Stamping out delinquency

Perennial tardiness is a quality not often appreciated in social circles. But in the business world many participants, including regulators, have long been prepared to turn a blind eye. This may all be about to change.

It is not news to anyone that regulatory disclosure requirements have become far stricter over the past several years and almost everyone expects this trend to continue. Not only are companies disclosing a lot more, but the timeframes for doing so have become far shorter. Changes in reporting regimes, resulting in an increase in number and breadth of filings, have highlighted the differences in how the two major US exchanges, and the SEC, deal with delinquent filers.

What may be a surprise to many investors and other observers is the apparent lack of consequences for failing to submit certain filings by the prescribed deadlines. For all the hard talk about reporting deadlines, fines and potential delisting, there are a lot of companies who are seriously late in submitting paperwork, yet very few ever incur any significant penalty.

As a result of shareholder pressure and a general lack of action by the NYSE and Nasdaq, the SEC has been stepping up enforcement on delinquent filers. Early in 2005 the SEC announced that it would crack down on companies late in filing Form 10K. In the year following the announcement the regulator revoked (or is in the process of revoking) Securities Act registration of 115 companies. The numbers for 2006 are expected to be higher than in previous years.

With investors demanding greater protection and increased transparency the NYSE is proposing a change to its listing rules that would see it automatically delist any company that is more than twelve months late in filing the annual report.

It would seem reasonable to believe that four years after the birth of Sarbanes-Oxley, companies would be comfortable with the new reporting regime. This is not the case, however. Many large, well-capitalized companies are still struggling with filing deadlines. There are a number of reasons for this: Some are in dispute with outside auditors, others have seen the departure of a CFO and other still are struggling with options expensing and backdating. There are a handful of companies that are just plain late.

Investors in companies where filings are delinquent are understandably concerned but taking action may exacerbate the problem and damage shareholder value. Allowing a perennial delinquent to go unpunished is not acceptable either, hence the proposed new rules at the NYSE.

Glen Tyranski, senior vice president of regulation at the NYSE, explains that ‘companies are now late for a wide variety of reasons. Some of these are minor and easily fixed but some are an indication of more serious underlying problems.’ He also highlights that the SEC is taking a far greater interest and is applying pressure to ensure all listed companies are up to date with filings.

‘There are a small number of filers that are perennially late,’ Tyranski explains, ‘and it is these companies that we are most interested in talking with.’

A difference of opinion

The NYSE has always had a very consultative approach to dealing with listing standard violations, so much so that some investors feel the group is sometimes too soft on companies. The general perception seems to be that there should be a clearly defined, one-size-fits-all process for bringing late filers back into compliance. The reality is that filing processes vary greatly from company to company and opinion varies widely on the best way to ensure compliance without excessively punishing the company or placing shareholder value at risk.

‘We understand that reporting of financial data takes a lot longer than it used to and that the pressure on internal controls has been increased,’ explains Tyranski. It is for this reason that the review timeline for late filers has been changed. At present, once a company misses a filing deadline, it is issued a written notice of its delinquent status. The exchange then monitors the company until the report is issued and there is a maximum nine-month period before a formal review is conducted. If the report is not issued within that nine-month timeframe, a meeting is called and the exchange will decide if a further three-month extension should be granted.

Some investors and other exchanges criticize this system, claiming that it effectively provides an automatic nine-month extension for filing.

Tyranski acknowledges investor concerns: ‘Some parties feel that the current process is not strict enough and have asked for a more stringent regime.’ The nine-month window for review will, under the proposal, be shortened to six months. It is important to note, according to Tyranski, that ‘in reality, all companies that are late with filings are monitored all the time.’ He explains that, if the special committee is not satisfied that the company is making legitimate efforts to re-establish compliance, it can, in theory, delist that company at any time after the missed filing.

A very small number of  companies have been delisted in the past few years by the NYSE and it is interesting to note that Nasdaq has delisted an average of ten times more companies in the past three years. NYSE currently has six companies on its watch list compared to 77 at Nasdaq. Already this year Nasdaq has delisted 11 companies for regulatory or compliance reasons. Nasdaq takes a dramatically different approach to late filers. It issues a delisting notice the moment a filing is missed at which point the company must enter an appeal process.

