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

The House of Representatives has overwhelmingly approved legislation to expand the pool of issuers who may rely on the SEC’s Regulation A rules for smaller exempt offerings.

The House’s recently approved bill, the Improving Access to Capital Act (H.R. 2864) would direct the SEC to ease certain restrictions on the use of Regulation A. In particular, Rule 251 would be revised to eliminate the prohibition on the use of Regulation A by entities that are subject to the reporting obligations under Section 13 or Section 15(d) prior to an offering. In other words, going forward, use of Regulation A would no longer be restricted to non-reporting issuers.

The Improving Access to Capital Act would also call the SEC to revise Section 251(a)(2) such that any issuer subject to section 13 or 15(d) of the 1934 Act would  be viewed as having met the reporting obligations for Tier II offerings under Section 257(b) of Regulation A provided that such issuer meets their section 13 reporting obligations. This revision would remove the separate periodic and current reporting requirements (i.e. Forms 1-K, 1-SA and 1-U) for smaller offering up to the $50 million threshold.

The newly passed legislation reflects the House’s continuing effort to walk-back regulations implemented during the prior administration; in this instance, removing aspects of the Commission’s recent revamp of Regulation A in March of 2015 (“Regulation A+“)

New York City Comptroller Scott M. Stringer and the New York City Pension Funds launched the “Boardroom Accountability Project 2.0.” The campaign seeks to make corporate boards more diverse, independent, and climate-competent.

Comptroller Stringer sent letters to the boards of 151 companies calling on them to publicly disclose the skills, race and gender of board members and to discuss their process for adding and replacing board members, known as the “board refreshment” process, with the Comptroller’s Office.

Comptroller Stringer is asking companies to use a standardized matrix to disclose the race and gender of their directors, along with board members’ skills. The matrix calls for disclosure of specific skills such as risk management and ethics, voluntary disclosure of sexual orientation and disclosure of director’s gender as male, female or non-binary.

In addition, Comptroller Stringer and the New York City Pension Funds are pressing companies to commit to working with them and other large, long-term shareowners to identify suitable independent candidates — including ones that bring diverse perspectives and other skills, such as climate expertise, to the boardroom.

Comptroller Stringer demonstrated in the past that he wields a potent club, as shown by his efforts to have companies adopt proxy access. While it is impossible to predict the ultimate outcome of this campaign, at the very least it will enjoy some notable successes.  As a result, there is a high probability the standardized matrix, or parts of it, will become common place.  Therefore, public companies that do not receive Comptroller Stringer’s letter should consider including all or part of the standardized matrix in their proxy statement.

Barbara Duka was an employee of Standard & Poor’s Ratings Services. The SEC contended that Duka loosened S&P’s methodology for rating commercial mortgage-backed securities to help the company generate ratings business from issuers. S&P had settled allegations against it in a separate matter.

The SEC brought charges against Duka in the SEC’s administrative court.  Duka contended the administrative proceeding was unconstitutional and the United States District Court for the Southern District of New York agreed and preliminarily enjoined the SEC from conducting the proceeding.  The Second Circuit later vacated the District Court’s order and the administrative proceeding progressed to a conclusion.  The industry watched to see if the SEC administrative court would render a one-sided decision in favor of the SEC.

The SEC charged Duka with willfully violating the anti-fraud provisions set forth in Securities Act Section 17(a) and Exchange Act Section 10(b) and Rule 10b-5. Resolution of the charges came down to whether the Division of Enforcement met its burden to show that Duka acted with the intent to deceive, manipulate, or defraud. Considering the record, the Administrative Law Judge found there was no evidence that Duka acted with such intent. Instead, the evidence told a different story that was inconsistent with the SEC’s arguments. It demonstrated that Duka, in effecting a change in rating methodology, did so for analytical reasons—rather than for commercial or professional gain—and with the knowledge of appropriate S&P personnel.

