The SEC’s  “Recovery of Erroneously Awarded Compensation” a/k/a “Clawback” Rules – A Policy Template and Timing and Implementation Details

Hot Topic, Reporting, Uncategorized

The SEC’s October 2022 “Listing Standards for Recovery of Erroneously Awarded Compensation” Final Rulewill require companies whose securities are listed on national securities exchanges to develop and adopt  policies for the recovery or “clawback” of incentive compensation that has been “erroneously awarded” when a company restates its financial statements. Because the SEC generally cannot directly regulate corporate governance matters, the new requirements are being implemented through listing standards that national securities exchanges will soon be required to adopt.

Based on the Final Rule, clawback policies will be required to:

    • Apply to all current and former executive officers,
    • Require clawback of incentive compensation that was based on a financial measure that is changed when a company restates its financial statements, and
    • Apply to the three years before the date on which the company restates its financial statements.

Gary Brown, Partner at Nelson Mullins Riley & Scarborough LLP, and SEC Institute workshop leader and PLI author, has drafted an “Incentive Compensation Recoupment Policy” template to help companies get a head start in this process.  You can find the policy template here.

If you would like to learn more about the provisions of and timing for the new requirements, some highlights are provided below.  You can also learn more in this Fact Sheet and the Final Rule.

The Final Rule became effective on January 27, 2023.  Based on this effective date, the timing requirements of the Final Rule are:

    • February 26, 2023 – last day by which national securities exchanges are to file proposed clawback listing standards;
    • November 28, 2023 – last day by which clawback listing standards must become effective; and
    • January 27, 2024 – last day by which listed companies must adopt and comply with an appropriate clawback policy.

Of course, if the exchanges enact listing standards earlier than the deadlines outlined above, companies will have to adopt policies before January 27, 2024.

Three important notes:

    • These new rules apply to all listed companies – including SRCs, emerging growth companies and foreign private issuers,
    • The clawback provisions will apply to both “Big R” and “little r” restatements, and
    • The requirement to pursue clawback recoveries will be subject to very limited “impracticability” exceptions.

In our next post we will review the related new disclosure requirements and form changes.

As always, your thoughts and comments are welcome!

Inflation – An MD&A Reminder

Hot Topic, Reporting

It its 2020 MD&A Modernization Rule, the SEC eliminated this separate paragraph addressing the impact of inflation:

(iv)  For the three most recent fiscal years of the registrant or for those fiscal years in which the registrant has been engaged in business, whichever period is shortest, discuss the impact of inflation and changing prices on the registrant’s net sales and revenues and on income from continuing operations.

This disclosure dated back to earlier periods when inflation had been a material issue for many companies.  In 2020, when the rule was adopted, inflation had not been a significant issue for most companies since the 1980s.  The rationale for this change in the Final Rule is based on the assumption that inflation may not be material to “most registrants”:

The purpose of the elimination is to streamline Item 303 by eliminating the specific reference to these topics, which may not be material to most registrants. This change is consistent with the principles-based disclosure framework of Item 303

That said, the principles-based nature of MD&A means that if inflation is a material issue for a company in any period, it should be addressed in MD&A.  This principle is clearly articulated in the Final Rule:

We do not believe that these changes will result in a loss of material information for market participants.   Registrants will still be required to discuss in their MD&A the impact of inflation and changing prices, if material, as is currently required.

In the current environment, the staff has been reminding companies of this requirement in the comment letter process.  Here are two examples.

Results of Operations, page 42

    1. Please expand your disclosure to address any known trends, events or uncertainties that have had, or that are reasonably likely to have, a material impact on your cash flows, liquidity, capital resources, cash requirements, financial position, or results of operations, as may be attributable to the inflation risk that you discuss on page 19.

Please clarify the extent to which your revenues and cost of product sales have been or are expected to be impacted by inflation, and discuss any plans that you have to respond to or counter any adverse circumstances.

