VIA E-MAIL TO email@example.com
October 3, 2002
Securities and Exchange Commission
Re: File No. S7-22-02
Ladies and Gentlemen:
We submit this letter in response to the request of the Securities and Exchange Commission (the "SEC") for comments on its Release No. 33-8106/34-46084; File No. S7-22-02, entitled "Additional Form 8-K Disclosure Requirements and Acceleration of Filing Date" (the "Release").
The group submitting this letter consists of a Stanford Law School securities law professor and securities lawyers practicing in the Silicon Valley area who collectively work for seven private law firms. The views reflected in this letter constitute a consensus of our individual perspectives. They do not reflect the official positions of the law firms or other organizations with which we are affiliated, or the clients of any of our law firms. Because this is a consensus document, we and our firms each reserve the right to express views that may not be fully reflected in this letter.1
The law firms with which we are affiliated primarily represent technology companies, and have been involved with a large majority of the capital formation activity in Silicon Valley. We are individually familiar with the issues that arise in the preparation and filing of reports by public companies and their insiders under the Securities Exchange Act of 1934 (the "Exchange Act"), and we believe that we have a broad insight into the workings of the public company reporting process in the high-technology industry, particularly as it has developed in Silicon Valley.
The following summarizes our comments, which are discussed in more detail below:
II. General Comments
A. The Two Business Day Deadline Is Frequently Impractical
The Release proposes that all Form 8-K filings be made within two business days of the designated triggering event. We believe that this deadline is impractical, especially when the filing requirement calls for companies to make materiality judgments and MD&A-type disclosures.
Some of the items for which the Release would mandate Form 8-K filings are discrete events where it is relatively easy to determine whether the event has occurred, for example, the resignation of an officer or director, the replacement of an independent auditor, and the receipt of a delisting notice from an exchange. Based on our experience representing publicly traded companies, we strongly believe that even for these discrete events, many companies will not be able to prepare and file a Form 8-K for an event within the two business day deadline. This belief is reinforced by our recent experience with the two business day deadlines for filing Forms 4. We have found it very difficult to gather the information, complete the Form 4 and file the Form 4 with the SEC within the two business day deadline. Indeed, the Form 4 disclosures are much simpler, and can be filed in a number of different ways that give issuers more flexibility, than the proposed Form 8-K disclosures.
More troubling, the proposed disclosure items that require a determination of materiality would be impossible even for the best-run companies to disclose within two business days. In order to make a filing about entry into a "material" contract or the occurrence of another "material" event, company decision-makers need to:
In addition, given various requirements of the Sarbanes-Oxley Act of 2002 and of governance and listing standards under consideration by The New York Stock Exchange and Nasdaq Stock Market, companies may find it necessary or appropriate to discuss or circulate the proposed filings with their Disclosure Committee (if they have one), their independent auditors and their Audit Committee.
It is unreasonable to expect issuers to condense these steps into two days without risking frequent errors, widely variable quality of disclosure, and other unintended consequences.
Some commenters with respect to the "aircraft carrier" release may have been of the view that some of the Form 8-K disclosures proposed in that release could be filed within two or three days of the triggering event. However, most of those items (such as the filing of earnings releases, changes in auditors and resignations of directors) involved relatively straightforward events. In contrast, many of the disclosure items addressed in the Release require companies to engage in a complicated process of detecting, analyzing, drafting, and circulating detailed disclosures regarding "material" contracts and events. Therefore, we believe that the SEC should not rely on the "aircraft carrier" comments in assessing the ability of issuers to respond to the accelerated Form 8-K filing deadline for the items proposed in the Release. We have proposed, in Section II.J. below, alternative filing deadlines for the expanded Form 8-K disclosures.
We also believe that Rule 12b-25 is not responsive to issuers' needs for time to complete Form 8-K disclosures properly. Filing a Rule 12b-25 notice, without explanation, would alarm the market, because it signals that the company plans to disclose potentially material information. This would naturally lead to speculation about whether the news is positive or negative, and would be an unnecessary and expensive increase in volatility in the trading of the company's securities.
B. Two Business-Day Filing Deadlines Will Result in Disclosure That Lacks Thoughtful Analysis
Even if an issuer is able to rush through the steps outlined above and timely file a Form 8-K with the SEC within two business days, it is not likely within that time to have conducted a thoughtful analysis of the relevant issues, especially where an MD&A-type analysis is required. Such an analysis, on its own, often requires more than two business days to complete. In some cases a company may be able to begin its analysis in advance, but in many cases a company may not have all the facts until the date of the event that triggers the disclosure obligation. As a result, this proposal would not accomplish the goal of providing investors with a thorough evaluation of significant events that affect the company. Simply put, there is often an unavoidable tradeoff between the speed with which a disclosure is made and the precision, analytic depth, and thoughtfulness of the disclosure. The proposed two-day filing deadline places an extreme emphasis on speed over all other considerations, including precision and thoughtfulness.
C. Use of Materiality-Based Disclosure Triggers Will Result in More Subjective, Less Consistent Disclosures Among Companies
Materiality judgments are among the most difficult judgments that companies must make when complying with the disclosure rules under the federal securities laws. Because they require subjective assessments of the particular facts facing a particular company, different companies may come to different conclusions when analyzing similar situations. This is especially true when the judgments must be made hastily, with insufficient time to reflect on developments and analyze information. Requiring real-time disclosures based on these judgments will subject companies to second guessing and will likely result in inconsistent levels of disclosures among public companies.
We recommend that Form 8-K disclosures be confined to situations where readily-determinable triggering events have occurred - for example, proposed Items 2.02, 3.02, 3.03, 4.01, 4.02, 5.02 and 5.03. We also recommend that to the extent possible the content of the required disclosure be structured around objective facts about those triggering events.
D. Expanded Form 8-K Disclosures Would Require Substantial Changes to Corporate Disclosure Procedures, Which Will be Very Costly and Time Consuming to Implement
The Release implicitly proposes that companies, in addition to reviewing their operations and making disclosures on a periodic quarterly basis as they are accustomed to doing, will continuously evaluate their activities to detect potential disclosure matters. This system would require issuers on a day-to-day basis to determine (among other things) whether a material agreement was executed or terminated, whether a previously non-material agreement has become material due to external developments, whether a material business relationship may be in jeopardy, and whether a contingent financial obligation may have been created or triggered. This would be a dramatic change from the periodic evaluation of results that issuers currently undertake.
