Taking Stock of Christopher Cox: Part 1 of 2

Christopher Cox, the current SEC chairman, is sure to head out the door soon after a new prez is inaugurated.  So, just as last night's State of the Union address stimulated debate about the incumbent's record and what his legacy would be, it's time for us financial reporting wonks to do the same for Cox. In this first of two posts, I'm going to inventory his major rule making initiatives affecting financial reporting.  I'll give Cox his report card in a second, and much briefer, post to follow in a day or two.

Revised and Expanded Executive Compensation Disclosures

After having received a record 20,000 comment letters on proposed rule changes, the SEC issued new disclosure rules to close loopholes and significantly expand executive compensation disclosures.  From an investor perspective, it may be the highlight of the Cox administration:

• The existing Summary Compensation Table was augmented by the total compensation for each “named executive officer” (NEO); additional tabular disclosures and a major new section entitled Compensation Discussion and Analysis (CD&A).
• The CD&A and all other narrative executive compensation disclosures are required to be written in “Plain English", a first for information included in '34 Act filings. 
• Disclosures regarding option grants (in general and to specific executives) were expanded, and revised since the proposing release to reflect concerns with backdating.
• Tabular and narrative disclosures of director compensation were added. 
• Form 8-K was modified to capture some employment arrangements with NEOs and any material amendments.

Securities Offering Reforms for Large Companies, and Stricter ’34 Act Requirements in the Process

The infamous 1998 Release (33-7606A) dubbed the ‘Aircraft Carrier’ was a noble, yet politically doomed attempt to revamp the entire registration system under the ’33 Act. The new set of rules (SEC Release 33-8591) is a much more modest attempt to eliminate “unnecessary and outmoded” hurdles to the offering process without goring too many of the securities industry’s oxen.  The following briefly describes some of the most notable rules changes:

• Amendments to Form 10-K—Two new items were added.  Item 1A requires risk factor disclosure (with updates for changes in risk factors disclosed in subsequent 10-Q’s).  Item 1B requires an accelerated filer, or a  “well-known seasoned issuer” (WKSI—a new term), to describe any material and unresolved written staff comments issued more than 180 days before the end of the fiscal year covered by the Form 10-K.  In addition, the cover page of the Form 10-K will include a check box to indicate whether the filer is a WKSI.
• Additional permissible communications during the “quiet period”—The new rules create exceptions to the filing requirements for electronic road shows and written communications.  For example, ‘tombstone’ offering announcements in business periodicals may now include information about the issuer and the securities being offered.  (WSJ must love this!)
• Prospectus delivery requirements are relaxed—Is the writing finally on the wall for the financial printing industry?  Trees are overjoyed to know that the new rules revise the prospectus delivery requirements so that electronic access to a prospectus can satisfy the delivery requirements under the Act.
• Shelf registrations—Many seasoned public companies offer securities on a continuous basis through “shelf registrations,” for which WKSIs will be afforded automatic effectiveness.  In addition, all companies eligible to make shelf registration may now register an unlimited number of securities.  (Prior to this release, the number of registered securities had been limited to the amount that could be reasonably expected to be sold within two years.)

Electronic Delivery of Proxy Materials

On January 22nd of this year, the SEC published its final rule permitting electronic delivery of proxy materials for most shareholder meetings, largely as proposed 14 months ago.  The framework for the new rules has been dubbed the “Notice and Access Model”, and is available for proxy solicitation by both management and others.  Under the model, “Notice of Internet Availability” of proxy materials must be sent out prior to the date of the shareholders’ meeting and content of the Notice is limited to ensure prominence of the information provided.   The Notice must also include a toll-free number and e-mail address for requesting hard copies.  If any of the permitted materials (e.g., notice of meeting, proxy statements, proxy card, annual reports, and amendments) are furnished on-line, then all must be furnished on line.

Note, however, that Internet delivery of proxy materials is not an option for meetings at which shareholder approval is needed for mergers and acquisitions, other business combinations, asset sales and exchange offers.

XBRL

The SEC recently announced the completion of all work on developing XBRL data tags for the entire system of U.S. GAAP.  Once EDGAR is transformed into the interactive data format and filers are required to include the tags, it will become possible for analysts to download financial reports directly into spreadsheets and to use other specialty software to do instant financial comparisons across any desired subset of firms.  The SEC also announced that the market capitalization of companies participating in the voluntary XBRL program now exceeds $2 trillion. 

