Developments in Securities Regulation, Corporate Governance, Capital Markets, M&A and Other Topics of Interest. MORE

In connection with an M&A transaction, in In Re Pattern Energy Group Inc. Stockholders Litigation the Delaware Court of Chancery determined that that the plaintiff had stated a claim against the director defendants for breach of the duty of loyalty.  The Court then considered the director defendants’ argument that any such breach was cleansed by a stockholder vote and that therefore dismissal was appropriate under Corwin. Corwin gives rise to the irrebuttable presumption of the business judgment rule when a transaction “is approved by a fully informed, uncoerced vote of the disinterested stockholders.”

Plaintiff contended that Corwin does not apply because the vote was uninformed and because a significant block of votes by a preferred holder, CBRE, was not disinterested. According to plaintiff CBRE was neither disinterested nor uncoerced.  Plaintiff argued the vote was not uncoerced as CBRE was contractually obligated to vote its preferred shares in accordance with CBRE Board’s recommendation regardless of its own economic interest.  In addition, plaintiff claimed CBRE was not disinterested because its “preferred shares rolled over into the combined company with an increased dividend rate.”

The Court agreed with the plaintiff. When CBRE acquired its preferred stock it agreed that in the event of any proposed merger it would vote its preferred shares in a manner consistent with the recommendation of the Board. The Court found that because of CBRE’s contractual obligation to vote in favor of the merger, which CBRE agreed to without being informed of the merger’s terms, the director defendants could not invoke Corwin’s protections. Accordingly, CBRE’s vote in favor of the Merger was not informed, and therefore the votes should not be counted to determine of Corwin cleansing applied.

Defendants also failed to demonstrate that CBRE’s vote was voluntary. The business judgment rule standard of review applies only if disinterested and informed stockholders have had the voluntary choice to accept or reject a transaction. According to the Court, the term ‘ratification’ applies only to a voluntary stockholder vote. The essence of Corwin is a court declines to second-guess the board when the stockholders, as a second set of decision makers, have approved the economic merits of a transaction for themselves. To be a meaningful ratifying vote, the stockholder must be voting on the transaction of her own accord and on the transaction’s merits. A stockholder voting in favor of a specific transaction because it had previously contracted to vote in favor of any transaction in exchange for consideration is not offering the second review that supports application of the business judgment rule.

The Court also found CBRE was interested with respect to the Merger and CBRE’s vote could not be counted to determine of Corwin cleansing applied.  CBRE bargained for the right to rollover its preferred stock at a premium into the post-closing company and keep its shares after a merger. In addition, after a change in control, the annual dividend rate on CBRE’s preferred stock would increase by as much as seventy-five basis points, and the holders would receive an accelerated payment on certain otherwise contingent dividends. As a result, CBRE’s merger benefits were not shared with the Company’s public common stockholders, who were to be cashed out. Accordingly, CBRE was interested by virtue of the preferred stock purchase agreement, as it stood to receive benefits from the merger that were not shared with the cashed-out majority.

In Re Pattern Energy Group Inc. Stockholders Litigation involved an M&A transaction where the sales process of Pattern Energy Group Inc. was run by an undisputedly disinterested and independent special committee that recognized and nominally managed conflicts, proceeded with advice from an unconflicted banker and counsel, and conducted a lengthy process attracting numerous suitors that the special committee pressed for value.  The foregoing positive attributes were offset by selecting a bidder that did not offer the highest price at the behest of perhaps conflicted parties supported by conflicted management.

While the decision on a motion to dismiss covers significant ground on many matters, the Court also found the directors engaged in bad faith when delegating preparation of the proxy statement to management. The Board adopted a resolution giving certain officer defendants the power to “prepare and execute” the merger proxy “containing such information deemed necessary, appropriate or advisable” by only the officer defendants, and then to file the proxy with the SEC without the Board’s review.

