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

The SEC has issued a Risk Alert and FAQs to remind broker-dealers of their obligations when they sell unregistered securities on behalf of clients.  This occurs when founders and employees sell their initial stakes in companies that have gone public or when investors sell securities in public companies that were acquired in private placements.

The publication of the staff guidance was accompanied by the announcement of an enforcement action against two firms for improperly selling billions of shares of penny stocks through such unregistered offerings.

The Risk Alert summarizes deficiencies that were discovered by the SEC’s Office of Compliance Inspections and Examinations, or OCIE, during a targeted sweep of 22 broker-dealers frequently involved in the sale of microcap securities.  The sweep uncovered widespread deficiencies including:

  • Insufficient policies and procedures to monitor for and identify potential red flags in customer-initiated sales.
  • Inadequate controls to evaluate how customers acquired the securities and whether they could be lawfully resold without registration.
  • Failure to file suspicious activity reports, as required by the Bank Secrecy Act, when encountering unusual or suspicious activity in connection with customers’ sales of microcap securities.

While the Risk Alert and enforcement actions were directed at penny and micro-cap stocks, I wouldn’t be surprised if many broker dealers ratchet up their compliance in this area.  So expect more questions and a longer time line when trying to sell unregistered securities.  For instance, expect a lot of questions even if you tender a certificate that does not have restrictive legends.  The SEC says reasonable inquiry must still be made.

ABOUT STINSON LEONARD STREET

Stinson Leonard Street LLP provides sophisticated transactional and litigation legal services to clients ranging from individuals and privately held enterprises to national and international public companies. As one of the 75 largest firms in the U.S., Stinson Leonard Street has more than 520 attorneys and offices in 14 cities, including Minneapolis, Mankato and St. Cloud, Minn.; Kansas City, St. Louis and Jefferson City, Mo.; Phoenix, Ariz.; Denver, Colo.; Washington, D.C.; Decatur, Ill.; Wichita and Overland Park, Kan.; Omaha, Neb.; and Bismarck, N.D.

The views expressed herein are the views of the blogger and not those of Stinson Leonard Street or any client.

The Payson Center for International Development of Tulane University Law School released a study analyzing the results of a June 2014 survey of issuers who filed the required Form SD.  The study investigates the market impact of Section 1502 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, which applies public disclosure law to Tin, Tantalum, Tungsten and Gold (3TG) – so-called conflict minerals.

The study’s findings reveal that issuers mobilized substantial in-house and external resources, an aggregate total of $709.7 million, to set up conflict mineral programs in order to furnish the required information by June 2, 2014, as per the disclosure law and rule.  Issuers each invested an average of $545,962 worth of time and effort to comply with the law, the value of each company’s conflict mineral program largely comprised of in-house corporate time, external human resources, an IT evaluation and IT system expenses.  Small issuers, with less than $100 million in revenue, spent $190,330 worth of resources on average – roughly 1/3rd as much as their large issuer counterparts.

With 112 issuers participating in the study, Tulane believes the data is representative of the 1,300 issuers who filed the required Form SD with the SEC.

ABOUT STINSON LEONARD STREET

Stinson Leonard Street LLP provides sophisticated transactional and litigation legal services to clients ranging from individuals and privately held enterprises to national and international public companies. As one of the 75 largest firms in the U.S., Stinson Leonard Street has more than 520 attorneys and offices in 14 cities, including Minneapolis, Mankato and St. Cloud, Minn.; Kansas City, St. Louis and Jefferson City, Mo.; Phoenix, Ariz.; Denver, Colo.; Washington, D.C.; Decatur, Ill.; Wichita and Overland Park, Kan.; Omaha, Neb.; and Bismarck, N.D.

The views expressed herein are the views of the blogger and not those of Stinson Leonard Street or any client.

 

The Ninth Circuit recently examined whether Item 303 of Regulation of S-K, which sets forth the MD&A rules, creates an affirmative duty of disclosure on which to pin a Rule 10b-5 case.  The case centered around a significant stock price drop after the issuer disclosed it would incur a $150 million to $200 million charge related to product defects.  Plaintiffs claimed the company knew it would be liable for the defective products long before the disclosures and made several intervening SEC filings that violated Rue 10b-5.  On appeal the plaintiffs argued the disclosure duty under Item 303 of Regulation S–K is actionable under Section 10(b) and Rule 10b-5.