In order to satisfy any such expanded Form 8-K requirements, companies would need to create procedures to gather data continuously about events that might fit a disclosure category and provide that data to the appropriate decision makers, enable them to evaluate whether these events require disclosure, and, if so, still allow time to perform the remaining procedures described above. Most companies do not have these continuous disclosure procedures in place, because today they prepare disclosure at the end of each quarter. The existing system of periodic reporting permits more time to reflect on the developments that have affected the company's operations. Developing and implementing new procedures will involve significant time, effort and expense, increased internal staffing and increased use of external advisers such as lawyers and accountants. The costs to implement and maintain these procedures are not comparable to the costs that issuers currently incur to prepare and file Forms 8-K. Unlike existing Form 8-K requirements, the proposed Form 8-K disclosures would require issuers to assess their business operations constantly, monitoring everyday business matters as well as the unusual and extraordinary items currently required and to make subjective judgments and disclosures with little time for reflection or review. As a result, it is not appropriate to use current Form 8-K costs to estimate the costs to comply with the changes proposed in the Release.
Developing and implementing these procedures will be especially challenging in light of the multitude of new securities and corporate governance requirements with which companies are currently coping.
Therefore, as discussed above, we recommend that Form 8-K disclosures be confined to situations where readily-determinable triggering events have occurred and that to the extent possible the content of the required disclosure be structured around objective facts about those triggering events.
E. Proposed Rules May Require Disclosure of Confidential and Competitively Sensitive Information and Could Permit Manipulation of Negotiations by Third Parties
Some of the Form 8-K disclosure requirements proposed in the Release could require disclosure of extremely sensitive information, such as letters of intent regarding acquisitions, significant customer and supplier contracts and pricing or royalty information under material agreements. Often such disclosure would be considered so potentially harmful that it would affect the negotiation process itself and make it more difficult for companies to complete significant transactions. If disclosed prematurely, this information could be used by competitors to undercut the reporting company. For example, as discussed in more detail in Section III.A., if a target company is required to file a non-binding letter of intent, another potential suitor could review the terms and launch a counterbid in an attempt to either take over the target or to simply disrupt the original suitor's chances of completing the transaction. The need to file such agreements could discourage third parties from entering into agreements with these companies at all, out of a desire not to have the terms of their relationship publicized through an SEC filing. This would place companies obligated to disclose the existence of, and details about, these types of transactions (such as smaller public companies) at a significant disadvantage to privately held companies and foreign companies (which are not subject to these disclosure requirements) and larger public companies (where less is material). Therefore, as discussed in more detail in Section III.A below, we recommend that the proposed rules be revised to eliminate the requirement to disclose letters of intent and to provide a more workable mechanism for companies to request confidential treatment of sensitive aspects of events and transactions that are required to be disclosed.
Some of the proposed items (Items 1.02, 1.03 and 2.04) require issuers to file Forms 8-K based upon receipt by the issuer of termination and other notices from third parties. Structuring the disclosure obligations in this manner will provide these third parties with inappropriate negotiating leverage. For example, if the other party to a contract knows that the company must file a Form 8-K if a termination notice is sent, that party may use this fact as a negotiating tactic to extract better terms. That party may use this tactic even where it has no intention of terminating and it would not threaten to send a termination notice if the counterparty were sufficiently large that no Form 8-K filing would be triggered. Therefore, as discussed in greater detail in Sections III.B., C. and E. below, we recommend that, if these items are adopted, the triggering events be revised to give the receiving company greater control in determining when a termination (or other triggering event) has occurred.
F. Difficult New Judgments and Disclosures Will Place a Significant and Disproportionate Burden on Small Issuers Without Significant Benefits to the Investing Public
As discussed above, the proposed Form 8-K disclosure requirements will require companies to change in significant ways how they monitor, analyze, prepare and file disclosures regarding certain potentially "material" events. These procedures will be costly to issuers.
The costs associated with expanded Form 8-K disclosures will fall disproportionately on smaller companies. These companies typically lack extensive finance, accounting and legal staffs, may be given lower priority by their outside auditors, and often rely on outside counsel to handle disclosure responsibilities that larger companies would handle in-house.
Even more important, the lower revenue levels, smaller asset bases and general business volatility of smaller companies suggests that more contracts and events are likely to be material for them than would be the case for larger companies. Therefore, all other factors being equal, smaller companies are likely to have to file a greater number of Form 8-K disclosures than larger companies, where fewer transactions are likely to be material due to the larger companies' higher revenue levels and larger asset bases.
The greater number of filings is also likely to cause more competitive harm to smaller companies, both directly as a result of the required disclosures, and indirectly in a greater unwillingness of third parties to do business with them for fear of having the terms of their agreements disclosed. Further, these smaller companies are likely to be particularly susceptible to market volatility from premature Form 8-K disclosure about the negotiation of an acquisition or other significant transaction.
We believe that the costs and burdens faced by smaller companies are not justified by the benefits to the investing public associated with expanded Form 8-K disclosures. Companies with lower revenues and fewer employees generally have lower market capitalizations, meaning that more timely information about smaller companies will generate fewer aggregate benefits for investors. Thus, the expanded Form 8-K disclosures increase costs for the companies as to which the disclosures will generate the fewest aggregate benefits.
The following graphs help illustrate the extent to which the cost-benefit analysis of the disclosure obligations contemplated by the new Form 8-K requirements differ materially from a cost-benefit analysis as it might be applied to traditional disclosure requirements.
Figure 1 describes a cost-benefit analysis of a "traditional" disclosure rule in which larger issuers incur larger costs but also generate larger benefits as a consequence of their compliance with the new disclosure requirement.
The horizontal axis measures the scale of the issuer. The left vertical axis measures the average per-issuer costs that a given disclosure rule will generate for an issuer of corresponding scale as measured along the horizontal axis. The right vertical axis measures the average per-issuer benefit that the same disclosure rule will generate for an issuer of corresponding scale as measured along the horizontal axis.
The dashed line measures the costs that are incurred by issuers as a function of the issuer's scale. This line gradually increases, demonstrating that as issuers become larger, their operations are more complex and the costs of compliance increase. The solid line measures the benefits that issuers generate as a consequence of their compliance. This line also gradually increases because, as larger issuers provide better information to the market, the quantity of market capitalization that is more accurately priced also increases.
The fact that the solid line in Figure 1 is uniformly above the dashed line suggests that, on average, the cost-benefit analysis of the hypothetical disclosure rule described in Figure 1 supports the conclusion that the rule generates aggregate benefits in excess of aggregate costs and that a special exemption for smaller issuers is not warranted.
Figure 2, however, illustrates a very different situation - a situation that is far more likely to describe the cost-benefit analysis of the proposed Form 8-K filing requirements.
The critical distinction illustrated by Figure 2 is that, as the scale of an issuer increases, the probability that the issuer will have to make additional Form 8-K filings under the proposed rules decreases because fewer transactions will be large enough to be considered material. Accordingly, a small issuer may find itself making one additional filing a month whereas a large issuer might make one or two additional filings a year. Compliance costs for smaller issuers can therefore, all other factors being equal, reasonably be expected to be higher than for larger issuers. Thus, the dashed line that describes those compliance costs in Figure 2 will be gradually decreasing. The average benefits to investors of disclosure for smaller issuers will, however, remain smaller than the average issuer benefits of equivalent disclosures for larger issuers. The solid line in Figure 2 that describes the benefits associated with faster disclosure of material events is thus increasing in scale, as in Figure 1.