Guess?, Inc., August 8, 2022

Management’s Discussion and Analysis of Financial Condition and Results of Operations, page 44

    1. We note you disclosed that your operating results for 2022 were negatively affected by inflationary cost pressures. Please revise to address the following:
        • Disclose any known trends or uncertainties that have had or are reasonably likely to have a material impact on your cash flows, liquidity, capital resources, cash requirements, financial position, or results of operations arising from, related to, or caused by the inflation;
        • Expand to identify the principal factors contributing to the inflationary pressures you have experienced and clarify the resulting impact to the company; and
        • Expand your disclosure to identify specific actions planned or taken, if any, to mitigate inflationary pressures.

FedEx Corporation, September 1, 2022

As always, your thoughts and comments are welcome!

Getting Ahead of the MD&A Update Curve – Quantitative and Qualitative Disclosures About Material Changes

Hot Topic, Reporting

As we discussed in a prior post, three parts of the SEC’s 2020 MD&A modernization have become focus areas in the comment process:

    • Critical accounting estimate disclosures
    • Quantitative and qualitative disclosures about material changes
    • Meaningfully addressing liquidity and capital resources

We also explored how one of the reasons behind this increase in MD&A comments could be that companies are reluctant to change MD&A, even when the change is to comply with a new rule or to improve MD&A!

In an earlier post we explored a comment letter exchange focused on critical accounting estimate disclosures.

Today’s post presents an example comment and company response for the second of these three areas, providing quantitative and qualitative disclosures about material financial statement changes.

The Regulation S-K Item 303 guidance for this disclosure is very direct:

Where the financial statements reflect material changes from period-to-period in one or more line items, including where material changes within a line item offset one another, describe the underlying reasons for these material changes in quantitative and qualitative terms.

Companies frequently describe qualitative factors behind changes without quantitative information to explain their relative magnitude.  While this has been a frequent comment area before the 2020 change, it has become the source of even more comments now that there is an objective requirement in S-K Item 303.  This is clearly an easily avoided comment.

Here is an example disclosure from a company’s Form 10-K that generated a comment to provide both quantitative and qualitative information.

Voyage expenses

To the extent that we employ our vessels on voyage charters, we incur expenses that include but are not limited to bunkers, port charges and canal tolls, as these expenses are borne by the vessel owner on voyage charters. Bunkers, port charges, and canal toll expenses primarily increase in periods during which more vessels are employed on voyage charters.

Voyage expenses for the year ended December 31, 2021 were $104.6 million, compared with $89.5 million for the year ended December 31, 2020. Voyage expenses have primarily increased due to an increase in bunker consumption expense, an increase in broker commission expense and an increase in port expenses.

The SEC’s comment is simple and direct:

Results of Operations for Years Ended December 31, 2021 and 2020, page 78

    1. We note that you list multiple factors that contribute to changes in your results. For example, you disclose several factors contributing to the increase in voyage expense. Revise your disclosure to quantify each material factor that contributes to a change in your revenues or expenses. Refer to Item 303(b) of Regulation S-K.

The company’s response is also simple and direct, as well as detailed:

The Company acknowledges the Staff’s comment and undertakes in future filings to include additional information to quantify material factors that contribute to a change in our revenues or expenses. To illustrate the Company’s intention with respect to such disclosure, we have provided below the relevant portions of the 2021 Form 10-K, revised to include such additional information (with underlined and strikethrough text indicating additions and deletions, respectively):

Voyage expenses

To the extent that we employ our vessels on voyage charters, we incur expenses that include but are not limited to bunkers, port charges and canal tolls, as these expenses are borne by the vessel owner on voyage charters. Bunkers, port charges, and canal toll expenses primarily increase in periods during which more vessels are employed on voyage charters.

Voyage expenses for the year ended December 31, 2021 were $104.6 million, compared with $89.5 million for the year ended December 31, 2020. Voyage expenses have primarily increased primarily due to an increase in bunker consumption expense of $8.0 million, which was driven by an increase in bunker fuel prices, an increase in broker commission expense of $4.6 million, which was driven by an increase in related revenues, and an increase in port expenses of $2.0 million, which was driven by an increase in the number of voyage days.

