Securities Mosaic® Blogwatch
June 1, 2016
Gibson Dunn discusses PCAOB Issuance of Another Proposal to Change Audit Report
by Michael Scanlon, Brian Lane, Lori Zyskowski and Michael Titera

The Public Company Accounting Oversight Board ("PCAOB") recently re-proposed an audit standard to amend the form and content requirements for the independent auditor’s report on financial statements.[1] The new proposal retains the pass/fail model present in the existing audit report but also requires the auditor to include new disclosures in the audit report about "critical audit matters" that are identified during the course of the audit. The re-proposal also requires new disclosures about the length of the auditor’s tenure and the applicable auditor independence requirements.

The re-proposal is the latest chapter in a standard-setting project that dates back to 2011, when the PCAOB issued a concept release[2] on potential changes to the audit report, and that evolved in 2013, when the PCAOB issued its original proposal[3] on this topic. The PCAOB’s re-proposal narrows in some respects the scope of the disclosure requirements for critical audit matters that appear in the audit report, and also drops the component of the original proposal that would have required the auditor to review and report on matters outside the financial statements. But the re-proposal still represents an important development for the financial reporting landscape that issuers and their audit committees should review and consider in detail, including as described below under "Steps to Consider."

The deadline for commenting on the PCAOB’s proposal is August 15, 2016.

What are CAMs?Required Disclosures in the Audit Report about Critical Audit Matters

Under the re-proposal, a critical audit matter ("CAM") is defined as "any matter arising from the audit of the financial statements that was communicated or required to be communicated to the audit committee and that: (1) relates to accounts or disclosures that are material to the financial statements and (2) involved especially challenging, subjective, or complex auditor judgment."

The proposed definition thus has three component pieces. First, a CAM must be a matter that was voluntarily communicated to the audit committee or that was required to be communicated to the audit committee under Auditing Standard 1301 (formerly AS No. 16), Communications with Audit Committees. As issuers and audit committees are well aware, the scope of these required communications is not narrow, with AS 1301 containing more than fifteen topics and several dozen related paragraphs that specify what must be communicated to the audit committee. Second, a CAM must relate to an account or disclosure that is "material" to the financial statements. Notably, the proposed definition does not require the communication itself to involve a material issue, but rather that the communication must be about an account or disclosure that is material to the financial statements. And third, the proposed definition provides that a CAM must have involved an "especially challenging, subjective, or complex auditor judgment." The proposal seeks to inject some objective criteria to help guide this test by laying out several factors that an auditor should take into account in determining whether a matter involved such judgments, specifically:

  • the auditor’s assessment of the risks of material misstatement, including significant risks;
  • the degree of auditor subjectivity in determining or applying audit procedures to address the matter or in evaluating the results of those procedures;
  • the nature and extent of audit effort required to address the matter, including the extent of specialized skill or knowledge needed or the nature of consultations outside the engagement team regarding the matter;
  • the degree of auditor judgment related to areas in the financial statements that involved the application of significant judgment or estimation by management, including estimates with significant measurement uncertainty;
  • the nature and timing of significant unusual transactions and the extent of audit effort and judgment related to these transactions; and
  • the nature of audit evidence obtained regarding the matter.

The new proposal provides that if the auditor determines that a CAM exists, the auditor must include disclosure in the audit report that identifies the CAM, describes the principal considerations that led the auditor to determine that the matter is a CAM, describes how the CAM was addressed in the audit, and identifies the relevant financial statement accounts and/or disclosures that relate to the CAM.

The CAM definition offered in the original proposal was more expansive because it did not specifically relate back to disclosure of matters that were communicated to the audit committee. By incorporating the concept of matters required to be communicated to the audit committee, the re-proposal draws on existing AS 1301 to provide some guideposts for determining which matters may be treated as CAMs. However, given the lengthy list of required communications in AS 1301 and that the re-proposal includes both required communications and those that are voluntarily communicated to the audit committee, the range of matters that could be CAMs remains quite broad and could lead to significant new disclosures in the audit report, as discussed in more detail below under "Steps to Consider."

The new proposal specifies that CAMs would not have to be disclosed in audit reports issued in connection with audits of brokers and dealers; investment companies other than business development companies; or employee stock purchase, savings, and similar plans.

Additional New Disclosures in the Audit Report

Auditor Tenure. The re-proposal requires the auditor to include in its report "[a] statement containing the year the auditor began serving consecutively as the company’s auditor." Under the proposed requirement, the auditor tenure would include the years the auditor served as the company’s auditor both before and after the company became subject to SEC reporting obligations. Although the Board unanimously approved the issuance of the proposal, several Board members indicated they were not certain this disclosure is needed. These sentiments were expressed in part because many issuers have voluntarily included enhanced audit committee-related disclosures in their proxy statements and such disclosures often include information about the length of service by the auditor.

Independence. The re-proposal also requires a statement in the audit report that the auditor "is a public accounting firm registered with the PCAOB (United States) and is required to be independent with respect to the company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the SEC and the PCAOB."

Clarification of Auditor Responsibilities. Under the re-proposal, the auditor also has to include in its audit report the phrase "whether due to error or fraud," when describing the auditor’s responsibilities under PCAOB standards to obtain reasonable assurance about whether the financial statements are free of material misstatements. This phrase is not included in the existing auditor’s report and the release accompanying the re-proposal says that the phrase is added to clarify that the auditor is responsible for detecting material misstatements, whether such misstatements are due to error or fraud.

Steps to Consider

With this re-proposal, the PCAOB appears to be moving closer to requiring changes to the pass/fail model that has served as the basis for an unqualified audit report for many decades. As a result, issuers and their audit committees would be well served to review in depth the new disclosures contemplated by the proposal—particularly as they are disclosures for which the auditor will have the final say; consider the potential implications and costs associated with the new disclosures, including the questions and potential issues discussed below; and evaluate whether to comment on the proposal. In considering this topic, issuers and audit committees also may wish to engage with their auditors to understand what types of issues in prior audits may be considered CAMs under the proposal and what corresponding disclosures would have looked like if they had been disclosed in connection with those prior audit reports.

