Month-In-Brief: Securities Law

CURRENT MONTH (April 2021)

Securities Regulation

NYSE Rule Amendments

By Madeline A. Moore, K&L Gates LLP

On April 2, 2021, the Securities and Exchange Commission (SEC) approved a proposed rule change filed by the New York Stock Exchange (NYSE) to amend certain of the shareholder approval requirements and the requirements for related party transactions in the NYSE Listed Company Manual (the “Amendments”).  The Amendments are intended to align the NYSE’s shareholder approval requirements more closely with the requirements of the Nasdaq Stock Market and the NYSE American.

Prior to the Amendments, Section 312.03(b) generally required shareholder approval prior to certain issuances of common stock to “related parties.” Section 312.03(b) was amended to:

• Require prior shareholder approval for certain issuances of common stock to directors, officers, and substantial security holders of the company (each, a “Related Party”).
• No longer require shareholder approval for issuances to Related Parties’ subsidiaries, affiliates or other closely related persons or to any companies or entities in which a Related Party has a substantial interest (except where a Related Party has a 5% or greater interest in the counterparty).
• Require shareholder approval of cash sales to Related Parties only if the price is less than the minimum price (as defined in Section 312.04 of the NYSE Listed Company Manual).
• Require shareholder approval for an issuance of common stock or securities convertible into or exercisable for common stock where such securities are issued as consideration in a transaction or series of related transactions in which any Related Party has a 5% or greater interest (or such persons collectively have a 10% or greater interest), directly or indirectly, in the company or assets to be acquired or in the consideration to be paid in the transaction and the present or potential issuance of common stock, or securities convertible into common stock, could result in an increase in outstanding shares of common stock of 5% or more, or where otherwise required under NYSE rules.
• Delete two now irrelevant provisions: (1) the exemption for cash sales meeting the minimum price and relating to 5% or less of shares of common stock or voting power; and (2) the early stage company exemption. The Amendments also remove the reference to the early stage company exemption from Section 312.04.

Prior to the Amendments, Section 312.03(c) required shareholder approval of any transaction relating to 20% or more of a company’s outstanding common stock or voting power, with exceptions for public offerings for cash and “bona fide private financings.” Section 312.03(c) was amended to:

• Replace the reference to “bona fide financing” with “other financing (that is not a public offering for cash) in which the company is selling securities for cash,” thereby eliminating the requirement that, for the exception, the company sell the securities to multiple purchasers, and that no one purchaser, or group of related purchasers, acquires more than 5% of the common stock or voting power. The Amendments also eliminate the separate provision for sales to broker-dealers and delete the definition of “bona fide private financing” from Section 312.04(g).
• Provide that, if the securities in a financing (that is not a public offering for cash) in which the company is selling securities for cash are issued in connection with an acquisition of the stock or assets of another company, shareholder approval will be required if the issuance of the securities alone or when combined with such acquisition, is equal to or greater than 20% of the shares of common stock or voting power before the issuance.

Section 3.1203T, which was adopted to provide temporary COVID-19 relief from certain requirements of Section 312.03, was deleted as part of the Amendments.

Prior to the Amendments, Section 314.00 provided a general definition of related party transactions and required that each related party transaction be reviewed and evaluated by an appropriate, but unspecified, group within the company. Section 314.00 was amended to:

• Define the term “related party transaction” for purposes of Section 314.00 as “transactions required to be disclosed pursuant to Item 404 of Regulation S-K under the Exchange act (but without applying the transaction value threshold under that provision)”. For foreign private issuers, “related party transaction” refers to “transactions required to be disclosed pursuant to Form 20-F (but without regard to the materiality threshold of that provision).”
• Require that the company’s audit committee or another independent body of the board of directors conduct a reasonable prior review and oversight of all related party transactions for potential conflicts of interest and prohibit such a transaction that such body determines to be inconsistent with the interests of the company and its shareholders.