The SEC also charged Duka with negligently violating Section 17(a)(2) and (3) of the Securities Act. The charges centered around an alleged failure to disclose the revised ratings methodologies.  To demonstrate liability under Section 17(a)(2), the SEC was required to show that Duka negligently obtained money or property by means of any untrue statement or omission of a material fact. The Administrative Law Judge easily dispensed with the SEC’s argument.  Duka did not receiving any money or property from the ratings process, and the fact that her employer did was insufficient.

To demonstrate liability under Section 17(a)(3), the Administrative Law Judge had to determine Duka failed to exercise reasonable care and thereby caused investors to receive misleading information about the issuers’ transactions or somehow prevented investors from learning material information about those transactions. While S&P’s disclosures were unclear on the issue, and could perhaps be viewed as literally true, the Administrative Law Judge found the documentation presented an incomplete picture and omitted information about the revised ratings methodologies.  The Administrative Law Judge found Duka failed to exercise reasonable care because approval to use the revised methodology was contingent on the methodology being disclosed in relevant documentation.  Whether Duka was normally responsible for reviewing the documentation was not relevant. According to the Administrative Law Judge, she agreed as a condition of using the new methodology to ensure that use was disclosed and failed to live up to her end of that agreement.

The Administrative Law judge found that Duka did not aid or abet S&P’s violations in two other instances but that Duka caused S&P’s violation of Section 15E(c)(3) of the Exchange Act. The reason was S&P’s publication of ratings did not fully disclose the change in methodology and that violated S&P’s code of conduct. As a result, S&P failed to maintain or enforce an effective internal control structure governing the implementation of and adherence to policies, procedures, and methodologies for determining credit ratings.

The Administrative Law Judge issued a cease and desist order and required Duka to pay a civil monetary penalty of $7,500. The Administrative Law Judge declined to bar Duka from associating with a nationally recognized statistical rating organization.

In 2015 the NYSE amended its policy with respect to material news releases. One of the amendments was to include advisory text in Section 202.06 of the Listed Companies Manual requesting that listed companies intending to release material news after the close of trading on the Exchange wait until the earlier of the publication of their security’s official closing price on the Exchange or fifteen minutes after the scheduled closing time on the Exchange.  The reason for the change was that securities trade in other markets after the NYSE closes, and investor confusion arises if the trades in other markets are at prices different than NYSE trades being completed at the NYSE closing price.

Notwithstanding the addition of the advisory text, the NYSE has continued to experience situations where material news released shortly after 4:00 p.m. has caused significant investor confusion. Accordingly, the NYSE now proposes to amend Section 202.06 to prohibit listed companies from issuing material news after the official closing time for the NYSE’s trading session until the earlier of publication of such company’s official closing price on the Exchange or five minutes after the official closing time.  The NYSE believes that designated market makers are able to complete the closing auctions for the securities assigned to the market maker in almost all cases within five minutes of the NYSE’s official closing time.

In the proposed rule, the NYSE continues to recommend that companies that intend to issue material news after the NYSE’s official closing time delay doing so until the earlier of publication of such company’s official closing price on the NYSE or fifteen minutes after the Exchange’s official closing time.

The foregoing change is in addition to changes to NYSE rules related to dividend announcements, which the NYSE is currently seeking to delay to facilitate implementation of the new rules.

For those who want to start preparing for the 2018 proxy season, our preliminary list of important considerations is set forth below:

Directors’ and Officers’ Questionnaires

We are not aware of any regulatory changes that would require directors’ and officers’ questionnaires to be updated.

Say-on-Pay Frequency Vote

Rule 14a-21(b) requires a say-on-pay frequency vote every six years. Many issuers included a frequency vote in their 2017 proxy because they were subject to the initial rules when they became effective for shareholders’ meetings occurring on or after January 21, 2011. However, “smaller reporting companies” as of January 21, 2011, and new smaller reporting companies after that date, were not required to hold a frequency vote until the first meeting occurring on or after January 21, 2013. Thus, for many smaller reporting companies the outside date for the next say-on-pay frequency vote may be pushed out until the 2019 proxy season.  However, each issuer should review its own facts and circumstances.