Our next post will explore the third of these frequent comment areas, liquidity and capital resources discussions.

As always, your thoughts and comments are welcome!

CorpFin Updates the Financial Reporting Manual

Reporting

On January 30, 2023, CorpFin announced an update to the Financial Reporting Manual (FRM).  Updated information includes:

    • The phone number for contacting CorpFin Office of the Chief Accountant staff;
    • A link to a new online submission for financial statement waiver or substitution requests;
    • Guidance for financial disclosures about guarantors and related matters – S-X Rules 3-10 and 3-16, as amended; and
    • Guidance related to the implementation of ASU 2018-12, Financial Services – Insurance (Topic 944): Targeted Improvements to the Accounting for Long-Duration Contracts.

The update also removed information that is no longer applicable.

Still awaiting updates are sections addressing:

    • Disclosures about acquired and disposed businesses,
    • Qualifications of accountants, and
    • Management’s discussion and analysis.

You can read more about this update and find the FRM here.

As always, your thoughts and comments are welcome!

Getting Ahead of the MD&A Update Curve – Critical Accounting Estimates

Reporting, SEC Hot Topic, Uncategorized

As we discussed in this post, three parts of the SEC’s 2020 MD&A modernization have become focus areas in the comment process:

    • Critical accounting estimate disclosures
    • Quantitative and qualitative disclosures about material changes
    • Meaningfully addressing liquidity and capital resources

We also explored how one of the reasons behind this increase in MD&A comments could be that companies are reluctant to change MD&A, even when the change is to comply with a new rule or to improve MD&A!

This post presents an example comment and company response for the first of these three areas, critical accounting estimate disclosures.  While the example, particularly the revised disclosure, is lengthy, the lesson is simple.  Critical accounting estimates are not the same thing as accounting policies.  This is a very simple comment to avoid.

The Regulation S-K Item 303 guidance for critical accounting estimate disclosures, which was in FR 72 prior to the 2020 rule modernization, requires companies to go beyond accounting policy disclosure in the financial statements:

Critical accounting estimates. Critical accounting estimates are those estimates made in accordance with generally accepted accounting principles that involve a significant level of estimation uncertainty and have had or are reasonably likely to have a material impact on the financial condition or results of operations of the registrant. Provide qualitative and quantitative information necessary to understand the estimation uncertainty and the impact the critical accounting estimate has had or is reasonably likely to have on financial condition or results of operations to the extent the information is material and reasonably available. This information should include why each critical accounting estimate is subject to uncertainty and, to the extent the information is material and reasonably available, how much each estimate and/or assumption has changed over a relevant period, and the sensitivity of the reported amount to the methods, assumptions and estimates underlying its calculation.

Here is an example disclosure from a company’s Form 10-K that became the source of a critical accounting estimate comment. (Note that the title in this example is out of date.  It should, as stated in S-K Item 303, be Critical Accounting Estimates.)

Critical Accounting Policies and Estimates

The preparation of financial statements in accordance with GAAP requires management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities, revenues and expenses, and the disclosure of contingent assets and liabilities at the date of the financial statements. We believe our estimates and assumptions are reasonable; however, actual results could differ from those estimates.

Our most significant accounting policies are described in Note 2 of the Notes to Consolidated Financial Statements. Some of those significant accounting policies require us to make difficult, subjective, or complex judgments, or estimates. An accounting estimate is considered to be critical if it meets both of the following criteria:

(1) the estimate requires assumptions about matters that are highly uncertain at the time the accounting estimate is made, and

(2) different estimates reasonably could have been used, or changes in the estimate that are reasonably

We have identified the following critical accounting policies:

      • Revenue Recognition
      • Loyalty Program Accounting
      • Asset Impairment Analysis
      • Valuation of the TRA Liability

(Note: For the sake of illustration only the Loyalty Program Accounting disclosure is included here.  You can find the entire disclosure by the company here.)

