CURRENT MONTH (June 2023)
PCAOB Proposes New Auditing Standard for Noncompliance with Laws and Regulations
By Thomas W. White, Retired Partner, WilmerHale
The Public Company Accounting Oversight Board (PCAOB) has proposed a new auditing standard prescribing procedures for auditors to identify potential noncompliance with laws and regulations (sometimes referred to by the awkward acronym “NOCLAR”), including fraud, and to evaluate the impact of any such noncompliance on an issuer’s financial statements. In an unusual development for the PCAOB, the proposal passed by a 3–2 vote, over the dissents of the Board’s two CPA members, Duane M. DesPartes and Christina Ho.
Auditors presently have responsibilities with respect to possible “illegal acts” under Section 10A of the Securities Exchange Act and auditing standards governing auditors’ consideration in an audit of fraud (AS 2401) and illegal acts by clients (AS 2405). The current standards affirmatively require auditors to perform audit procedures to identify violations of laws or regulations that “have a direct and material impact on financial statements” (such as tax laws) but require less inquiry about illegal acts involving violations of law or regulations that may have only an indirect impact on financial statements (such as creating a contingent liability).
The PCAOB proposes to replace current AS 2405 and amend other standards to substantially expand the auditor’s responsibilities with respect to NOCLAR. The proposed new standard replaces the term “illegal acts” with “noncompliance with laws and regulations,” though the Board considers the terms to be substantively the same. The standard also eliminates the distinction between laws and regulations that have a direct impact on financial statements and those that may have only an indirect impact.
The proposal prescribes extensive requirements for the auditor to plan and perform procedures to:
- identify laws and regulations applicable to a company with which “noncompliance could reasonably have a material effect on the financial statements”;
- assess and respond to risks of material misstatement of the financial statements due to noncompliance with those laws and regulations; and
- identify whether there is information “indicating noncompliance with those laws and regulations may have occurred.”
If the auditor obtains information indicating that noncompliance with a law or regulation has or may have occurred, the auditor must perform additional specified procedures, “regardless of whether the effect of such noncompliance is perceived to be material to the financial statements.” These include:
- Obtaining an understanding of the nature and circumstances of any such noncompliance.
- Determining whether it is “likely” that any such noncompliance has occurred.
- If the auditor determines that it is “likely” that noncompliance has occurred, determining the “possible effect of the likely noncompliance on the financial statements” and performing additional procedures to determine whether the likely noncompliance:
- “results in material misstatement of the financial statements” or
- results in other information in documents containing financial statements, or the manner of its presentation, “being materially inconsistent with information appearing in the financial statements or containing a material misstatement of fact.”
If the auditor determines that any likely noncompliance has a material effect on the financial statements, the auditor must determine whether the senior management has taken timely and appropriate remedial action. The auditor must also communicate to management and the audit committee information indicating that noncompliance may have occurred, regardless of materiality, as well as the auditor’s subsequent determinations regarding whether it is likely that noncompliance has occurred and the effect of such noncompliance on the financial statements.
Notably, the Board recognizes that many of the steps required by the standard will involve legal considerations. It indicates that auditors may need to engage their own legal counsel to advise them with respect to such matters.
According to PCAOB Chair Erica Y. Williams, “By catching and communicating noncompliance sooner, auditors can help companies course correct and better protect investors from risk.” In dissenting, Board Member DesPartes expressed concern that the proposed requirement to identify potential noncompliance without regard to materiality “is well beyond both the scope of the financial statement audit and the auditor’s core competency; and will trigger the need—at great cost—to significantly increase the use of lawyers and others as specialists on many, if not all PCAOB audit engagements on a recurring basis.” Board Member Ho similarly stated that the proposed standards before the Board today “contain a breathtaking expansion of the auditors’ responsibilities, which I believe will hurt investors.”
SEC Spring Rulemaking Agenda Published
By Anna T. Pinedo, Mayer Brown
The Office of Information and Regulatory Affairs published the Spring 2023 Unified Agenda of Regulatory and Deregulatory Actions. This includes the SEC’s spring rulemaking agenda. Securities and Exchange Commission Chair Gensler had the following comment: “In every generation since President Franklin Roosevelt’s, our Commission has updated its ruleset to meet the challenges of a new hour. Consistent with our legal mandate, guided by economic analysis, and informed by public comment, this agenda reflects the latest step in that long tradition. Thus, I am pleased to support it.”
