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

On December 18, 2018, the SEC approved final rules on hedging that require companies to disclose practices or policies related to the ability of employees or directors to engage in hedging transactions with respect to a company’s equity securities.

The hedging rules, as mandated by Section 955 of the Dodd-Frank Act, add Item 407(i) to Regulation S-K to require disclosures of policies impacting employees (including officers) and directors ability to purchase securities or other instruments to hedge or offset equity securities held or issued to an employee or director. The rules expressly apply to equity securities of a company, any parent of the company, any subsidiary of the company, or any subsidiary of any parent of the company.

Companies can comply with the new requirement by disclosing their hedging policies in full or by providing a “fair and accurate” summary of the hedging policy including the category of persons subject to the policy and the specific hedging transactions that are permitted or prohibited under the policy.

A 2010 report from the Senate Committee on Banking, Housing, and Urban Affairs suggests that the rule is intended to “allow shareholders to know if executives are allowed to purchase financial instruments to effectively avoid compensation restrictions that they hold stock long-term, so that they will receive their compensation even in the case that their firm does not perform.” As such, like many of the Commission’s disclosure rules, the finalized rules are intended to provide additional transparency to shareholders but do not require companies to prohibit hedging transactions or to otherwise adopt practices or a policy addressing hedging by any category of individuals. In this respect, the rules require companies that do not have any hedging policy only to state that fact and acknowledge that hedging transactions are generally permitted.

Large accelerated and accelerated filers will need to include the hedging disclosures in proxy and information statements for the election of directors for fiscal years beginning on or after July 1, 2019.  Smaller reporting companies and emerging growth companies were given an additional year to phase-in the disclosures which will be required for SRCs and EGCs in proxy and information statements on or after July 1, 2020.

The first CAM I am aware of is in this SEC filing:

Critical Audit Matter

The critical audit matter communicated below is a matter arising from the current period audit of the financial statements that was communicated or required to be communicated to the audit committee and that: (1) relates to accounts or disclosures that are material to the financial statements and (2) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the financial statements, taken as a whole, and we are not, by communicating the critical audit matter below, providing separate opinions on the critical audit matter or on the accounts or disclosures to which it relates.

As discussed in Note 3 to the financial statements, the financial statements include investments valued at $8,658,675 (49% of net assets) as of September 30, 2018, whose fair values have been estimated by management in accordance with policies approved by and under the general oversight of the Board of Trustees in the absence of readily determinable fair values.

The principal considerations for our determination of the investments whose fair values have been estimated by management in accordance with policies approved by and under the general oversight of the Board of Trustees in the absence of readily determinable fair values are that auditing these investments involved our complex and subjective judgment and the investments are material to the financial statements as a whole.

Our audit procedures related to these investments included the following procedures, among others to address the critical audit matter: We tested the effectiveness of the controls over the Fund’s valuation methodologies and evaluated the relevance of the qualitative components embedded in the methodology models. We also agreed underlying supporting documentation from outside specialists where applicable, agreed to actual empirical sales data as available and tested the computational accuracy of the models.

CoinAlpha Advisors LLC was formed for the purpose of investing in digital assets. From October 2017 through May 2018 CoinAlpha raised approximately $600,000 from 22 investors, residing in at least five U.S. states. Through this offering, the investors purchased limited partnership interests in a fund formed by CoinAlpha in exchange for a pro rata share of any profits derived from the fund’s investment in digital assets.

The fund filed a Form D Notice of Exempt Offering of Securities with the SEC. It’s interesting that they checked the 506(b) box and not the 506(c) box on the Form D.

The SEC alleged CoinAlpha did not have pre-existing substantive relationships with nine of the fund’s investors and engaged in a general solicitation of public interest in the securities offering through CoinAlpha’s website, which was generally accessible without password protection. Additionally, CoinAlpha engaged in general solicitation through blog postings, and media interviews and digital asset and blockchain conferences, accessible both via live attendance and through the Internet. Despite collecting accredited investor questionnaires and representations from investors certifying to their accredited investor status, Respondent did not take reasonable steps to verify that investors in the Fund were accredited investors.

During the subsequent SEC investigation, CoinAlpha retained a third party who determined that all 22 investors were accredited investors.

The SEC found CoinAlpha engaged in an unregistered public offering. CoinAlpha did not admit or deny the SEC’s findings.

