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

R.L. Polk & Co. Inc., a private company, was allegedly more than 90% controlled by the Polk family. The Company was in the consumer marketing business with holdings such as Carfax, Inc.  In March 2011, the Company initiated a self-tender to purchase 37,037 shares of its common stock at $810 per share in cash.  A financial advisor rendered a fairness opinion to the Company’s Board in connection with the self-tender.  Prior to the self-tender, the Company had explored other alternatives, in which the financial advisor participated, such as a reverse merger to reduce the number of stockholders to qualify for Subchapter S status.  The reverse merger was never consummated. The financial advisors fees for the abandoned reverse merger alternative were rolled into the Company’s fees for work on the self-tender, allegedly based on the advice of the Company’s law firm.

Fifteen months after the self-tender, the Company engaged a different financial advisor to discuss possible strategic alternatives. The Company was acquired in June 2013 for $2,675 per share, an amount equal to more than three times the offer price in the 2011 self-tender.  In addition, the Board had declared special dividends amounting to one third of the self-tender price following completion of the self-tender and prior to completion of the acquisition.

Class action litigation ensued, and the Delaware Court of Chancery rendered its decision on the Defendants’ motion to dismiss in Buttonwood Tree Value Partners, L.P. v R.L. Polk & Co., Inc. et al. The Court declined to dismiss the allegations against three directors that were members of the Polk family.  The Court noted the Complaint included minimally sufficient allegations that the Polk family and the Polk directors acted as a controlling block.  According to the Court, it was reasonably conceivable the Polk’s stood on both sides of the transaction in an attempt to maintain their control.  The entire fairness standard therefore applied at the pleading stage, and the control group has the burden of proving entire fairness.  Since it was a motion to dismiss, the Court did not make any factual or other findings of wrong doing or breach of fiduciary duties.

The Court granted the motion to dismiss as to the Company’s directors that were not members of the Polk family. The Plaintiffs failed to plead non-exculpated claims related to the breach of loyalty against these independent directors.  The independent directors did not act in bad faith by omitting alleged material disclosures.  To do so would require showing an extreme set of facts that the disinterested directors were disregarding their duties or the decision was so far beyond the bounds of reasonable judgement that it was essentially inexplicable on any ground other than bad faith.  According to the Court, absent knowledge of a fraudulent scheme, inadequate disclosures related to the background of the self-tender were not the type of omissions that implicated bad faith.

The Plaintiffs also brought aiding and abetting claims against the financial advisor for the self-tender and the Company’s law firm. The Court noted to state a claim for aiding and abetting a breach of fiduciary duty, Plaintiffs must:

Allege facts demonstrating a fiduciary relationship, a breach of the fiduciary’s duty, knowing participation in that breach by the defendants, and damages proximately caused by the breach. The standard for aiding and abetting is a “stringent one, one that turns on proof of scienter of the alleged abettor.” That is, a claim for aiding and abetting often turns on meeting the “knowing participation” element. Therefore, “there must be factual allegations in the complaint from which knowing participation can be reasonably inferred.”  “Knowing participation in a board’s fiduciary breach requires that the third party act with the knowledge that the conduct advocated or assisted constitutes such a breach.” Additionally, “the element of knowing participation requires that the secondary actor have provided substantial assistance to the primary violator.”

The Court observed that almost all corporate boards retain law firms to advise them on significant transactions, and that those lawyers are limited by professional responsibilities in their freedom of action concerning information communicated by clients. If pleading a plausible breach of duty on the part of a director or controller is also sufficient to implicate her lawyer as an aider and abettor, a significant and perverse chilling effect on the ability of fiduciaries to obtain legal counsel would result.