The plaintiff contended that the delegation to prepare the proxy constituted an unexculpated acted of bad faith. Specifically, the plaintiff claimed the director defendants acted in bad faith by abdicating their strict and unyielding duty of disclosure, and relatedly, by knowingly fail to correct a proxy statement that they knew was materially incomplete and misleading.

The Court cited precedent which noted that while the board may delegate powers to the officers of the company as in the board’s good faith, informed judgment are appropriate, that power is not without limit.  The precedent provided the board may not either formally or effectively abdicate its statutory power and its fiduciary duty to manage or direct the management of the business and affairs of this corporation. As a result, the Court found it is well established that while a board may delegate powers subject to possible review, it may not abdicate them. Under Delaware law, the board must retain the ultimate freedom to direct the strategy and affairs of the Company for the delegation decision to be upheld.

In the next step of the analysis, the Court noted abdication of directorial duty evidences disloyalty.  In this case the Court noted the plaintiff alleged that the director defendants delegated to conflicted management total and complete authority to prepare and file the proxy and that the director defendants did not review the proxy before it was filed.

The director defendants did not provide any information to rebut the plaintiff’s allegations.  The plaintiff’s allegations were consistent with the delegating Board resolution. For example, there were no meeting minutes demonstrating that the director defendants oversaw the proxy’s preparation or that they reviewed the proxy before the officer defendants filed it with the SEC.

The Court had to accept the plaintiff’s allegations as true for the purpose of the motion to dismiss.   Therefore, the Court found plaintiff had alleged facts making it reasonably conceivable that the director defendants delegated full authority to prepare and disseminate the Proxy to the allegedly conflicted officer defendants, and did so in bad faith.  According to the Court, bad faith is reflected in the choice of agent and the complete scope of delegation.

Expanding on the bad faith analysis, the Court noted the Board delegated drafting the proxy to the officer defendants, known conflicted individuals who had been ostensibly walled off from the sale process but still assisted in tilting the playing field toward buyer. Second, the Court found the scope of the delegation went too far. The Board’s resolution granted the officer Defendants full power and discretion to prepare the Proxy with information they thought it needed to contain, and then to file the Proxy with the SEC without the Board’s review. The Board authorized interested parties to unilaterally describe the process to the stockholders with finality, thereby infecting the stockholder vote as well.

According to the Court, the plaintiff also adequately alleged that the director defendants failed to correct a proxy they knew to be false and misleading. The Complaint’s allegations indicated that the director defendants knew the truth so if the director defendants had reviewed the proxy, even if only after it was issued, they would have known it was false or misleading. Because the Company issued further disclosures before the stockholder vote in a supplemental proxy, the director defendants conceivably had the opportunity to correct any alleged misstatements but failed to do so.

The Securities and Exchange Commission charged eight companies for failing to disclose in SEC Form 12b-25 filings, commonly known as Form NT, that their request for seeking a delayed quarterly or annual reporting filing was caused by an anticipated restatement or correction of prior financial reporting. The companies agreed to pay penalties of $25,000 to $50,000 each.

According to the SEC, Rule 12b-25 provides that if an issuer fails to file a Form 10-K or 10-Q within the time period prescribed for such report, the issuer, no later than one business day after the due date for such report, shall file a Form 12b-25 with the Commission, disclosing the issuer’s inability to file the report timely and the reasons therefore in reasonable detail. Form 12b-25 requires the issuer to affirm, among other things, that the subject periodic report will be filed within fifteen calendar days, for a Form 10-K, or within five calendar days, for a Form 10-Q, of the report’s prescribed due date, and requires that the report actually be filed within such period. Form 12b-25 also requires the issuer to confirm whether or not it anticipates that any significant change in results of operations from the corresponding period for the prior fiscal year will be reflected by the earnings statements to be included in the subject periodic report. If such change is anticipated, the issuer must attach a narrative and quantitative explanation of the anticipated change and, if appropriate, state the reasons why a reasonable estimate of the results cannot be made.

