In 2020, we saw a flurry of COVID-19-related activity at the SEC designed to help companies navigate the business impact of the pandemic. That, however, didn’t stop the SEC from pushing through several key rulemaking initiatives on its regulatory agenda.
This blog post highlights certain changes in SEC reporting and disclosure across several key topics, along with practical takeaways.
SEC reporting and disclosure impacted by some key 2020 focus areas
We saw a good deal of activity in the SEC reporting and disclosure realm during the second half of 2020, particularly when it comes to reporting and disclosure changes for companies, including China-based issuers, proxy advisory firms, and resource extraction issuers. What follows is a discussion of the changes in these three focus areas.
1) China-based issuer disclosure considerations
In November 2020, the SEC’s Division of Corporation Finance released CF Disclosure Guidance: Topic No. 10, calling for more risk disclosures from companies based, or with the majority of their operations, in the People’s Republic of China (“China-based issuers”) (available on Thomson Reuters Checkpoint, along with other Staff guidance, SEC statements, and rulemaking discussed herein). This call to beef up disclosures is a byproduct of US investors having increased exposure over the past 10 years to China-based issuers whose disclosures run the risk of being incomplete or misleading because even though these registrants generally have the same disclosure obligations and legal responsibilities when accessing US public capital markets as do other non-US registrants, the SEC may be “materially limited” when it comes to enforcing high-quality disclosure standards for them.
Some China-based issuers may be asking why bother complying since the call for more disclosure is in the form of guidance, without legal force or effect. Though the guidance isn’t a rule or regulation, the subject matter has gotten considerable attention. Even the Division of Investment Management has issued related guidance, and more guidance and rulemaking are expected to follow. You should expect SEC Staff to use the guidance as a roadmap for determining whether to issue comments when reviewing your filings.
Let me help put into context the importance of the Staff guidance. It comes in response to a Report on Protecting United States Investors from Significant Risks from Chinese Companies, issued in July 2020 by the President’s Working Group on Financial Markets consisting of former SEC Chairman Jay Clayton and others, which made a number of recommendations, including that regulators require “enhanced and prominent” risk disclosures associated with investing in China-based issuers and issue clarifying interpretive guidance. Then in August 2020, Clayton and other senior SEC officials responded to the Report, sharing that SEC Staff had been directed to prepare proposed rulemaking in response to the Report’s recommendations. Finally, we mustn’t forget that in December 2020, the Holding Foreign Companies Accountable Act (also available on Thomson Reuters Checkpoint)—designed to address the PCAOB’s lack of access to information needed to complete audit firm inspections—became law, providing that a foreign company traded on a US exchange would face delisting for using an auditor unable to be inspected by the PCAOB for three straight years.
Now that the importance has been underscored, let’s look at some disclosure considerations that you should keep top-of-mind as you evaluate material risks associated with your operations in China and related disclosure obligations:
High-quality, reliable financial reporting. In light of restrictions currently faced by the PCAOB when it comes to inspecting audit work and practices of PCAOB-registered public accounting firms in China, ask yourself whether you:
- Provide clear disclosure of these inspection limitations.
- Disclose the difficulty that the SEC, PCAOB, and other regulators may have in obtaining audit work papers from your auditors and the resultant impact on you and your shareholders.
- Disclose that your inability to satisfy listing standards or other requirements could result in delisting and adversely affect your liquidity.
Organizational structure. Chinese regulations restrict foreign investment in Chinese companies operating in certain industries. As a workaround, many China-based issuers form non-Chinese holding companies that enter into contractual arrangements with Chinese operating companies meant to mirror direct ownership, but there are heightened risks if the Chinese government decides that the agreements establishing these variable interest entities (VIEs) don’t comply with Chinese law and regulations. With this in mind, consider whether you:
- Use VIEs in your organizational structure and if so, whether you include ample disclosure about the related party transactions and warn investors about the associated risks.
Regulatory environment. China’s legal system is noticeably different from the one in the US and may raise risks and uncertainties related to evolving laws and regulations, as well as their inconsistent interpretation and enforcement. In light of this, consider whether you disclose how:
- These risks and uncertainties could lead to failure to obtain or maintain licenses and permits to do business in China.
- Uncertainties in China’s legal system could limit the enforcement of contractual arrangements.
- Chinese governmental authorities have significant discretion that can be used to influence how the company conducts business operations.
China-based issuers, going forward, think about modifying your SEC reporting and disclosure practices so that they address the considerations set forth in the Staff guidance, as the SEC will likely be watching.
2) Stricter proxy advisory firm regulation
Effective November 2, 2020, the SEC adopted amendments to its rules governing proxy solicitations, in Final Rulemaking Release No. 34-89372, in an effort to allow clients of ISS, Glass Lewis and other proxy voting advice businesses reasonable, timely access to more transparent, accurate, and complete information on which to base voting decisions.