Issuers that formerly qualified as “emerging growth companies” (EGCs) under the JOBS Act should also remain mindful of say-on-pay requirements as issuers that no longer qualify as EGCs lose their exemption from the requirements under Exchange Act Sections 14A(a) and (b). Such former EGCs are required to begin providing say-on-pay votes within one year of losing EGC status (or no later than three years after selling securities under an effective registration statement if an issuer was an EGC for less than two years).  Typically, such companies will also hold say-on-pay frequency votes when they hold their first say-on-pay vote as a non-EGC.

And if you hold a frequency vote, do not forget the requirement to amend your Form 8-K that discloses voting results to “disclose the company’s decision in light of such vote as to how frequently the company will include a shareholder vote on the compensation of executives in its proxy materials until the next required vote on the frequency of shareholder votes on the compensation of executives.” The amendment must be made within 150 calendar days after the end of the meeting at which the say-on-pay frequency vote was held.

Pay Ratio Disclosure

In February 2017, then acting Chairman Michael S. Piwowar announced his intention to conduct a review of the Dodd-Frank pay ratio rule. The Financial CHOICE Act, introduced and passed in the House in June 2017, would repeal the pay ratio disclosure rule, but the legislation has not progressed to the Senate. There has been no subsequent indication that implementation of the rule will be delayed, so the pay ratio rule will be effective for the upcoming proxy season.  The rule requires a public company to disclose the ratio of the median of the annual total compensation of all employees to the annual total compensation of the chief executive officer. The disclosure is required for proxy statements that include information about a fiscal year that begins after January 1, 2017.  A new public company will have to disclose a pay ratio for the first fiscal year after the year it becomes a reporting company. The SEC’s FAQs are a good source of further detailed information regarding implementation and calculation of the ratios as well.

ISS Proxy Voting Policies

ISS is in the process of formulating changes to its voting recommendation policies and has released its 2018 policy survey. The survey generally foreshadows changes to policies for the upcoming proxy season.  This year’s survey demonstrates an increased focus on gender diversity in board composition, shareholder authorization for share issuances and buybacks, implications of virtual/hybrid shareholder meetings, and disclosure of pay ratios.  We recommend that issuers monitor ISS’ new and updated policies, including ISS’s official proxy voting guidelines, which are typically issued in December for the upcoming proxy season.

Hyperlinking of Exhibits

The SEC has adopted rules which will require public companies to include a hyperlink to each exhibit identified in an exhibit index. This includes Form 10-K.  The final rules will take effect on September 1, 2017.  The rule is applicable to smaller reporting companies unless they make EDGAR filings using the ASCII format. ASCII filers have an additional year to comply with the rule. If a public company becomes aware of an inaccurate hyperlink, the link must generally be corrected in a manner specified in the rules.

Form 10-K Cover Page

The SEC revised the cover page of Form 10-K when adopting rules to incorporate certain provisions of the JOBS Act. Broadly speaking the cover page has been revised to include a “check the box” item to indicate that the person filing the report is an “emerging growth company” and an additional box to check as follows:  “If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 7(a)(2)(B) of the Securities Act.”

Inflation-adjusted threshold for EGCs

The SEC also revised the definition of “emerging growth company” to provide an inflation-adjusted threshold for the annual gross revenue amount that determines EGC status. Until further revised by the SEC in five years (as required per the statutory language of the JOBS Act), the maximum inflation-adjusted EGC revenue threshold is $1,070,000,000.

Resource Extraction Rules

The resource extraction rules, which would have required disclosures from companies engaged in the oil, natural gas, and mineral extraction industries to disclose payments made by the companies to governments beginning in 2019, were eliminated by Congressional action under the Congressional Review Act in February 2017.

