Red Flags Everywhere! – Ten Risks for Directors – Week 9

Each week for the next 10 weeks, we will publish an installment of our Red Flags Everywhere! series, highlighting key risk areas that public companies and their board of directors should keep top of mind.

This series will serve as a lead up to MoFo’s upcoming Red Flags and Red Wine Tabletop program taking place in our Palo Alto office on May 7. Members of our Securities Litigation, Employment and Labor, and Capital Markets Groups will guide attendees through a ripped-from-the-headlines fact pattern designed to spark interactive discussion and practical analysis that will be valuable to every board advisor.

This week, we focus on SEC reporting and shareholder disclosure. Directors have a duty to make a good-faith effort to stay reasonably informed about the company’s disclosure practices and to exercise appropriate oversight of the processes and controls that support accurate reporting, often through ongoing oversight by board committees.

If you are interested in learning more about MoFo’s Red Flags Everywhere tabletop event, please reach out to Deborah Argueta. See all the Red Flags client alerts.

Board Oversight of SEC Reporting and Shareholder Disclosure Should Be Structured and Deliberate

The federal regime puts primary responsibility around financial reporting on the CEO, CFO, and other management, but that does not relieve the board of directors of its own responsibilities with respect to public disclosures. Indeed, the federal securities laws and state fiduciary duty law provide for personal liability for directors arising from material misstatements or omissions to investors. Although directors do not typically draft disclosure documents or make statements directly to investors, they may be held personally liable where they knew, or in the exercise of reasonable diligence should have known, that a company disclosure was materially false or misleading. For example, directors may face liability where information available to them in the boardroom was inconsistent with the company's public statements, or where they disregarded red flags that should have prompted further inquiry.

 The primary sources for this liability include:

• Section 11 of the Securities Act provides for strict liability for directors who sign a registration statement that contains material misstatements or omissions, subject to a due diligence defense. Strict liability makes registration statements a particularly high-risk area for directors.
• Section 10(b) of the Exchange Act/Rule 10b-5 provides for personal liability for materially false or misleading statements to investors. This type of liability requires a showing of scienter—intent to deceive or extreme recklessness. Liability can attach to statements made in various contexts, including statements on earnings calls or in investor presentations.
• Section 14(a) of the Exchange Act/Rule 14a-9 provides for personal liability for material misstatements or omissions in proxy solicitation materials. This type of liability requires a showing of negligence on the part of the director.
• State laws provide an additional source of potential liability. Directors can be held liable for disclosure claims brought under state common law theories such as common law fraud and negligent misrepresentation, as well as breach of fiduciary duty. Delaware, for example, has long recognized that “directors of Delaware corporations are under a fiduciary duty to disclose fully and fairly all material information within the board’s control when it seeks shareholder action.”[1]

To reduce liability risk, directors should understand their duties as they relate to oversight and review of the company's SEC reporting and public disclosures. Directors are expected to make a good-faith effort to stay reasonably informed about the company’s disclosure practices and to exercise appropriate oversight of the processes and controls that support accurate reporting, often through ongoing oversight by board committees. This does not mean that every director must carefully scrutinize every sentence in every filing. It does mean, however, that directors should approach their review with diligence—particularly where the information being disclosed relates to matters the board has deliberated, or where the disclosure concerns a subject that the board or a board committee is specifically charged with overseeing. Directors should follow up when information available to them may bear on the accuracy or completeness of a disclosure. From time to time, directors also may be asked to communicate directly with investors — for example, as part of shareholder engagement efforts. When they do, directors should speak carefully and take steps to confirm that their statements are consistent with the company’s public disclosures. 

Good disclosure oversight starts with sound practices and adequate lead time —not last-minute page turns.

At a practical level, the board is responsible for overseeing the company’s maintenance of adequate disclosure controls and procedures. Much of this oversight is delegated to board committees—in particular, the audit committee, which plays a central role in overseeing financial reporting, and the compensation committee, which oversees executive compensation disclosures.  Certain disclosures also create heightened risk, and therefore merit heightened vigilance regardless of where oversight responsibility sits.

Oversight of periodic financial statements. 

SEC Rule 13a-15(e) requires public companies to implement disclosure controls and procedures that are “designed to ensure that information required to be disclosed by the issuer in the reports that it files or submits under the [Exchange] Act (15 U.S.C. 78a et seq.) is recorded, processed, summarized and reported, within the time periods specified in the Commission’s rules and forms.” As part of the board’s general oversight responsibility, directors should satisfy themselves that management has implemented and maintains such controls effectively.

The audit committee also plays a central role in periodic disclosure oversight. SEC Rule 10a-3 establishes core audit committee responsibilities, including oversight of the company’s auditors. Exchange standards go further. For example, under NYSE Section 303A.07 and its related Commentary, the audit committee charter must address oversight of the integrity of the financial statements and legal and regulatory compliance. The Commentary further provides that the committee should review and discuss with management and, as appropriate, the independent auditor, annual and quarterly financial statements and MD&A, earnings releases and earnings guidance, and policies with respect to risk assessment and risk management. Nasdaq likewise requires a formal written audit committee charter addressing oversight of the company’s accounting and financial reporting processes and the audits of the financial statements.[2]

In practice, the audit committee should take the lead on oversight of the 10-Ks, 10-Qs, earnings releases, and public disclosures using non-GAAP measures, including oversight of critical accounting judgments, disclosure controls, and changes in internal control over financial reporting consistent with its chartered duties.