  • Scope of the New CAM Definition. In its re-proposal, the PCAOB made efforts to reign in the breadth of its original concept for critical audit matters, but aspects of the proposed CAM definition still may present concern. The audit standard governing communications that the auditor is required to make to the audit committee is itself expansive, as noted above. The definition also includes any communication made to the audit committee outside of the required communications. It also appears that CAMs may not be limited to communication about material issues, but rather could include disclosure of an issue that may not itself be material but that may involve a material account or disclosure. And, the question of whether an issue was "especially challenging, subjective, or complex auditor judgment" by its terms still leaves the auditor with broad discretion to determine whether a matter is a CAM that should be disclosed in the audit report. Auditor discretion in making this determination of course could cut either way, but issuers and their audit committees may wish to consider whether the degree of uncertainty in how the proposed CAM definition will be applied in practice, given its potential breadth and subjectivity, merits comment.
  • Auditor Disclosure of Original Information. In reviewing the original proposal, a number of commenters expressed concern that the proposal would place the auditor in the position of being the source of disclosure of original information about a company—in other words, having to make disclosures before a company itself has made the disclosure or, in effect, forcing a company’s hand to make disclosures. The PCAOB’s re-proposal responded to this concern by noting that "[s]ince the auditor would be communicating information regarding the audit rather than information directly about the company and its financial statements, the communication of critical audit matters should not diminish the governance role of the audit committee and management’s responsibility for the company’s disclosure of financial information." Companies and audit committees may wish to consider if this response is sufficient to allay the noted concerns, particularly given the nature of the proposed disclosure topics that have to be addressed once a CAM has been identified—as reflected by the three pages of sample disclosures for a CAM that appear in the proposing release. The PCAOB’s proposed standard also includes a note intended to address concerns about the auditor becoming the source of original (and potentially confidential) information about the company. This note says that the auditor will not be expected to provide information about the company that has not been made publicly available by the company "unless such information is necessary to describe the principal considerations that led the auditor to determine that a matter is a critical audit matter or how the matter was addressed in the audit." Companies and audit committees may wish to consider whether this exception in effect nearly swallows the rule, and if so, what disclosure considerations may be implicated, including whether it would put the auditor in a position of having to make disclosures in the first instance about any number of matters, such as loss contingency considerations or investigations.
  • Uncertainty in Application. A number of concerns expressed in relation to the original proposal also appear not to have been fully addressed by the re-proposal. Companies and their audit committees may wish to comment on these issues as well. For example, because the re-proposal may require disclosure of matters that have been voluntarily reported to the audit committee, some have expressed the view that the approach outlined could lead auditors to hesitate in raising matters to audit committees as it would then trigger potential CAM reporting. Conversely, some have expressed concern that there will be a tendency to over-disclose the existence of CAMs given the subjectivity in the proposed standard and the potential adverse consequences for the auditor associated with being second-guessed in whether a CAM should have been disclosed. Still others have expressed concern that the range of CAM disclosure practice amongst firms and engagement teams will lead to unhelpful variability across audit reports. Concerns expressed about the original proposal with respect to the increased strain on audit committee resources and timing issues associated with completing the audit—for example, when financial reporting or audit-related issues that have CAM implications arise at the last moment—also seem relevant in relation to the re-proposal. Although varied in nature, the common theme underlying these concerns appears to be that uncertainty in application will result from requiring CAM disclosures in the audit report, particularly in light of the subjectivity inherent in the definition and the significance of the changes to the audit reporting model.


[1] Proposed Auditing Standard—The Auditor’s Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion and Related Amendments to PCAOB Standards, PCAOB Release No. 2016-003 (May 11, 2016), available at

[2] Concept Release on Possible Revisions to PCAOB Standards Related to Reports on Audited Financial Statements and Related Amendments to PCAOB Standards, PCAOB Release No. 2011-003 (June 21, 2011), available at

[3] Proposed Auditing Standards—The Auditor’s Report on an Audit of the Financial Statements When the Auditor Expresses an Unqualified Opinion; The Auditor’s Responsibilities Regarding Other Information In Certain Documents Containing Audited Financial Statements and the Related Auditor’s Report; and Related Amendments to PCAOB Standards, PCAOB Release No. 2013-005 (Aug. 13, 2013), available at

The preceding post comes to us from Gibson, Dunn & Crutcher LLP, and is based on their memorandum published on May 18, 2016 and available here.

May 31, 2016
An Examination of Changes in Earnings Management after Receiving SEC Comment Letters
by Bret Johnson, Lauren Cunningham, Ling Lei Lisic, Scott Johnson
Editor's Note:

Scott Johnson is Assistant Professor of Accounting at Virginia Tech. This post is based on an discussion paper authored by Professor Johnson; Lauren Cunningham, Assistant Professor of Accounting at the University of Tennessee; Bret Johnson, Assistant Professor of Accounting at George Mason University; and Ling Lei Lisic, Associate Professor of Accounting at George Mason University.

The Securities and Exchange Commission (SEC) has long been concerned that earnings management practices result in adverse consequences for investors, including masking the true nature of economic transactions, and has often called for increased regulatory oversight of the financial reporting process. In our paper, The Switch Up: An Examination of Changes in Earnings Management after Receiving SEC Comment Letters, which was recently made publicly available on SSRN, we examine the influence of firm-specific regulatory oversight, in the form of SEC comment letters, on firms’ earnings management practices.

Firms can manage earnings using two primary methods: accrual-based earnings management (AEM), such as using “cookie jar” reserves, and real activities-based earnings management (REM), such as the opportunistic timing of discretionary expenses. Prior research provides evidence of a cost-benefit trade-off between these two methods (e.g., Cohen, Dey, and Lys 2008; Zang 2012). As the cost of one earnings management practice increases, companies shift to other, less costly, forms of earnings management. Cohen et al. (2008) document a decreasing trend in AEM and an increasing trend in REM in the years following the passage of the Sarbanes-Oxley Act of 2002 (SOX), suggesting that SOX imposes increased regulatory scrutiny on AEM, and thus increases the cost of AEM. Companies then offset the constrained AEM by engaging in additional REM. Survey results confirm that, post-SOX, managers likely switched to REM because it is more difficult to detect (Graham, Harvey, and Rajgopal 2005), but it is still unclear which provisions of SOX (or other concurrent factors) resulted in this shift from AEM to REM.

To carry out the SEC’s oversight role, the Division of Corporation Finance periodically reviews companies’ filings and issues comment letters to monitor and enhance compliance with regulatory disclosure and accounting requirements. The SEC review process underwent substantial changes post-SOX, including improved transparency (i.e., comment letter correspondence is now available to the public) and increased frequency of reviews (i.e., higher probability of being reviewed). We expect that these regulatory changes of the SEC review process induce companies to reduce their AEM because accounting issues (e.g., accruals) are often the focus of the SEC’s reviews. We expect that companies will increase their REM because the SEC is less likely to scrutinize real business transactions as long as they are properly disclosed.

It is not clear whether the general threat of review, post-SOX, is enough to change firms’ earnings management behavior or whether it is the receipt of an actual comment letter. Firms do not know the exact timing of the review process unless they actually receive a comment letter, but they do know that they will be reviewed by the SEC at least once every three years. Thus, it is possible that the threat of the review process alone may constrain AEM. However, the receipt of a comment letter serves as a salient cue that the company is being monitored by the SEC and suggests that management may react specifically to the receipt of a comment letter. SEC comment letters are a top priority item and are given immediate attention by senior company management including the Chief Executive Officer and Chief Financial Officer (Johnson 2010). Therefore, we expect that, in addition to any behavior modifications accompanying the general threat of SEC review in the post-SOX period, companies will react to the receipt of an actual comment letter by reducing AEM and increasing REM.

Using augmented models from Zang (2012), which focus on suspect firms that meet or just beat specific earnings benchmarks, we find that AEM significantly decreases and REM significantly increases in the two years after the receipt of an SEC comment letter. These results are consistent with our hypothesis that, after receiving a comment letter, companies reduce their AEM, due to higher cost of regulatory scrutiny, and shift to more REM, which is less likely to be the SEC’s focus. Additionally, when considering the timing of the comment letters in relation to the changes in earnings management, we find that comment letters have an immediate impact in the subsequent year, and the impact has lasting effects for at least two years after the receipt of the letters.

To better understand whether our results are driven by general scrutiny from the SEC or accounting-specific scrutiny, we also perform cross-sectional analysis based on the type of SEC reviewer and the type of comments in the letter. Specifically, we divide the sample of comment letters into attorney and accountant reviews based on the titles of the reviewers referenced in the letters and then further divide the accountant reviews into accounting-related and non-accounting-related comments. Cross-sectional results suggest that our main results are driven by comment letters that come from an accountant review and contain at least one accounting-related comment. We find no significant change in AEM or REM when the comment letter stems from an attorney review or contains only non-accounting-related comments. Thus, it appears that general scrutiny from the SEC (i.e., commenting on non-accounting issues such as risk factors, internal control disclosures, etc.) is not sufficient to induce management to reevaluate the cost of accrual-based earnings management behavior. Alternatively, companies only change their earnings management behavior when the comment letters specifically address accounting-related issues.