A link to the SEC’s spring rulemaking agenda is included below. Notably, a number of final rules are slated for October 2023 (this is only an estimated timeframe), including the following:
- Climate change disclosure rules
- Cybersecurity risk governance rules
- Special purpose acquisition companies rules
- Amendments to 13D/G
During the fall, the agenda also suggests that the SEC will propose the following:
- Amendments to Regulation D and Form D
- Human Capital Management Disclosures
- Revisions to the Definition of Securities Held of Record (the Section 12(g) threshold)
As with prior rulemaking agendas during the Chair Gensler–led SEC, the agenda includes a wide range of proposed and final rules, covering an extensive number of areas. See the complete agenda.
NYSE and NASDAQ Propose October 2, 2023, Effective Date for Clawback Listing Standards
By Laura D. Richman, Mayer Brown
On June 5, 2023, the New York Stock Exchange (“NYSE”) filed an amendment to its proposed Dodd-Frank clawback listing policy providing for an effective date of October 2, 2023. Similarly, on June 6, 2023, Nasdaq filed an amendment proposing an October 2, 2023. Effective date for its Dodd-Frank clawback listing standards. If the US Securities and Exchange Commission (“SEC”) approves the revised listing standards with this effective date, companies listed on the NYSE or Nasdaq will have until Friday, December 1, 2023, to adopt compliant clawback policies, which will be welcome news for listed companies. However, even with an extension of time provided by a later effective date, listed companies should now be preparing for implementation of this new clawback policy requirement.
Both the NYSE and Nasdaq noted that that their proposed effective date is consistent with the expectations set forth in the SEC’s Rule 10D-1 adopting release that “issuers will have more than a year from the date the final rules are published in the Federal Register to prepare and adopt compliant recovery policies.” The need for more time to prepare for compliance with the clawback listing standards was also a concern raised in comment letters submitted to the SEC on behalf of listed issuers.
In April 2023, the SEC designated June 11, 2023, as the date by which it would either approve or disapprove, or institute proceedings to determine whether to disapprove, the clawback listing standards, which means the SEC should soon announce whether it will approve these listing standards with an October 2, 2023 effective date. See the Notice of Designation of a Longer Period for Commission Action on Proposed Rule Change for the NYSE and Nasdaq.
Background. The SEC adopted Rule 10D-1 in October 2022, directing national securities exchanges to establish listing standards that prohibit the listing of any security of a company that does not adopt and implement a written policy requiring the recovery, or “clawback,” of certain incentive-based executive compensation. For more information on Rule 10D-1, see our Legal Update and a previous Business Law Today article. In keeping with the schedule required by the SEC, the NYSE and Nasdaq proposed clawback listing standards in February 2023. For more information on those listing standards, see our blog post.
Other Amendments. The NYSE’s amendment also revised cure period provisions so that they apply to all incidents of noncompliance with Section 303A.14 clawback listing standards and not just delayed adoption of recovery policies. In addition, the NYSE’s amendment modified the text of Section 303A.00 of the NYSE Listed Company Manual to clarify that the following categories of listed issuers are required to comply with the requirements of Section 303A.14:
- closed-end and open-end funds;
- passive business organization, listed derivative, or special purpose securities;
- foreign private issuers; and
- all companies listing only preferred or debt securities on the NYSE (including securities listed under Rule 5.2(j)).
SEC Adopts Final Rules to Remove and Replace Credit Ratings References in Regulation M
On June 7, 2023, the Commissioners of the U.S. Securities and Exchange Commission (the “SEC”) unanimously voted to adopt amendments to remove references to credit ratings from Regulation M, and replace these with alternative standards of creditworthiness. The existing exceptions in Rules 101 and 102 of Regulation M for certain investment-grade-rated securities will be replaced with exceptions for: (1) nonconvertible debt securities and nonconvertible preferred securities of issuers having a probability of default of 0.055% or less, measured over a certain period of time, and as determined and documented by the lead manager of the distribution using a “structural credit risk model” as defined in the final rules; and (2) asset-backed securities that are offered pursuant to an effective shelf registration statement filed on Form SF-3. The SEC also added a record preservation requirement for broker-dealers in connection with their probability of default determinations in reliance on the new exception in Rule 101.
The final rules adopted are largely similar to the amendments originally proposed by the SEC in March 2022, with certain modifications implemented to address feedback received during the comment period.
The final rules will become effective sixty days after publication in the Federal Register.