Figure 2 suggests that there is a scale at which the benefits of the new disclosure requirements outweigh the costs. For issuers to the left of this point, the average costs of disclosure exceed the benefits. For issuers to the right of this point, the average benefits exceed the costs. If this characterization of the cost-benefit profile of the proposed rule is accurate, then the SEC cannot conclude without further careful analysis that the aggregate benefits of the rule exceed its costs. In addition, if this characterization is correct, then there is a powerful argument for the introduction of a minimum scale test below which issuers should not be subject to the new Form 8-K requirements. Indeed, for those issuers, given their low materiality thresholds, the high frequency of filings that would be triggered by those low materiality thresholds, and the low benefits that would result because of the issuers' low market capitalizations, the proposed rule would result in a situation in which the costs of faster and more extensive disclosure would exceed the benefits.
Given the imbalance between the costs and benefits of the proposed rules as they relate to smaller companies, we suggest that the SEC consider adopting an exemption from these rules for smaller companies and thereby limit these requirements to companies for which the cost-benefit ratio is more likely to be positive.
For example, we suggest that the SEC consider limiting the proposed disclosures to companies that are included in the S&P 500. These companies make up the vast bulk - approximately 75% of the market value - of all public companies, cover a diversity of industries, and are generally companies with the size, experience and reporting infrastructure necessary to respond to increasingly complex and lengthy disclosure requirements in a shortened time frame. We suggest that a company would be subject to the expanded subjective Form 8-K disclosure requirements at the beginning of the first fiscal year after its selection for inclusion in the S&P 500 index, and would remain subject to these requirements until it ceased to be a reporting company, became a small business issuer or otherwise successfully petitioned the SEC to change its status.
Alternatively, annual revenues would provide a rational metric to determine companies subject to these types of Form 8-K disclosures. We suggest $1.2 billion in annual revenue as a reasonable threshold for making issuers subject to these disclosure requirements. This standard is identical to that the SEC used in the Section 21(a) certification order that it issued on June 27, 2002. We believe that revenue is a reasonable indicator of whether the issuer is sufficiently seasoned and staffed so as to be capable of dealing with these more complex and time sensitive reporting requirements. Typically, a company that attains a high level of revenue has done so over a considerable time, in which it must also have developed mature financial and reporting systems and experienced legal, accounting and compliance personnel. Such a company is more likely to be in a position to put in place complex procedures that will allow it to prepare and file expanded Form 8-K disclosures with the SEC. As is the case with companies in the S&P 500 index, these companies in the aggregate represent the vast bulk of the market value of all public companies. Revenue also provides a better measure of the companies that have the ability to absorb the additional expense and overhead that will be necessary to comply with these requirements. Companies with relatively low levels of revenues, even if they are mature companies, should not be required to make these filings because they are unlikely to have the resources to devote to a new challenge of this sort, especially in light of all of the other regulatory changes to which public companies are already responding.
G. The Consequences for Failing to Make Timely Filings Are Too Harsh
As discussed above, many of the expanded Form 8-K disclosures require companies to make subjective materiality judgments without much time for thoughtful analysis. These judgments are inherently subject to second-guessing because they are not based on objective standards. It is unfair to penalize a company that makes a good faith determination that a particular item was not material by preventing the company from using Form S-3 or Form S-8, or by deeming its insiders ineligible to use Rule 144, if the SEC later second guesses the company's judgment and determines that a disclosure should have been made.
Mandating that companies lose their Form S-3 eligibility (and Form S-8 and Rule 144 availability) for failing to make the same materiality assessments as the SEC presents several troubling issues. For example, what would happen if a company, not yet realizing that the SEC might disagree with a materiality assessment that it made, conducts an offering using a Form S-3 registration statement because it believed it was Form S-3 eligible? Will employees exercising options under the company's Form S-8 while the company is unaware that it has missed a Form 8-K filing receive restricted stock that cannot be resold immediately? Similarly, will shareholders that sold shares under Rule 144 before the company became aware of the SEC's view be deprived of the benefits of that safe harbor?
To address these issues, we suggest that the SEC use the loss of Form S-3 eligibility (and Form S-8 and Rule 144 availability) as a discretionary, not an automatic, penalty for the Form 8-K items that have subjective triggers. We believe that, in assessing this sort of discretionary penalty, the SEC should take into consideration a company's good faith attempts to comply with the Form 8-K disclosure requirements.
H. Expanded Triggering Events Will Result in Flood of Filings That Mask the Truly Important Disclosures
The significant expansion in the type and number of Form 8-K triggering events will significantly increase the volume of Form 8-K filings. This increase in the number of filings could lead investors to view these filings as more routine, thereby creating a risk that truly material information will escape notice. We believe that the SEC's estimate that the proposed Form 8-K revisions would only result in two more filings per company per year is far too low, especially for smaller companies, which, given their size, are parties to a greater number of transactions and business relationships that are considered material.
To assist the public in sorting through the flood of Form 8-K filings that will be made by companies, we suggest that the SEC devote some of its allocated funds to making the EDGAR database more easily searchable by the public - at a minimum, by sorting the Forms 8-K by reportable item number.
I. The SEC Should Make Clear that Form 8-K Filing Does Not Necessarily Mean that Information Disclosed Is Material
We believe that many events covered by the proposed expanded Form 8-K items would constitute material company information, requiring insiders in possession of that information, in order to avoid liability under Rule 10b-5, to refrain from trading in the company's securities until the information has been disclosed to and absorbed by the market. However, we do not believe that this is always the case. For example, an amendment to a company's articles of incorporation or bylaws will not always be material (such as one conforming the bylaws to changes in Delaware law permitting electronic transmissions of consents), yet proposed Item 5.03 would require a Form 8-K to be filed for any such amendment. Therefore, we recommend that the SEC affirmatively state that the information disclosed in a Form 8-K filing is not deemed to be "material" solely by reason of the Form 8-K reporting requirements.
J. If the Proposed Rule is Adopted, the Deadline For Filing Should be Lengthened, the Effective Date of Changes Should be Delayed and Accelerated Deadlines Should be Phased-In
We believe that the SEC should treat the Form 8-K disclosure items that do not require the application of judgment or a materiality assessment in a different manner from those items that do require these judgments. While companies will have an easier time preparing and filing Form 8-K disclosures for the more straightforward items (such as resignations of officers and directors and receipt of delisting notices from exchanges), we believe that a two business-day filing deadline will still be difficult for those items. Therefore, we suggest that the SEC consider lengthening this deadline to five business days (subject to our further comments on particular sections of the proposed rules, discussed below).