The results of our study provide important implications for regulators. Although we find that SEC comment letters have the positive outcome of constraining questionable accrual-based earnings management practices, they also have the potentially unintended negative outcome of increasing the manipulation of real activities, which may be even more costly to investors in the long run. Therefore, regulators should be mindful of a more complete picture of the earnings management consequences of the comment letter process.

The full paper is available for download here.

May 31, 2016
Holding Activists and Proxy Advisory Firms Accountable?
by David Katz, Laura McIntosh, Wachtell Lipton
Editor's Note:

David A. Katz is a partner and Laura A. McIntosh is a consulting attorney at Wachtell, Lipton, Rosen & Katz. The following post is based on an article by Mr. Katz and Ms. McIntosh that first appeared in the New York Law Journal. Related research from the Program on Corporate Governance includes The Long-Term Effects of Hedge Fund Activism by Lucian Bebchuk, Alon Brav, and Wei Jiang (discussed on the Forum here); The Myth that Insulating Boards Serves Long-Term Value by Lucian Bebchuk (discussed on the Forum here); The Law and Economics of Blockholder Disclosure by Lucian Bebchuk and Robert J. Jackson Jr. (discussed on the Forum here); and Pre-Disclosure Accumulations by Activist Investors: Evidence and Policy by Lucian Bebchuk, Alon Brav, Robert J. Jackson Jr., and Wei Jiang.

The nation’s capital is center stage for the latest round of debates as to the impact of shareholder activism on American business. With the introduction of the Brokaw Act by four Democratic senators in March, followed by the announcement in May of a new D.C.-based lobbying organization formed by a bipartisan group of prominent activists, the long-running controversy over the unprecedented influence of shareholder activism has officially reached Washington. The activist agenda now includes public policy, and it appears that the influence of these powerful investors is to be wielded on K Street as it has been on Wall Street. By raising their own profile via a Washington-based lobbying entity, activists will place themselves and their business practices squarely in the spotlight. Perhaps a more significant public presence will engender a more favorable reputation for activists, or perhaps it will increase activist accountability to lawmakers and public shareholders; or, perhaps, it will do both.

At the same time, lawmakers are taking significant steps toward much-needed regulation of proxy advisory firms. With a bipartisan bill introduced this week, Congress outlined a comprehensive oversight framework for increasing the transparency and accountability of proxy advisory firms.

Rising Activism Concern

The immense financial power of activist investors and their aggressive attacks on corporations have caused concern on Capitol Hill. Last month, Pershing Square’s William Ackman was called to testify before a Senate committee regarding his investments in Valeant Pharmaceuticals International, as well as his involvement in Fannie Mae, Freddie Mac, and Herbalife. Valeant’s notorious strategy of drug acquisitions and massive price increases had yielded higher shareholder value (for a time) but inflicted extortionate costs on hospitals and patients. During the high-profile hearings, both Democratic and Republican senators expressed outrage at the practices, which were disavowed by Ackman and outgoing Valeant CEO Mike Pearson.[1]

The Valeant hearings took place just one month after the Brokaw Act was introduced in the Senate to curb abuses of outdated disclosure laws by activist investors. Co-sponsoring Senator Tammy Baldwin (D-Wis.) had strong words directed at activists: “We cannot allow our economy to be hijacked by a small group of investors who seek only to enrich themselves at the expense of workers, taxpayers and communities.”[2] Named after a small town in Wisconsin that was bankrupted by the closing of a plant after activists targeted the company, the Brokaw Act is intended to expedite and broaden required disclosures of activity in target company stock.[3]

The Brokaw Act would direct the U.S. Securities and Exchange Commission to amend the §13(d) reporting rules in several key ways. First, the Brokaw Act would reduce the 10-day filing window for an initial Schedule 13D filing to two business days. Second, it would require the disclosure of short positions over 5 percent on Schedule 13D. Third, it would expand the definition of beneficial ownership to include a direct or indirect pecuniary interest, in addition to voting or dispositive power. Investors would therefore have to include shares held in swaps and other cash-settled derivatives, not merely equity securities or securities convertible into equity securities. Fourth, the Brokaw Act would specifically require the disclosure of activity by hedge funds and groups of hedge funds under §13(d). The explicit inclusion of hedge funds in the definition of “persons” is a signal that the SEC is directed to pay close attention to activists and to “wolf pack” activity intended to evade the disclosure requirements. These four amendments would significantly increase the transparency and fairness of the disclosure rules, closing loopholes that are routinely exploited by activists and other sophisticated investors. The proposed revisions would result in higher quality information released in a timelier fashion, to the benefit of the public equity markets.[4] Although the Brokaw Act does not go far enough to close all of the loopholes available to activists, it would be a significant step forward.

The Brokaw Act was introduced by Sen. Baldwin along with Sen. Jeff Merkley (D-Ore.) and co-sponsored by fellow Senators Elizabeth Warren (D-Mass.) and Bernie Sanders (D-Vt.). As election-year legislation sponsored by Democrats in the Republican-controlled Senate, the Brokaw Act is unlikely to be enacted in the foreseeable future. Yet the benefits of the proposed reforms would be wide-ranging and nonpartisan. Just as senators on both sides of the aisle joined to condemn Valeant’s business practices in the April hearings, Republicans and Democrats should unite to support this modernizing legislation.

Activists Respond

Earlier this month, a new lobbying effort was announced by a group of activist investors. The Council for Investor Rights and Corporate Accountability (CIRCA) is “committed to promoting the actions of shareholder activists, and their positive impact on corporate governance and business policies at publicly traded companies.”[5] In other words, the organization will advocate for activists’ interests in Washington and generally seek to further the activist agenda, including by making the case that shareholder activism benefits publicly traded companies, their shareholders, and by extension, the economy in general. CIRCA reportedly is a coordinated effort by Ackman, Carl Icahn, Daniel Loeb of Third Point, Paul Singer of Elliott Associates, and Barry Rosenstein of Jana Partners. [6] These investors manage roughly $90 billion of assets and have publicly targeted a wide range of well-known companies, with varying results.

CIRCA clearly is intended to counter the anti-activist momentum that has been gathering among lawmakers and market participants alike. This is not the first such effort; in 2008, Carl Icahn established the United Shareholders of America group, which was intended to be “a voice for large and small Washington to combat pro-management forces.” [7] The “U.S.A.” as it was known, seems to have been a relatively short-lived effort that has been subsumed into Icahn’s personal endeavors. CIRCA, by contrast, appears to be a higher-profile and more ambitious effort.

In Washington, the Valeant hearings, the proposed Brokaw Act, and the presidential campaign rhetoric in this election cycle no doubt have left activists feeling increasingly vulnerable to the possibility of legislation unfavorable to their interests. On Wall Street, criticism from prominent institutional investors of activists’ “short-termism” and collusive tactics have put activists on the defensive. Last year, BlackRock chairman and chief executive Larry Fink pointed to “the proliferation of activist shareholders seeking immediate returns” as a significant concern for companies trying to build long-term value.[8] The activists behind CIRCA had been discussing for several years the possibility of forming an organization, reportedly prompted by the formal petition for amendments to the §13(d) disclosure requirements submitted to the SEC by Wachtell, Lipton, Rosen & Katz in 2011, and with CIRCA they have now formalized their efforts.[9] According to news reports, the organization intends to eschew political action and focus on convincing policy makers and the public that their activities create value for shareholders generally.

Activists and Accountability

Shareholder activists often claim to be a countervailing force against the power of entrenched boards of directors. According to a CIRCA representative, “CIRCA was founded on the widely accepted idea that a well-functioning system of checks and balances between boards of directors and shareholders is fundamental to long term economic growth and U.S. prosperity.”[10] Activists assert that their demands for change in corporate strategy, management, board composition, and other elements of corporate governance serve to hold boards accountable for their decisions and performance. CIRCA’s mission appears to be to convince lawmakers and the public that activists serve the public good.