PCAOB Staff Outlines Plans for 2021 Auditor Inspections

By Thomas W. White, Retired Partner, WilmerHale

Pursuant to the Sarbanes-Oxley Act, the Public Company Accounting Oversight Board conducts a continuing inspection program that reviews selected audit engagements and quality control systems of audit firms registered with the PCAOB.  Large accounting firms are inspected annually and others every three years.  The inspection program is relevant to public companies and their stakeholders insofar as it provides useful information about auditors’ overall performance and promotes audit quality.

The PCAOB recently released two staff publications setting forth changes that it is making to inspections in 2021 and important areas of planned focus:

• The staff’s 2021 Staff Outlook for Inspections indicates that inspections will “directly focus on the effects of the [COVID-19] pandemic on public companies’ financial reporting.”  The staff plans to select audits for review in industries experiencing particularly significant disruptions or elevated risks during the pandemic.  Inspections will also focus on financial statement items and other reporting matters that have been particularly affected by the pandemic, including impairments, going concern, allowance for loan losses, and fraud risk.  The staff also states that its 2021 inspection approach will “enhance the overall unpredictability of our inspections,” by significantly increasing the percentage of audits selected randomly and selecting more “non-traditional” audit areas for inspection.  According to the staff, “this approach will encourage firms to consistently strive for the performance of quality audits on all public companies, and discourage an approach that might only focus on those audits or areas that may be perceived as more likely to be selected for review as part of a PCAOB inspection.”
• Additionally, the PCAOB released an Audit Committee Resource that suggests questions that audit committees could ask their auditors, particularly in light of the PCAOB’s focus on the financial reporting and audit risks posed by the pandemic.  Areas of potential questions include auditors’ risk assessments, firms’ quality control systems, how firms comply with auditor independence requirements, fraud procedures, critical audit matters, how firms implement new auditing standards and supervision of audits involving other auditors.

PCAOB Establishes Standards Advisory Group

By Thomas W. White, Retired Partner, WilmerHale

The Public Company Accounting Oversight Board has established a new Standards Advisory Group (SAG).  According to PCAOB Chairman William D. Duhnke III, “[b]uilding on our concerted effort to improve our outreach over the last several years, we are now taking the PCAOB’s engagement to a higher level by creating a new, more effective structure for the Board to receive advice from our stakeholders on key PCAOB initiatives.”  The new SAG replaces the Board’s previous Standing Advisory Group and Investor Advisory Group.

The purpose of the SAG is to advise the members of the PCAOB with respect to professional standards, including existing auditing and related attestation standards, quality control standards, ethics standards, and independence standards; proposed standards; and potential new or amended standards.  If requested by the Board, the SAG may also advise the Board on other matters that are of significance to the Board.

The SAG will be comprised of 18 members who will serve two-year terms, categorized as follows: 

• five members with securities investment or portfolio management experience;
• three members who are members of an audit committee or board of an entity audited by a PCAOB-registered accounting firm;
• three members who have direct or indirect responsibility for preparation of financial statements of public companies or broker-dealers;
• three members who are members of the academic community, corporate governance or corporate finance experts or have relevant specialized knowledge; and
• four members who are individuals from registered audit firms (who will be nominated by the Center for Audit Quality).

The SAG will carry out specific tasks assigned to it by the Board.  Each assigned task will be carried out by a separate task force.

March 31, 2021: SEC Division of Corporation Finance Staff Issues Cautionary Guidance Related to Business Combinations with SPACs . . .

By Hillary Holmes, Peter Wardle, Gerald Spedale, Gibson Dunn

There were more initial public offerings (IPOs) of special purpose acquisition companies (SPACs) in 2020 alone than in the entire period from 2009 until 2019 combined, and in the first three months of 2021, there have been more SPAC IPOs than there were in all of 2020. All of these newly public SPACs are looking for business combinations and many private companies are or will be considering a combination with a SPAC as a way to go public.