Conflict Minerals Rules

The SEC staff issued no-action guidance which stated the staff would not recommend enforcement if a Company did not report under Item 1.01(c) of Form SD to describe the results of due diligence conducted on its supply chain to determine origination of conflict minerals used in its products. This survey suggests many issuers continued to respond to Item 1.01(c) notwithstanding the staff guidance.

Providing Paper Copies of Annual Reports to the SEC

Exchange Act Rule 14a-3(c) and Rule 14c-3(b) require registrants to mail seven copies of the annual report sent to security holders to the Commission “solely for its information.” A similar provision in Form 10-K requires certain Section 15(d) registrants to furnish to the Commission “for its information” four copies of any annual report to security holders. The SEC staff advised in a Compliance and Disclosure Interpretation that it will not object if a company posts an electronic version of its annual report to its corporate web site by the dates specified in Rule 14a-3(c), Rule 14c-3(b) and Form 10-K respectively, in lieu of mailing paper copies or submitting it on EDGAR. If the report remains accessible for at least one year after posting, the staff will consider it available for its information.

Inline XBRL

The SEC has proposed rules that would require financial statements to be provided in the Inline XBRL format. Final rules have not been issued. Inline XBRL allows filers to embed XBRL data directly into an HTML document, eliminating the need to tag a copy of the information in a separate XBRL exhibit. Inline XBRL would be both human-readable and machine-readable for purposes of validation, aggregation and analysis.  However, the SEC has not enacted final rules requiring the use of Inline XBRL.  While the SEC permits the use of Inline XBRL, we suggest checking with your auditor first as to any sensitivity to providing information in this manner.

PCAOB’s Changes to Audit Report

The Public Company Accounting Oversight Board adopted a new auditor reporting standard that will require audit reports to include additional information about the audit. Specifically, auditors will be required to describe “Critical Accounting Matters” encountered during the audit and the auditor’s response to them, or state that no Critical Accounting Matters were encountered.  Generally speaking, Critical Accounting Matters are matters that require especially challenging, subjective, or complex auditor judgment.

In addition to Critical Accounting Matters, the new standard makes the following changes:

  • Independence—a statement that the auditor is required to be independent;
  • Addressee—the auditor’s report will be addressed to the company’s shareholders and board of directors or equivalents (additional addressees are also permitted);
  • Enhancements to basic elements—certain standardized language in the auditor’s report has been changed, including adding the phrase whether due to error or fraud, when describing the auditor’s responsibility under PCAOB standards to obtain reasonable assurance about whether the financial statements are free of material misstatements; and
  • Standardized form of the auditor’s report—the opinion will appear in the first section of the auditor’s report and section titles have been added to guide the reader.

The new standard will not apply to public companies unless/until it receives SEC approval. To date, the SEC has published the PCAOB standard for comment but final rules have not been adopted. The PCAOB standard provides that all provisions other than those related to critical audit matters will take effect for audits of fiscal years ending on or after December 15, 2017.  Provisions related to critical audit matters will take effect for audits of fiscal years ending on or after June 30, 2019, for large accelerated filers; and for fiscal years ending on or after December 15, 2020, for all other companies to which the requirements apply. In other words, if the SEC approves the PCAOB standard late in 2017 or early in 2018, the components other than the Critical Accounting Matters will apply to annual reports for 2017.  Auditors may elect to comply before the effective date, at any point after SEC approval of the final standard.

Communication of Critical Audit Matters is not required for audits of brokers and dealers reporting under the Exchange Act Rule 17a-5; investment companies other than business development companies; employee stock purchase, savings, and similar plans; and EGCs. Auditors of these entities may choose to include critical audit matters in the auditor’s report voluntarily.

Revenue Recognition and Lease Accounting

For the 2017 Form 10-K, Staff Accounting Bulletin No. 74 requires companies to provide transition disclosures of the impact that a recently-issued accounting standard will have on its financial statements when that standard is adopted in a future period. Public companies will need to address the new revenue recognition standard and the new lease accounting standard.  Public companies will apply the new revenue standard to annual reporting periods beginning after December 15, 2017.  Public companies will apply the new lease accounting standard for fiscal years beginning after December 15, 2018.