The activist lobby is likely to have something of an uphill battle. In the populist, anti-financial-industry mood of the moment, exacerbated by the rhetoric of presidential candidates, sophisticated investors are viewed as predators rather than protectors of the investing public. Moreover, thoughtful and influential leaders continue to point to activists as inimical to worthwhile corporate goals. Larry Fink’s February 2016 letter to S&P 500 chief executives encouraged companies to clearly articulate long-term plans for value creation as a defense against the superficially attractive but typically short-term visions of activists.[11] In the same vein, Leo E. Strine, chief justice of the Delaware Supreme Court, observed in March 2016 that, all too frequently, companies faced with activist attacks suddenly change their corporate strategy rather than staying with a pre-existing business plan that has been regularly and deeply reviewed by the board and senior management.[12] Chief Justice Strine has written in recent years about the dangers of short-term investors’ dominating corporate decisionmaking and has advocated for the creation of a system that will employ shareholders’ rights in a way “that is more beneficial to the creation of durable wealth for them and for society as a whole.”[13]

Taking an optimistic look ahead, it is just possible that activist lobbying may end up creating a situation in which activists are compelled to change their practices for the better. Making the public case for activism runs the risk of drawing more negative attention to activists’ enormous financial power, unscrupulous tactics, and mixed records of successes and failures. In trying to demonstrate that they hold boards accountable and benefit the American economy, activists may find that they themselves are held more accountable than ever before. And, just as Ackman found himself repudiating the controversial business practices of Valeant under the glare of the Senate hearings, activists engaged in public dialogue with lawmakers and other leaders may find themselves renouncing some of their more egregious, short-termist tactics. To the extent that activists attempt to style themselves the champions of Main Street investors, they will feel pressure to defend, mitigate, or abandon their obviously self-serving activities.

The dynamics of a meaningful activist lobbying effort will be interesting to observe. It certainly could be a welcome development if it leads somehow to a greater focus by activists, other investors, and corporations alike on strategic planning and meaningful long-term value creation. Perhaps unlikely, nonetheless such an outcome would indeed represent a “positive impact” of activist efforts on Wall Street, Main Street, and the American economy.

Proxy Advisory Firm Reform Act

Another bill, introduced in the House of Representatives on May 24, 2016, aims to create an oversight framework for proxy advisory firms such as ISS and Glass Lewis.[14] The Proxy Advisor Firm Reform Act of 2016, introduced by Rep. Sean Duffy (R-Wis.) and Rep. John Carney (D-Del.), would require proxy advisory firms to register with the SEC. As part of the registration process, a firm would have to provide information regarding its procedures and methodologies, its organizational structure and whether it has a code of ethics. In addition, addressing a widespread concern, a proxy advisory firm would have to disclose any potential or actual conflicts of interest created by its ownership structure and the services it provides to clients, including whether it engages in consulting services for companies, its largest clients (which can be disclosed confidentially to the SEC), and the policies and procedures in place to manage conflicts that may arise in this context.

Under the proposed legislation, registered proxy advisory firms would have to file an annual report with the SEC containing information on the number of shareholder proposals reviewed in the past year, the number of recommendations that were made, how many employees reviewed the proposals, and how many of the proposals were sponsored by clients of the proxy advisory firm. Proxy advisory firms also would be required to file and make publicly available their policies regarding the formulation of their proxy voting policies and voting recommendations. The bill would give corporations the right to review and comment on a proposed recommendation by a proxy advisory firm before the recommendation is provided to investors. Corporations would have a private right of action against a proxy advisory firm that did not provide this opportunity. Finally, registered proxy advisory firms would be required to appoint an internal compliance officer.

This bill would represent a significant step toward much-needed oversight of unduly influential proxy advisory firms. It would dramatically increase transparency and improve accountability, going well beyond the scope of the SEC’s 2014 Staff Legal Bulletin No. 20. The issuance of SLB 20 followed a concept release and roundtable by the SEC and addressed several important issues relating to proxy advisory firms. SLB 20 clarified the duties and obligations of proxy advisors and of investment advisors that rely on proxy advisors’ services. Still, more is needed, and as former SEC Commissioner Daniel Gallagher noted in his testimony before the House Financial Services Committee on May 17, the proposed legislation “would pick up where SLB 20 left off by providing a comprehensive regulatory regime to address many of the fundamental concerns that still remain regarding the activities of proxy advisers.”[15]

Increased accountability for activists and for proxy advisory firms would be highly beneficial to corporate America. It is to be hoped that Congress will give the Brokaw Act and the Proxy Advisory Firm Reform Act full and fair hearings and that, ultimately, bipartisan support for both bills will result in a significantly improved regulatory environment for both investors and public companies.


[1] See Cynthia Koons & Anna Edney, “Ackman, Valeant Offer Apologies, Concessions at Drug Hearing,”, April 27, 2016, available here.
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[2] See Donna Borak & David Benoit, “Democrats Take Aim at Activist Investors,”, March 17, 2016, available here.
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[3] The text of the proposed legislation is available here.
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[4] Wachtell, Lipton, Rosen & Katz has consistently advocated for modernization of the reporting regime. See Theodore N. Mirvis, et al., “Legislation Calls for Important Revisions to 13(d) Beneficial Ownership Reporting Rules,” WLR&K Memorandum, March 18, 2016, and citations linked therein. The memorandum is available here.
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[5] See Reuters, “Activist Investor Heavyweights Form New Lobbying Arm,” May 18, 2016, available here.
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[6] See David Benoit, “Activist Investors Have a New Target: Washington,”, May 18, 2016, available here.
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[7] See Peter Galuszka, “Icahn Launches the United Shareholders of America,”, Oct. 13, 2008, available here.
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[8] Larry Fink’s 2015 letter is available here.
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[9] See Benoit, supra. Wachtell, Lipton, Rosen & Katz’s 2011 petition to the SEC is available here.
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[10] See Reuters, supra.
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[11] Larry Fink’s 2016 letter is available here.
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[12] See Michael J. de la Merced, “Delaware’s Chief Justice Speaks out on Big Mergers and Investors,” NY Times Dealbook, March 17, 2016, available here.
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[13] Leo E. Strine Jr., “Can We Do Better by Ordinary Investors? A Pragmatic Reaction to the Dueling Ideological Mythologists of Corporate Law,” Essay, 114 Columbia L.R. 449, 476, Jan. 31, 2011, available here.
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[14] The text of the bill, H.R. 5311, can be found here.
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[15] Testimony of Daniel M. Gallagher before the U.S. House of Representatives Committee on Financial Services, “Legislative Proposals To Enhance Capital Formation, Transparency, and Regulatory Accountability,” May 17, 2016, at 11.
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May 31, 2016
UK Referendum and "Brexit"
by Ian Patrick Meade, Christopher Leonard & Tim Pearce
What's happening?
  • On 23 June, the United Kingdom is holding a referendum on withdrawing from the European Union. A vote to leave is forecast to have significant impacts on financial markets and participants in those markets on a global basis. These forecast impacts include short-term extreme volatility in global currency, equity and fixed income markets in the immediate aftermath of a vote to leave. Long term forecast impacts include destabilization of the EU as whole, significant impact on U.S./EU trade, and massive dislocations in the valuations of European banks and brokers, along with a range of other macroeconomic factors.
  • Why is this important?
    • The outcome is almost impossible to predict. Polling is consistently in the 46/44 remain/leave range, with the remaining 10 percent being “undecided.” Statisticians believe that the majority of the undecideds are more likely to vote to leave the EU. The timing of the vote also minimizes likely turnout amongst younger voters, who are more likely to remain.  In short, the markets are getting very worried.
    • International investors are already reducing their European exposures in anticipation of a vote to leave. Some are saying that significant market dislocation is occurring in traditionally liquid markets exposed to “Brexit risk.”
    • Some predictions suggest that a vote to leave would be the single most significant event in financial markets since the insolvency of Lehman Brothers in 2008, with potentially much broader long term ramifications for international trade. (For example, the euro and the pound would devalue, and there would be a flight to the U.S. dollar, leaving the Fed in a position where it may have to hold or cut rates, rather than raise as intended.)
    What is the relevant law?
    • U.K. and EU constitutional rules deal with the process for Brexit. They are likely not fit for purpose if the relevant process is initiated.  The European treaties anticipate a two-year “notice period” in which a leaving member’s new relationship with the EU can be agreed.  It would be optimistic to believe that a comprehensive agreement could be reached within that time frame.
    • All significant U.K. legislation and rules relating to fund managers and funds are derived from EU rules. A vote to leave, or a disputed “close call” result, will likely disrupt these legislative frameworks significantly, both in the United Kingdom and more widely across the EU.
June 1, 2016
Between Bridges (June 1, 2016): CFTC to Hold Public Roundtable Regarding Regulation AT; Five Topics To Be Discussed Including Who Should be Covered
by Gary DeWaal

