2019 Proxy Season Hot Topics: Part 3 − SEC hedging rules, auditor report, Form 10-K changes


Proxy Season Hot Topics

Corporate Governance Alert


As we enter the 2019 proxy season, we want to bring your attention to a few topics that are likely to play a prominent role in the coming months. In our first alert, available here, we discussed changes in the voting policies of ISS, the SEC's continued focus on non-GAAP measures and the SEC's proxy plumbing roundtable. In our second alert, available here, we took a deeper dive into issues directly impacting the 2019 proxy season to discuss changes in the voting policies of Glass Lewis, virtual-only shareholder meetings, issues regarding board refreshment, composition and diversity, say-on-pay, CEO pay ratio and director compensation arrangements.

In this alert, we discuss some issues beyond proxy-related matters that are likely to impact public companies in general, including the new SEC hedging rules, changes to the independent auditor's report, changes to the Form 10-K cover pages and exhibit hyperlinks.

We are excited about our new format for this series and invite you to call the authors of this alert or your DLA Piper contact if you have any questions or would like to discuss any of the issues reviewed in the series.


In late December 2018, the SEC adopted final rules to require companies to disclose in proxy or information statements for the election of directors any practices or policies regarding the ability of employees or directors to engage in certain hedging transactions with respect to company equity securities. The final rules implement Section 14(j) of the Securities Exchange Act of 1934, which was enacted by Section 955 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. As explained by the SEC, the "statutory purpose of Section 14(j) is to provide transparency to shareholders at the time of an annual meeting, which is when directors are elected, about whether a company's employees or directors may engage in transactions that reduce or avoid the incentive alignment associated with equity ownership related to their employment or board service."

New paragraph (i) to Item 407 of Regulation S-K requires companies to describe any practices or policies regarding the ability of employees, directors or their designees to hedge their company's equity securities. To be clear, the new rule does not require a company to prohibit or limit any such hedging. Instead, a company is required to provide a description of any practices or policies that apply, including the category of persons covered and any categories of hedging transactions that are specifically permitted or disallowed. In addition, companies are not mandated to require such a policy. They can, instead, disclose that they do not have any such practices or state that hedging transactions are generally permitted. In addition, Item 407(i) specifies that the equity securities for which disclosure is required are equity securities of the company, any parent of the company, any subsidiary of the company, or any subsidiary of any parent of the company.

Issuers must include the new disclosure in proxy and information statements for the election of directors during fiscal years beginning on or after July 1, 2019. There is a limited exception for "smaller reporting companies" or "emerging growth companies" (each as defined in Securities Exchange Act Rule 12b-2), which are required to comply with the new disclosure requirements in proxy and information statements for the election of directors during fiscal years beginning on or after July 1, 2020. Listed closed-end funds and foreign private issuers are not subject to the new disclosure requirements.

DLA Piper action items

  • Consider including the following question in the D&O Questionnaire:

"Have you purchased or sold any financial instruments (including prepaid variable forward contracts, equity swaps, collars or exchange funds) that are designed to hedge or offset any decrease in the market value of equity securities (i) granted to you by the Company as part of your compensation, or (ii) held, directly or indirectly, by you?

If yes, please describe the transaction dates, including the number and type of securities and the date(s)."

  • Review the interplay between Item 402(b) and Item 407(i) of Regulation S-K and the related disclosure obligations.
  • Review existing policies and practices that relate to hedging transactions and keep track of changes adopted by your peer group regarding this issue.


In October 2017, the SEC approved long-awaited changes to the form and content of the PCAOB's standard unqualified independent auditor's report intended to enhance the value of the report to both internal and external company stakeholders (full text of the new rule is available here). In addition to its usual pass or fail opinion, the new report model includes (1) enhancements to report format and auditor-related disclosures and (2) sharing of "critical audit matters" (CAMs), which are subjective or complex matters encountered during the audit. The new requirements are being implemented with a phase-in approach for audits of fiscal years ending on or after December 15, 2017, June 30, 2019 and December 15, 2020. The changes present both opportunities and challenges to independent auditors and company audit committees and will require increased planning and communication between the two groups in order to have the intended effect.