The SEC orders find that each of the companies announced restatements or corrections to financial reporting within 4-14 days of their Form NT filings despite failing to provide details disclosing that anticipated restatements or corrections were among the principal reasons for their late filings. The orders also find that the companies failed to disclose on Form NT, as required, that management anticipated a significant change in quarterly income or revenue.

According to the SEC, they will “continue to use data analytics to uncover difficult to detect disclosure violations.”  Data analytics are sometimes referred to as robo-cop routines.  It’s probably not that hard to match up Form 12b-25’s with Form 8-K’s announcing restatements filed in short proximity of one another.

The House of Representatives has passed the “The Promoting Transparent Standards for Corporate Insiders Act” (H.R. 1528) by a vote of 355-69.  The bill directs the Securities and Exchange Commission to study and report on possible revisions to regulations regarding 10b5-1 trading plans. 10b5-1 plans allow employees of publicly traded companies and others to sell their shares without violating insider trading prohibitions. The bill requires the SEC to revise its regulations consistent with the results of the study.

The House Committee on Financial Services is considering legislation on a number of matters that would affect public companies.  An example of some of the matters under consideration include:

  • A bill that would require public companies to submit quarterly reports to both the SEC and investors detailing the amount, date, and nature of the company’s expenditures for political activities.
  • The ESG Disclosure Simplification Act would require issuers to disclose certain environmental, social and governance (ESG) metrics to shareholders, the connection between those metrics and the issuer’s long term business strategy, and the method by which the issuer determines how ESG metrics impact its long term strategy. The bill would also require the U.S. Securities and Exchange Commission (SEC) to adopt rules requiring issuers to disclose ESG metrics in filings that require audited financial statements.
  • A bill that would require public companies to annually disclose the voluntarily, self-identified gender, race, ethnicity and veteran status of their board directors.

Whether Republicans or Democrats are in charge, many bills considered by this Committee do not progress very far.  Probably the greatest chance of any of this progressing is if it is incorporated in a larger bill.

The SEC Division of Examinations has issued a Risk Alert to highlight observations from recent exams of investment advisers, registered investment companies, and private funds offering ESG products and services.

According to the Risk Alert, during examinations of investment advisers, registered investment companies, and private funds engaged in ESG investing, the staff observed some instances of potentially misleading statements regarding ESG investing processes and representations regarding the adherence to global ESG frameworks. The staff noted, despite claims to have formal processes in place for ESG investing, a lack of policies and procedures related to ESG investing; policies and procedures that did not appear to be reasonably designed to prevent violations of law, or that were not implemented; documentation of ESG-related investment decisions that was weak or unclear; and compliance programs that did not appear to be reasonably designed to guard against inaccurate ESG-related disclosures and marketing materials.

The Risk Alert provides additional thoughts in various areas which include:

  • Portfolio management practices were inconsistent with disclosures about ESG approaches.
  • Controls were inadequate to maintain, monitor, and update clients’ ESG-related investing guidelines, mandates, and restrictions.
  • Proxy voting may have been inconsistent with advisers’ stated approaches.
  • Unsubstantiated or otherwise potentially misleading claims regarding ESG approaches.
  • Inadequate controls to ensure that ESG-related disclosures and marketing are consistent with the firm’s practices.
  • Compliance programs did not adequately address relevant ESG issues.

The SEC has reissued and updated its guidance regarding COVID-19 matters and its effect on some matters related to annual meetings.  The guidance addresses:

  • Changing the Date, Time, or Location of a Shareholder Meeting
  • “Virtual” Shareholder Meetings
  • Presentation of Shareholder Proposals
  • Delays in Printing and Mailing of Full Set of Proxy Materials

John Coates, Acting Director, Division of Corporation Finance, issued a statement questioning the application of the safe harbor for forward looking information in the Private Securities Litigation Reform Act (PSLRA) to a de-SPAC transaction.  A de-PAC transaction occurs when a SPAC, which is already public, acquires a private company which results in the private company being publically owned.