The Commodity Futures Trading Commission announced last week that staff will host a public roundtable to discuss five aspects of Regulation Automated Trading, initially proposed in November 2015.

The broad matters to be addressed are

  • the definition of direct electronic access;
  • market participants covered by Regulation AT;
  • alternatives to the Commission’s proposed requirements to mandate pre-trade risk controls and system testing by all impacted registrants that engage in algorithmic trading;
  • how impacted registrants might comply with Regulation AT’s requirements when using third-party software or systems; and
  • source code retention and access.

The roundtable will be held on June 10, 2016, at the CFTC offices in Washington, DC beginning at 9 am.

In addition, the CFTC announced that, in conjunction with the roundtable, it would reopen the comment period for Regulation AT for items on its agenda, as well as items that may come up during the roundtable. The supplemental comment period will run from June 10 through June 24, 2016.

No panelists have yet been named by the CFTC. In connection with the session on how registrants might comply with certain of Regulation AT's requirements when using third-party software or systems, the CFTC suggested that staff would present possible alternatives.

(Click here for a comprehensive overview of Regulation AT in the article, “CFTC’s Proposed New Algorithmic Trading Rules Augur Potential Increased Obligations and Costs, and a New Registration Requirement” in the November 29, 2015 edition of Between Bridges. Click here for a summary of industry comments in the article, “Industry Comments to Regulation AT Argue CFTC Proposed Rules Too Prescriptive; Registration and Source Code Requirements Particularly Objectionable” in the March 20, 2016 edition of Bridging the Week.)

My View: It seems that CFTC staff has now completed its review of the over 50 comment letters the Commission received in response to Regulation AT from a broad spectrum of industry participants. Although no analysis was provided in conjunction with the release of the agenda for the June 10 roundtable, it appears that staff may be struggling with the Commission’s expectation that Regulation AT would likely impact only 420 registrants (including 100 new persons required to register as Floor Traders). However, it appears that Regulation AT could significantly impact a large percentage of all existing CFTC registrants (this universe constituted 3,953 persons as of April 30, 2016, including 2,557 commodity pool operators and commodity trading advisors), that employ smart order routing systems, let alone idea origination software.

To the extent a larger than expected number of registrants are within the scope of Regulation AT, staff appears to be considering how to reduce application of many of the requirements of the proposed rules for a good number of such persons – in particular the obligation to implement and utilize pre-trade risk controls and engage in system monitoring and testing. There appears to be thought that futures commission merchants could perform all risk control requirements for all or at least a substantial portion of all customer orders. There also appears to be thought that, to the extent that certain customers are still required to apply their own risk controls and engage in system testing, FCMs could “perform due diligence regarding such customers’ compliance” with applicable requirements.

Finally, there seems to be some desire to consider alternative ways to determine who must be registered as Floor Traders and, even possibly, who should be covered by Regulation AT at all. Although proposed Regulation AT suggests direct electronic access being the trigger for a non-registrant to be required to register as a Floor Trader, staff appears to considering whether a quantitative measure of some kind should provide the basis for triggering so-called “AT Person” status, including registration as a Floor Trader. This would be more consistent with the likely European outcome under the Markets in Financial Instruments Directive II scheduled to take effect in January 2018 for so-called “high frequency traders.”

June 1, 2016
SEC, Financial Reporting, and Financial Fraud
by Andrew Cauchi, Paul Ferrillo, Robert Carangelo, Weil Gotshal
Editor's Note:

Paul A. Ferrillo is counsel at Weil, Gotshal & Manges LLP specializing in complex securities and business litigation. This post is based on a Weil publication by Mr. Ferri, Robert F. Carangelo, and Andrew Cauchi; the complete publication, including footnotes, is available here

For those who have been through multiple business cycles, the SEC’s recent focus on financial fraud and accounting irregularities is nothing new. While there have been periods of time during which the SEC focused on financial fraud, there are also intervals when other issues are more prominent, like the most recent financial crisis.

Nevertheless, it appears that the SEC is once again paying increased attention to financial reporting cases. In 2015, the SEC brought enforcement cases against 191 parties (in contrast to 128 parties in 2014), a significant increase over prior years. Simply scanning the list of settled enforcement cases supports SEC Chair White’s recent statement that the SEC “has reinvigorated its investigative and enforcement efforts” in this area, and is closely scrutinizing “the gatekeepers of financial reporting, continuing to hold accountants, auditors, and audit committees accountable under appropriate circumstances.”

Below, we will discuss the potential reasons for a renewed focus on financial reporting and financial fraud. We also will review recently reported settled SEC actions relating to financial fraud. Issuers need to be careful not to take shortcuts around recognized accounting rules or their accounting advisors.

The SEC’s Renewed Focus on Financial Reporting and Financial Fraud Cases

There are numerous reasons why in every recent speech SEC Chair White, Director of Enforcement Andrew Ceresney and Margaret McGuire, Chair of the SEC’s Financial Reporting and Audit Group (“the FRAud Group”) are talking about accounting cases.

One driver may be the state of the economy in the United States today. As Chair White noted in a recent speech about the abundance of “unicorn” valuations among certain startup companies, over the last several years, the Internet has spawned many well-known companies. Indeed, as Chair White recently noted in a speech made in Silicon Valley (discussed on the Forum here),

We all know the significant impact that technology innovation coming from Silicon Valley continues to have on our lives. We see the effect everywhere—companies that trace their start to basements, shared office spaces and classrooms are changing how we get around our cities, how we analyze big data, how we find places to stay when we travel, how we communicate with each other, and even how we put satellites in space.

But perhaps this technological innovation comes with certain costs. As Chair White noted, for as many companies that are monumental successes, there are a far greater number of failures. And for as many companies that are well funded, “70 percent of failed start-ups die within 20 months after their last financing, having raised an average of $11 million.” The race to start companies created the need to capitalize and fund them, and raising money from stockholders has required companies to make disclosures regarding their potential success. But as a result of this quest to tap the capital markets for funds, there are “implications of this trend for investors, including employees of these companies, who are typically paid, in part, in stock and options. These are areas of concern for the SEC and, I hope, an important focus for entrepreneurs, their advisers, as well as investors.”