The NYSE points out that  its listed companies are traditionally far larger than those at the Nasdaq (although this has certainly leveled out in the past few years) and therefore its companies have more complicated situations. Tyranski says that in some cases they have been ready to take delisting action but have been encouraged not to under rule 1231, which allows for exemptions for companies of especially significant national or market interest.

A dangerous cycle

Companies that miss filings often point the finger of blame at outside auditors. Auditing firms are taking more time to sign off on accounts as a result of changes to the regulatory environment. This is putting pressure on companies. The situation is made worse if any filing is missed. During 2005 the NYSE altered its rules to include quarterly filings in its rules of governance for listed companies.

A missed filing can lead to a delay spiral. The auditor is likely to become nervous and want to perform more in-depth examinations because of the extra attention that is focused on a company after a missed filing. This is mostly driven by a fear of litigation. If a restatement is deemed necessary, which has been the case at many companies in the past year, then an auditor will often want to review several previous years as well. If this happens it may refuse to sign off current year data until the historical review is completed.

Tyranski advises that  companies in this situation should issue regular operating data. This process will ensure that investors and analysts are kept up to date and it will also help to build goodwill with the exchange when it comes time to review the situation.

This trend of greater diligence is sometimes referred to as the ‘drive to precision.’ The pressure on companies and auditors to get everything right is even more  intense. Combine that with impossibly short deadlines and it is easy to see how companies miss some deadlines. Both major US exchanges are aware of this tenuous aspect and adopt flexible approaches but it is important ‘to have some teeth if they are needed,’ says Tyranski.

While the new rule proposal focuses on stricter delisting standards there are other options open to the exchange when dealing with delinquent shareholders. There are also different degrees of importance in the filings continuum. Some regular filings, like announcements of board changes, are generally considered less sensitive than annual reports, compensation filings and annual reports.

Once a filing date is missed a number of possible outcomes may result. Bank loan default clauses can be triggered, although this is not under the auspices of a stock exchange. Filing and trading in certain types of securities, bonds and derivatives can be blocked or restricted. Depending on the exchange at which a company listed, an issuer can, under 1933 Act rules updated in 2005, lose its well-known seasoned issuer (WKSI) status for a year or sometimes more. This will result in the company being entirely unable to take advantage of the short-form registration statements such as Form S-3 that permits ‘incorporation by reference.’

These diminutive punishments are occasionally deemed a lot more appropriate and it is generally felt that they have less of a potential impact on the value to shareholders.

This is an important point when the NYSE is considering delisting action against a company, explains Tyranski. If a company is delisted there is a very serious impact on shareholders. Obviously there will be an automatic loss of liquidity which will make it more difficult for investors to remove their money if they choose. Although this argument is countered by some because most companies are on the review list for at least nine months before they are delisted. This gives any shareholder ample time to get their money out should they want. Once a company falls off the stock exchange, the level of regulation, and thus shareholder protection, falls significantly.

In a previous interview last year, Stewart Landefeld, a partner at Perkins Coie, explained that all public companies and shareholders need to be aware of the serious implications of late filing.

‘Both Nasdaq and [the] NYSE are being more active in delisting late filers,’ he notes. ‘This coupled with the ongoing SEC crackdown and newly adopted rules for streamlining the process of delisting [and deregistration] will likely mean more delistings. Getting delisted means shareholders lose access to a highly liquid market in which to trade the stock and get quotes. It is also likely that issuers will have greater difficulty raising capital.’

He suggests that companies that have problems with previous year’s accounts, such as those having restatement trouble and undergoing review of historical figures, should spend more time focusing on working with the exchange, auditors and outside counsel to achieve current year compliance. This will greatly reduce the likelihood of the exchange or the SEC using delisting powers.

Both the NYSE and Nasdaq maintain on their web sites lists of delinquent filers, recently delisted companies and those under investigation.

Given a move toward even shorter deadlines and the growing trend of globalization, which increases the complexity of filing, it is likely there are going to be more late filers. The question for stock exchanges is how to best punish the offenders and get them back into compliance. Shareholders may have an easier job – deciding with their feet, or pockets more accurately – to simply sell stock of companies that are late in filing. This will no doubt put even greater pressure on the corporate secretary, general counsel and others involved in managing the reporting process.