In SEC v. Blockvest, LLC, the United States District Court for the Southern District of California examined the SEC’s argument for a preliminary injunction halting an initial coin offering, or ICO.

The complaint alleged that Defendants have been offering and selling alleged unregistered securities in the form of digital assets called BLV’s. According to the SEC, Blockvest and its promoter, Ringgold, falsely claimed their ICO has been “registered” and “approved” by the SEC and using the SEC’s seal on the website. In response, Ringgold asserted that Blockvest has never sold any tokens to the public and has only investor, Rosegold Investments LLP, (“Rosegold”) which is run by him where he has invested more than $175,000 of his own money.

According to the Defendants, Blockvest utilized BLV tokens during the testing and development phase and a total of 32 partner testers were involved.  During this testing, 32 testers put a total of less than $10,000 of Bitcoin and Ethereum onto the Blockvest exchange where half of it remains at the time of the Court’s order.  The other half was used to pay transactional fees to unknown and unrelated third parties.   No BLV tokens were ever released from the Blockvest platform to the 32 testing participants.    The BLV tokens were only designed for testing the platform and the testers would not and could not keep or remove BLV tokens from the Blockvest Exchange.

The Court examined the first prong of the Howey test which requires an investment of money.  The SEC argued that Blockvest’s website and whitepaper presented an offer of an unregistered security in violation of Section 5 of the Securities Act.  The Court noted the SEC’s argument presumed, without evidentiary support, that the 32 test investors reviewed the Blockvest website, the whitepaper and media posts when they clicked the “buy now” button on Blockvest’s website. However, the SEC and the Defendants provided starkly different facts as to what the 32 test investors relied on, in terms of promotional materials, information, economic inducements or oral representations at the seminars, before they purchased the test BLV tokens.  Therefore, because there were disputed issues of fact, the Court could not make a determination whether the test BLV tokens were “securities” under the first prong of Howey.

The second prong of the Howey test requires an expectation of profits. The Court noted no evidence was provided to demonstrate the investors’ expectation of profits.  The Court held without full discovery and disputed issues of material facts, the Court cannot make a determination whether the BLV token offered to the 32 test investors was a “security.”

Ringgold also asserted he will not pursue the ICO and will provide SEC’s counsel with 30 days’ notice in the event they decide to proceed.  As there was not a reasonable likelihood the wrong would be repeated, the SEC also failed this test for the grant of a preliminary injunction.

In Re Tangoe, Inc. Stockholders Litigation was one of those situations where everything that could go wrong did.  According to the Plaintiff, the Tangoe directors breached their fiduciary duties to Tangoe stockholders by steering the Company into an ill-advised take-private acquisition with a negative premium by Marlin Equity and recommended the transaction to stockholders in the midst of a storm conjured by the Board’s alleged false filings with the SEC, a failed effort to restate the Company’s financials and correct the false filings, the subsequent delisting of the Company’s stock by the NASDAQ exchange, the near deregistration of the stock by the SEC due to the Board’s ongoing failure to file the restatement, rumblings of a proxy contest that threatened the Director Defendants’ Board seats  and, finally, the enticement of significant equity awards to the Director Defendants that would be triggered only by a change of control.

While I don’t believe it, the Plaintiff dramatically alleged that the Director Defendants, rather than navigate through or around the storm, sailed Tangoe directly “into an iceberg and then faithlessly commandeered the lifeboats, leaving stockholders to drown.”

Ultimately the Director Defendants recommended that stockholders tender into a negative premium deal.  Inevitable litigation followed, and the Director Defendants moved to dismiss the Complaint.  Their showcase argument was that they were entitled to business judgment rule deference under Corwin v. KKR Fin. Hldgs. LLC because a majority of disinterested, fully informed and uncoerced stockholders approved the Transaction.  The Plaintiff claimed Corwin was not applicable because it had pled facts from which it may reasonably be inferred that stockholders were either coerced to tender or did so without the benefit of material information.

The Court found the facts pled supported a reasonable inference that stockholder approval of the negative premium transaction was not fully informed in the absence of audited financial statements and other adequate financial information about the Company and its value. According to the Court there was an information vacuum, which was compounded by the fact that the Company had failed to file multiple 2016 quarterly reports and had not held an annual stockholders meeting for nearly three years.  The Court also noted that Board did not advise stockholders that all forensic accounting had been completed and only a formal audit remained, depriving stockholders the opportunity to wait and see the audited results.

