Federal deregulation efforts are taking place while at the same time we are witnessing heightened expectations of governance accountability. The rapid convergence of these two trends is creating a seminal challenge for the audit and compliance committee of many corporate boards.
At the surface, it is hard to spot any corporate negatives to the administration’s deregulation initiatives. Indeed, boards may well embrace the expectation of relaxed regulations and more limited civil and criminal enforcement activity.
Yet, there is a legitimate concern that executives and line managers who are ordinarily prone to “push the edge of the envelope,” may interpret deregulation as a “green light” to pursue business strategies that may be legally problematic. This attitude could threaten the authority and influence of the committee’s compliance agenda.
This relaxing of executive attitudes towards legal boundaries would come at the worst possible time, with emerging expectations of fiduciary obligations heading in exactly the opposite direction. Rather than relaxing expectations of compliance program oversight, these trends (reflected in court decisions, regulatory actions, and academic commentary) would hold directors more directly accountable for corporate compliance failures. “Where was the board when all this was going on?” Now especially, the audit and compliance committee is well advised to be pro-active in asserting its oversight powers.
These converging initiatives are highlighted by several recent developments.
The “Brand Memorandum” from the Department of Justice (DOJ) is the most recent compliance extension of administration-driven deregulation. The specific focus of the Brand Memorandum is to (i) confirm that the DOJ may not use its enforcement authority to effectively convert agency guidance into binding rules; and (ii) prohibit DOJ attorneys from using noncompliance with guidance documents as a basis for proving legal violations in civil enforcement actions, including but not limited to actions brought under the False Claims Act.
Examples of such guidance include documents such as preamble commentary, manuals, bulletins, fraud alerts, policy guidance, advisory opinions, and national and local coverage determinations. Often times, such guidance is woven into corporate compliance programs and risk guidelines, as may be relevant to a particular industry sector.
The Brand Memorandum provides defendants with a valuable tool in defending FCA actions—whether brought by the DOJ or relator’s counsel—that attempt to use alleged noncompliance with agency sub-regulatory guidance as support for a False Claims Act theory. It does not, however, suggest any relaxation of existing DOJ enforcement practices.
The pending release of long-anticipated revisions to the controversial Yates Memorandum would likely add to the audit and compliance committee’s burden. According to Deputy Attorney General Rod Rosenstein, the changes to Yates will be “modest,” and are intended to address possible ambiguities and potentially inconsistent applications of policy.
The main idea of the Yates Memorandum, holding individuals accountable for corporate wrongdoing where appropriate, is expected to be kept in place. But the corporate compliance concern is the potential for organizational misperceptions that because of the Brand Memorandum, “Yates has been repealed,” and that individual accountability is no longer a focus of government enforcement policies.
Board Accountability Developments
The Delaware Supreme Court requires a very high burden of proof to sustain a claim for breach of the director’s Caremark compliance program oversight duty. However, leading governance observers acknowledge the potential that, given harsh fact patterns (e.g., material harm to consumers or shareholders), courts may less strictly apply the Caremark standard in the future. A recent decision of the Federal District Court in Northern California, involving a derivative action against the officers and directors of a financial services firm for breach of fiduciary duty, lends credence to this concern.
There, the court denied a motion to dismiss filed by the defendant officers and directors. The court was sufficiently persuaded by the totality of red flags of which the board was allegedly aware, and the fact that many of them were presented in the form of direct communications and reports to the board. The court also appeared persuaded by the fact that many of the defendant officers and directors also served on committees with direct oversight over the alleged conduct that was the source of the losses cited in the complaint. Thus, the case continues.
The Federal Reserve Bank’s February enforcement action against Wells Fargo & Co., with its concurrent impact on officers and directors, is the most recent indication that regulatory agencies may be willing to hold directors personally accountable for serious corporate compliance and conduct failures occurring during the period of their board service. The Fed clearly sought to hold governance responsible for the weakness of the company’s risk management and legal compliance programs. It is conceivable that this enforcement action may serve as a model for other regulatory agencies confronting issues associated with corporate compliance breakdowns.
More generally notable are efforts such as the New York City Comptroller’s Boardroom Accountability Project 2.0, which is intended to improve the quality of boards of directors.
A Possible Approach
Boards may need to take proactive steps in order to counter the consequences of the convergence of deregulation and accountability. It may be important to send a clear message throughout the organization that corporate policies on legal compliance, corporate conduct, and legal risk evaluation of business initiatives will not change—and may even be strengthened. This action would build upon the elements of director accountability increasingly identified by courts and regulatory entities; i.e., that compliance committees should be particularly engaged in monitoring the legal risks of business strategies.