Essentially, the Plaintiff’s claim against the law firm boiled down to the law firm’s alleged advice to reallocate the financial advisors fees from the entity involved with the abandoned reverse merger to the Company for the self-tender transaction. According to the Plaintiffs, this was done for the purpose of hiding, from stockholders considering a tender, the fact that the financial advisor had participated in the aborted freeze-out before opining on the fairness of the self-tender, thus facilitating inadequate disclosures on the financial advisor’s role to the stockholders.  The Court dismissed the claim against the law firm on the basis that the accounting change recommended by the law firm only appears nefarious if the law firm was privy to a scheme to, shortly after the self-tender, orchestrate a sale at a far higher price. The Court found Plaintiffs failed to allege facts sufficient to infer such knowledge on the law firm’s part.

As to the financial advisor, the Plaintiffs relied on omissions from disclosures regarding the financial advisor’s work on valuation matters related to the reverse merger. According to the Court:

The Complaint lacks sufficient facts from which I may infer that [the financial advisor’s] alleged failure to attempt to correct these omissions results in “knowing participation” in the alleged breach of the Individual Defendants’ fiduciary duties. The Directors were aware of all the facts that the Complaint presumes [the financial advisor] knew. A general duty on third parties to ensure that all material facts are disclosed, by fiduciaries to their principals, is, so far as I am aware, not a duty imposed by law or equity. There is, obviously, no allegation here that [the financial advisor] worked a fraud on the directors, or otherwise caused misrepresentations in connection with the Self-Tender by withholding information from fiduciaries. The Plaintiffs allege only a passive awareness on the part of a non-fiduciary of the omission of material facts in disclosures to the stockholders, made by fiduciaries who themselves were aware of the information. Such passive awareness on the part of [the financial advisor] does not constitute “substantial assistance” to any breach resulting from the Individual Defendants’ failure to disclose the facts.

 

The SEC issued an investigative report cautioning market participants that offers and sales of digital assets by “virtual” organizations are subject to the requirements of the federal securities laws. Such offers and sales, conducted by organizations using distributed ledger or blockchain technology, have been referred to, among other things, as “Initial Coin Offerings” or “Token Sales.” Whether a particular investment transaction involves the offer or sale of a security – regardless of the terminology or technology used – will depend on the facts and circumstances, including the economic realities of the transaction.

The SEC’s Report of Investigation found that tokens offered and sold by a “virtual” organization known as “The DAO” were securities. The DAO sold tokens representing interests in its enterprise to investors in exchange for payment with virtual currency. Investors could hold these tokens as an investment with certain voting and ownership rights or could sell them on web-based secondary market platforms. Based on the facts and circumstances of this offering, the Commission, as explained in the report, determined that the DAO tokens are securities.

The DAO’s intended purpose was to “To blaze a new path in business for the betterment of its members, existing simultaneously nowhere and everywhere and operating solely with the steadfast iron will of unstoppable code.”

Because the tokens were found to be securities, offers and sales of the tokens were therefore subject to the federal securities laws. The report confirms that:

  • Issuers of distributed ledger or blockchain technology-based securities must register offers and sales of such securities unless a valid exemption applies.
  • Those participating in unregistered offerings also may be liable for violations of the securities laws.
  • Securities exchanges providing for trading in these securities must register unless they are exempt.

The SEC’s report stemmed from an inquiry that the agency’s Enforcement Division launched into whether The DAO and associated entities and individuals violated federal securities laws with unregistered offers and sales of DAO Tokens in exchange for “Ether,” a virtual currency. The DAO has been described as a “crowdfunding contract” but it would not have met the requirements of the Regulation Crowdfunding exemption because, among other things, it was not a broker-dealer or a funding portal registered with the SEC and the Financial Industry Regulatory Authority.

In light of the facts and circumstances, the SEC decided not to bring charges in this instance, or make findings of violations in the report, but rather to caution the industry and market participants: the federal securities laws apply to those who offer and sell securities in the United States, regardless whether the issuing entity is a traditional company or a decentralized autonomous organization, regardless whether those securities are purchased using U.S. dollars or virtual currencies, and regardless whether they are distributed in certificated form or through distributed ledger technology.

