LAWYER Securities in the Electronic Age Wall Street CONTINUED ON PAGE 3 Article REPRINT SEC/SRO Update: SEC Proposes Rules for Hedging Disclosure; and MD&A Lessons Learned from Broadwind Energy BY YELENA M. BARYCHEV & MELISSA PALAT MURAWSKY Yelena M. Barychev and Melissa Palat Murawsky are Partners at Blank Rome LLP (www.blankrome.com). Ms. Barychev and Ms. Murawsky advise public companies on private and public offerings of securities, as well as on mergers and acquisitions and other corporate transactions. They also advise public companies on corporate and securities law issues, including executive compensation and corporate governance matters. The views expressed herein are those of the authors and not necessarily those of Blank Rome LLP or any of its clients. Contact: barychev@blankrome.com or murawsky@blankrome.com. SEC Proposes Rules for Hedging Disclosure On February 9, the Securities and Exchange Commission (SEC), as required by Section 955 of the Dodd-Frank Act, 1 issued proposed rules 2 requiring enhanced proxy disclosure of a company s hedging policies for its directors, officers and other employees. The proposed rules would require a company to disclose, in any proxy statement or information statement relating to an election of directors, whether its directors, officers or other employees are permitted to hedge or offset any decrease in the market value of equity securities that are either granted by the company as compensation, or held (directly or indirectly) by the individual. Currently, companies are required to make disclosures regarding their hedging policies in the company s Compensation Discussion and Analysis (CD&A) section of their proxy. In the CD&A section of a proxy, companies are required to disclose material information necessary to an understanding of a company s compensation policies and decisions regarding its named executive officers. Item 402(b)(2)(xiii) provides that, if material, disclosure regarding a company s equity or other security ownership requirements or guidelines (specifying applicable amounts and forms of ownership), and any company policies regarding hedging the economic risk of such ownership should be included in the CD&A. The CD&A disclosure requirement does not apply to smaller reporting companies, emerging growth companies, registered investment companies or foreign private issuers. The new proposed rules would expand both Reprinted from the. Copyright 2015 Thomson Reuters. For more information about this publication please visit www.west.thomson.com ARTICLE REPRINT
2015 Thomson Reuters. This publication was created to provide you with accurate and authoritative information concerning the subject matter covered, however it may not necessarily have been prepared by persons licensed to practice law in a particular jurisdiction. The publisher is not engaged in rendering legal or other professional advice, and this publication is not a substitute for the advice of an attorney. If you require legal or other expert advice, you should seek the services of a competent attorney or other professional. For authorization to photocopy, please contact the Copyright Clearance Center at 222 Rosewood Drive, Danvers, MA 01923, USA (978) 750-8400; fax (978) 646-8600 or West s Copyright Services at 610 Opperman Drive, Eagan, MN 55123, fax (651)687-7551. Please outline the specific material involved, the number of copies you wish to distribute and the purpose or format of the use. For subscription information, please contact the publisher at: west.legalworkspublications@thomson.com The opinions and viewpoints expressed in the articles and columns of are exclusively those of the individual authors and should not be attributed in any way to the members of the Editorial Advisory Board, individually, or as a whole. Editorial Board MANAGING EDITOR: GREGG WIRTH CHAIRMAN: JOHN F. OLSON Gibson, Dunn & Crutcher ADVISORY BOARD: BRANDON BECKER Executive Vice President and Chief Legal Officer at TIAA-CREF BLAKE A. BELL Simpson Thacher & Bartlett STEVEN E. BOCHNER Wilson Sonsini Goodrich & Rosati Palo Alto, CA JORDAN ETH Morrison & Foerster LLP EDWARD H. FLEISCHMAN Former SEC Commissioner ALEXANDER C. GAVIS Vice President & Associate General Counsel Fidelity Investments JAY B. GOULD Pillsbury Winthrop Shaw Pittman LLP PROF. JOSEPH A. GRUNDFEST Professor of Law, Stanford Law School MICALYN S. HARRIS ADR Services Ridgewood, NJ PROF. THOMAS LEE HAZEN University of North Carolina Chapel Hill ALLAN HORWICH Schiff Hardin LLP Chicago, IL TERESA IANNACONI Partner, Department of Professional Practice KPMG Peat Marwick MICHAEL P. JAMROZ Partner, Financial Services Deloitte & Touche STANLEY KELLER Edwards Wildman Palmer LLP Boston, MA CARY I. KLAFTER Vice President, Legal & Government Affairs, and Corporate Secretary Intel Corporation BRUCE W. LEPPLA Lieff Cabraser Heiman & Berstein LLP SIMON M. LORNE Vice Chairman and Chief Legal Officer at Millennium Partners, L.P. MICHAEL D. MANN Richards Kibbe & Orbe JOSEPH MCLAUGHLIN Sidley Austin, LLP WILLIAM MCLUCAS WilmerHale LLP BROC ROMANEK General Counsel, Executive Press, and Editor TheCorporateCounsel.net JOHN F. SAVARESE Wachtell, Lipton, Rosen & Katz JOEL MICHAEL SCHWARZ Attorney, U.S. Government STEVEN W. STONE Morgan Lewis LLP LAURA S. UNGER Former SEC Commissioner and Acting Chairman ERIC S. WAXMAN Skadden, Arps, Slate, Meagher & Flom LLP Los Angeles, CA JOHN C. WILCOX Chairman, Sodali Ltd. JOEL ROTHSTEIN WOLFSON Bank of America Merrill Lynch West LegalEdcenter 610 Opperman Drive Eagan, MN 55123 2015 Thomson Reuters One Year Subscription n 12 Issues n $867.96 (ISSN#: 1095-2985) For authorization to photocopy, please contact the Copyright Clearance Center at 222 Rosewood Drive, Danvers, MA 01923, USA (978) 750-8400; fax (978) 646-8600 or West s Copyright Services at 610 Opperman Drive, Eagan, MN 55123, fax (651) 687-7551. Please outline the specific material involved, the number of copies you wish to distribute and the purpose or format of the use. This publication was created to provide you with accurate and authoritative information concerning the subject matter covered. However, this publication was not necessarily prepared by persons licensed to practice law in a particular jurisdication. The publisher is not engaged in rendering legal or other professional advice, and this publication is not a substitute for the advice of an attorney. If you require legal or other expert advice, you should seek the services of a competent attorney or other professional. Copyright is not claimed as to any part of the original work prepared by a United States Government officer or employee as part of the person s official duties. 2 2015 THOMSON REUTERS