The committee may thus choose to increase its focus on, among other steps, ensuring that (i) the business strategies approved by the board are consistent with the risk management capabilities of the company; (ii) the company’s risk management and legal compliance programs are sufficiently robust to prevent improper behavior; (iii) the board has sufficient information to carry out its responsibilities; (iv) robust inquiry and demand for further information is made about serious compliance issues that come to the board’s attention; and (iv) corporate culture recognizes the importance of adherence to internal policies, and awareness of regulatory agency guidance documents.
Michael W. Peregrine, a partner at the law firm of McDermott Will & Emery, advises corporations, officers, and directors on matters relating to corporate governance, fiduciary duties, and officer and director liability issues. His views do not necessarily reflect the views of the firm or its clients.Mr. Peregrine thanks his partner, Tony Maida, for his contributions to this post.
This article is the second half of the discussion of the sweeping ramifications of The Tax Cuts and Jobs Act of 2017 (“Tax Act”). Part one discussed the transition tax on deemed repatriation of foreign earnings, the reduction in the corporate tax rate from 35 percent to 21 percent, the changes in the taxation of the international operations of U.S. companies, and changes to interest and depreciation deductions.
In this article, we address provisions of the Tax Act that potentially accelerate tax liabilities, repeal the performance-based exception to the limits on compensation deductions for certain corporations, change the treatment of net operating losses, and cut back the favorable tax treatment of research and development expenses.
David C. Cole
1. Potential Acceleration of Tax Liabilities. Before the Tax Act became law, the requirements for the recognition of taxable income were independent from those for financial reporting—or so-called “book” purposes. In fact, certain types of income could be recognized for tax purposes later than the period in which they were recognized as revenue for book purposes. The Tax Act narrows these taxable income deferral opportunities by accelerating the recognition of certain taxable income to more closely match financial reporting.
This new rule is of particular concern in light of the new accounting rules under the Financial Accounting Standards Board’s Accounting Standards Codification (ASC) Topic 606. Under those accounting rules, expected revenue must generally be recognized as goods or services are provided to customers. Thus, unbilled receivables for partially performed services might be recognized for book purposes—and now for tax purposes, too—ratably as the services are performed, rather than when the services are complete or when the taxpayer has the right to demand payment from the customer. Similarly, items such as performance bonuses might be recognized for book purposes—and now for tax purposes—over the life of the contract, rather than when the standards for receiving the bonus have actually been met.
David C. D’Alessandro
The new tax rules may also affect taxpayers whose contracts with customers contain multiple-element deliverables (e.g., software sales agreements that include a license, updates, and support services, or sales of goods that include a warranty), because the rules now require that the allocation of payments among these deliverables be the same for tax and financial reporting purposes.
What Directors Should Do. This potential acceleration of the recognition of taxable income could have significant cash flow consequences for certain businesses. Directors, and in particular audit committee members, should ensure that the company’s treasury and tax departments have coordinated and evaluated the potential acceleration of tax liabilities as a result of the combined effect of the Tax Act changes and ASC 606. Depending on the extent of any accelerated tax liabilities, it may be necessary for a company to consider potential liquidity sources to meet its 2018 tax obligations.
2. Repeal of Performance-Based Exception to Limits on Compensation Deductions. Public companies may not deduct compensation paid to certain executives in excess of $1 million. Previously, there was an exception to this rule for performance-based compensation that met certain requirements. However, the Tax Act removed the performance-based exception effective for tax years beginning after December 31, 2017. As a result, a public company will generally not be able to deduct compensation in excess of $1 million paid to its chief executive officer, chief financial officer, or its three other most highly-compensated officers. The Tax Act provides some relief through a transition rule, which preserves the deduction for performance-based compensation that is paid pursuant to a written binding contract that was in effect on and not materially modified after November 2, 2017 (the “Transition Rule”).
What Directors Should Do. In light of the removal of the tax incentives for granting performance-based compensation to certain executives, companies may be interested in revising their performance-based compensation programs by, for example, shifting a greater percentage of a covered executive’s compensation to guaranteed salary. However, the terms of some equity and cash incentive plans nevertheless require performance-based compensation to comply with the now-repealed requirements for deductibility, which would limit the changes that could be made to programs without amending the plans. As such, before changes are made to a company’s compensation programs, directors should ensure that the terms of the applicable plans are reviewed to determine if amendments to the plans are necessary to accommodate such changes to the compensation programs.
Additionally, some large institutional investors and proxy solicitation firms have indicated that they expect companies to continue with their existing compensation programs that condition awards on the achievement of rigorous, transparent, pre-established performance goals. Directors should also consider how changes to a company’s performance-based compensation programs will be viewed by the company’s shareholders.