New Reporting Flexibility for "Smaller Reporting Companies"

Since the inception in 1992 of the small business disclosure system, eligibility for the use of small business forms (SB-1, SB-2, 10-KSB and 10-QSB) and Regulation S-B had not changed from the dual $25 million revenue and public float tests.  Some of the most significant accommodations provided by the regime included the following:

• Only two years of GAAP financial statements, and an audited balance sheet for the most recent fiscal year-end;
• No five-year summary of selected financial data, or market-risk disclosures;
• Scaled-back MD&A, related party and corporate governance disclosures;
• No compensation committee interlock and insider participation disclosure; and
• Reduced executive compensation disclosure, most notably, Compensation Discussion & Analysis not required

The new SEC rules broaden the eligibility for the these accommodations to all non-shells whose public float is less than $75 million (to be adjusted for inflation every 5 years) as of the last business day of the previous second fiscal quarter.  By the SEC’s estimate, this creates a population of “smaller reporting companies” (a new term) that contains 1,600 more companies than the current “small business issuer” population, or more than 10% of all companies reporting to the SEC.

In addition to broadened eligibility, the new rules aim to broaden their use by transferring the accommodations directly into Regulation S-K, and allowing for them to be used on an “a la carte basis” by eligible reporting companies.  Regulation S-B and its associated forms are thereby eliminated, and a new check box is added to the cover pages of remaining forms for a reporting company to indicate whether it has elected to use any of the accommodations.

Two New Exemptions from Registration for Compensatory Employee Stock Options

The SEC has adopted two new exemptions from the registration requirements of the Securities Exchange Act of 1934 for certain stock options—one for private companies and another for public companies. 

The exemption for private companies is set forth in Rule 12h-1(f), and is based on related no-action letters issued by the SEC prior to the adoption of the new rule.  It applies to stock options meeting the following conditions:

• The options are issued under formal compensatory plans.
• They are held by the issuer's employees, directors, consultants and similar parties.
• Transfer is restricted, together with the shares to be issued upon exercise of the stock options, with certain limited exceptions such as transfers to family members and change of control transactions

To further qualify for the exemption, the issuer must provide financial statements and information about the risks associated with holding the investment at least every six months.

The exemption available to public companies is set forth in Rule 12h-1(g) meeting the first two of the conditions listed above.  Issuers are not required to provide financial statements or other information to the holders of the options because there is already sufficient information publicly available, as they are already filing periodic reports to the SEC.

Access to Short-Form Registration and Shelf Offerings is Broadened

Acting on recommendations made in the final report of the Commission’s Advisory Committee on Smaller Public Companies to expand eligibility for short form registration and shelf offerings, the Commission revised eligibility for use of Forms S-3 and F-3.  Form S-3 has been the “short form” used by eligible domestic companies enabling incorporation by reference from previously filed documents for registering offerings under the Securities Act of 1933.  Form F-3 is the S-3 counterpart available to foreign private issuers. 

Both of these forms also enable companies to conduct offerings “off the shelf” under Rule 415, which can allow companies to have more control over timing of offerings, avoid delays and interruptions in the offering process and can reduce or even eliminate the costs of filing post-effective amendments to the registration statement.  However, shelf offerings of equity securities were capped at 20% of public float each year.

Until now, Forms S-3 and F-3 were available for primary offerings (i.e., proceeds from securities offered to be received for the company’s own account) only (1) by companies with a public float in excess of $75 million, or (2)  offerings of non-convertible investment grade securities, certain rights offerings, dividend reinvestment plans and conversions, and secondary offerings of securities registered on a national exchange. 

The changes to eligibility for use of the S-3 and F-3 are two:

1. The public float requirement has been eliminated, and in its place has been substituted the requirement that the company has a class of common equity securities listed on a national securities exchange.
2. The public float cap of 20% on primary offerings has been increased to one-third for all companies.

While the Committee recommended even broader reforms inspired by enhancements to market efficiency resulting from electronic access to company information, the SEC chose to act more cautiously.  Their primary concerns are that smaller companies have been much more susceptible to market and accounting manipulations, in part because they may not be followed as closely by the investor community.  Moreover additional risk has been created by the SEC itself by allowing smaller public companies to take advantage of the abbreviated disclosure requirements discussed above.