While public companies generally have their hands full planning for proxy season and preparing for shareholders meetings, we recommend significant thought be given to preparing for the first quarter 10-Q when the new revenue recognition standard will be adopted. We have set forth our thoughts on the initial MD&A and reviewed disclosures made by some of the early revenue recognition adopters.

In addition, public companies that adopt the new revenue recognition standard using the full retrospective method may encounter difficulties if a Form S-3 is filed after the first quarter of 2018. Item 11(b)(ii) of Form S-3 requires restated financial statements to be filed if there has been a change in accounting principles that requires a material retroactive restatement of financial statements.  This would require filing of restated financial statements for 2015, 2016 and 2017 significantly in advance of the 2018 Form 10-K, and restated 2015 financial statements would not otherwise be required.  This can be avoided if the Form S-3 is filed during the first quarter of 2018.   Form S-8 does not include an identical provision but General Instruction G.2 of Form S-8 requires that “material changes in the registrant’s affairs” be disclosed in the registration statement.

T+2 Settlement

The SEC has adopted new rules requiring settlement of securities transactions on a T+2 basis, as opposed to the existing T+3 basis. The new rule is effective September 5, 2017.  One effect of the new rules is that the ex-dividend date will be just one trading day prior to the record date.  References to the ex-dividend date should be adjusted accordingly in announcement of dividends.

NYSE Dividend Notification Requirements

The SEC has approved a change to the NYSE’s rules which requires listed companies to provide dividend notifications to the Exchange at least 10 minutes prior to disseminating them publicly when the notification is made outside of Exchange trading hours of 7:00 a.m. ET and the end of the NYSE trading session (4:00 p.m. ET). No change is being made to the NYSE’s rules with respect to dividends between 7:00 a.m. ET and the end of the NYSE trading session.

Following SEC approval of the revised rule, the NYSE filed a further proposed rule change to delay implementation of the rule. According to the NYSE, the delay is necessary to provide listed companies with additional time to prepare to comply with the new requirements and for the NYSE to provide the necessary support to its staff in reviewing notifications. The NYSE plans to provide reasonable advance notice of the new implementation date to listed companies by emailing a notice to them that will also be posted on nyse.com. The new implementation date will be no later than February 1, 2018.

Rule 14a-8: Shareholder Proposals

Companies should be mindful in the upcoming proxy season of the potential for the typical shareholder proponents and other activist shareholders to submit shareholder proposals under SEC Rule 14a-8 seeking to further shareholders’ ability to nominate directors, which is referred to as proxy access. Shareholder proposals focused on proxy access were the most common type of shareholder proposal in the 2017 proxy season and all signs suggest this trend will continue.  As a result, companies that have not yet adopted proxy access should be prepared to receive shareholder proposals recommending adoption of such a provision.  Companies that have already adopted a proxy access provision should be prepared to receive shareholder proposals focused on broadening applicable thresholds for shareholder nomination of directors such as eliminating limits on shareholder aggregation.

Other popular topics for shareholder proposals in 2018 are expected to address independent board chairs, board diversity and social, environmental and political proposals.

Rule 14a-8 has not been amended to limit shareholder proposals and provisions of the Financial Choice Act seeking to do so have not advanced to the Senate for consideration. In addition, absent some unanticipated action by the SEC under new Chairman Jay Clayton, the SEC’s interpretation of Rule 14a-8 as embodied in the no-action letter process to exclude proposals is not expected to change in 2018.

Other Regulatory Initiatives

Proposed rules have been issued on the following topics, but final rules have not been adopted:

In an investigation conducted at the request of four Senators, the SEC Inspector General concluded “we do not find that Commissioner Piwowar’s actions as Acting Chairman violated any of the laws currently governing the SEC and our review identified no evidence that his actions could either undermine the SEC’s mission or potentially prove to be a waste of SEC staff time and resources.”