SEC Releases C&DIs on Compliance with New Insider Trading Disclosures
On May 25, 2023, the staff of the US Securities and Exchange Commission’s Division of Corporation Finance released three Compliance and Disclosure Interpretations (“C&DIs”) on the recent amendments to Rule 10b5-1 regarding insider trading arrangements and related disclosures. Specifically, C&DIs 120.26 and 120.27 identify the dates by which companies must first include the new disclosures in their periodic reports and proxy statements, while C&DI 120.28 clarifies timing considerations for individuals trading under separately maintained Rule 10b5-1 plans.
For additional information on the amendments to Rule 10b5-1, including a summary of the principal changes and a discussion of practical considerations, see our Legal Update.
The text of the new C&DIs are as follows:
C&DI Question 120.26: When are companies required to begin providing the quarterly Item 408(a) disclosures and the annual Item 402(x) and Item 408(b) disclosures (Item 16J of Form 20-F disclosures for foreign private issuers) in periodic reports?
Answer: Release No. 33-11138 states that companies other than smaller reporting companies will be required to comply with the new disclosure and tagging requirements in Exchange Act periodic reports on Forms 10-Q, 10-K and 20-F “in the first filing that covers the first full fiscal period that begins on or after April 1, 2023.” Therefore, the following compliance dates apply:
- December 31 fiscal year-end company – Quarterly disclosures must first be provided in the Form 10-Q for the period ended June 30, 2023, and should continue to be provided in the Form 10-Q for the period ended September 30, 2023 and the Form 10-K for the fiscal year ended December 31, 2023.
- June 30 fiscal year-end company – Quarterly disclosures must first be provided in the Form 10-K for the fiscal year ended June 30, 2023.
- December 31 fiscal year-end company – Annual disclosures must first be provided in the Form 10-K or 20-F for the fiscal year ended December 31, 2024.
- June 30 fiscal year-end company – Annual disclosures must first be provided in the Form 10-K or 20-F for the fiscal year ended June 30, 2024.
Smaller reporting companies must comply with these new disclosure and tagging requirements in the first filing that covers the first full fiscal period which begins on or after October 1, 2023. Therefore, the following compliance dates apply:
- December 31 fiscal year-end company – Quarterly disclosures must first be provided in the Form 10-K for the fiscal year ended December 31, 2023.
- June 30 fiscal year-end company – Quarterly disclosures must first be provided in the Form 10-Q for the period ended December 31, 2023.
- December 31 fiscal year-end company – Annual disclosures must first be provided in the Form 10-K or 20-F for the fiscal year ended December 31, 2024.
- June 30 fiscal year-end company – Annual disclosures must first be provided in the Form 10-K or 20-F for the fiscal year ended June 30, 2025.
C&DI Question 120.27: When are companies required to begin providing the disclosures in proxy or information statements?
Answer: For transition purposes only, companies other than smaller reporting companies must first provide this information in proxy statements for the first annual meeting for the election of directors (or information statements for consent solicitations in lieu thereof) after completion of the first full fiscal year beginning on or after April 1, 2023. Smaller reporting companies must first provide this information in proxy statements for the first annual meeting for the election of directors (or information statements for consent solicitations in lieu thereof) after completion of the first full fiscal year beginning on or after October 1, 2023.
C&DI Question 120.28: The Rule 10b5-1(c) affirmative defense generally is not available if a person has multiple Rule 10b5-1 contracts, instructions, or plans in place. However, Rule 10b5-1(c)(1)(ii)(D)(2) permits a person (other than the issuer) to maintain two separate Rule 10b5-1 plans at the same time so long as trading pursuant to the later-commencing plan is not authorized to begin until after all trades under the earlier-commencing plan are completed or have expired without execution. If an individual terminates the earlier-commencing plan (i.e., the earlier-commencing plan does not end by its terms and without any action by the individual), when can trading begin under the later-commencing plan?
Answer: Pursuant to Rule 10b5-1(c)(1)(ii)(D)(2), if an individual terminates the earlier-commencing plan, the later-commencing plan will be subject to an “effective cooling-off period.” The effective cooling-off period will begin on the termination date of the earlier-commencing plan and will last for the time period specified in Rule 10b5-1(c)(1)(ii)(B). On the other hand, if the earlier-commencing plan ends by its terms without action by the individual, the cooling-off period for the later-commencing plan is not reset and trading may begin as soon as the plan’s original cooling-off period is satisfied. Depending on when the later-commencing plan was adopted, this could be as soon as immediately after the earlier-commencing plan ends. See Footnote 180 of Release No. 33-11138.