Loyalty Program Accounting – The Company records a liability for loyalty points earned by passengers under its Sun Country Rewards program using two methods: (1) a liability for points that are earned by passengers on purchases of the Company’s services is established by deferring revenue based on the redemption value net of breakage; and (2) a liability for points attributed to loyalty points issued to the Company’s Visa card holders is established by deferring a portion of payments received from the Company’s co-branded agreement. The Company’s Sun Country Rewards program allows for the redemption of points to include payment towards air travel, land travel, taxes, and other ancillary purchases. The Company estimates breakage for loyalty points that are not likely to be redeemed. These estimates are based on historical experience of loyalty point redemption activity and other factors, such as program changes and modifications that could affect the ultimate usage pattern of loyalty points.

While this seems like a fairly robust accounting policy disclosure, as a critical accounting estimate disclosure it generated this comment:

Management’s Discussion and of Financial Condition and Results of Operations Critical Accounting Policies and Estimates, page 4

    1. The disclosures of your critical accounting policies and estimates appear to be a
      repetition of certain of your significant accounting policies. Please revise your disclosures to address the material implications of the uncertainties that are associated with the methods, assumptions and estimates underlying your critical accounting estimates. Your expanded disclosure should address the risk related to using different assumptions and analyze their sensitivity to change based on outcomes that are deemed reasonably likely to occur. For additional guidance, refer to Item 303(b)(3) of Regulation S-K and the related Instruction 3 to paragraph (b) of Item 303.

The essence of this comment is a frequent theme, that simply repeating an accounting policy is not a critical accounting estimate disclosure.  Here is the company’s response, which, as you can read, significantly expands the disclosure (note, it’s ok to skim this lengthy disclosure!):

The Company respectfully acknowledges the Staff’s comment and will revise future filings in response to the Staff’s comment. Utilizing the disclosure from the most recent annual report on Form 10-K, the following reflects our proposed updated disclosures to be included in future filings. The Company notes there have been no changes to the selection and application of its critical accounting policies and estimates. The Company will continue to evaluate any reasonably likely changes that could impact its critical accounting estimates and provide updated disclosure in future filings as necessary. All numbers below are presented in thousands consistent with the disclosure approach used in the Company’s most recent annual report on Form 10-K.

Critical Accounting Policies and Estimates

……..

Loyalty Program Accounting

The Sun Country Rewards program provides loyalty awards to program members based on accumulated loyalty points. The Company records a liability for loyalty points earned by passengers under the Sun Country Rewards program using two methods: (1) a liability for points that are earned by passengers on purchases of the Company’s services is established by deferring revenue based on the redemption value, net of breakage; and (2) a liability for points attributed to loyalty points issued to the Company’s Visa card holders is established by deferring a portion of payments received from the Company’s co-branded agreement. The Company’s Sun Country Rewards program allows for the redemption of points to include payment towards air travel, land travel, taxes, and other ancillary purchases. The balance of the Loyalty Program Liabilities fluctuates based on seasonal patterns, which impact the volume of loyalty points awarded through travel or issued to co-branded credit card and other partners (deferral of revenue) and loyalty points redeemed (recognition of revenue). The Company records an estimate for loyalty points breakage in Passenger Revenue upon issuance of the loyalty points. Loyalty points held by co-branded credit card members do not expire. All other loyalty points expire if unused after three years.

Points Earned Through Travel Purchases. Passenger sales that earn Sun Country Rewards provide customers with travel services and loyalty points, which are each considered distinct performance obligations. The Company values each performance obligation on a standalone basis. The Company determines the standalone selling price of loyalty points issued using a redemption value approach which considers the value a passenger will receive upon redemption of the loyalty points. Consideration allocated to loyalty points is deferred, net of estimated breakage, and recognized as Passenger Revenue when both the loyalty points have been redeemed and the passenger travel occurs.