As part of this effort, the SEC modified its definition of proxy solicitation to include proxy voting advice, as well as its antifraud rule for proxy solicitations to add failure to disclose material information regarding proxy voting advice to the list of false or misleading statements. With proxy voting advice now qualifying as a solicitation, proxy advisors would be required to comply with burdensome SEC reporting and disclosure requirements without an exemption. To be eligible for such an exemption, proxy advisory firms must (1) disclose conflicts of interest that they have with those of you that are the subject of their advice, especially since it’s common for them to do consulting work for registrants, and (2) adopt written policies and procedures making proxy voting advice available to you no later than when the advice goes to clients and establishing a mechanism for clients to be made timely aware of your written responses.
Keep in mind, registrants, that unlike the proposal, the final rules don’t give you a chance to review and comment on proxy advisory firms’ recommendations before delivery to clients, or require that a proxy advisory firm include a hyperlink to your response statement in its voting advice. Also keep in mind that proxy advisory firms aren’t required to comply until December 1, 2021, just in time for the 2022 proxy season.
Now for some important takeaways:
- The new Congress may overturn this rulemaking under the Congressional Review Act (CRA). After all, it was the subject of a strong dissent, and SEC Investor Advocate Rick Fleming has recommended its nullification.
- If this rulemaking survives nullification efforts, the impact won’t extend to M&A transactions, proxy contests and certain other time-sensitive solicitations, or to voting advice about foreign private issuers.
- Proxy advisors may condition distribution of their advice to you on your filing a definitive proxy statement at least 40 calendar days before your annual meeting. So, some of you may want to consider revising your timelines to ensure that you’re able to take advantage of these new access rules.
- Though many of you already issue soliciting material in response to proxy voting advice, the new framework allows for an earlier opportunity to do so. It may be worthwhile to prepare in advance so that you’re set up to quickly review voting advice and promptly respond.
3) Resource extraction issuer payments
In December 2020, the SEC issued Final Rulemaking Release No. 34-90679, once again adopting rules implementing Exchange Act Section 13(q) that will become effective March 16, 2021 and require resource extraction issuers—those of you oil, natural gas, and mining companies obliged to file reports under Exchange Act Section 13 or 15(d)—to annually file Form SD with information about payments related to the commercial development of oil, natural gas, or minerals that are made to a foreign government or the Federal Government.
The SEC’s effort to increase the transparency of your payments is its third attempt. Exchange Act Rule 13q-1 and amendments to Form SD were originally adopted in 2012 and later vacated in 2013 by the US District Court for the District of Columbia. In 2016, the SEC adopted revised Rule 13q-1 and Form SD, but in 2017, the revised rules were disapproved by a joint resolution of Congress under the CRA. Although the joint resolution vacated the 2016 rules, the statutory mandate under Section 13(q) remained, and the SEC was obligated to propose rules that weren’t “substantially the same” as the disapproved rules.
The final rules adopted in December 2020 break considerably from the 2016 rulemaking in several ways by, among other things:
- Defining “project” to require disclosure at the national and major subnational political jurisdiction level as opposed to the contract level when it comes to disclosure of company-specific, project-level payment information.
- Adding new conditional exemptions for scenarios where a foreign law or a pre-existing contract prohibits the required disclosure and for those of you that are smaller reporting companies and emerging growth companies.
- Adding relief for those of you who’ve recently completed IPOs.
- Extending the payment-disclosure deadline so that after a two-year transition period, you’ll be required to annually submit Form SD no later than 270 days following the end of your most recently completed fiscal year (meaning if you’re a calendar year-end company, for example, you’ll need to file your first report by September 30, 2024).
Ironically, these new SEC reporting and disclosure rules for resource extraction payments are once again on the CRA chopping block. Even if the new rules survive nullification efforts, the SEC anticipates other challenges and has set out its position on how the rules may operate if the two most controversial elements—definition of project and scope of exemptions—are rejected by courts. Take heed, registrants, that if the definition of project is overturned, you must continue making all required disclosures, but you may use your own reasonable definition of project while the matter’s under consideration. Similarly, if any exemptions are overturned, you must continue making all required disclosures, though the SEC may issue exemptive orders while reconsidering how to proceed. As with the new proxy advisor rules discussed earlier, let’s keep our eyes peeled regarding the fate of these rules.
For more information on the foregoing, check out SECPlus Filings Highlight, Hollysys and Others May Be Harmed by Enactment of Holding Foreign Companies Accountable Act, and SEC Accounting and Reporting Update (SARU) Nos. 2020-49, SEC Staff Guidance Concerning Disclosures of Material Risks by China-Based Issuers, 50, Identification of and Disclosures by Foreign Private Issuers Domiciled in Countries That Restrict PCAOB Access to Audit Inspections, and 51, Rules Implementing Section 1504 of the Dodd-Frank Act Concerning Disclosures by Resource Extraction Issuers of Certain Payments to the US Government or a Foreign Government.