The actions investigated by the Inspector General were:

  • Statements issued by Chairman Piwowar with respect to the conflict minerals rules, instructing SEC staff to develop recommendations for the rules and related no-action guidance issued by the SEC staff.
  • Soliciting comments on the pay ratio rule and directing SEC staff to reconsider the implementation of the rule.
  • Removing the ability of certain senior officers of the SEC Division of Enforcement to issue formal orders of investigation.

Some of the reasons the Inspector General gave to support the conclusions were:

  • President Trump chose Commissioner Piwowar as Acting Chairman until a permanent Chairman could be confirmed.
  • Commissioner Piwowar’s decision to opine and seek public input on the final SEC pay ratio and conflict minerals rules did not constitute “agency action;” therefore, no quorum of Commissioners was required.
  • As acting Chairman, Commissioner Piwowar had the ability to direct SEC staff and SEC administrative units to carry out Commission business.
  • The Reorganization Act of 1949 and related documentation authorized then-Acting Chairman Piwowar to remove the sub-delegation of authority to issue formal orders of investigation because this decision involved “the distribution of business among [personnel employed under the Commission] and among administrative units of the Commission.”

The SEC’s Office of the Chief Accountant and Division of Corporation Finance released Staff Accounting Bulletin (SAB) No. 116 that brings existing SEC staff guidance into conformity with the Financial Accounting Standard Board’s adoption of and amendments to ASC Topic 606. ASC Topic 606 sets forth the new revenue recognition standard. The SAB modifies SAB Topic 13, Revenue Recognition, SAB Topic 8, Retail Companies, and Section A, Operating-Differential Subsidies of SAB Topic 11, Miscellaneous Disclosure. The guidance in SAB 116 applies upon a registrant’s adoption of ASC Topic 606. Until such time, the SAB states that registrants should continue referring to prior staff guidance on revenue recognition.

The SEC also issued a release to update its guidance for bill-and-hold arrangements by stating that registrants should no longer refer to the criteria in Accounting and Auditing Enforcement Release No. 108, In the Matter of Stewart Parness (AAER 108), to recognize revenue for such arrangements upon the registrants’ adoption of Accounting Standards Codification (ASC) Topic 606, Revenue from Contracts with Customers. The release states that until a registrant adopts ASC Topic 606, it should continue referring to the guidance included in AAER 108.

Finally, the SEC issued a release to update its 2005 Commission Guidance Regarding Accounting for Sales of Vaccines and Bioterror Countermeasures to the Federal Government for Placement into the Pediatric Vaccine Stockpile or the Strategic National Stockpile. The release states that consistent with ASC Topic 606, manufacturers should recognize revenue for vaccines that are placed into the Vaccines for Children Program and the Strategic National Stockpile.  The release states that until a registrant adopts ASC Topic 606, it should continue referring to the guidance included in the 2005 Release.

The statements in Staff Accounting Bulletins are not Commission rules or interpretations nor are they published as bearing the Commission’s official approval. They represent interpretations and practices followed by the SEC’s Office of the Chief Accountant and the Division of Corporation Finance in administering the federal securities laws.

The SEC has approved a change to the NYSE’s rules which requires listed companies to provide dividend notifications to the Exchange at least 10 minutes prior to disseminating them publicly when the notification is made outside of Exchange trading hours of 7:00 a.m. ET and the end of the NYSE trading session (4:00 p.m. ET). Companies providing this advance notification to the Exchange will not be required to wait for Exchange approval before issuing their announcements.

No change is being made to the NYSE’s rules with respect to dividends between 7:00 a.m. ET and the end of the NYSE trading session.

You can find more information here.