Points Earned through the Co-Branded Credit Card Program. Under the Company’s co-branded credit card program, funds received for the marketing of a co-branded credit card and delivery of loyalty points are accounted for as a multiple-deliverable arrangement. The Company determined the arrangement has two distinct performance obligations: loyalty points to be awarded; and use of our brand and access to our customer lists, and certain other advertising and marketing elements (collectively, the marketing performance obligation). Funds received from the co-branded credit card program are allocated to the two performance obligations based on relative standalone selling price. The assumptions used to allocate the funds received are not considered critical to the application of the accounting model for the Company’s loyalty program. Consideration allocated to loyalty points is deferred, net of estimated breakage, and recognized as Passenger Revenue when both the loyalty points have been redeemed and the passenger travel occurs. Consideration allocated to the marketing performance obligation is recognized as revenue as the spend occurs and is recorded in Other Revenue.

The Company estimates breakage for loyalty points that are not likely to be redeemed. Loyalty points are combined in one homogenous pool, that includes both air and non-air travel awards, and are not separately identifiable. The estimated breakage rate is primarily based on historical experience of loyalty point redemption activity and other factors that may not be indicative of future trends, such as the COVID-19 pandemic, program changes or modifications that could affect the ultimate usage pattern of loyalty points. The Company continuously monitors its breakage rate assumptions and may adjust its estimated breakage rate for loyalty points in the future. Changes in the Company’s estimated breakage rate assumptions impact revenue recognition prospectively.

During the year ended 2021, the Company recognized $852 of loyalty points breakage within Passenger Revenue. A 10% change in the Company’s loyalty point estimated breakage rate would have resulted in a change to Passenger Revenue of approximately $170.

Our next post will explore another frequent comment area, providing both quantitative and qualitative explanations for material changes.

As always, your thoughts and comments are welcome!

Are You Behind the MD&A Update Curve?

Hot Topic, Reporting

In November 2020 the SEC made several changes to the MD&A requirements in Regulation S-K Item 303. While many of the changes dealt with “modernization” clarifications and related details, others were more substantive in nature.  Unfortunately, many companies did not implement the required changes to MD&A the year the rule became effective.  As a result, the SEC has been issuing more and more comments focused on the rule’s substantive requirements.  What has become clear, now is the time to be sure your MD&A appropriately deals with these requirements.

From recent SEC comments, we can observe that the SEC staff is currently focused on the following three areas of MD&A:

Critical accounting estimate disclosures

Quantitative and qualitative disclosures about material changes

Meaningfully addressing liquidity and capital resources

Here are example comments that demonstrate the staff’s concerns in each of these areas:

Critical accounting estimate disclosures

  1. In accordance with Item 303(b)(3), please provide a discussion and analysis
    of critical accounting estimates and assumptions that:
      • identifies your critical accounting estimates or assumptions;
        • supplements, but does not duplicate, the description of accounting policies in the notes to the financial statements; and
      • provides greater insight into the quality and variability of information regarding financial condition and operating performance.

Quantitative and qualitative disclosures about material changes

  1. We note that you list multiple factors that contribute to changes in your results. For example, you disclose several factors contributing to the increase in voyage expense. Revise your disclosure to quantify each material factor that contributes to a change in your revenues or expenses. Refer to Item 303(b) of Regulation S-K.

Meaningfully addressing liquidity and capital resources

  1. Please discuss your material cash requirements from known contractual and other obligations as of December 31, 2021, the anticipated source of funds needed to satisfy such cash requirements and the relevant time period for the related cash requirements in accordance with Item 303(b)(1) of Regulation S-K. In this regard, we note you have purchase obligations relating to take-or pay contracts of approximately $283 million as of December 31, 2021. For further guidance refer to Instruction 4 to Item 303(b) of Regulation S-K.

All too often companies are reluctant or slow to change MD&A.  The fear of SEC comments or other questions frequently impedes improving MD&A disclosure. However, in the current environment, exactly the opposite is true.  Not making appropriate updates to MD&A may well result in SEC comments.  These comments could easily be avoided by making appropriate updates.