Mr. Coates takes issue with the often repeated claim by some but not all SPAC enthusiasts that an advantage of SPACs over traditional IPOs is lesser securities law liability exposure for targets and the public company itself. This asserted lesser liability is focused on using projections and other valuation materials of a kind that is not commonly found in conventional IPO prospectuses because such materials are thought to benefit from the safe harbor for forwarding looking information provided by the PSLRA.  The PSLRA does not provide such protection for IPOs because of a statutory exclusion but some believe that since a SPAC is already public the safe harbor is available.

Mr. Coates notes that the term “initial public offering” is not defined in the PSLRA. He also asserts that the economic essence of an initial public offering is the introduction of a new company to the public.  According to Mr. Coates, a de-SPAC transaction is also the introduction of a new company to the public.  It therefore follows to Mr. Coates that a de-SPAC transaction is also an initial public offering as contemplated by the PSLRA and therefore the safe harbor for forward looking information may not be available.

Mr. Coates views are his own, not those of the Commission, and may or may not be accepted by a court.

FINCEN has issued an Advance Notice of Proposed Rulemaking, or ANPRM to solicit public comment on a wide range of questions related to the implementation of the beneficial ownership information reporting provisions of the Corporate Transparency Act, or CTA.

The CTA requires reporting of beneficial ownership information by “reporting companies.” The CTA defines a reporting company as a corporation, LLC, or other similar entity that is (i) created by the filing of a document with a secretary of state or a similar office under the law of a state or Indian tribe, or (ii) formed under the law of a foreign country and registered to do business in the United States by the filing of a document with a secretary of state or a similar office under the laws of a state or Indian tribe. The CTA exempts certain categories of entities from the reporting requirement.

The CTA defines a beneficial owner of an entity as an individual who, directly or indirectly, through any contract, arrangement, understanding, relationship, or otherwise (i) exercises substantial control over the entity, or (ii) owns or controls not less than 25 percent of the ownership interests of the entity.

Specifically, reporting companies must report, for each identified beneficial owner and applicant, the following information: (i) Full legal name; (ii) date of birth; (iii) current residential or business street address; and (iv) a unique identifying number from an acceptable identification document or the individual’s FinCEN identifier.

The ANPR poses the following questions for public comment amongst many others:

  • How should FinCEN interpret the phrase “other similar entity,” and what factors should FinCEN consider in determining whether an entity qualifies as a similar entity?
  • What types of entities other than corporations and LLCs should be considered similar entities that should be included or excluded from the reporting requirements?
  • To what extent should FinCEN’s regulatory definition of beneficial owner in this context be the same as, or similar to, the customer due diligence rules adopted by FINCEN or the standards used to determine who is a beneficial owner under Rule 13d-3 adopted under the Securities Exchange Act of 1934?
  • Should FinCEN define either or both of the terms “own” and “control” with respect to the ownership interests of an entity? If so, should such a definition be drawn from or based on an existing definition in another area, such as securities law or tax law?
  • Should FinCEN define the term “substantial control”? If so, should FinCEN define “substantial control” to mean that no reporting company can have more than one beneficial owner who is considered to be in substantial control of the company, or should FinCEN define that term to make it possible that a reporting company may have more than one beneficial owner with “substantial control”?

The PCAOB has released a publication captioned “Audit Committee Resource: 2021 Inspections Outlook.”  The purpose of the three-page publication is to assist audit committees in engaging in informed dialogue with their auditors on the PCAOB’s planned focus of their examination of public company audits.

Topics covered in the publication include:

  • Auditor’s risk assessments
  • Firms’ quality control systems
  • How firms comply with auditor independence requirements
  • Fraud procedures
  • Critical audit matters
  • How firms implement new auditing standards
  • Supervision of audits involving other auditors