The court analyzed the origin of disclosure duties under Rule 10b-5 according to the Supreme Court precedent.  Looking to the Matrixx Initiatives case, the court noted neither Section 10(b) nor Rule 10b-5 creates an affirmative duty to disclose any and all material information. Disclosure is required under these provisions only when necessary to make statements made, in light of the circumstances under which they were made, not misleading. Also, the court looked to Basic Inc. v. Levinson which stated “silence, absent a duty to disclose, is not misleading under Rule 10b-5.”

The court also examined an opinion from the Third Circuit.  The court noted that management’s duty to disclose under Item 303 is much broader than what is required under the standard pronounced in Basic.  Citing the Third Circuit case with approval, the court noted because the materiality standards for Rule 10b-5 and Item 303 differ significantly, the demonstration of a violation of the disclosure requirements of Item 303 does not lead inevitably to the conclusion that such disclosure would be required under Rule 10b-5.

The court ultimately held that Item 303 does not create a duty to disclose for purposes of Section 10(b) and Rule 10b-5. According to the court such a duty to disclose must be separately shown according to the principles set forth by the Supreme Court in Basic and Matrixx Initiatives.

ABOUT STINSON LEONARD STREET

Stinson Leonard Street LLP provides sophisticated transactional and litigation legal services to clients ranging from individuals and privately held enterprises to national and international public companies. As one of the 75 largest firms in the U.S., Stinson Leonard Street has more than 520 attorneys and offices in 14 cities, including Minneapolis, Mankato and St. Cloud, Minn.; Kansas City, St. Louis and Jefferson City, Mo.; Phoenix, Ariz.; Denver, Colo.; Washington, D.C.; Decatur, Ill.; Wichita and Overland Park, Kan.; Omaha, Neb.; and Bismarck, N.D.

The views expressed herein are the views of the blogger and not those of Stinson Leonard Street or any client.

The CFTC has published its final rule to exclude most swaps used for hedging purposes by municipal and other governmental utilities from counting against the $25 million swap dealer de minimis threshold that currently applies to swap dealing activities with “special entities” (i.e., governmental organizations, pension plans, and endowments). The final rule closely resembles the proposed rule, which was issued in response to widely voiced concerns that the standard de minimis limit was unduly limiting the number of counterparties willing to offer swaps to municipal and other governmental utilities.

Final Rule

Under the final rule, “utility operations-related swaps” with “utility special entities” will only count against the general $8 billion de minimis threshold (to be reduced to $3 billion at an undetermined phase-in date) applicable to a counterparty’s aggregate gross notional amount of swap-dealing swaps during any 12-month period and not the additional, much lower, $25 million limit applicable to swap dealing with special entities.

The rule defines “utility special entity” as a special entity that:

(i) Owns or operates electric or natural gas facilities, electric or natural gas operations or anticipated electric or natural gas facilities or operations;
(ii) Supplies natural gas or electric energy to other utility special entities;
(iii) Has public service obligations or anticipated public service obligations under Federal, State or local law or regulation to deliver electric energy or natural gas service to utility customers; or
(iv) Is a Federal power marketing agency as defined in Section 3 of the Federal Power Act, 16 U.S.C. 796(19).

The rule defines “utility operations-related swap” as a swap that meets the following conditions:

(i) A party to the swap is a utility special entity;
(ii) A utility special entity is using the swap [to hedge or mitigate commercial risk] in the manner described in § 50.50(c) of this chapter;
(iii) The swap is related to an exempt commodity [e.g., energy or metals commodity] as that term is defined in Section 1a(20) of the Act—or (new to the final rule) an agricultural commodity insofar as such commodity is used for fuel for generation of electricity or is otherwise used in the normal operations of the utility special entity; and
(iv) The swap is an electric energy or natural gas swap; or the swap is associated with: [t]he generation, production, purchase or sale of natural gas or electric energy, the supply of natural gas or electric energy to a utility special entity, or the delivery of natural gas or electric energy service to customers of a utility special entity; fuel supply for the facilities or operations of a utility special entity; compliance with an electric system reliability obligation; or compliance with an energy, energy efficiency, conservation, or renewable energy or environmental statute, regulation, or government order applicable to a utility special entity.