Enhancements to report format and auditor-related disclosures

Changes to the audit report format and required auditor-related disclosures are currently in effect for all audits conducted under PCAOB standards for fiscal years ending after December 15, 2017, including audits of non-accelerated filers, smaller reporting companies and emerging growth companies (ECGs). The new auditor report must:

  • disclose auditor tenure
  • include a statement that the auditor is required to be independent
  • adopt a standardized format with the opinion located in the first section of the report and
  • describe the auditor's responsibility to obtain reasonable assurance as to whether the financial statements are free of material misstatements "whether due to error or fraud."

A related amendment to PCAOB standards requires that the auditor provide an advance draft of the auditor report to the company's audit committee and discuss it with the committee. The changes regarding auditor tenure, along with the other format updates, are intended to add a layer of transparency into auditor oversight and improve overall readability of the report.

Changes related to critical audit matters (CAMs)

Changes regarding the determination, communication and documentation of CAMs, including disclosure of CAMs on the report itself, are required for large accelerated filers for audits of fiscal years ending on or after June 30, 2019 and for all other filers (except for ECGs) for audits of fiscal years ending after December 15, 2020.

CAMs involve any matter arising from an audit that (1) were communicated or required to be communicated to the audit committee; (2) relate to accounts or disclosures material to the financial statements; and (3) involve especially challenging, subjective, or complex auditor judgment. They are most likely to be identified in areas where investors have expressed particular interest, such as significant management estimates and judgements made in preparing the financial statements, areas of high audit risk and disclosure of significant unusual transactions, among others.

CAMs are not intended to diminish or detract from the auditor's overall opinion on the financial statements, nor to be taken as separate conclusions on individual financial statement items or that such items may be materially misstated. Rather, they are meant to provide additional color on how the auditors addressed certain complex or challenging financial statement items unique to the particular audit. To allay concerns and potential misconceptions about the new standards among auditors, audit committees and investors, the PCAOB has provided considerable guidance to help with implementation, including specific factors for auditors to consider when determining whether a matter is a CAM and guidance regarding form and manner of disclosure of CAMs on the auditor report.

Auditors should consider the following factors in identifying a CAM:

  • the auditor's assessment of risk of material misstatements
  • the degree of judgment required of management and auditors, including whether the matter involves estimates with measurement uncertainty
  • the nature and timing of significant unusual transactions and the amount of effort required to ascertain them
  • the degree of auditor subjectivity required to evaluate the matter
  • the nature and extent of auditor effort required, including the degree to which specialized skills or knowledge is needed and
  • the nature of audit evidence obtained regarding the matter.

Depending on the matter, the auditors may base their conclusion on one or a combination of factors from the list above. While the number of CAMs will vary by audit, it is quite likely that most auditor reports will include at least one CAM (though they may include none). In any event, auditors should make an effort to avoid boilerplate lists of CAMs repeated across audits of different companies. Regarding form and manner of disclosure, introductory language on the auditor report must expressly state that the inclusion of CAMs does not alter the auditor's opinion as a whole, nor is the auditor providing separate opinions on the CAMs or related financial statement disclosures. When describing CAMs, the PCAOB expects auditors to do so in a concise, understandable manner that avoids the use of highly technical accounting and auditing terms. In addition, auditors are instructed to avoid inclusion of previously undisclosed items in its discussion of CAMs on the auditor report and, where original information would be necessary, to discuss such disclosure with company management in advance and to limit it to areas uniquely within the purview of the auditor's responsibilities (eg, describing the principal considerations leading the auditor to conclude an item is a CAM).

DLA Piper action items

  • Consider in advance the nature and extent of the company's financial statement disclosures and make a preliminary determination of items that may constitute CAMs.
  • Discuss potential CAMs with auditors as early as possible in the course of the audit, particularly any items not previously disclosed, to determine whether and how both the auditor's and the audit committee's unique perspectives on such items can best enhance the understanding of investors.