Finally, it will be important for companies with outstanding long-term, performance-based awards to preserve the deductibility of those awards pursuant to the Transition Rule. As such, companies should determine whether performance-based compensation arrangements that were in effect on November 2, 2017 qualify as grandfathered under the Transition Rule and, if so, consider the implications of any potential modifications to such plans.
3. Changes to the Treatment of Net Operating Losses. The Tax Act makes significant changes to the utilization of net operating losses (“NOLs”). Previously, NOLs could generally be carried back to a taxpayer’s prior two tax years and carried forward for 20 years. Extended carryback periods applied to certain product liability-type losses and casualty and disaster losses. Also, under prior law, the corporate alternate minimum tax precluded corporations from completely eliminating their tax liability through NOL deductions. Instead, the alternative minimum tax (AMT) imposed an effective 2 percent tax rate on a corporation that otherwise would owe no tax because of NOLs.
Under the Tax Act, corporations (other than certain farmers and property and casualty insurers) cannot carry back NOLs arising in tax years beginning on or after January 1, 2018. Those losses are no longer a means to generate cash refunds of previously paid taxes. Also, a corporation may not eliminate more than 80 percent of its taxable income (determined without regard to the NOL deduction) for a given year. Thus, although the corporate AMT was repealed under the Tax Act, this limitation effectively results in a minimum tax of 4.2 percent on a corporation suffering losses (more than doubling the previous effective rate). On the positive side, NOLs now can be carried forward indefinitely instead of only 20 years.
What Directors Should Do. The changes to NOLs are particularly troublesome for early stage companies, corporations in cyclical businesses, and companies that suffer product liability-type and substantial casualty or disaster losses. Losing the ability to carry back NOLs to generate tax refunds and the ability eliminate all taxable income with NOL deductions will negatively affect cash flow. Because of these changes, corporations should attempt to better match their income and deductions annually to reduce the extent of the NOLs they generate.
Directors of companies that incur NOLs should ensure that their tax departments are sensitive to this issue and are considering ways to better match income and deductions. For example, in years that appear likely to generate a net operating loss, opportunities to trigger or accelerate taxable income should be considered. Also, the new 100 percent deduction for the acquisition of tangible assets (discussed in Part I of this article) is not mandatory. Accordingly, consideration should be given to electing out of that “immediate expensing” if doing so avoids creating NOLs.
4. Cutbacks to the Favorable Treatment of Research and Development (R&D) Expenses. The tax laws have long provided favorable treatment for certain R&D expenses in order to encourage U.S. companies to invest in research. These include a current deduction for such expenses and a tax credit based on specified increases in the level of certain R&D spending. Under the Tax Act, however, the favorable treatment of R&D expenses is scheduled to be reduced in future years.
First, beginning in 2022, corporations may no longer currently deduct R&D expenses. Instead, those expenses must be capitalized and amortized over 5 years (in the case of U.S. research) and 15 years (in the case of non-U.S. research). Also, the Tax Act created a new Base Erosion and Anti-Abuse Tax (BEAT) that applies to larger U.S. corporations that make certain payments to non-U.S. affiliates. Beginning in 2026, the amount of tax a U.S. corporation would owe under the BEAT will no longer reduced by its R&D credit—potentially resulting in a significant decrease in the value of such credit.
What Directors Should Do. Given the future effective date of the R&D changes, companies may wish to consider lobbying Congress to repeal the Tax Act changes before they become effective. In addition, the numerous changes to the taxation of international operations discussed in Part I of this article should be considered as part of any restructuring or expansion decisions. In the case of locating or expanding R&D centers, the pending changes reducing the tax benefits of U.S. R&D expenses should be included in that analysis.
George M. Gerachis serves as head of Vinson & Elkins’ Tax and Executive Compensation and Benefits (ECB) department. He represents corporate and individual clients in a wide range of tax planning and tax controversy matters. David C. Cole is a tax partner at Vinson & Elkins and represents corporations, partnerships, and high net worth individuals in a wide range of domestic and international tax matters. David C. D’Alessandro is an executive compensation and benefits partner at Vinson & Elkins and advises employers and executives in the structuring of employment agreements and executive compensation arrangements.
Now that the U.S. Securities and Exchange Commission (SEC) has released an order approving the Public Company Accounting Oversight Board’s (PCAOB) new rules on the auditor’s report, what items should the audit committee and shareholders look for there?
The Auditor’s Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion and Related Amendments to PCAOB Standards, released by the PCAOB June 1 and approved by the SEC October 23, contains five main changes, including one that requires careful reading between the lines.
As NACD summarized in a recent brief to its members, the new PCAOB standard will require auditors to:
Standardize the format of the auditor’s report, placing the auditor’s opinion in the first section of the auditor’s report, followed by the basis for the opinion. This change makes the auditor’s opinion easier to find in the auditor’s report.