Another impetus for more SEC cases involving financial reporting may simply be that technology has created a tremendous ability for the SEC to review terabytes of information in financial statements almost instantaneously. As noted in recent speeches by Mr. Ceresney and Ms. McGuire, the SEC has new tools such as the its Corporate Issuer Risk Assessment tool (“CIRA”), which through “Big Data” technology, allows the SEC to review more than 100 different accounting methods and metrics to examine whether “things look funny” or not, “at the click of a mouse.”

Recent SEC Enforcement Actions

On June 5, 2015, the SEC entered into a settlement with Computer Sciences Corporation (“CSC”) and some of its former executives for allegedly manipulating financial results and concealing problems related to the company’s largest and most valuable contract. CSC entered into a contract with the United Kingdom’s National Health Service (“NHS”) to build an electronic patient-record system. The parties amended the contract after CSC ran into problems developing the software, and it ultimately became clear that CSC was not going to be able to develop the system at all. In fact, CSC received several notices from the NHS that it was in default of the contract.

The SEC alleged that its disclosure rules and Generally Accepted Accounting Principles (“GAAP”) required the company to disclose the fact that it would likely experience material adverse financial consequences due to its failure to perform the NHS contract. However, CSC did not make any such disclosures despite having actual knowledge that it was in default on the NHS contract. To the contrary, CSC’s CEO Michael Laphen reported to investors that the contract was profitable and would be completed on schedule. CSC’s financial executives, including CFO Michael Mancuso, purportedly added items to the company’s accounting models that had no basis in reality, resulting in artificial and inflated income. Furthermore, the SEC alleged that with Laphen’s approval, CSC based its accounting models on the contract amendments it was proposing to the NHS rather than the actual contract.

The penalties for CSC were severe: although it did not admit to liability, CSC paid a $190 million fine. Five of the eight executives charged also agreed to settlements without admitting the charges. Laphen agreed to pay a $750,000 penalty and return to CSC more than $3.7 million under the clawback provision of Sarbanes-Oxley. Similarly, Mancuso agreed to return $369,100 in compensation and pay a $175,000 penalty.

The SEC took aim at financial reporting again in an action against a consumer financial services company Bankrate and several of its executives. Former Bankrate CFO Edward DiMaria, along with former finance and accounting executives Matthew Gamsey and Hyunjin Lerner, allegedly schemed to artificially increase revenues and decrease expenses to meet analyst estimates for Bankrate’s EBITDA. DiMaria purportedly directed two divisions of the company to book “round” dollar amounts of additional revenue with no support. The complaint also alleged that Bankrate improperly reduced certain expenses or failed to book them at all. When Bankrate’s stock rose as a result of the inflated financial results, DiMaria allegedly sold more than $2 million in company stock.

Without admitting or denying the charges, Bankrate agreed to pay a $15 million penalty. In a separate complaint filed against DiMaria and Gamsey in the Southern District of New York, the SEC is seeking financial penalties, officer-and-director bars, and prohibitions in working in public company accounting. The SEC is also seeking to recover the profits obtained by DiMaria when he sold his stock following the release of the inflated financial results.

More recently, on March 31, 2016, the SEC charged Navistar International Corp. with misleading investors about its development of an advanced technology truck engine and its potential certification by the Environmental Protection Agency (“EPA”). Navistar settled the charges by paying a $7.5 million fine, without admitting or denying the charges. However, in a separate complaint filed in the Northern District of Illinois, the SEC charged former Navistar CEO Daniel Ustian with misleading investors and aiding and abetting violations.

The SEC alleged that Navistar and Ustian failed to fully disclose the company’s difficulties in having its new truck engine meet U.S. emissions standards. The complaint alleges that the EPA reported to Navistar on several occasions that it had serious concerns about the company’s engine and that the engine would not likely be approved by the agency. However, in the company’s 2011 Form 10-K, Navistar reported that the company believed the engine met the EPA’s certification requirements and that the agency was planning on certifying the engine.

Gatekeepers are in the Crosshairs Again

Like its historical attention to financial reporting and financial fraud in general, the SEC has always focused on “the gatekeeper,” which includes audit committee members and a company’s outside auditors. In his recent speech to the Directors Forum, Mr. Ceresney noted:

Audit committee members and external auditors in particular are among the most important gatekeepers in this process, and each has a responsibility to foster high-quality, reliable financial reporting. We recognize that audit committee members and auditors exercise a significant amount of judgment on a day-to-day basis and we are not in the business of second-guessing good faith judgments. However, audit committee members who fail to reasonably carry out their responsibilities, and auditors who unreasonably fail to comply with relevant auditing standards in their audit work, can expect to be in our focus.

In this new era of technological innovation, it is likely the SEC will continue to focus on the gatekeeper function as a check against the rush to “unicorn” valuations and their eventual quest for a liquid exit.

There are lessons to be learned from recent SEC actions: (1) audit committee members need to insist on independence from their auditors, and listen to them when they push back on management calculations; (2) audit committee members need to insist on a robust financial reporting process and challenge management when necessary; and (3) when audit committee members learn of potential misconduct, they need to learn the facts before SEC filings are made.

“CIRA” Gives the SEC More Visibility into Financial Reporting Matters

It is not surprising that technology exists to automate the review of audited financial statements. As noted in many SEC speeches, they do exist and are being applied to audited financial statements that have been filed with the SEC. As Mr. Ceresney noted in his Directors Forum speech, “CIRA provides us with a comprehensive overview of the financial reporting environment of Commission registrants and assists our staff in detecting anomalous patterns in financial statements that may warrant additional inquiry. CIRA’s multiple dashboards enable the staff to compare a specific company to its peers in order to detect abnormal, relative results, focus on particular financial reporting anomalies, and generate lists of companies that meet the criteria for further analysis.”

In some cases, based upon the metric in question, there could be “false positives.” CIRA is only as good as the search algorithm employed by the examiner and can only provide results that are “data” driven. In the case of a false positive, an issuer should generally have nothing to fear. The computation might be explainable with context and thus should not raise concern. There could also be a “positive” finding as well, indicating a potential anomaly in the issuer’s financial statements. That might mean at the very least the issuer’s file might find itself moved up in the review process. At the other end of the spectrum is a positive finding by CIRA, coupled with a whistleblower’s allegations, which likely will draw the SEC’s attention quickly. CIRA’s big contribution to the SEC is its ability to do more with less, meaning in an era of flat budgets or reduced budgets, the SEC will still have the ability to monitor its registrants.

As noted by Chair White in her address in Silicon Valley, technological innovation has forever changed the United States and the world. Technological innovation has created some of the world’s largest businesses and market capitalizations. It has also changed the method in which businesses conduct their day-to-day business. Businesses can take advantage of the latest tools to store, compile and use information, detect customer habits, and to run their businesses more efficiently and profitably. They can even conduct their businesses in the cloud and thus not be tied to any one location. However, issuers must recognize that the SEC has access to the latest technology, as well, which gives the Commission the ability to view—and in some circumstances, scrutinize—issuers’ financial statements more readily and rapidly than before.

The complete publication, including footnotes, is available here.

June 1, 2016
5 Wishes for Securities Litigation Defense: Greater Insurer Involvement in Defense-Counsel Selection and Strategy
by Douglas W. Greene

One of my "5 Wishes for Securities Litigation Defense" last month was for greater D&O insurer involvement in securities class action defense.

This simple step would have extensive benefits for public companies and their directors and officers. D&O insurers are repeat players in securities litigation, and they have the greatest economic interest in the outcome – both in particular cases, and overall. They want the defendants – their insureds – to win. They employ highly experienced claims professionals, many of whom have been involved in exponentially more securities class actions than even the most experienced defense lawyers.

Given insurers’ stake and expertise, defendants should involve them in key strategic decisions – working with them to help find the right defense counsel for the particular case, to help shape the overall defense strategy at the inception of the case, and to help make good decisions about the use of policy proceeds. With such an approach, I have no doubt that directors and officers would make it through securities cases more successfully, efficiently, and comfortably.