The level of board involvement beyond the audit committee will vary by filing type. The 10-K is signed by at least a majority of the board of directors—and in practice, typically by all directors. When reviewing, the board should pay particular attention to the major judgments and areas of uncertainty, and whether the narrative in MD&A and risk factor disclosures is consistent with what directors are hearing in the boardroom.

For 10-Qs, audit committee review is generally sufficient, though the board should be kept informed of any material changes in disclosure or accounting judgments from the prior period. Most routine 8-Ks do not require advance board or committee review, but 8-Ks involving significant judgment calls or filings triggered by board action may warrant review by the relevant committee or the full board, as appropriate.

At a high level, a typical disclosure process may include:

• a disclosure calendar for periodic SEC reports with the expected filing date and draft distribution dates;
• a cross-functional management disclosure committee or equivalent that provides management-level oversight of the disclosures;
• pre-set escalation triggers for unusual transactions and major judgments—to the disclosure committee or other senior officers, and potentially to the board or a board committee; and
• circulation to the board (or board committees, as appropriate) with adequate time for members to review, along with a summary or highlighting of key disclosure points.

Oversight of proxy statements.

Proxy statements warrant particular attention from directors. Because they are used to solicit shareholder votes, directors are expected to exercise appropriate oversight so that the proxy statement fairly and accurately discloses the material facts that shareholders need to make an informed vote. That obligation arises under Section 14(a) of the Exchange Act and Rule 14a-9. Schedule 14A sets minimum disclosure requirements, but meeting those requirements does not necessarily satisfy Rule 14a-9 if the proxy statement still omits or misstates material information.

The proxy rules underscore the importance of this review: liability can arise from negligence. In other words, even unintentional misstatements or omissions in proxy materials may give rise to claims against directors involved in the solicitation. Even so, the courts recognize that directors are not guarantors of accuracy. For example, directors generally are not expected to recalculate financial figures or re-create reports unless an obvious error or irregularity was apparent or should have been apparent to them.

The proxy also contains certain committee reports that each committee should review.

• Audit Committee Report: The audit committee publishes its own report in the proxy statement that is signed by its members. This report includes disclosure that the committee reviewed and discussed with management the audited financial statements, reviewed and discussed with the independent auditors written disclosures regarding the auditors’ independence, and other matters required by applicable auditing standards. At the heart of this report is the committee’s recommendation to the board to include the audited financial statements in the company’s annual report.
• Compensation Committee Report: The proxy must also include a compensation committee report that confirms that the committee reviewed and discussed the Compensation Discussion and Analysis (CD&A) with management and recommended its inclusion in the proxy. The CD&A discusses the philosophy and rationale behind executive compensation packages, specifically regarding the CEO and top officers.
• Corporate Governance/Nominating Committee: Although not a formal committee report, the proxy also includes detailed descriptions of the director nomination process, qualifications of the director candidates, committee structure, and director independence. The corporate governance or nominating committee should take the lead on reviewing this information as part of its oversight role.

Directors should review the proxy and should have adequate opportunity to raise questions or flag concerns before it is finalized. Committees responsible for specific sections of the proxy should pay special attention to those sections.

Oversight of earnings calls and investor presentations.

While boards are not typically involved in drafting earnings call scripts or investor presentations, directors should be aware of the key messages being communicated to the market on the company’s behalf. Earnings calls, investor day presentations, and other public communications can create meaningful legal exposure—including under Regulation FD, which prohibits selective disclosure of material nonpublic information to analysts and other market participants, and under Section 10(b) and Rule 10b-5, the broad antifraud provisions that can reach material misstatements and omissions in numerous contexts including earnings calls and investor presentations. These risks are heightened when public communications go beyond what is contained in periodic SEC filings and introduce new factual assertions, characterizations of company performance or forward-looking statements that have not been vetted through the same disclosure process as a 10-K or proxy statement.

For NYSE-listed companies, the NYSE Listed Company Manual assigns a specific role to the audit committee here. Under the NYSE rules and related commentary, the audit committee is expected to discuss earnings press releases, as well as financial information and earnings guidance provided to analysts and rating agencies—including the types of information to be disclosed, the types of presentation to be made, and in particular the use of “pro forma” or “adjusted” non-GAAP financial measures. Consistent with this mandate, the audit committee should be satisfied that management has established appropriate procedures for reviewing earnings call scripts, investor presentations, and related materials. Controls should include attention to consistency with SEC filings, proper presentation of non-GAAP measures (including required reconciliations), and identification of any material new statements or shifts in messaging before the company speaks to the market. Although Nasdaq’s listing rules do not include the same specific requirements, many audit committees of Nasdaq-listed companies follow similar practices as a matter of sound governance.