To the extent that the SEC proceeds with some or all of the proposed Form 8-K disclosures that require materiality judgments or MD&A-type disclosures, we believe that the SEC should initially adopt a deadline that allows companies significantly more time to gather and analyze the necessary data and to draft, review and file the requested disclosures. To make this process more manageable, while still accelerating the disclosure of information to the public, we suggest that the SEC require companies to make these types of disclosures on a monthly basis (rather than the current quarterly basis), subject to our further comments on particular sections of the proposed rules, discussed below. For example, a Form 8-K filing would be required within five business days of the end of each month to cover all of the events occurring within the month. This would allow companies to put in place procedures to gather information during the month and would allow them to analyze this information and prepare thoughtful and meaningful disclosures as part of a predictable and scheduled review of their business. A monthly Form 8-K would also reduce the number of Form 8-K filings and address in part the concerns identified above that numerous filings may mask truly important disclosures.
If the SEC decides to expand the Form 8-K triggering events and accelerate the filing deadlines for Form 8-K, we strongly urge the SEC to phase-in any changes. As discussed above, it is not clear that companies will be able to comply with the accelerated filing deadlines. To even attempt to comply, they will need time to make substantial changes in their procedures and likely hire additional staff to carry out these procedures. These changes are made more difficult by all of the other changes to which companies are responding, as a result of other recent SEC rulemaking and the Sarbanes-Oxley Act of 2002. While Congress, in adopting Section 409 of the Sarbanes-Oxley Act, recognized the importance of disclosing material changes in a company's financial condition and operations on a rapid and current basis, Congress did not designate a deadline for the SEC to adopt rules implementing these disclosure objectives, nor did it require the SEC to take specific actions, as it did in other sections of the Sarbanes-Oxley Act. Therefore, it appears that these disclosure objectives are not viewed with the same urgency as, and should be addressed after, other actions that are required under the Sarbanes-Oxley Act. As a result, we suggest that any proposed changes to the Form 8-K disclosure requirements not be effective for issuers until after all of the other changes mandated by the Sarbanes-Oxley Act are in place and companies have had sufficient time to adjust to the changes. This would suggest a phase-in for any Form 8-K changes that would not begin until at least late 2003.
After a designated period of time, the SEC could then assess the practicality of further shortening the deadline for either or both types of disclosures.
K. Some of the Form 8-K Disclosures Require Forward-Looking Statements for Which the Existing Safe Harbors Are Inadequate
Some of the proposed Form 8-K disclosures require companies to include forward-looking statements. For example, proposed Item 1.02 requires companies to discuss management's analysis of the effect of the termination of a material agreement on the company, which in many cases will require the company to discuss the expected future impact of the termination on the company's business and operating results. The Release indicates that, because most of the disclosures in the proposed new items relate to specific events that have occurred, providing that the information not be "filed" would be inappropriate. The Release also references the availability of safe harbors under Section 21E of the Securities Exchange Act of 1934 and Rule 175 under the Securities Act of 1933 (see notes 100 and 101 of the Release and the accompanying text). As we discussed in our August 6, 2002 letter regarding Release No. 33-8098; 34-45907 (Disclosure in Management's Discussion and Analysis About the Application of Critical Accounting Policies) (the "August Letter"), we do not believe that these existing safe harbors are adequate safeguards against the risk of litigation from private parties with respect to forward-looking statements.
As we discussed in the August Letter, the law is unsettled as to whether a statement of present fact qualifies as an assumption that is within the statutory definition of a "forward-looking statement" or whether the omission of an assumption related to a forecast qualifies for the safe harbor. If a company's assessment of the impact of an event (such as the termination of a material agreement) is construed as a statement of current fact, then it may not be sheltered by the existing safe harbors. Further, if a company fails to describe an aspect of its analysis regarding the expected effects of an event, then the omitted data or assumptions may not, in the view of some courts, qualify for the safe harbor. This would allow plaintiffs to pursue dubious allegations of fraud by hindsight against issuers who would not make detailed forward-looking statements but for the requirements of the proposed Form 8-K items.
Therefore, as discussed in the August Letter, we believe the SEC should adopt a rule that exempts from all private party actions, express or implied, all statements that are mandated by the Release regarding management's analysis of the effects of any of the Form 8-K events covered by the proposed rule. Issuers will remain liable in civil and administrative proceedings brought by the SEC. Issuers and senior executives alike will also remain exposed to broadly expanded criminal liability in connection with any fraudulent misrepresentations or omissions related to the newly required disclosures. These serious and expanded forms of civil and criminal liability are, we believe, more than adequate to stimulate careful compliance by the issuer community. As part of our recommendation, we respectfully suggest that the SEC consider reissuing whatever rules, if any, that it determines to propose in this area together with an appropriate private litigation safe harbor.
III. Comments on Specific Items
While we disagree with many of the new requirements proposed in the Release because we are persuaded that their costs exceed their benefits for a very large number of issuers, we are submitting below comments specifically addressing those proposed disclosure items that we believe are most burdensome.
A. Item 1.01 - Entry into a Material Agreement
Proposed Item 1.01 would require public companies to file a Form 8-K to disclose certain information regarding a material agreement within two business days after entering into the agreement, and to attach the agreement to the Form 8-K.
Too Burdensome for Smaller Issuers. The proposed disclosure is overly burdensome to smaller public companies and detrimental to their investors. Determining whether an agreement is material to the company is often difficult, and smaller companies face this decision more often because any single contract or event is more likely to have a large impact on their businesses. Smaller public companies may encounter an unexpected cost from this situation if larger public companies and private companies refrain from entering into a contract because of the prospect that it will be publicly disclosed.
Disturbs Orderly Quarterly Process. Currently, material agreements are filed with the Form 10-Q or Form 10-K covering the quarter in which the agreement was entered into. This permits company management to review the contracts in light of the quarter's activities and results. It also permits management to engage in a thoughtful review to determine whether or not a contract is material. Currently, management can review what percentage of revenues a customer contract may have represented in the past quarter in order to decide whether or not the company was substantially dependent on the contract and therefore must file the contract as an exhibit pursuant to Item 601(b)(10)(ii)(B) of Regulation S-K. Under the proposed rules, management would have to predict the effect of a new contract on the company's business and financial statements within a day or two of entering into the contract. If management is too conservative for fear of failing to timely file a Form 8-K, too many contracts will be disclosed and filed, which will result in less meaningful rather than more meaningful information being provided and will be detrimental to the issuer's competitive position. More fundamentally, management's conservatism as reflected tin such a decision to file could be misconstrued as a negative view on probable performance within the quarter. If management does not file a Form 8-K, and has in good faith predicted incorrectly the impact of a particular contract, the company may be deemed to have failed to file (or timely filed) a required Form 8-K, which will, among other things, make it ineligible to use Form S-3 for at least a year.
Non-Binding Agreements Should Not Trigger Disclosure. Proposed Item 1.01 also requires disclosure of material letters of intent and other non-binding agreements. Companies often enter into letters of intent or other non-binding agreements during the negotiation of a transaction or relationship, because they are useful tools to outline terms and to show progress and good faith that is necessary to arrive at a final agreement. In the Release, the SEC states that it does not intend to change current law as to when disclosure about negotiations is required, but having to disclose non-binding agreements during negotiation of the definitive agreement would certainly be a substantial change.