Yet in most cases, insurers are shut out of meaningful involvement in the defense, with many defense lawyers treating them almost like adverse parties, and other defense lawyers merely humoring them as they would a rich relative. Although this dysfunction is rooted in a complex set of factors, it could easily be fixed.

Why Are D&O Insurers Alienated?

When the general public thinks about insurance, they usually think of auto insurance or other duty-to-defend insurance, under which the insurer assumes the defense of the claim for the insureds. In contrast to duty-to-defend insurance, public company D&O insurance is indemnity insurance, under which the insurer is obligated to reimburse the company and its directors and officers for reasonable and necessary defense costs and settlement payments, up to the policy’s limit of liability.

Indemnity insurance gives the defendants control over the litigation, including counsel selection and strategic approach, with the insurer retaining limited rights to participate in key decisions. Although those rights give insurers a foot in the door, competitive pressures among primary D&O insurers work to minimize insurers’ involvement. For example, an insurer faced with unreasonably high defense costs must decide whether to pay them in full to avoid conflict, or to pay only the "reasonable and necessary" amounts, as the policy specifies – an approach that maximizes the policy proceeds for the insureds by not squandering policy limits on excessive legal fees. But if the insurer pays only reasonable and necessary amounts, it may be criticized in the marketplace by the broker or other insurers as being stingy with claims handling – and the insureds may be left holding the bill for the unreasonable excess fees.

In general, insurers take a relatively hands-off approach to D&O claims because they assume that their customers want them to stay out of the defense of the claim. But in my experience, this is a misconception. The priority for most companies and their directors and officers is simply the greatest protection possible, including assurances that they will not be left to pay any uncovered legal fees or settlement payments. In fact, not only do most insureds not want to be stuck paying their lawyers for short-pays, they don’t even want to write any checks at all after satisfying the deductible – instead preferring the insurer to take charge of the bills and pay the lawyers and vendors directly.

In other words, most public companies actually want their D&O insurance to respond more like duty-to-defend insurance. And if given a choice between having the freedom to choose any defense counsel and having total control over the defense, and saving on their premium and giving the insurers greater rights to be involved, I’m confident most public companies would choose to save on the premium, as long as they are confident that they will still be well-defended. This is especially so for smaller public companies, for whom the cost of D&O insurance can be a hardship, and against whom the plaintiffs’ bar is bringing more and more securities class actions. And few companies, large or small, would knowingly spend more on their premiums just to subsidize skyrocketing biglaw partner compensation – the D&O insurance elephant in the corner of the room.

Why do insurers have this misconception? To be sure, after a claim is filed, the insurer often gets an earful from the insureds’ lawyers and broker about the insureds’ indemnity-insurance freedoms. But these aggressive positions are typically not the positions of the insureds themselves. Instead, these positions are driven by defense counsel, usually for self-interested reasons: to get hired, to justify excessive billing, or to settle a case for a bloated amount because the defense is compromised by mounting defense costs or the defense lawyer’s inability to take the case to trial.

Frequently, defense lawyers will set the stage for their clients to have a strained relationship with their insurers by feeding them a number of stock lines:

  • This is a bet-the-company case that requires all-out effort by us to defend you, so we have to pull out all the stops and do whatever is necessary, no matter what the insurer has to say.
  • The insurer may ask you to interview several defense firms before choosing your lawyers. Don’t do that. They’ll just want to get some inferior, cut-rate firm that will save them money. But you’ll get what you pay for – we’re expensive for a reason! (And don’t forget that we have stood by you, through thick and thin, since before your IPO, back when you were a partner here. Plus, we gave you advice on your disclosures and stock sales, so we’re in this together.)
  • The business of any insurance company is to try to avoid paying on claims, so the insurer may try to curtail our level of effort, and may even refuse to pay for some of our work. But trust us to do what we need to do for you. You might need to make up the difference between our bills and what the insurer pays, but we can go after the insurer later to try to get them to pay you back for those amounts.
  • The insurer will ask us for information about the case. They’ll say they want to help us, but they’re really just trying to find a way to deny coverage.
  • We’ll tell you when we think the time is right to settle the case, and for how much. The insurer will try to avoid paying very much for settlement. But if we say the settlement is reasonable, they won’t have a leg to stand on.
  • We’ll need you to support us in these insurance disputes. You don’t need to get involved directly – we can work with the insurer and broker directly if you agree. Agree? Good.

In this way, defense lawyers set the insurer up as an adversary. But these self-serving talking points get myriad things wrong.

First, and most importantly, D&O insurers are not the insured’s adversaries in the defense of a securities class action. To the contrary, insurers’ economic interests are aligned with those of the insureds. Insurers want to help minimize the risk of liability, through good strategic decisions. Although keeping defense costs to a reasonable level certainly benefits the insurer, it also benefits the insureds by preserving policy proceeds for related or additional claims on the policy, so that the insureds will not need to pay any defense or settlement costs out-of-pocket, and will avoid a significant premium increase upon renewal. And insurers want their insureds to have superior lawyers – inferior lawyers would increase their exposure. Their interest in counsel selection is to help their insureds choose the defense counsel that is right for the particular case. The key to defense-counsel selection in securities class actions, for insureds and insurers alike, is to find the right combination of expertise and economics for the particular case – in other words, to find good value.

A D&O insurer’s business is not to avoid paying claims. D&O insurance is decidedly insured-friendly – which isn’t surprising given its importance to a company’s directors and officers. D&O insurers pay billions of dollars in claims each year, and there is very little D&O insurance coverage litigation. Although D&O insurance excludes coverage for fraud, the fraud exclusion requires a final adjudication – it does not even come into play when the claim is settled, and even if the case went to trial and there was a verdict for the plaintiffs, it would only be triggered under limited circumstances. Indeed, if they are utilized correctly, D&O insurers can be highly valuable colleagues in securities class action defense. Because they are repeat players in securities class actions, they are able to offer valuable insights in defense-counsel selection, motion-to-dismiss strategy, and overall defense strategy. They have the most experience with securities class action mediators and plaintiffs’ counsel, and often have key strategic thoughts about how to approach settlement. The top outside lawyers and senior claims professionals for the major insurers have collectively handled many thousands of securities class actions. Although their role is different than that of defense counsel, these professionals are more sophisticated about securities litigation practice than the vast majority of defense lawyers.

I have achieved superior results for many clients by working collegially with insurers – from helping shape motion-to-dismiss arguments, to learning insights about particular plaintiffs’ lawyers and their latest tricks, to selecting the right mediator for a particular case, to achieving favorable settlements that don’t leave the impression of guilt. Treating insurers as adversaries robs defendants of this type of valuable guidance.

How Can We Achieve Greater Insurer Involvement?

D&O insurers should set aside their preconceived notions about what the insureds really care about and want. Insurers need to appreciate that their insureds often welcome their expertise and experience – especially at smaller public companies that have less familiarity with securities class actions, and a more pressing need to control their costs. Not only is there an opportunity for greater involvement within the current D&O insurance product, but there is a market for new terms and products that allow greater insurer involvement, with corresponding premium or coverage advantages to the insureds.

Many insurers correctly address their claim-handling capabilities as part of the underwriting process. As part of this discussion, insurers should set the expectation that the insureds will consult with the insurer about the defense-counsel selection process before the defendants select counsel. Insurers have a unique perspective on the pros and cons of particular defense counsel, since they know the capabilities and economics of the relatively small bar of securities class action defense counsel very well. They can help the insureds identify several defense firms that would be a good match for the substantive characteristics of the case. For example, they might know that a particular firm has helpful experience in cases involving a particular industry or type of allegation, or has a good or bad track record with the assigned judge. Insurers can also help match the economics of the litigation with particular firms. They would know whether or not a particular firm is able to effectively defend a case within the limits of the D&O insurance, and conversely, they would know whether a firm has enough resources to effectively handle a large claim.