Following SEC approval of the revised rule, the NYSE filed a further proposed rule change to delay implementation of the rule. According to the NYSE, the delay is necessary to provide listed companies with additional time to prepare to comply with the new requirements and for the NYSE to provide the necessary support to its staff in reviewing notifications.  The NYSE plans to provide reasonable advance notice of the new implementation date to listed companies by emailing a notice to them that will also be posted on nyse.com. The new implementation date will be no later than February 1, 2018.

In a case arising out of the inversion transaction where Medtronic merged with Coviden, the Minnesota Supreme Court spoke on the proper test of determining when an action is derivative or direct in In re Medtronic, Inc. Shareholder Litigation.  The distinction is important, because derivative claims are subject to the demand and pleading requirements of Minn. R. Civ. P. 23.09.  The Plaintiff in this case did not comply with those requirements.

In this transaction, Medtronic acquired Covidien through a new holding company, Medtronic plc, incorporated in Ireland, with Medtronic and Covidien then becoming wholly owned subsidiaries of the Irish holding company (“new Medtronic”). Shareholders of Medtronic had their stock converted into shares in new Medtronic on a one-for-one basis, while shareholders of Covidien received $35.19 and 0.956 shares of new Medtronic for every share of Covidien stock held. Ultimately, former Medtronic shareholders collectively owned approximately 70 percent of new Medtronic and former Covidien shareholders collectively owned approximately 30 percent of new Medtronic.

As a result of the inversion transaction, Medtronic, previously a Minnesota corporation, now operates as a wholly owned subsidiary of an Irish company and thus is subject to Ireland’s tax laws. The Plaintiff alleged that Medtronic reduced the interest of its shareholders to 70 percent of new Medtronic in order to secure and protect the tax benefits it sought in this transaction. In addition, because the Internal Revenue Service treats an inversion transaction as a taxable event for the shareholders of the U.S. company, Medtronic shareholders incurred a capital-gains tax on Medtronic shares held in taxable accounts but received no compensation from the company for this tax liability. On the other hand, Plaintiff alleged, Medtronic officers and directors who incurred an excise-tax liability on their stock-based compensation as a result of the transaction were reimbursed by Medtronic for that expense.

After reviewing Minnesota case law, the Minnesota Supreme Court held that “when shareholders are injured only indirectly, the action is derivative; when shareholders show an injury that is not shared with the corporation, the action is direct.” The Minnesota Supreme Court rejected the Delaware tests set forth in Tooley v. Donaldson, Lufkin & Jenrette, Inc., 845 A.2d 1031 (Del. 2004) which was adopted by the Minnesota Court of Appeals below.  The Court noted “[w]e do not see a need to resort to Delaware law to answer the direct-versus-derivative question here given the guidance available from our own precedent. Moreover, the Tooley test has been limited to claims asserting breach of fiduciary duty.”

The Court then examined the various claims at issue to determine if they were derivative or direct. The Plaintiff alleged harm due to the excise-tax reimbursement paid to Medtronic’s officers and directors. The Court found these were derivative claims.  According to the Court, these claims essentially alleged that Medtronic improperly reimbursed corporate officers and directors for the excise-tax liability that resulted from the transaction, without following statutory procedures before doing so or in violation of duties owed to Medtronic shareholders. Regardless of the specific theory for these claims, the Court found the claims alleged wrongful conduct caused an injury to Medtronic as a corporation, not to the individual shareholders, because corporate reimbursement of an excise-tax liability resulting from the transaction is at bottom an alleged waste of corporate assets. Further, if Plaintiff were to prevail on these claims, the recovery would go to Medtronic (as a return of the improperly paid funds) rather than to the shareholders.

Next, the Court examined capital-gains-tax claims. The Complaint alleged that the shareholders were harmed because the tax liability is imposed on them solely in their status as shareholders. Medtronic itself did not incur a capital-gains tax liability on the transaction, and therefore could not recover for the injury caused by this alleged harm. Because any recovery would go only to the shareholders who incur a capital-gains tax liability, rather than to the corporation, the Court noted that claims asserting this harm were direct.