First, under Basic Inc. v. Levinson, 485 U.S. 224 (1988), an assessment of materiality involves both the probability and the magnitude of the event. Clearly, the probability of an agreement actually being effected is much lower at the non-binding letter of intent stage than it is at the execution stage. Thus, even an agreement that may be deemed "material" if and when it is signed may not be "material" at the non-binding letter of intent stage due to the lower probability. The proposed rule would change the definition of "materiality" under current law in this respect.
Second, even if the agreement is determined to be "material" under the Basic analysis, under Rule 10b-5 promulgated under the Exchange Act, as interpreted by the courts, the issuer is not obligated to disclose material information publicly so long as neither the issuer nor its insiders are trading securities in the market. The SEC is proposing to change the "disclose or abstain" rule by turning this long-standing premise of securities law on its head. Rather than permitting issuers to use their judgment as to when an item is "ripe" for public disclosure, the SEC would mandate disclosure that is certain sometimes to be premature and likely to cause unnecessary market volatility and misleading information.
Premature Disclosure Causes Investor Confusion. The requirement to file non-binding agreements has the real potential to create confusion among investors. For various reasons, non-binding agreements often do not result in final binding agreements, and the public is never made aware of the preliminary negotiations. However, if every preliminary agreement is made public, investors can improperly conclude that a definitive agreement will be reached under terms similar to those disclosed in the Form 8-K filing, even if the filer warns that the agreement may never be finalized or that the terms may be significantly different in a final contract. A rule that requires companies to make quick judgments to determine the necessity and content of disclosure, coupled with the likelihood that investors will not know how to assess the materiality of such an agreement at this early stage in the negotiation process, can be detrimental to the goal of a well-informed public making rational investment decisions.
Issuers Will Suffer Competitive Harm. The proposed requirement to file non-binding agreements will also lead to competitive harm to some issuers. If key deal terms are made public before the parties are required to commit to finalizing the transaction, competitors of the parties will be given a chance to disrupt the transaction or outbid one of the parties. In the merger and acquisition context, for instance, if a target company were to file a non-binding letter of intent, another potential suitor could review the terms and launch a counterbid in an attempt to either take over the target or to simply disrupt the original suitor's chances of completing the transaction. It would put the company "in play." It is also unclear whether the confidentiality agreements and "no shop" agreements that are normally entered into between parties at the outset of a possible acquisition are material and must be filed, which filing could greatly defeat their purpose and hinder the transaction's progress. Similarly, in customer contract and supply contract situations, competitors would be able to learn of the terms of a pending transaction and outbid or disrupt such a transaction before either party must commit. In addition to the competitive harm, the potentially large expenditure of management and monetary resources over a long period of time to win a contract could be wasted, causing great financial harm to the company.
Small Companies May Lose Contracts. The requirement to file non-binding agreements could also cause large public companies, which would not consider a given agreement to be material, to avoid entering into non-binding agreements when negotiating highly confidential transactions with smaller public companies that might be required to file such non-binding agreements. The large public company party may not want to disclose terms that can be viewed by its competitors and other parties with which it may enter into similar contracts. This could put smaller public companies at a disadvantage compared to larger public competitors, which are less likely to consider a given transaction material, or private competitors, which are not required to make the terms public.
Premature Disclosure May Cause Termination of Negotiations. In addition, by its very nature, either party may back out of a non-binding agreement before consummation. Once the terms of the non-binding agreement are disclosed, investors of one or both parties may react negatively if they view the initial terms as unfavorable. This could lead a party whose stock is negatively impacted to decide not to enter into the contract or try to renegotiate terms. As the contract is non-binding, that party can terminate or renegotiate the contract with no penalty. This puts the other party at risk of being unable to complete a deal if the terms it has negotiated are perceived as being "too favorable" to such other party. This could have a very detrimental effect on business negotiations generally and lead to the cancellation of transactions that would have had long-term benefits to the parties if the agreement had been finalized.
More Time is Needed for Exhibit Filing. Even if a company is able quickly to determine in a day or two that a contract is material, filing the agreement as an exhibit to Form 8-K within two business days is unnecessarily burdensome, particularly if confidential treatment of portions of the contract are being sought pursuant to Rule 24b-2 under the Exchange Act. The process for determining what portions of a contract should be kept confidential can be lengthy, as it often requires that the decision makers for the parties agree on what is to be redacted and what is to be made public. There may also be time-consuming mechanical work in transferring the contract into the proper electronic format, redacting the portions the parties desire to keep confidential, and drafting the confidential treatment request detailing the specific reasons as to why the various redacted portions should be granted confidentiality.
Conclusion: Item 1.01 Should Not Be Adopted. We suggest that Item 1.01 not be adopted and that material agreements continue to be described and filed with periodic reports. In the alternative, the requirement to file letters of intent or other non-binding agreements should be deleted from the rule. In addition, if Item 1.01 is adopted, companies should only need to describe the material contract in the Form 8-K, but be allowed to file the exhibit, together with any confidential treatment request, with the next Form 10-Q or Form 10-K. This would still accomplish the SEC's goal of prompt disclosure to investors. Furthermore, proposed Item 1.01 requires a brief description of the agreement and the material rights and obligations of the parties. There is no exception in the proposed rule for leaving out information that could cause competitive harm and that would be allowed to be kept confidential in a confidential treatment request under Rule 24b-2 of the Exchange Act. We suggest that, if Item 1.01 is adopted, it include an exception allowing for no disclosure of information that could be kept confidential under Rule 24b-2.
B. Item 1.02 - Termination of a Material Agreement
Determination of Materiality Takes Time. As mentioned above, it is often difficult to determine whether an agreement is material. This problem is obvious when determining whether a new contract is material, but issues can also arise when a contract is terminated. Under the proposed rule, whenever a contract is terminated, management must determine if that contract was material, whether or not it had been previously filed. As described above, this can be difficult, especially in a short period of time.
Difficult to Determine "Material" Conditions to Termination. Under proposed Item 1.02, a company need not disclose negotiations or discussions regarding termination of an agreement. A company must disclose termination, however, if the other party sends a termination notice to the company (which need not even be in writing if the contract allows) and generally all material conditions to termination have been satisfied. It may be difficult for a company to determine whether all "material" conditions to termination have been satisfied. This uncertainty could lead to a late Form 8-K filing if it takes the company more than two business days to distinguish whether a termination has truly taken place or the other side of the contract is merely claiming that it has occurred in order to provide leverage for re-negotiating the contract. Concerned about complying with the two business day deadline and the consequences of a missed or late filing, a company can be pressured into filing a Form 8-K if it simply receives a termination notice. In that case, the contract might not actually be terminated, and investors will have received misleading information. Moreover, different companies may reasonably comply with the rules differently, resulting in divergent disclosures for comparable company situations.