Differences From Proposed Rule

In addition to the extension to agricultural commodities described in item (iii) above, the final rule differs from the proposal in providing a safe harbor that allows a person relying on the utility special entity exclusion to rely on the written representations of a utility special entity counterparty that such counterparty is a utility special entity and that its swap with such person is a utility operations-related swap, unless such person has information that would cause a reasonable person to question the accuracy of such representations. Records of the representations must be kept in accordance with the CFTC’s 5-year record keeping requirement in 17 C.F.R. § 1.31. Unlike the proposed rule, the final rule does not require counterparties relying on the exclusion to file a notice of such reliance with the National Futures Association or to generally maintain books and records substantiating its eligibility to rely on the exclusion under Section 1.31.

Effective Date of Final Rule

The final rule becomes effective October 27, 2014. Until such time, parties may rely on the substantially similar relief provided by CFTC No-Action Letter No. 14-34 (Mar. 21, 2014).

A case against a hedge fund, and one of its partners and in-house counsel, related to actions at a portfolio company and alleging breach of fiduciary duties survived a motion to dismiss.  The portfolio company, alleged to be insolvent, was a credit derivative product company that had a subsidiary that wrote credit default swaps. A creditor of the portfolio company brought an action alleging breach of fiduciary duty.  A partner of the hedge fund and its in-house counsel were members of the board of directors of the portfolio company and were named as defendants in the action, together with the hedge fund.

The hedge fund held all of the junior notes of the portfolio company.   The complaint alleged that the board of the portfolio company had the ability to defer interest payments on junior notes, that the junior notes would not receive anything in an orderly liquidation, that the hedge fund owned all of the junior notes, and that the board decided not to defer paying interest on the junior notes to benefit the hedge fund.   The court stated a conscious decision not to take action is just as much of a decision as a decision to act.

By virtue of the decision not to defer interest, funds flowed from the portfolio company to the hedge fund. As the owner of 100% of the portfolio company‘s equity, the hedge fund controlled the company and stood on both sides of the transaction. Delaware law imposes fiduciary duties on those who effectively control a corporation.  In the past, Delaware courts have held that challenges to similar transfers from an insolvent subsidiary to its controller state a derivative claim for breach of fiduciary duty.  Based on a review of precedent,  the court found the complaint stated a derivative claim for breach of fiduciary duty to the extent they challenged the failure to defer interest on the junior notes. The  court added the defendants will have the burden of proving that the failure to defer interest on the junior notes was entirely fair.

Using a similar analysis to that employed for the junior notes, the court refused to grant a motion to dismiss related to allegedly excessive payments under a license agreement to an affiliate of the hedge fund.  As before, the court held the hedge fund “stands on both sides of the transaction, making entire fairness the governing standard of review with the burden of proof on the defendants.”

The complaint also alleged that the defendants  breached their fiduciary duties by amending operating guidelines of the portfolio company to permit it to invest in riskier securities and make speculative investments while the portfolio company was insolvent.   The court noted that current Delaware law does not require the board to shut down the portfolio company’s business and manage towards a near-term dissolution for the benefit of creditors. Notwithstanding a company‘s insolvency, the directors continue to have the task of attempting to maximize the economic value of the firm.  The court stated in such a scenario the directors are protected by the business judgment rule.  After a lengthy analysis examining arguments that the board was attempting to favor the sole stockholder, the court held the plaintiff cannot rebut the business judgment rule by alleging that the board of the portfolio company has decided to pursue a relatively more risky business strategy to benefit the hedge fund as its sole common stockholder. Although the portfolio company was insolvent, and although the directors were dual-fiduciaries, the board did not face a conflict between the interests of the primary residual claimants (the creditors) and the interests of secondary residual claimants (the stockholders).

ABOUT STINSON LEONARD STREET

Stinson Leonard Street LLP provides sophisticated transactional and litigation legal services to clients ranging from individuals and privately held enterprises to national and international public companies. As one of the 75 largest firms in the U.S., Stinson Leonard Street has more than 520 attorneys and offices in 14 cities, including Minneapolis, Mankato and St. Cloud, Minn.; Kansas City, St. Louis and Jefferson City, Mo.; Phoenix, Ariz.; Denver, Colo.; Washington, D.C.; Decatur, Ill.; Wichita and Overland Park, Kan.; Omaha, Neb.; and Bismarck, N.D.

The views expressed herein are the views of the blogger and not those of Stinson Leonard Street or any client.