In the next few posts, we will explore each area in detail, reviewing example disclosures and the comments they generated.

As always, your thoughts and comments are welcome.

CorpFin Issues Sample Letter to Companies Addressing Crypto Asset Markets

Hot Topic, Reporting

With the current disruption and distress in crypto asset markets, on December 8, 2022, the SEC Division of Corporation Finance issued a Sample Letter to Companies highlighting frequent crypto asset market comments.  The first example comment in the letter focuses on the overall impact of crypto asset market disruption on a business:

Provide disclosure of any significant crypto asset market developments material to understanding or assessing your business, financial condition and results of operations, or share price since your last reporting period, including any material impact from the price volatility of crypto assets.

The letter also provides example crypto asset market comments for the description of the business, MD&A and risk factors.

As always, your thoughts and comments are welcome!

CorpFin Addresses Universal Proxy Questions

Reporting

The SEC’s November 2021 adoption of universal proxy rules was expected to create detailed questions related to their use.  As a reminder, universal proxy cards allow shareholders to vote in the same way they could if they voted in person at a meeting.  To make this possible, a universal proxy includes all duly nominated persons from all parties on the same card.  This allows shareholders to select candidates from different slates as they vote on the universal proxy card.

On December 6, 2022, CorpFin issued three Compliance and Disclosure Interpretations (C&DIs) addressing questions concerning dissident shareholder nominations and universal proxy cards.  You can find the three new C&DIs here.

As always, your thoughts and comments are welcome!

Fraud – A Forewarning Message from the Chief Accountant?

Hot Topic, Reporting

Financial reporting frauds have historically occurred in waves and sometimes in tidal waves as in the period of Enron, Worldcom, Tyco, Adelphia, Quest, etc.  When economic times turn challenging or become uncertain, fraud frequently increases.

Given the time since a major wave of financial reporting frauds and the current economic environment, it may not be a coincidence that Paul Munter, the SEC’s Chief Accountant, released a Statement titled “The Auditor’s Responsibility for Fraud Detection” on October 11, 2022.  (At that time Mr. Munter was Acting Chief Accountant.)

In the Statement, Mr. Munter focuses on the auditor’s gatekeeper responsibilities as they relate to financial statement fraud.  The Statement discusses detailed considerations in a number of areas, including the auditor’s role and responsibilities; the importance of a strong system of quality controls, risk assessment and responses; and good practices.

Mr. Munter’s Statement begins with an important reminder about the nature of the auditor’s role:

“Auditors must plan and perform an audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud.”

In addition, the Statement highlights that:

“The PCAOB auditing standards further require auditors to exercise due professional care, which requires the auditor to exercise appropriate levels of professional skepticism [emphasis added] throughout the audit.”

With respect to the auditor’s responsibility, after noting several auditing standards that include fraud considerations, Mr. Munter goes on to say:

“We emphasize that the auditor’s risk assessment and use of the fraud lens is a continual and iterative process that continues until the issuance of the audit report.”

The Statement includes an important point concerning an auditor’s quality control system, which is that budget, time, and other kinds of pressure could distract an auditor from appropriately identifying fraud risk.

In his discussion of risk assessment and responses, Mr. Munter emphasizes the importance of professional skepticism, noting:

“For instance, the mindset of ‘trust but verify’ may represent potential bias if it is anchored in the belief that management is honest and has integrity. Such a mindset may interfere with an auditor’s ability to effectively evaluate signs of fraud when evaluating misstatements or to objectively challenge evidence provided by management.”

With respect to appropriate “good practices,” the Statement notes that examples of fraud risk factors in the auditing literature should not be considered a checklist.  Rather, they should inform the process of building a tailored list of fraud risk factors for each engagement.

This “early warning” Statement, which addresses many other important fraud related issues, is likely based on a desire to get out in front of any incentives that could result in increases in fraud in coming periods.  It may also inform parts of the PCAOB inspection process.  Auditors and companies should begin incorporating its points in their year-end planning now.

As always, your thoughts and comments are welcome!