More broadly, all directors should have sufficient awareness of the company’s key themes and investor messaging so that they are positioned to ask informed questions when these topics arise in the boardroom.

Key Takeaways

Board oversight of disclosures is not a one-size-fits-all exercise. Rather, boards mitigate risk by tailoring oversight to the specific type of disclosure and having the right committees and processes to provide such oversight.

1. Ongoing company disclosures (10-Ks, 10-Qs, 8-Ks, earnings releases). Management typically prepares these materials, often with a disclosure committee providing management-level oversight. The audit committee should take the lead on reviewing the financial statements, MD&A, earnings-release framework, non-GAAP measures, disclosure controls, and any unusual items, consistent with its chartered duties. The full board should focus on major judgments and areas of uncertainty and whether the narrative is consistent with what directors are hearing in the boardroom. For 10-Qs, audit committee review is generally sufficient, though the board should be kept informed of material changes from the prior period. Most routine 8-Ks do not require advance board review, but 8-Ks triggered by board action—such as CEO changes, director departures, amendments to bylaws, major transactions, or shareholder-vote matters—may warrant review by the relevant committee or the full board, as appropriate.

2. Proxy statements and disclosures reflecting board processes and decisions. The proxy statement warrants particular attention. Committees responsible for specific sections— audit committee report, compensation committee report and CD&A, and governance and nomination disclosures—should pay particular attention to those sections. Proxy disclosures about director independence, board structure, committee composition, succession planning, CEO compensation, and governance policies are areas where the board has direct knowledge of the underlying facts, making it important that the disclosure accurately reflects the board’s process and deliberations. Directors should have adequate opportunity to raise questions or flag concerns before the proxy is finalized.

3. Risk oversight, MD&A trends, and voluntary disclosures. Certain disclosures merit heightened attention because they sit at the intersection of strategy, operations, and disclosure. Item 407(h) requires disclosure about the board’s role in risk oversight, and Item 303 requires discussion of known trends, demands, commitments, events, and uncertainties that are reasonably likely to materially affect liquidity, capital resources, or results of operations. Directors should be attentive to whether the company's public statements in these areas are consistent with what management has presented to the board —and whether any voluntary sustainability or governance statements are consistent with the company’s SEC disclosures and board minutes.[3] In addition, although companies routinely assist directors with the preparation and filing of Form 4 and other Section 16 reports, the reporting obligation is personal to each director under the law. Directors should ensure that the company is kept informed of all covered trading activity and arrangements, including any 10b5-1 trading plans, and should comply with company policies on preclearance, blackout periods, and reporting so that filings are timely and accurate.

4. Earnings calls and investor communications. Earnings calls, investor presentations, and other public communications can create meaningful legal exposure under Regulation FD and Section 10(b), particularly when they introduce new factual assertions or forward-looking statements that have not been vetted through the same disclosure process as periodic SEC filings. Under the NYSE listing standards, the audit committee has a specific role in overseeing earnings releases, earnings guidance, and the use of non-GAAP measures. The audit committee should be satisfied that management has appropriate procedures for reviewing these disclosures for consistency with SEC filings. More broadly, all directors should have sufficient awareness of the company’s key themes and investor messaging so that they are positioned to ask informed questions when these topics arise in the boardroom.

Bottom Line: Disclosure oversight is not about directors redlining every filing. It is about sound practices, adequate lead time, and clear committee roles—so that the right information reaches the right people soon enough for meaningful consideration. A board that delegates appropriately to its committees, stays reasonably informed, and engages with the disclosure process will be well positioned to meet both its fiduciary duties and its responsibilities under the federal securities laws.

The prior Red Flags alerts are available here:

• Week 1: Director Oversight of AI Requires Strong Processes and Good-Faith Engagement
• Week 2: Board Engagement with Political and Social Issues Should Be Tied to Stockholder Value
• Week 3: Board Refreshment and Director Risk: Navigating Investor Demands and Delaware Constraints
• Week 4: Board Oversight of the CEO Should Be Active and Independent
• Week 5: Rule 10b5-1 Plans and Insider Trading Policies Should Be Real, Current, and Enforced
• Week 6: Board Oversight of Internal Investigations: Serious Allegations Merit Serious Oversight
• Week 7: Board Communications Can Become Evidence: Treat Email, Text, and Chat Hygiene as a Governance Issue
• Week 8: Attorney-Client Privilege in the Boardroom is Powerful, But Not Invincible

[1] Stroud v. Grace, 606 A.2d 75, 84 (Del. 1992).

[2] 17 C.F.R. sec. 240.10A-3; Standards Relating to Listed Company Audit Committees, SEC Release No. 33-8220 (Apr. 9, 2003); NYSE Listed Company Manual sec. 303A.07; Nasdaq Listing Rule 5605(c).

[3] 17 C.F.R. secs. 229.303, 229.407(h); Proxy Disclosure Enhancements, SEC Release No. 33-9089 (Dec. 16, 2009).