-date information to help you stay informed of the legal issues related to COVID-19.