Finally, the Court examined allegations of harm due to dilution of Plaintiff’s (and class members’) interest in the corporation. In the Complaint, Plaintiff did not contend that the inversion diluted shareholders’ interests in the company by decreasing the value of the corporation itself. Instead, Plaintiff alleged that Medtronic structured the inversion to secure and then protect the corporation’s expected tax benefit by taking from its shareholders a portion of their interest in the corporation, thus decreasing their ownership share in new Medtronic. Medtronic asserted that this alleged harm is simply a standard overpayment claim, that is, that Plaintiff alleged only that Medtronic paid too much to Covidien shareholders as part of the transaction, which is mismanagement or waste of corporate funds and therefore derivative.

The Court noted that unlike a derivative overpayment claim, in which the shareholders claim that their shares have diminished in value by reason of the decrease in value of the corporation’s assets due to overpayment in a transaction, Plaintiff alleged that class members’ ownership interest and voting power were diluted by Medtronic to provide adequate protection for the tax benefits it sought in the transaction with Covidien. In other words, rather than a simple loss of economic value, Plaintiff alleged an injury based on the loss of certain rightful incidents of his ownership interest, which is an injury that falls only on shareholders and not on the corporation. Therefore, the Court determined this was a direct claim. The Court observed that it must accept the allegations of the Complaint as true at this stage of the case, and therefore the Court was not expressing an opinion on Plaintiff’s ability to prevail on claims that allege a dilution injury.

David I. Osunkwo was a principal at Strategic Consulting Advisors, LLC, or SC Consulting. SC Consulting offered compliance consulting and CCO services to two SEC registered investment adviser firms under common control, Aegis Capital, LLC and Circle One Wealth Management, LLC. Respondent Osunkwo, a principal at SC Consulting, was designated as CCO to both Aegis Capital and Circle One.

Circle One filed an annual amendment to its Form ADV with the Commission in April 2011 that was intended to reflect a merger between the two investment advisers under common ownership and control of the same corporate parent holding company. In a settled enforcement proceeding, the SEC alleged the filing materially overstated the assets under management and total number of client accounts for Aegis Capital and Circle One. According to the SEC, the Form ADV filed by Circle One in April 2011 for the 2010 fiscal year overstated Aegis Capital’s and Circle One’s combined AUM by over $119 million and combined total number of client accounts by at least 1,000 accounts.

The SEC alleged Osunkwo received the following email from the CIO when preparing the amendment to the Form ADV:

“David – . . . I believe AUM was as follows on 12/31 Funds: $36,800,000

Schwab/Fidelity: $96,092,701 (1,179 accounts) (not sure how many customers) Circle One: probably higher than $50m, but hopefully [another employee] told you a number today

Total is in the $182.89m range . . . .”

The SEC alleged Osunkwo and SC Consulting adopted these estimates, without taking sufficient steps to ascertain their accuracy, when they filed Circle One’s annual amendment to Form ADV for the December 31, 2010 year end.

The SEC also said that as a result of the impending deadline for filing the Form ADV, Osunkwo listed the CIO as signatory certifying the ADV without confirming with the CIO. As a result, the form that Osunkwo and SC Consulting filed misstated that the CIO had also certified the contents to be true and correct.

The settlement order states as a result of the conduct, Osunkwo willfully violated Section 207 of the Advisers Act, which makes it “unlawful for any person willfully to make any untrue statement of a material fact in any registration application or report filed with the Commission under Section 203, or 204, or willfully to omit to state in any such application or report any material fact which is required to be stated therein.”

Osunkwo was required to pay a civil money penalty of $30,000 and was suspended from certain activities such association with any broker, dealer, investment adviser, municipal securities dealer, municipal advisor, transfer agent, or nationally recognized statistical rating organization for a period of twelve (12) months.

Osunkwo did not admit or deny the findings in the SEC order.