No finding has been made by the Court that the directors engaged in improper conduct as the only question before the Court was whether to grant the Director Defendants’ motion to dismiss.

ISS has published preliminary frequently asked questions related to compensation policies for 2019. Some key observations are noted below.

Will any of the quantitative pay-for-performance screens change for 2019?

No. There will be no changes to the quantitative screens for the 2019 proxy season. The secondary Financial Performance Assessment screen will continue to use GAAP/accounting performance measures. However, ISS will continue to explore the potential for future use of Economic Value Added (EVA) measures to add additional insight as part of the financial performance analysis. To that end, EVA measures will be featured in ISS research reports on a phased-in basis over the 2019 proxy season, although not as part of the quantitative screen methodology.

Are there any changes regarding the application of the excessive non-employee director (NED) compensation policy?

Last year, ISS introduced a policy that provides for potential adverse vote recommendations for the board committee responsible for approving/setting NED pay when there is an established pattern (two or more consecutive years) of excessive pay levels without a compelling rationale or other clearly explained mitigating factors.

In light of recent feedback received through the policy survey and investor roundtables, ISS intends to revise its methodology for identifying NED pay outliers for the purposes of this policy. Further, ISS endeavors to increase the transparency around the methodology used for identifying pay outliers. For these reasons, ISS will not be issuing adverse director recommendations under this policy in 2019; rather, the first possible adverse vote recommendations under this policy will be delayed until 2020. More details on the revised methodology will be provided in the comprehensive FAQ coming inDecember.

Will the EPSC passing scores change?

No, the passing scores for all U.S. EPSC models will remain the same as in effect for the 2018 proxy season. As in prior years, there will be weighting/point reallocations among some of the individual factors within each EPSC model.

Are there any new “overriding” factors?

Yes. In order to address investor concerns around potentially highly dilutive equity compensation programs, ISS is introducing a new negative overriding factor relating to excessive dilution for the S&P 500 and Russell 3000 EPSC models only. The new overriding factor will be triggered when the company’s equity compensation program is estimated to dilute shareholders’ holdings by more than 20 percent (for the S&P 500 model) or 25 percent (for the Russell 3000 model).

This overriding factor examines share capital dilution (as opposed to voting power dilution) calculated as: (A + B + C) ÷ CSO, where: A = # new shares requested; B = # shares that remain available for issuance; C = # unexercised/unvested outstanding awards; and CSO = common shares outstanding.

Are there any substantive changes to the other EPSC factors?

The change in control (CIC) vesting factor will be updated to provide points based on the quality of disclosure of CIC vesting provisions, rather than based on the actual vesting treatment of awards. Specifically, full points for this factor will be earned where the company’s equity plan discloses with specificity the CIC vesting treatment for both performance- and time-based awards. If the plan is silent on the CIC vesting treatment for either type of award, or if the plan provides for merely discretionary vesting for either type of award, then no points will be earned for this factor.

ISS has released updates to its 2019 benchmark proxy voting policies.  There is no impact for the upcoming 2019 proxy season for U.S. companies.

Board Gender Diversity

ISS has announced a new voting policy on directors for companies with no female directors serving on their boards, with a year’s grace period before implementation. The new policy will be effective for meetings on or after Feb. 1, 2020, and will be applicable for companies in either the Russell 3000 or S&P 1500 indices. After the year-long grace period, which will allow boards who wish to do so to recruit qualified women candidates, adverse voting recommendations may be issued against nominating committee chairs at boards with no gender diversity. ISS will generally issue recommendations against the election of the chair of the nominating committee, but on a case-by-case basis, the elections of other directors who are responsible for the board nomination process may be impacted (for example, at companies with no formal nominating committee). In exceptional circumstances, the policy would allow the absence of board gender diversity to be temporarily explained and excused.