Removal of check-the-box exception for smaller reporting companies

On September 10, 2018, the SEC expanded the definition of "Smaller Reporting Company" (SRC) to include companies with less than $250 million in public float as well as those with under $100 million in annual revenues if their public float is less than $700 million. The revised definition makes it possible for a Smaller Reporting Company also to meet the requirements to be an accelerated filer. Accordingly, the Form 10-K cover page no longer includes the familiar "(Do not check if a smaller reporting company)" instruction next to the "Non-accelerated filer" box where filers must check the box to indicate their filer status. Filers are advised to simply delete this language on their Form 10-K cover pages going forward.

Changes to XBRL Exhibit and Interactive Data File Requirements

On September 17, 2018, the SEC eliminated the requirement to make available eXtensible Business Reporting Language (XBRL) exhibits and interactive data files on a company's website. Accordingly, the Form 10-K cover page instructions have been updated to delete three references to posting this information to the registrant's corporate website. Other than striking this language, the cover instructions remains unchanged with respect to XBRL and Interactive Data File requirements.

Form 10-K filers are advised to update their task and responsibility checklists to revisit the updated Form 10-K made available on the SEC's website and ensure that the outdated language related to these two items has been removed from the filers' Form 10-K cover page.


Since September 1, 2017, the SEC has required Form 10-K filers to include an active hyperlink to each exhibit listed in the exhibit index of Form 10-K filings and to submit Forms 10-K in HyperText Markup Language (HTML) format to support the active hyperlinks for each exhibit. The SEC's adopting release for the hyperlink requirement can be found here. While the hyperlink rules were effective as of September 1, 2017, non-accelerated filers and smaller reporting companies that submitted filings in the American Standard Code for Information Interchange (ASCII) format had until September 1, 2018 to comply with the Form 10-K exhibit hyperlink requirement. Non-accelerated filers and smaller reporting companies that are relatively new to the exhibit hyperlink process are encouraged to prepare their Form 10-K exhibit hyperlinks early in the process and work closely with their financial printers on preparing the active hyperlinks in HTML format.

The active hyperlink requirements apply both to exhibits that are filed as part of the Form 10-K and those incorporated by reference to a prior filing. Volume II, Chapter 5 of the EDGAR Filer Manual contains detailed instructions and technical requirements for preparing the exhibit hyperlinks. Filers are advised to continue to coordinate with their financial printers throughout this process and ensure that both filer and financial printer are technologically equipped to properly and reliably add the active exhibit hyperlinks in the required manner.

Filers also should note that the SEC's hyperlink requirements do not apply to any XBRL exhibits because such exhibits are not incorporated by reference into other filings. Exhibits filed on paper only are also exempt from the hyperlink requirements and companies may continue to incorporate exhibits previously filed on paper only by reference. The SEC will not require companies to refile such exhibits in order to comply with the later hyperlink requirements.

DLA Piper action items

  • Prepare to "test" each of the hyperlinks in the current exhibit index that bring forward an exhibit filed in a previous Form 10-K in order to ensure that all of the hyperlinks are properly connected to the corresponding item in the exhibit index.
  • Remember that an inaccurate exhibit hyperlink will not necessarily result in a materially deficient Form 10-K filing, nor automatically prevent a filer from taking advantage of a short-form registration statement. Nonetheless, the SEC continues to monitor and test exhibit hyperlinks, and failure to properly hyperlink an exhibit will result in SEC scrutiny and additional financial printing costs.
  • Recall that Item 601(a)(2) of Regulation S-K now requires the Form 10-K exhibit index (Item 15) to appear before the Signatures section, which is often the last section of the document.

Find out more about these concerns by contacting Sanjay Shirodkar, Jason Harmon, Brooke Goodlett or Jared Jensen, and see the entire 2019 Proxy Season Hot Topics Series here.