After an IPO, a SPAC has a limited amount of time to acquire a target company. Many of these business combinations move quickly and a private company becomes a public reporting company in a relatively short period of time. It is important for sponsors, target companies and investors to be aware of some of the special attributes of SPACs and the post-business combination public company.

On March 31, 2021, the staff of the Division of Corporation Finance (Staff) of the Securities and Exchange Commission issued a statement addressing certain accounting, financial reporting and governance issues related to SPACs and the combined company following a SPAC business combination.  In our full April 6, 2021 publication summarizing the Staff’s statement, we note key securities law considerations relating to:  

• shell company restrictions
• books and records and entity controls requirements, and
• initial listing standards of the national securities exchanges.

March 31, 2021:  . . .  And so does the Staff of the SEC’s Office of the Chief Accountant

By Rani Doyle, EY*

In a separate statement, the staff of the SEC’s Office of the Chief Accountant noted risks related to SPACS, noting several accounting areas that SPACs and SPAC targets should focus on, including:

• transition to public company disclosure requirements and US GAAP for public business entities, including reporting on segments and earnings per share;
• determination of the accounting acquirer;
• accounting for earn-out or compensation arrangements; and
• accounting for complex financial instruments including warrants.

The SEC staff emphasized the need for management of the new merged public company to understand and have a plan in place to comply with both the general requirements in the Exchange Act to maintain adequate books and records and internal controls and the specific requirements related to internal control over financial reporting and disclosure controls and procedures. The SEC staff also emphasized the importance of board oversight before, during and after the de-SPAC merger and noted that companies listed on a national stock exchange are required to have a majority of independent members and an independent audit committee with members who possess specialized experience, among other requirements. Effective communication between the audit committee, auditor and management is important to address reporting, control or audit issues that may arise during and after the merger process, the staff said.

In addition, the SEC staff said auditors need to apply appropriate acceptance and continuance procedures when a formerly private audit client prepares to go public through a SPAC merger to make sure they are staffing the audit team with people who have enough time and the appropriate level of experience to perform the audit. The staff also noted that the company and the auditor need to comply with SEC and PCAOB independence standards.

Click here for the full text of the EY note on this SEC staff statement.

April 8, 2021:  Acting Director of the SEC’s Division of Corporation Finance Releases Public Statement re: Liability Risks in De-SPAC transactions

By John Patrick Clayton, Kerry E. Berchem, Alice Hsu, Anthony J. Renzi Jr., Jacqueline Yecies & Stephanie Lindemuth, Akin Gump

On April 8, 2021, John Coates, the Acting Director of the SEC’s Division of Corporation Finance, released a public statement expressing concern about claims of some practitioners and commentators regarding SPACs. In particular, Mr. Coates questions the view that a private company faces less exposure to securities law liability when “going public” through a business combination with a SPAC (a “de-SPAC” transaction) than when employing a conventional IPO structure. After emphasizing the significant investor protections concerns this assertion raises, Mr. Coates refutes the claim by describing the manner in which the existing federal securities law regime protects SPAC investors. Mr. Coates also proposes an interpretation of the Private Securities Litigation Reform Act (PSLRA) that would limit the scope of its safe harbor when SPAC participants make forward-looking statements in connection with de-SPAC transactions.

Despite the customary disclaimer cautioning readers that the public statement only expresses the views of Mr. Coates and not those of the SEC, the public statement may provide insight as to how the SEC Staff is thinking about de-SPAC transactions. Our full publication, dated April 14, 2021, summarizes Mr. Coates’s points relating to material misstatements or omissions, the PSLRA, and steps to mitigate liability exposure. 

April 12, 2021: SEC Acting Chief Accountant Paul Munter and Acting Director, Division of Corporation Finance, John Coates Issue a Statement on Accounting and Reporting Considerations for Warrants Issued by SPACs

By Brian Hecht, Mark J. Reyes, and Mark D. Wood, Katten

On April 12, 2021, the Division of Corporation Finance of the SEC issued a Staff Statement from the Acting Director, John Coates, and Acting Chief Accountant, Paul Munter, relating to the accounting treatment of warrants issued by SPACs.