the disclosure requirements regarding hedging policies and the types of companies required to make disclosure regarding hedging policies. The new proposed rules would expand both the disclosure requirements regarding hedging policies and the types of companies required to make disclosure regarding hedging policies. The proposed rules would add paragraph (i) to Item 407 of Regulation S-K and would require companies to disclose whether the registrant permits any employees (including officers) or directors, to purchase financial instruments (including prepaid variable forward contracts, equity swaps, collars and exchange funds) or otherwise engage in transactions that are designed to, or have the effect of hedging or offsetting any decrease in the market value of a company s equity securities. Companies that permit hedging by certain employees would be required to disclose the categories of persons who are permitted to engage in hedging transactions and those who are not. In addition, companies would also be required to disclose the categories of hedging transactions that they permit and those that they prohibit. The new disclosure would apply to all issuers registered under Section 12 of the Exchange Act, including smaller reporting companies, emerging growth companies, and listed closed-end funds, but excluding foreign private issuers and other types of registered investment companies. The proposed rules do not require a company to prohibit its directors, officers or other employees from engaging in hedging transactions in the company s securities or to adopt hedging policies. Rather, the proposed rules, consistent with the SEC s view 3 of the statutory purpose of Section 14(j) of the Exchange Act, are intended to provide investors with additional information, enabling them to ascertain whether a company s directors, officers or other employees, through hedging transactions, are able to avoid any requirements that they hold stock long-term, and thereby receive their compensation even if their company underperforms. The disclosure aims to give stockholders a better understanding of whether the interests of a company s directors, officers and other employees are aligned with their own interests. MD&A Lessons Learned from Broadwind Energy On February 5, in SEC v. Broadwind Energy, et al., 4 the SEC charged Broadwind Energy, Inc., its former Chief Executive Officer and its Chief Financial Officer for accounting and disclosure violations that, as the SEC stated in its press release, 5 prevented investors from knowing that reduced business from two significant customers had caused substantial declines in the company s long-term financial prospects. The penalties were not earth-shattering: subject to the court s approval, Broadwind agreed to pay a $1 million penalty, and its former CEO and its CFO agreed to pay approximately $700,000 in combined disgorgement and penalties. The SEC brought various charges, including, but not limited to, the violation of Section 17(a) (2) of the Securities Act (in connection with an offering conducted by Broadwind) and the violation of Section 13 of the Exchange Act and Rule 13a-14 under such Act, but this case is interesting because it deals with the eternal question that public company management and their securities lawyers are dealing with every day: How much disclosure is enough disclosure for the investors to make a reasonable decision whether to buy or sell the company s securities? Broadwind s fact pattern, as outlined in the SEC s complaint filed in the U.S. District Court for the Northern District of Illinois, makes it clear that during the third quarter of 2009, Broadwind began to plan more definitively for the impairment of its subsidiary s intangible assets related to contracts with two major customers; and Broadwind s internal documents identified an expected impairment charge of $48 million related to the contract with one of such customers. Broadwind shared this expectation and these documents with its outside audit firm, its investment bankers 2015 THOMSON REUTERS 3
and the subsidiary s primary lender. Broadwind also incorporated impairment in its planning for the upcoming audit of its 2009 financial results. Broadwind s revenue from the two major customers declined 43% and 25%, respectively, for the nine months ended September 30, 2009 compared to the same period ended September 30, 2008. The SEC argued that Broadwind s disclosure in the Management s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) section of its Form 10-Q for the third quarter of 2009 was materially misleading. Such disclosure read, in part, as follows: [A] continued economic slowdown may result in impairment to our fixed assets, goodwill and intangible assets. We perform an annual goodwill impairment test during the fourth quarter of each year, or more frequently when events or circumstances indicate that the carrying value of our assets may not be recovered. The recession that has occurred during 2008 and 2009 has impacted our financial results and has reduced purchases from