Analysis of Effects of Termination Takes Time. Proposed Item 1.02 requires that management analyze and disclose the effects on the company of the termination of a material contract. Two business days is not sufficient to draft, review and file a meaningful and well thought out "mini-MD&A." In the SEC's proposing release regarding disclosure of critical accounting policies (Rel. No. 33-8098) and its adopting release regarding officer certification of quarterly and annual reports (Rel. No. 33-8124), the SEC has pushed for formalized discussions among a disclosure team and top management and audit committee members with respect to Exchange Act filings. It is unlikely that such discussions can take place in the short time frame provided in the proposed rules.
Termination Notice May Be Misused to Provide Leverage. The proposed rule will provide leverage to a party that wants to change the terms of a contract or wants to terminate a contract on more favorable terms to itself. Because the other party to a contract knows that the company must file a Form 8-K if a termination notice is sent (and the material conditions are satisfied) in the case where the contract between the parties has been previously filed, the other party may use this fact as a negotiating tactic to extract better terms, even where it had no intention of terminating. Because the disclosure of the termination may be so harmful to a company, it may have to choose between acquiescing to unfavorable terms or suffering the damage of a public announcement of termination. This would be detrimental to the company and its shareholders. The dangers of becoming subject to such negotiation tactics are particularly profound for smaller issuers, for reasons already explained.
Expiration of an Agreement By Its Terms is Not Material. As drafted, the proposed rule may require disclosure of the termination of material contracts that merely terminate pursuant to their terms with no action by either party. It seems anomalous to draw attention in a Form 8-K disclosure to the mundane termination of an agreement. Further, it is common for companies to continue working under the terms of contracts that have expired, often because that is easier than having to draft up a new agreement.
Conclusion: Item 1.02 Should Not Be Adopted. We suggest that Item 1.02 not be adopted. The termination of agreements that are material to a company could be described in a more thoughtful manner with the benefit of hindsight if they could be disclosed in a Form 10-Q or Form 10-K MD&A. If the rule is adopted, it should not require disclosure of expirations of contracts by their terms or due to the lack of exercise of a renewal option. In addition, if the rule is adopted, it should not require the filing of an agreement that is being terminated if the agreement had not been previously filed. If the contract is no longer in effect, then there is no benefit to disclosing its terms and the potential need to seek confidential treatment would be burdensome, particularly if the two parties are at odds.
C. Item 1.03 - Termination or Reduction of Business Relationship with Customer
Triggers Are Too Subjective. Proposed Item 1.03 requires disclosure when the company becomes "aware" that a termination or reduction of a business relationship meeting the 10% threshold has occurred or will occur. While no disclosure is necessary if the company is in negotiations or discussions with the customer, it will be very difficult for a company to determine when the negotiation stage has ended and when it knows that a termination or reduction "will occur". Nor is it obvious how to determine when the company became "aware." It will be even more challenging to determine if a termination or reduction triggering a Form 8-K filing has occurred when the company is not in discussions with the customer. Some reductions may be the result of a customer unilaterally deciding to cut back orders over time without consulting the company. Further, the task of measuring a "reduction" begs the question whether it is a reduction from past levels of activity, from levels the customer contractually committed to, or from levels the company expected. Many of our clients have no backlog, standing customer orders, or long lead time production requirements, so the most significant "reductions" tend to be orders smaller or later than anticipated by the company's sales force, which is an untenable basis for requiring disclosure. We believe that any requirement for disclosure of a termination or reduction in business requires much more specificity and objectivity than the Release contains.
Method of Determining 10% is Unclear. Under the proposed rule, a Form 8-K filing is triggered when a termination or reduction equals 10% or more of a company's revenues during the company's most recent fiscal year. While the denominator for determining this threshold is the company's consolidated revenues for the most recent fiscal year, how and over what time frame the numerator is to be determined is not clear. For instance, if last year's revenues were $10 million, then a termination or reduction equaling $1 million must be disclosed. Is the Form 8-K filing triggered if the company expects $1 million less this year (or quarter?) compared to last year from the customer? Is it triggered if the company becomes aware that it may receive $1 million less than it expected to receive in the current fiscal year? If the customer contract did not specify how much the customer would purchase, how will the company be able to predict whether the potential loss in revenue will ever reach $1 million? Similarly, in the case where there is no customer contract and the customer from time to time delivers purchase orders to the company, how will a company know when a reduction in such orders equals a decrease of $1 million?
Customer May Threaten Reduction to Gain Leverage. A customer that is familiar with the Form 8-K requirements could use the rule to its advantage in negotiating with a company. The customer could threaten to send a correspondence that it is terminating its relationship unless the company grants some concession. This would put the reporting company in the awkward position of having to disclose that a key customer is terminating or give the customer the terms it was seeking. Again, this risk is particularly pronounced for smaller issuers.
Conclusion: Item 1.03 Should Not Be Adopted. We believe that proposed Item 1.03 is much too vague and does not represent the best approach for disclosing material losses of revenues from customers. A more meaningful solution would be to require companies to disclose any customer that represented 10% or more of revenues over the periods being presented in Forms 10-Q and Forms 10-K (giving the percentage) if the loss of that customer would have a material adverse effect on the company. This is currently required in the business section of Form 10-K pursuant to Item 101(c)(1)(vii) of Regulation S-K.
D. Item 2.03 - Creation of a Direct or Contingent Financial Obligation That is Material to the Issuer
We agree in principle with the SEC that the creation of material direct or contingent financial obligations should be disclosed by issuers in a timely manner. We submit, however, that Item 303 of Regulation S-K requires that issuers disclose material direct and contingent liabilities in a timely fashion. Item 303 of Regulation S-K requires quarterly disclosure (or more frequent if a registration statement is in effect) of uncertainties that are reasonably likely to result in a material decrease in liquidity. Such uncertainties would likely include most "direct or contingent financial obligations." However, if the SEC decides to adopt some form of Item 2.03, we have the following suggestions that we believe will clarify the more uncertain aspects of Item 2.03.
Impact on Smaller Companies. As discussed in Section II.F. above, we believe that requiring issuers to report transactions and events on a current basis, including material direct or contingent liabilities, will have a disproportionate impact on smaller reporting companies.
Definition of Transaction and Settlement. Proposed Item 2.03 of the Release states that a company must "disclose information whenever it or a third party enters into a transaction or agreement that creates any material direct or contingent financial obligation. . . ." Where there is no definitive agreement, a company must report a "transaction" when "settlement" occurs. Because the terms "transaction" and "settlement" are left undefined, they will be subject to different interpretations. In standard usage, each of the terms has a broad meaning, which will make it difficult for management to provide consistent and reliable disclosures pursuant to Item 2.03.
We suggest that the appropriate standard for triggering the obligation to disclose a direct or contingent financial obligation is when a registrant enters into a binding agreement. The point in negotiations at which an agreement is reached is well recognized in contract law and will provide registrants with a workable standard that will foster uniform and consistent disclosures.