In a new CDI, the SEC indicates it may be possible to use IP addresses to control internet communications so that offers are made only in one state and qualify for the intrastate exemption under Rule 147.  In Securities Act Rules CDI 141.05, SEC staff states:

“Issuers could implement technological measures to limit communications that are offers only to those persons whose Internet Protocol, or IP, address originates from a particular state or territory and prevent any offers to be made to persons whose IP address originates in other states or territories. Offers should include disclaimers and restrictive legends making it clear that the offering is limited to residents of the relevant state under applicable law. Issuers must comply with all other conditions of Rule 147, including that sales may only be made to residents of the same state as the issuer.”

ABOUT STINSON LEONARD STREET

Stinson Leonard Street LLP provides sophisticated transactional and litigation legal services to clients ranging from individuals and privately held enterprises to national and international public companies. As one of the 75 largest firms in the U.S., Stinson Leonard Street has more than 520 attorneys and offices in 14 cities, including Minneapolis, Mankato and St. Cloud, Minn.; Kansas City, St. Louis and Jefferson City, Mo.; Phoenix, Ariz.; Denver, Colo.; Washington, D.C.; Decatur, Ill.; Wichita and Overland Park, Kan.; Omaha, Neb.; and Bismarck, N.D.

The views expressed herein are the views of the blogger and not those of Stinson Leonard Street or any client.

The office of the Treasury Department known as the Federal Insurance Office, or FIO, released its second Annual Report on the Insurance Industry.  Under the Dodd-Frank Wall Street Reform and Consumer Protection Act, FIO must report annually to the President and Congress on the state of the insurance industry and any other information deemed relevant or requested.

The report begins with an overview of the insurance industry that presents and analyzes the financial performance and condition of the key U.S. insurance industry sectors.  This section also includes analysis of insurance industry capital markets activity, the continuing importance of non-U.S. reinsurers, and the expanding role of alternative risk transfer mechanisms such as insurance-linked securities.

In addition, the report includes a section focusing on matters of consumer protection and access to insurance, including affordability of personal auto insurance; portability of auto insurance for service members; force-placed insurance for homeowners; and topics concerning life insurance and annuities.  Finally, the report addresses a range of regulatory developments—at the state, federal, and international levels—which have occurred or progressed over the past year, and which have implications for the U.S. insurance sector.

ABOUT STINSON LEONARD STREET

Stinson Leonard Street LLP provides sophisticated transactional and litigation legal services to clients ranging from individuals and privately held enterprises to national and international public companies. As one of the 75 largest firms in the U.S., Stinson Leonard Street has more than 520 attorneys and offices in 14 cities, including Minneapolis, Mankato and St. Cloud, Minn.; Kansas City, St. Louis and Jefferson City, Mo.; Phoenix, Ariz.; Denver, Colo.; Washington, D.C.; Decatur, Ill.; Wichita and Overland Park, Kan.; Omaha, Neb.; and Bismarck, N.D.

The views expressed herein are the views of the blogger and not those of Stinson Leonard Street or any client.

To fulfill its statutory responsibilities, the CFPB collects large amounts of consumer financial data on credit card accounts, mortgage loans, and other products through one-time or ongoing collections. While the CFPB has taken steps to protect and secure these data collections, GAO determined that additional efforts are needed in several areas to reduce the risk of improper collection, use, or release of consumer financial data.

Areas cited by GAO which need improvement include:

  • Written procedures and documentation: CFPB lacks written procedures and comprehensive documentation for a number of processes, including data intake and information security risk assessments. The lack of written procedures could result in inconsistent application of the established practices.
  • Implementation of privacy and security steps: CFPB has not yet fully implemented a number of privacy control steps and information security practices, which could hamper the agency’s ability to identify and monitor privacy risks and protect consumer financial data.

GAO made 11 recommendations to enhance CFPB’s privacy and information security and 1 recommendation to the Office of the Comptroller of the Currency to ensure its data collections comply with appropriate disclosure requirements. CFPB and OCC agreed with GAO’s recommendations and noted steps they plan to take or have taken to address them.

ABOUT STINSON LEONARD STREET

Stinson Leonard Street LLP provides sophisticated transactional and litigation legal services to clients ranging from individuals and privately held enterprises to national and international public companies. As one of the 75 largest firms in the U.S., Stinson Leonard Street has more than 520 attorneys and offices in 14 cities, including Minneapolis, Mankato and St. Cloud, Minn.; Kansas City, St. Louis and Jefferson City, Mo.; Phoenix, Ariz.; Denver, Colo.; Washington, D.C.; Decatur, Ill.; Wichita and Overland Park, Kan.; Omaha, Neb.; and Bismarck, N.D.