Economic Value Added (EVA)

ISS has been assessing the potential use of EVA data in the Financial Performance Assessment screen of its pay-for performance model.  ISS has chosen to explore the potential of economic performance (EVA) factors to add insight into company performance beyond market performance (TSR) and accounting performance (GAAP) measures, and that further consideration of the additional insight that EVA could bring to investors as part of financial performance analysis would be welcome. To that end and for informational purposes, EVA metrics will be featured in ISS research reports on a phased-in basis over the 2019 U.S. annual meeting season.  ISS will not be introducing EVA measures into the quantitative pay-for-performance model for 2019 and will continue using accounting performance (GAAP measures) in the Financial Performance Assessment for the 2019 proxy

The SEC simultaneously announced a pair of settled enforcement actions related to illegally offered ICOs with extensive remedial provisions to fix the faulty offerings. You can find the enforcement actions here (Airfax) and here (Paragon).

The first step is to issue a press release stating you are going to offer to give everyone their money back.

The second step is to register the coins on Form 10 under the Exchange Act. A daunting task maybe, given little is known how to register coins. You will probably need audited financial statements and all that stuff. Then there are those pesky 34 Act reporting obligations which will follow such as 10-Ks, 10-Qs and 8-Ks. I wonder how Section 16 applies and who has to report.

The third step is to offer to give everyone their money back. According to the SEC you must distribute by electronic means reasonably designed to notify each potential claimant, a notice and a claim form, informing all persons and entities that purchased tokens of their potential claims under Section 12(a) of the Securities Act, including the right to sue “to recover the consideration paid for such security with interest thereon, less the amount of any income received thereon, upon the tender of such security, or for damages if [the purchaser] no longer owns the security” and informing purchasers that they may submit a written claim on the claim form directly to the token issuer.

When the settlements were announced the press release noted these settlements provide a model for companies that have issued tokens in ICOs and seek to comply with the federal securities laws.

There probably won’t be all kinds of token issuers beating the door down to follow this model. Nonetheless, it needs to be considered by those with viable business models going forward that crossed the line when offering tokens. The unappealing alternative is to wait out the statute of limitations with hamstrung viability from contingent liabilities related to the illegal offering of tokens.

I have been looking for the first real CAM and so far I haven’t found it. I’ve seen some dancing around the edges, like foreign auditors throwing in boiler plate going concern language under the heading “Critical Audit Matters” and some smaller domestic audit firms stating they did not find any CAMs.

So far my favorite pseudo-CAM can be found in this 10-K:

Critical Audit Matters

We have served as the Company’s auditor since 2016.

 

In Stein v. Blankfein et al the Delaware Court of Chancery considered a proposed settlement of litigation against directors of Goldman Sachs. The related complaint contained two counts for derivative relief for breach of fiduciary duties related to the payment of excessive compensation awards to non-employee directors and issuing stock-based awards that were void because of uninformed shareholder votes. The complaint also included two direct claims for breach of fiduciary duties for failure to disclose material information to stockholders when compensation plans were approved and for partial disclosures in proxy statements concerning the tax deductibility of cash-based incentive awards to named executive officers.

The Court described what the Company would give up by settling the claims. The Court noted the claims compromised were allegations that the Company’s directors are liable to the Company for excessively compensating themselves and for issuing stock-based incentive awards in reliance on stock incentive plans that were void at the time of the award. These claims are assets of the Company. The settlement, if confirmed, would release all stockholders’ and the Company’s rights to assert these and related claims going forward.

The Court than analyzed what the Company would obtain by settling the claims. According to the Plaintiff and the Director Defendants, the quid pro quo arose from the settlement of the Plaintiff’s direct claims against the Director Defendants. Those claims were composed of allegations that the Director Defendants breached fiduciary duties in failing to make required disclosures in connection with the Company’s recent stock incentive plans and proxy statements. The Director Defendants also agreed to cause the Company to do certain beneficial things, including making certain disclosures in the future and continuing certain practices, already implemented, with respect to executive compensation for at least three years. The Plaintiff alleged that the disclosures would bring future stock incentive plans into compliance with the Plaintiff’s interpretation of federal law, thus conveying a large but hypothetical monetary benefit on the Company.

However the Court declined to approve the settlement because it did not find the release of the derivative claims fair to the Company. According to the Court, in return for a release of the monetary claims against them, the Director Defendants give up nothing. Instead, the Director Defendants only agreed to cause the Company to take or refrain from certain actions that were largely mandatory given the Director Defendants’ fiduciary duties. Even if the undertaking of the Defendant Directors had merit, they were unrelated to claims for conflicted overpayment that were at the heart of the derivative claims.