Affiliates and Third Parties. Item 2.03 also states that a company must disclose information whenever "it or a third party" enters into an agreement, "whether or not the company is a party to the agreement." By requiring disclosure of transactions or agreements entered into by affiliates or third parties within two business days and by "starting the clock" upon the creation of the financial obligation, regardless of whether the issuer has any knowledge of the agreement, much less a copy of such agreement for review, the proposed rule creates a number of insurmountable analytical and logistical problems for issuers.
First, particularly with respect to agreements entered into by third parties, the issuer may not have first-hand, or for that matter any, knowledge that an agreement has been consummated. The third party may not promptly inform the issuer, for reasons ranging from ignorance of the requirement and logistical difficulties to an attempt to gain strategic advantage over the issuer. Furthermore, notice provisions in agreements typically allow a number of business days for providing notice to the other party that a particular event, such as consummation of a related agreement, has occurred, thereby making it unlikely that an issuer will be made aware that a new financial obligation has come into existence promptly enough to meet the proposed two business day filing requirement.
Second, the quality of reporting will suffer if the issuer must obtain, assess materiality, review, summarize and file on the EDGAR system the agreements of other parties within two business days. Many agreements containing direct or contingent financial obligations are lengthy and complex, and the market can receive unreliable information because the issuer lacks sufficient time to analyze the provisions of an agreement it neither drafted nor reviewed in advance.
As discussed above, we have proposed that Form 8-K items requiring materiality assessments (such as proposed Item 2.03) be filed on a monthly basis, rather than within two business days of the occurrence of a triggering event. For Item 2.03 in particular, we would further condition the filing requirement on the issuer's awareness of the agreement creating a material direct or contingent financial obligation and receipt of a copy of such agreement. This solution addresses both of the above concerns. An issuer will not be penalized for failure to report agreements of third parties of which it has no knowledge. Also, an issuer will have sufficient time following receipt of the agreement to assess its materiality and to review, summarize and disclose the obligations triggered by the agreement, thereby improving the quality of the disclosure.
Definition of "Material Contingent Financial Obligation." The term "material contingent financial obligation" must also be more clearly defined and interpreted in order for the required disclosures to be made consistently and reliably. Item 2.03 of the proposed rule requires management to disclose any "transaction or agreement that creates any material direct or contingent financial obligation to which the registrant is subject." Instruction 5 to Item 2.03 attempts to describe the term "material contingent financial obligation" by examples that are vague and over-inclusive.
The requirement to disclose "all other obligations that exist or may arise under the agreements" fails to take into account the probability that a particular contingency will occur and fails to distinguish between conditional contractual obligations that have a high likelihood of being triggered and prophylactic clauses, such as indemnification and penalty provisions, that have a low likelihood of occurring. As a result, the rule as drafted will likely encourage a flood of disclosure of possible events, regardless of the likelihood of their occurrence, making it difficult for the market to weigh various contingencies and determine which loss contingencies are worthy of concern.
We suggest that Item 2.03 of the proposed rules be modified to instruct issuers to take into account the likelihood that material contingent obligations will come to fruition. As explained above, the SEC can accomplish this by employing the concept of probability that is already embodied in Regulation S-K Item 303(a)(3), which requires issuers to disclose in their filings "any known . . . uncertainties that ... the registrant reasonably expects will have a material ... impact on net sales or revenues or income from continuing operations." In the context of contingent financial obligations, we suggest that issuers be required to report only those contingent financial obligations that the issuer "reasonably expects" will have a material impact on the issuer's business. Issuers and their advisors have grown familiar with the existing MD&A probability and materiality standards. Use of a familiar standard will enable issuers to achieve consistency and reliability in disclosures of contingent financial obligations without burdening issuers and the marketplace with voluminous disclosure of contingent events that are not reasonably expected to occur. The market will still be able to review material contingent obligations that have only a remote possibility of occurring, as such obligations will continue to be disclosed in the text of material contracts filed pursuant to Item 601 of Regulation S-K, but only those contingencies that are reasonably likely to occur would need to be expressly pointed out and discussed by the issuer.
E. Item 2.04 - Events Triggering a Direct or Contingent Financial Obligation
We agree in principle with the SEC that the triggering of material direct or contingent financial obligations should be disclosed by issuers in a timely manner. However, we believe that several problems exist with the current proposal.
Knowledge That a Triggering Event Has Occurred. As proposed, Item 2.04 requires an issuer to disclose a "triggering event" within two business days. However, in many cases, an issuer may, through no fault of its own, be unaware that a "triggering event" has occurred.
Compliance with Continuing Covenants and Conditions
Many contingent financial obligations are triggered when an issuer fails to remain in compliance with specified, ongoing representations, warranties and covenants, or when events have a material adverse effect on the issuer's business. Often, a period of time must elapse between the time when the issuer falls out of compliance with a specified contractual condition and the time when the issuer's internal controls report to the issuer that the required condition is no longer met. For instance, an issuer will typically not know it has fallen out of compliance with a financial covenant until it has completed its accounting for the relevant fiscal period, which can happen some days or weeks after the period has ended; or an issuer may not realize a material adverse effect until some time after the event that caused the adverse effect has occurred. While we do not believe that in such instances the SEC would consider an issuer in noncompliance with the proposed Item 2.04 disclosure because the issuer failed to file a Form 8-K until it became aware that the triggering event had occurred, we suggest a clarification of Item 2.04 to avoid confusion.
Item 2.04(a) currently states: "If a triggering event . . . occurs . . ." We suggest that Item 2.04(a) be revised to include a knowledge component as follows: "When the registrant becomes aware that a triggering event has occurred . . ."
Affiliates and Third Parties
Item 2.04, like Item 2.03, requires issuers to disclose events "regardless of whether the company is a party to the agreement under which the triggering event occurs." As noted above in our comments on Item 2.03, requiring issuers to disclose events triggered by agreements between third parties within two business days is impractical and penalizes the issuer for the acts or omissions of third parties. For the reasons discussed above, we suggest that the timing of the disclosure of triggering events be similarly changed to monthly filing, conditioned on the issuer's awareness of the event.
Disclosure of Financial Obligations Despite Ongoing Negotiations. Item 2.04(b) requires disclosure of a triggering event, even while negotiations are ongoing, when "a party to the agreement with the right to do so notifies the company or otherwise declares that the triggering event has occurred."
Use of Disclosure for Negotiating Leverage
The required disclosure under proposed Item 2.04 can, and we expect will, be abused by parties in a negotiation. For example, one party to a loan agreement, aware that disclosure of additional liability will decrease the issuer's stock price, can threaten to trigger a financial obligation if the issuer does not concede certain issues in the negotiation. Additionally, a dispute over the interpretation of contract language during a negotiation can lead to disputes over whether or not an obligation has been triggered and must be reported.