Ninth Circuit Upholds Forum Selection Clause
By Madeline Simpson, J.D. Candidate, Class of 2024, Boston College Law School
On June 1, 2023, an en banc panel for the US Court of Appeals for the Ninth Circuit upheld the validity of a forum selection clause in Gap Inc.’s corporate bylaws that mandates all derivative claims be brought in Delaware’s Chancery Court, even when the claim implicates federal securities law. (Lee v. Fisher, 34 F.4th 777, 779 (9th Cir. 2022)). By enforcing the forum selection clause, the Ninth Circuit affirmed the dismissal of the claims against Gap and its directors. The decision also foreclosed the possibility of litigating the plaintiff’s federal securities claim in any court.
In Lee v. Fisher, a shareholder asserted that Gap and its directors had violated Section 14(a) of the Securities Exchange Act of 1934 by filing misleading proxy statements regarding the company’s commitment to diversity in hiring. Federal courts have exclusive jurisdiction over Exchange Act claims, and therefore the complaint was filed in California federal court. However, Gap’s bylaws stipulate that any derivative action must be brought in Delaware state court. Because of the forum selection clause, the district court dismissed on forum non conveniens grounds, and the split en banc panel affirmed in the 6–5 decision.
The appeal raised three issues:
- Does Gap’s forum selection clause violate the Exchange Act’s anti-waiver provision?
- Is Gap’s forum selection clause unenforceable because it violates the federal public policy of allowing shareholders to bring derivative claims under Section 14(a)?
- Is Gap’s bylaw invalid under Delaware law?
The en banc panel’s majority answered all three questions in the negative, dismissing the derivative claim. Going forward, other corporations may be incentivized to include forum selection clauses like the one in Lee in their corporate bylaws to preclude shareholders from bringing their claims. The decision in Lee ignites a circuit split, with the Seventh Circuit having held a similar forum selection clause unenforceable. (Seafarers Pension Plan ex rel. Boeing Co. v. Bradway, 23 F.4th 714, 717 (7th Cir. 2022)). Now with the circuit split, there is an increased likelihood for Supreme Court review of this issue.
Supreme Court Decides Tracing Required for Section 11 Standing in Direct Listings
By Tess Cushing, J.D. Candidate, Class of 2024, Boston University School of Law
On June 1, 2023, the Supreme Court issued a unanimous decision in Slack Technologies v. Pirani. The Court held that, in order for a plaintiff who bought shares in a direct listing to state a claim under Section 11 of the Securities Act of 1933, they must plead and prove that they purchased shares under the allegedly misleading registration statement.
In 2019, Slack, a company that provides an instant messaging platform, completed a direct listing in which it offered 118 million registered shares along with 165 million pre-existing unregistered shares. Fiyyaz Pirani, a technology entrepreneur and investor, bought shares on the day Slack went public and later acquired additional shares. After the price of the shares dropped, he filed a complaint in the United States District Court for the northern District of California under Sections 11 and 12 of the Securities Act of 1933, alleging that the registration statement had been materially misleading. Slack moved to dismiss for failure to state a clam, arguing that there was no way to determine whether Pirani bought registered or unregistered shares, so he could not prove that he bought shares under the allegedly misleading registration statement. Pirani argued that Section 11 encompassed the pre-existing shares that were not issued pursuant to the registration statement because, but for the registration statement, they would not have been available for purchase. The District Court denied the motion to dismiss, and the Ninth Circuit accepted Slack’s appeal. A divided panel affirmed the ruling in favor of Pirani, and the Supreme Court granted certiorari.
The Supreme Court looked at the language of Section 11 and determined that the phrase “such security,” when viewed in the context of the rest of the statute, indicated that a plaintiff must be able to plead and prove that the shares were purchased under the registration statement. This reading is consistent with the existing body of case law regarding standing for Section 11 claims, but it eliminates the exception that the Ninth Circuit created for direct listings. It is nearly impossible to determine whether a plaintiff purchased registered or unregistered securities in a direct listing, so this decision has the potential to provide meaningful protection, at least under Section 11, for companies going public via direct listing.
The Supreme Court declined to make a judgment about whether the standing requirement applies to Section 12. The case was remanded back to the Ninth Circuit for a determination of whether Pirani had standing under Sections 11 or 12.