In a typical SPAC IPO, a SPAC will issue and sell to public investors units, comprised of one share of common stock and a fraction of a warrant to purchase additional shares of common stock. In addition, SPAC sponsors also will typically purchase warrants from the SPAC to fund SPAC offering and operating expenses. These privately placed warrants, when held by the sponsor and certain permitted transferees, include certain protective provisions, including a provision that prevents the SPAC from redeeming the privately placed warrants at such time as the warrants held by public stockholders would otherwise be redeemable. The protective provisions fall away when the private placement warrants are transferred to other third parties.

Historically, the financial statements of SPACs have classified warrants as equity. The Staff Statement challenges this long-applied accounting treatment and suggests that the warrants should instead be classified as a liability in financial statements if they contain certain customary provisions in the agreement governing the terms of these warrants. The two features that the Staff Statement focused on to support their view that the warrants should be treated as a liability apply in the case of a reorganization of the SPAC or tender or exchange offer with respect to the SPAC common stock. More particularly:

1. The Staff Statement highlights the fact that an equity-linked instrument, such as the warrants, must be considered indexed to the entity’s stock in order to qualify for equity classification, as opposed to liability classification, under applicable accounting rules. Nonetheless, certain variables may affect the settlement amount (i.e., the value upon exchange) for the warrants without causing liability accounting treatment. However, “the holder of the instrument” is not an approved variable input that may be considered. Accordingly, the Staff Statement expressed the view that, because in certain situations (including as a result of the protective provisions of the private placement warrants discussed above), the settlement amount of the private placement warrants containing the offending features will differ depending on whether such warrants are held by the SPAC sponsor or an unrelated third party, those warrants should be classified as a liability.
2. The Staff Statement also focused on the fact that the terms of the warrants (public and private) provide that, in the event of a tender offer or exchange offer with respect to the SPAC common stock that is accepted by holders of more than 50 percent of the common stock, all holders of the warrants would be entitled to receive cash for their warrants. In those situations, only holders of common stock that received and accepted the relevant cash tender offer would receive cash consideration. The fact that all warrant holders, but not necessarily all common stockholders, would receive cash consideration would require that those warrants be treated as a liability under applicable accounting rules, the Staff Statement concludes.

As a result, SPACs that have completed an IPO or that are planning for an IPO will likely need to take steps to address the conclusions set forth in the Staff Statement.

SPACs that have already completed their IPO will need to confirm whether their outstanding warrants contain the provisions that have been called into question by the Staff Statement, and if they do, consider along with their auditors, the impact on their financial statements for prior periods, including whether any accounting errors in prior period financial statements are “material” and financial statements need to be restated to account for outstanding warrants as liabilities rather than as equity. The Staff Statement provides that SPACs may correct material errors relating to the warrant accounting treatment by amending their most recent Form 10-K and any subsequently filed Form 10-Qs. In addition, going forward, these companies will need to determine whether quarterly valuations of the warrants and mark-to-market accounting treatment will be required.

SPACs that have not yet completed their IPO have additional options. This may include accounting for their warrants as liabilities on a go forward basis or structuring the warrants to exclude the features that would give rise to a need to classify the warrants as a liability and maintain the ability to classify the warrants as equity. The impact that the Staff Statement will have on the market for existing and future SPACs, and whether additional SEC guidance on SPAC accounting matters will be issued, is yet to be seen.

The Staff Statement represents staff views of Corp Fin and the Office of the Chief Accountant. It is not a rule, regulation, or statement of the SEC. However, issuers should anticipate the need to address the matters set forth in the Staff Statement in a satisfactory manner in connection with the SEC comment and review process with respect to IPOs and their ongoing periodic reports made under the Securities Exchange Act of 1934.

For more information, including a discussion on SPAC liability risk issues raised in John Coates’ April 8 statement, see our full article published in the National Law Journal on April 16, 2021.