Disclosure of Financial Obligation After Notice or Declaration
The notice trigger can also result in a misleading disclosure that a material financial obligation has been incurred when neither party to the negotiation expects the triggered financial obligation to be enforced. Frequently a notice or declaration that a financial obligation has been triggered is simply a tactic used to bring a party to the negotiating table. In other cases, notices of default may be issued during ongoing negotiations without the intention of triggering a default or acceleration, but rather to avoid waiving the notifying party's legal rights to enforce the financial obligation while the parties continue to negotiate. It is common practice in such instances for the parties to eventually revise their agreement without ever enforcing the "triggered" financial obligation. However, requiring issuers to file a Form 8-K when such tactical or preemptive default notices are issued will interfere with this aspect of the negotiating process and can mislead the market to believe that the issuer has incurred a material financial obligation when neither party to the contract expects the obligation to be enforced.
We suggest that the concerns identified in the last two paragraphs can be resolved by revising the final clause of the penultimate sentence of Item 2.04(b) to read: "unless a party to the agreement with the undisputed right to do so notifies the registrant or otherwise declares that the triggering event has occurred and the registrant reasonably expects that the financial obligation will be enforced." [added language is underlined] This revision allows parties to negotiate in good faith and utilizes the concept of probability already embodied in Regulation S-K Item 303(a)(3), as discussed above under Item 2.03.
Provision for Cure of Default or Acceleration. The proposed definition of "triggering event" in Item 2.04 does not clearly provide an exception for events of default or acceleration that are curable by the issuer. As proposed, one of the definitions for a "triggering event" in Item 2.04(b) is as follows: "(i) unconditionally, or subject to no condition other than the passage of time, a material direct or contingent financial obligation of the registrant has arisen . . . or been accelerated." We believe that, if an event of default, acceleration or similar event is curable by the issuer, the ability to cure the default would constitute a condition other than the passage of time and, therefore, no Form 8-K would be required until the cure period lapsed. However, the proposed rule does not explicitly exempt curable events of default, acceleration or other events from the definition of a triggering event.
We suggest that the definition of a "triggering event" in subsection (i) of Item 2.04(b) be modified to read as follows: "(i) unconditionally, or subject to no condition other than the passage of time, a material direct or contingent financial obligation of the registrant has arisen . . . or been accelerated, provided, however, that if such event of default or acceleration is curable by the registrant, it shall not constitute a triggering event until the registrant's right to cure such default has lapsed." [added language is underlined] Alternatively, this clarification could be set forth in the instructions to Item 2.04.
F. Item 3.02 - Notice of Delisting or Failure to Satisfy Listing Standards; Transfer of Listing
Proposed Item 3.02 would require a company to report, among other things, any notice from the national securities exchange or national securities association that the company or its securities no longer satisfy the listing requirements or have been delisted. The proposed Form 8-K disclosure must include a discussion of the company's planned response to the notice. We agree that the delisting, or inevitable delisting, from the company's principal market is a material event that should be disclosed promptly to stockholders. We note, however, that in the case of a company listed on the Nasdaq National Market whose stock is trading below $1, the company will receive two notices from Nasdaq. The first notice is an "alert" or "warning" letter received after the company's stock has traded below $1 for 30 consecutive business days. Under current Nasdaq rules, this first notice does not have to be disclosed. If the company's stock does not trade above $1 for ten consecutive business days over the next 90-day period, the company will receive a Staff Determination Letter, which under Nasdaq rules is required to be disclosed via a press release. We recommend that, to the extent that Nasdaq allows companies a grace period to regain compliance with a particular listing standard before disclosure of potential delisting is required, the SEC follow the same guidelines.
With respect to other rules for which no grace period is required, the company should be allowed a period of time, longer than two business days after receiving notice, to determine a course of action and to discuss the issue with the exchange or association after receiving the notice. It is possible that the notice from the exchange or association is based on faulty information (particularly if it is sent without conferring with the company first) and should not have been sent in the first place. Also, it is possible that the standard that is not satisfied is easily curable by the company. It can be very alarming to investors to learn that a company has received a notice for delisting. If the disclosure can be avoided because the notice was incorrectly sent or the problem was easily resolved after talking with the exchange or association, investors will benefit. If the failure to meet the listing standards is difficult to cure, or the company decides to list elsewhere, investors would still benefit from having a Form 8-K with a more thoughtful discussion filed after the company has had ample time to discuss the listing problem internally and with the association or exchange. Being alerted to the listing problem within two business days without allowing the company time to formulate a plan or fix the problem is detrimental to stockholders.
We suggest that Item 3.01 should only be triggered by a formal, written notice from the exchange or association. Furthermore, the company should be allowed five business days after receiving the notice to disclose its existence and the company's planned response. If the notice has been withdrawn during that time period, no filing should be required.
G. Item 5.02 - Departure of Directors or Principal Officers; Election of Directors; Appointment of Principal Officers
Proposed Item 5.02 would require disclosure when directors are elected or depart and when principal officers are appointed or depart. We understand that these events may be material in certain cases and that it is sensible to disclose them promptly to investors. However, we believe that disclosure of the reason for departures of directors or executive officers under the proposed rules is ill-advised and potentially harmful. Under existing Item 6 of Form 8-K, disclosure is required if a director departs as a result of a disagreement, provides a letter to the company describing the disagreement, and requests that the company publicly disclose the matter. Under proposed Item 5.02(a), disclosure about disagreements between the company and a departing director is broadened to include disagreements not in writing and removal for cause. Under proposed Item 5.02(b), the company will have to describe the reasons for the departure of a director for reasons other than those in proposed Item 5.02(a) and for the departure of a principal officer for any reason. We believe that the disclosure of the departure may be useful information for investors; however, disclosure of the reason for the departure adds little or no benefit to investors, but it creates embarrassment and legal and other problems for companies and their departing officers and directors. Furthermore, the company and the departing director or officer may have different views as to why the individual is departing, and proposed Item 5.02 does not have an appropriate mechanism for allowing the departing individual to give his or her side of the issue. Disclosure could also lead to violations of the individual's right to privacy and could complicate potential litigation issues related to a difficult departure.
We believe that the only situation in which a company should be required to disclose the reasons for the departure of a director (pursuant to proposed Item 5.02(a)) is the situation described in current Item 6 of Form 8-K. We further believe that no reason for the departure of a principal officer should be required to be disclosed under proposed Item 5.02(b).
* * *
Thank you for your consideration of the foregoing.
/s/ JOSEPH A. GRUNDFEST
Joseph A. Grundfest
FENWICK & WEST LLP
/s/ Eileen Duffy Robinett
/s/ Robert A. Freedman
HELLER EHRMAN WHITE & McAULIFFE LLP
WILSON SONSINI GOODRICH & ROSATI,
VENTURE LAW GROUP,
GRAY CARY WARE & FREIDENRICH LLP
BINGHAM McCUTCHEN LLP
PILLSBURY WINTHROP LLP