Disclose the auditor’s tenure, stating when the audit firm began its current service to the company. This new requirement comes in lieu of limiting audit firm tenure through mandatory audit firm rotation, a concept NACD and others have rejected in the past.
State that the auditor is required to be “independent.” This requirement is intended to strengthen shareholder confidence in the auditor’s report, possibly as an offset to the tenure disclosure, if it reveals that the auditor has been serving the client for more than a quarter century, for example.
State that the financial statements are free from material misstatements “whether due to error or fraud.” This change aligns with other recent or pending regulations on error vs. fraud, such as the proposed executive pay clawbacks rule still pending under Dodd-Frank, which mandated disgorgement of performance-based pay after financial restatements even if restatements were due to error rather than to fraud.
Report on critical audit matters (CAMs), defined as “matters communicated or required to be communicated to the audit committee and that: (1) relate to accounts or disclosures that are material to the financial statements; and (2) involved especially challenging, subjective, or complex auditor judgment.” A number of commenters said that the CAMs mandate is “redundant” with existing reports, which already reveal the required information. See for example NACD’s comment to the PCAOB or State Street’s comment.
The key letter in CAM is M, for material. For those who may wonder what may be “material” to the financial statements, join the club. The SEC has still never defined this term, leaving this job to the courts as they interpret federal securities laws.
The going definition of “material” is more than 40 years old. The SEC release cites TSC Industries v. Northway, Inc., 426 U.S. 438, 449 (1976), in which the U.S. Supreme Court states that a fact is material if there is “a substantial likelihood that the . . . fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.” In that same case, the Supreme Court said that determining materiality requires “delicate assessments of the inferences a ‘reasonable shareholder’ would draw from a given set of facts and the significance of those inferences to him . . .”
Such wisdom is not lost on the PCAOB and SEC. In its June 1 release, the PCAOB cites as CAMs the auditor’s evaluation of the company’s “goodwill impairment assessment” and, more broadly, the auditor’s assessment of the company’s “ability to continue as a going concern.” These two examples are material to financial statements. By contrast, the following two examples are not material to the financial statement: a loss contingency already discussed with the audit committee and “determined to be remote;” and a “potential illegal act.”
Audit committees need to ensure that their auditors are in a position to recognize critical audit matters, and to learn from those matters. But this does not mean looking for problems where there are none.
Significantly, SEC Chair Jay Clayton had this to say about the new standard:
“I would be disappointed if the new audit reporting standard, which has the potential to provide investors with meaningful incremental information, instead resulted in frivolous litigation costs, defensive, lawyer-driven auditor communications, or antagonistic auditor-audit committee relationships — with Main Street investors ending up in a worse position than they were before.
I therefore urge all involved in the implementation of the revised auditing standards, including the Commission and the PCAOB, to pay close attention to these issues going forward, including carefully reading the guidance provided in the approval order and the PCAOB’s adopting release.”
To Chairman Clayton’s point, the SEC makes this point in its approval order:
“As the [PCAOB] notes, in order to succeed, any claim based on these new statements would have to establish all of the elements of the relevant cause of action (e.g., when applicable, scienter, loss causation, and reliance). Moreover, as discussed above, CAMs could be used to defend as well as initiate litigation. …However, because of these risks and other concerns expressed by commenters, we expect the Board to monitor the Proposed Rules after implementation for any unintended consequences.“ (SEC approval order , pp. 32–33)
Shareholders and others should read between the lines of auditor’s report (appreciating the regulations behind it), but they should not expect auditors to “look under rocks” to find problems. That is the job of management, internal control, and the audit committee. The auditor’s job is to focus on the audit of the financial statements to ensure that they conform to generally accepted accounting principles (GAAP). Given the complexity of GAAP, that is a big enough job as it is.
The CAM standard can’t be mastered overnight and won’t be required any time soon. Auditors of large accelerated filers will not be required to adopt CAM changes until audits of fiscal years ending on or after June 30, 2019—with audits of all remaining filers to adopt CAM changes for fiscal years ending on or after December 15, 2020.
By contrast, all the other changes will apply to audits of fiscal years ending on or after December 15, 2017. That mean, essentially that auditors must work on this immediately, since most companies they are working with right now have fiscal years ending December 31, 2017. (According to Audit Analytics, 71 percent of public companies have a fiscal year ending December 31.)
So now is the time to prepare for the changes! In its above-cited report on the new rule, NACD prepared questions for directors to ask, along with related resources.
Questions for Boards
For which fiscal year will our auditor first be required to report on CAMs?
What areas during the audit do we anticipate our auditor will find challenging, subjective, or complex—and how can we preemptively address those concerns?
How will the auditor’s insights in the newly expanded report affect our ongoing work as we prepare the audit committee report for the proxy and review risk disclosures in the annual report on Form 10-K?