Although I am not an insurance lawyer, I believe this type of discussion is perfectly appropriate within the terms of existing insurance contracts. But if there is any doubt, existing policy forms could be tweaked to explicitly include greater insurer involvement. For example, the insurance contract could require the insureds to consult with the insurer about the defense-counsel process before engaging defense counsel, such as with a provision similar to the explicit requirement in D&O policies that insureds speak with the insurer before engaging in any settlement discussions.

Last, but certainly not least, I strongly believe that a public company duty-to-defend product for a "Securities Claim" would be highly attractive to many public companies, especially smaller companies. Many companies would gladly pay somewhat less for their D&O insurance in exchange for giving insurers somewhat greater control, as long as they know that they will be defended well. Such a policy would eliminate the risk that clients will have to make up for insurance short-pays, as they are often asked to do under indemnity insurance, while allowing the insurers to manage defense costs to help ensure that the policy proceeds will adequately cover the cost of defending and settling the litigation, and will not be needlessly expended. As the cost of securities class action defense continues to skyrocket, even as the size of the typical securities case continues to decline, it is time for the D&O insurance industry to consider introducing a product that will provide excellent coverage at a fair price that is affordable to smaller companies.

June 1, 2016
SEC Request For Declaratory Relief, Injunction Time Barred
by Tom Gorman

In Gabelli v. SEC, 133 S.Ct. 1216 (2013) the Court cautioned against leaving "defendants exposed to Government enforcement action . . . for an additional uncertain period into the future" beyond the five year limitation period of §2462 of Title 28. The High Court then concluded that the cause of action in an SEC enforcement action accrues when the alleged conduct occurred, not at some later point when it is discovered. The first circuit, construing the same statute, found that its time limits delimit the remedies available to the SEC. SEC v. Graham, No. 14-13562 (1st Cir. May 26, 2016).

The SEC filed an enforcement action against Barry J. Graham and others claiming that they sold unregistered securities in violation of the federal securities laws. Specifically, between November 2004 and July 2008 the defendants raised over $300 million from about 1,400 investors, selling unregistered securities. The agency filed its complaint on January 20, 2013. On cross-motions for summary judgment the district court dismissed with prejudice the SEC’s complaint as time-barred.

Section 2462 bars any action "for the enforcement of any civil fine, penalty, or forfeiture" if brought more than five years from the date the claim first accrued. Here the SEC sought injunctive and declaratory relief and disgorgement. The circuit court rejected the claim that the Section applied to the Commission’s request for injunctive relief. An injunction is an equitable remedy that is concerned with future conduct. As such it cannot be a penalty as that term is used in §2462. While that term is not defined in the statute, a penalty typically addresses a wrong done in the past. Since it is backward looking it is, in effect, the opposite of an injunction which is concerned only with the future. Accordingly, an injunction is not a penalty within the meaning of §2462.

The same cannot be said of the SEC’s request for declaratory relief the court concluded. The district court correctly concluded that the Section bars this request for relief. Declaratory relief is backward looking like a penalty. It is a "public declaration that the defendants violated the law [and] does little other than label the defendants as wrongdoers." The SEC’s contention that that such findings are the predicate to obtain other remedies does not change this point. Some of the remedies the agency might seek based on a declaration, such as penalties, are time-barred; others, such as an injunction, are not. At the same time declaratory relief is not necessary to obtain an injunction. To the contrary, to secure such relief the SEC need only establish a prima facie case of prior violations of the federal securities laws and a reasonable likelihood that the wrong will be repeated.

Finally, the district court properly concluded that the SEC’s request for disgorgement is time-barred by §2462. In reaching that conclusion the court found that disgorgement is in the same category as a forfeiture which is subject to the time limits of the Section. Disgorgement is, according to Black’s Law Dictionary, the "act of giving up something (such as profits illegally obtained) on demand or by legal compulsion . . ." That definition is very similar to the one for forfeiture which is, according to the same source, the "loss of a right, privilege, or property because of a crime, breach of obligations, or neglect of duty." (internal quotations omitted).

The SEC argued that disgorgement and forfeiture are distinct concepts. That theory was built on the notion that the court’s power to order disgorgement extends only to the amount of the ill-gotten gains. The circuit court, however, rejected this contention, finding that "even under the definitions the SEC puts forth, disgorgement is imposed as redress for wrongdoing and can be considered a subset of forfeiture. Because forfeiture includes disgorgement, §2462 applies to it. Accordingly, the court affirmed in part, reversed in part and remanded the action to the district court.

June 1, 2016
Insider Trading: An I-Banker & Plumber Walk Into a Bar...
by Broc Romanek

Given the popularity of my recent blog – "Insider Trading: A Director, Golfer & Gambler Walk Into a Bar…" – I couldn't resist a follow-up when I saw this press release from the SEC yesterday. It never ceases to amaze me how dumb some people on Wall Street are when it comes to insider trading. What did the I-banker think when the SEC Enforcement Staff saw that a plumber suddenly makes 10 bets on companies who miraculously were acquired shortly after the trades? Although I guess it feels like you got away with it the first few times, you figure you're golden all the way. Anyways, this is a good teaser for tomorrow's grand webcast...

Webcast: "Yes, It’s Time to Update Your Insider Trading Policy"

Tune in tomorrow for the webcast – "Yes, It’s Time to Update Your Insider Trading Policy" – to hear Chris Agbe-Davies of Spectra Energy, Ari Lanin of Gibson Dunn, Alan Dye of Hogan Lovells and and Marty Dunn of Morrison & Foerster provide practical guidance on revisiting your insider trading policy, as well as your insider trading training program for officers, employees and directors. The panel will cover:

1. Insider Trading: The Current Enforcement Environment
2. Overview of Pre-Clearance Procedures
3. Things to Consider in Drafting/Applying the Policy (including gifts, transactions with issuer, changes of election under 401(k) plans and ESPPs)
4. Blackout Periods
5. Policy Provisions About Sharing Information With Third Parties
6. Extending Coverage Beyond Employees
7. Pledging, Hedging and Short-Selling Transactions
8. Intersection with Rule 10b5-1 Plans
9. Employee Education

Our June Eminders is Posted!

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Broc Romanek

View today's posts

6/1/2016 posts

CLS Blue Sky Blog: Gibson Dunn discusses PCAOB Issuance of Another Proposal to Change Audit Report
The Harvard Law School Forum on Corporate Governance and Financial Regulation: An Examination of Changes in Earnings Management after Receiving SEC Comment Letters
The Harvard Law School Forum on Corporate Governance and Financial Regulation: Holding Activists and Proxy Advisory Firms Accountable?
AG Deal Diary: UK Referendum and "Brexit"
Bridging the Week: Between Bridges (June 1, 2016): CFTC to Hold Public Roundtable Regarding Regulation AT; Five Topics To Be Discussed Including Who Should be Covered
The Harvard Law School Forum on Corporate Governance and Financial Regulation: SEC, Financial Reporting, and Financial Fraud
D&O Discourse: 5 Wishes for Securities Litigation Defense: Greater Insurer Involvement in Defense-Counsel Selection and Strategy
SEC Actions Blog: SEC Request For Declaratory Relief, Injunction Time Barred Blog: Insider Trading: An I-Banker & Plumber Walk Into a Bar...

Blog posts are subject to copyrights held by the authors and are republished here with permission. Views expressed are those of the authors alone. Infringement Notification.