The views expressed herein are the views of the blogger and not those of Stinson Leonard Street or any client.

The former CEO of Saba Software, Inc. agreed to repay over $2.5 million in bonuses, other incentive-based or equity-based compensation, and stock sale profits pursuant to Section 304(a) of the Sarbanes-Oxley Act.  The action resulted from allegedly wrongful conduct where Saba consultants misstated revenues by manipulating time records by either recording time in advance of performance of work or failing to record time for hours worked in order to achieve their quarterly revenue and margin targets.

Section 304 of the Sarbanes-Oxley Act of 2002 requires the CEO and CFO of any issuer required to prepare an accounting restatement due to material noncompliance with the securities laws as a result of misconduct to reimburse the issuer for (i) any bonus or incentive based or equity-based compensation received by that person from the issuer during the 12-month periods following the false filings, and (ii) any profits realized from the sale of securities of the issuer during those 12-month periods.

There is no allegation the former CEO knew of or participated in the conduct.   The SEC order cites the well-known SEC position that Section 304 does not require that a CEO engage in misconduct to trigger the reimbursement requirement.  Note that Saba is based in Silicon Valley and the time records were manipulated in India, although the misdeeds were allegedly directed from North America.

There was no word on what happened to the CFO but the finance department was apparently trying to do the right thing.  The order states “senior Saba employees were told on multiple occasions by the finance department that the Company’s accountants and auditors needed to understand exactly how many hours were being worked and when (regardless of whether or not they were billed to the customer) in order to ensure that revenue was recognized accurately.”

The former CEO did not admit or deny the findings.

ABOUT STINSON LEONARD STREET

Stinson Leonard Street LLP provides sophisticated transactional and litigation legal services to clients ranging from individuals and privately held enterprises to national and international public companies. As one of the 75 largest firms in the U.S., Stinson Leonard Street has more than 520 attorneys and offices in 14 cities, including Minneapolis, Mankato and St. Cloud, Minn.; Kansas City, St. Louis and Jefferson City, Mo.; Phoenix, Ariz.; Denver, Colo.; Washington, D.C.; Decatur, Ill.; Wichita and Overland Park, Kan.; Omaha, Neb.; and Bismarck, N.D.

The views expressed herein are the views of the blogger and not those of Stinson Leonard Street or any client.

The SEC charged a private equity sponsor with breaching its fiduciary duty to a pair of private equity funds by sharing expenses between a company in one’s portfolio and a company in the other’s portfolio in a manner that improperly benefited one fund over the other. The private equity sponsor did not admit or deny the charges.

The SEC stated an investigation found that while the private equity sponsor integrated the two portfolio companies and managed them as one, the funds were separately advised and had distinct sets of investors. Despite developing an expense allocation policy as part of the integration, it was not followed on some occasions, resulting in the portfolio company owned by one fund paying more than its fair share of joint expenses that benefited the companies of both funds.

According to the SEC, the portfolio companies shared numerous annual expenses that generally were allocated between them based on each company’s contributions to their combined revenue.  However, there were times when a portion of the shared expenses were misallocated and went undocumented.   For example, the company owned by one fund paid the entire third-party payroll and 401(k) administrative expenses for the employees of both companies.  The subsidiary of one fund’s portfolio company sold supplies and performed services at cost for the other fund’s portfolio company even though that funds’s portfolio company did not pay any share of the overhead expenses for the subsidiary.  Additionally, there were several employees who performed work that benefited both companies, but their salaries were not allocated between the two.

ABOUT STINSON LEONARD STREET

Stinson Leonard Street LLP provides sophisticated transactional and litigation legal services to clients ranging from individuals and privately held enterprises to national and international public companies. As one of the 75 largest firms in the U.S., Stinson Leonard Street has more than 520 attorneys and offices in 14 cities, including Minneapolis, Mankato and St. Cloud, Minn.; Kansas City, St. Louis and Jefferson City, Mo.; Phoenix, Ariz.; Denver, Colo.; Washington, D.C.; Decatur, Ill.; Wichita and Overland Park, Kan.; Omaha, Neb.; and Bismarck, N.D.

The views expressed herein are the views of the blogger and not those of Stinson Leonard Street or any client.