certain of our key customers. We may determine that our expectations of future financial results and cash flows from one or more of our businesses has decreased or a decrease in stock valuation may occur, which could result in a review of our goodwill and intangible assets associated with these businesses. Since a large portion of the value of our intangibles has been ascribed to projected revenues from certain key customers, a change in our expectation of future cash from one or more of these customers could indicate potential impairment to the carrying value of our assets. Item 303 of Regulation S-K requires a public company to disclose in its MD&A any known trends or any known demands, commitments, events or uncertainties that will result in or that are reasonably likely to result in the registrant s liquidity increasing or decreasing in any material way. MD&A also requires a description of any known trends or uncertainties that have had or that the registrant reasonably expects will have a material favorable or unfavorable impact on net sales or revenues or income from continuing operations. [The Broadwind] case is interesting because it deals with the eternal question that public company management and their securities lawyers are dealing with every day: How much disclosure is enough disclosure for the investors to make a reasonable decision whether to buy or sell the company s securities? The SEC s position outlined in the complaint is that, based on the revenue decline combined with the customers lower forecasts of revenue and other developments, Broadwind and its CEO (the CFO started at Broadwind in mid-august 2009) should have known that the intangible assets were impaired. However, Broadwind failed to disclose the impairment of its assets in Form 10- Q for the quarter ended September 30, 2009, but instead used a generalized risk disclosure of the possibility of such a charge. The SEC also stated in its complaint that if Broadwind had conducted impairment testing in connection with its Form 10-Q for the 3 rd quarter 2009, Broadwind would have concluded that its contracts with two significant customers were fully impaired and recorded impairment charges of approximately $60 million in connection with such contracts. Broadwind ultimately disclosed the impairment in its Form 10-K for the fiscal year ended December 31, 2009. Following the disclosure of the impairment charge, the company s stock price declined by 29%. Putting aside the speculation about when it was the right time for Broadwind to conduct the impairment testing, it has been the SEC s position for more than a decade that MD&A trends disclosure should include the [q]uantification of the material effects of known material trends and un- 4 2015 THOMSON REUTERS
certainties, which can promote better understanding of whether the company s past performance is indicative of future performance. The SEC s 2003 Interpretive Release 6 made it clear that [a]scertaining this indicative value depends to a significant degree on the quality of disclosure about the facts and circumstances surrounding known material trends and uncertainties in MD&A. Quantitative disclosure should be considered and may be required to the extent material if quantitative information is reasonably available. The SEC s complaint in SEC v. Broadwind serves as a reminder that boiler plate generalized MD&A disclosure regarding known trends may be inadequate and misleading if management had an opportunity to provide more detailed and meaningful information. NOTES 1. Section 955 of the Dodd-Frank Act added Section 14(j) to the Exchange Act. Section 14(j) directs the SEC to require, by rule, each issuer to disclose in any proxy or consent solicitation material for an annual meeting of the shareholders of the issuer whether any employee or member of the board of directors of the issuer, or any designee of such employee or director, is permitted to purchase financial instruments (including prepaid variable forward contracts, equity swaps, collars, and exchange funds) that are designed to hedge or offset any decrease in the market value of equity securities either (i) granted to the employee or director by the issuer as part of the compensation of the employee or director; or (ii) held, directly or indirectly, by the employee or director. 2. See SEC 17 CFR Parts 229 & 240, Release No. 33-9723; 34-74232; IC-31450; File No. S7-01-15 RIN 3235-AL49 Disclosure of Hedging by Employees, Officers and Directors, available at http://www. sec.gov/rules/proposed/2015/33-9723.pdf. 3. The proposing release cites a report issued by the Senate Committee on Banking, Housing, and Urban Affairs which stated that Section 14(j) is intended to allow shareholders to know if executives are allowed to purchase financial instruments to effectively avoid compensation restrictions that they hold stock long-term, so that they will receive their compensation even in the case that their firm does not perform. In this regard, the SEC explained we infer that the statutory purpose of Section 14(j) is to provide transparency to shareholders, if action is to be taken with respect to the election of directors, about whether employees or directors are permitted to engage in transactions that mitigate or avoid the incentive alignment associated with equity ownership. 4. SEC v. Broadwind Energy, Inc., J. Cameron Drecoll and Stephanie K. Kushner; Civil Action No. 15-cv- 1142; U.S. Dist. Ct., North. Ill. East., available at http://www.sec.gov/litigation/complaints/2015/ comp-pr2015-24.pdf. 5. See SEC Charges Chicago-Area Alternative Energy Company for Accounting and Disclosure Violations ; Release 2015-24; Feb. 5, 2015; available at http://www.sec.gov/news/pressrelease/2015-24. html#.vooaxpnf-me. 6. SEC s 2003 Interpretive Release: Commission Guidance Regarding MD&A (Release No. 33-8350). 2015 THOMSON REUTERS 5