On Friday, July 28, 2017, Treasury Secretary Mnuchin will preside over an executive session of the Financial Stability Oversight Council (Council) at the Treasury Department. The preliminary agenda includes a discussion about the recommendations regarding the Volcker Rule in the Treasury Department’s June 2017 report issued pursuant to Executive Order 13772, “Core Principles for Regulating the United States Financial System”.

In addition, five federal financial regulatory agencies announced that they are coordinating their respective reviews of the treatment of certain foreign funds under section 619 of the Dodd-Frank Act, commonly known as the Volcker Rule, and the agencies’ implementing regulations.

These foreign funds are investment funds organized and offered outside of the United States that are excluded from the definition of “covered fund” under the agencies’ implementing regulations (“foreign excluded funds”). Section 619, and the implementing regulations, generally do not apply to investments in, or sponsorship of, these foreign excluded funds by a foreign banking entity.

However, complexities in the statute and the implementing regulations may result in certain foreign excluded funds becoming subject to regulation under section 619 because of governance arrangements with or investments by a foreign bank. As a result, a number of foreign banking entities, foreign government officials, and other market participants have expressed concern about possible unintended consequences and extraterritorial impact.

The staff of the agencies are considering ways in which the implementing regulations may be amended, or other appropriate action may be taken. It may also be the case that congressional action is necessary to fully address the issue. To aid full consideration, the federal banking regulators, which generally oversee foreign banks, announced that they would not take action under section 619 for qualifying foreign excluded funds, subject to certain conditions, for a period of one year.

The U.S. Department of the Treasury previously issued its first in a series of reports to President Donald J. Trump examining the United States’ financial regulatory system. The report included detailed recommendations regarding the financial regulatory system, many of which would not require further legislation to implement. Some of those recommendations relate to the Volcker Rule.

The report recommends entirely exempting banking entities with less than $10 billion in assets from the Volcker Rule. The relatively small risk that these institutions pose to the financial system does not justify the compliance burden of the rule, and the risk posed by the limited amount of trading that banks of this size could engage in can easily be addressed through existing prudential regulation and supervision.

Likewise, Treasury suggests banks with over $10 billion in assets should not be subject to the burdens of complying with the Volcker Rule’s proprietary trading prohibition if they do not have substantial trading activity. Trading conducted in amounts below designated thresholds would not warrant the extensive burden of compliance with the Volcker Rule but rather can be more efficiently addressed through appropriate capital requirements and through prudential supervision and regulation.

Five different regulators have responsibility for overseeing implementation of the Volcker Rule. In some cases, two agencies have responsibility for a single banking entity, such as a national bank that is a swap dealer.  This fragmentation of responsibility for determining how the rule should be applied to a particular banking entity or trading desk is inefficient for both the banks and the regulators.  Treasury recommends the regulatory agencies should ensure that their interpretive guidance and enforcement of the Volcker Rule is consistent and coordinated.

According to the report, the definition of “proprietary trading” should also be simplified. One prong of the definition, the “purpose test,” turns on a fact-intensive, subjective inquiry. To evaluate a trade under the purpose test, a banking entity is required to determine whether a trade was made principally for the purpose of short-term resale, benefitting from actual or expected short-term price movements, realizing short-term arbitrage profits, or hedging such a position.  To mitigate the subjective inquiry, the regulations create a rebuttable presumption that any position held for fewer than 60 days constitutes proprietary trading.  According to Treasury, this presumption, simply replaces one problem with another—exchanging subjectivity for overbreadth.  Treasury recommends the proprietary trading prohibition should be revised by eliminating the regulations’ rebuttable presumption that financial positions held for fewer than 60 days constitute proprietary trading. In addition, Treasury believes policymakers should assess whether the purpose test should be eliminated altogether, to avoid requiring banks to dissect the intent of a trade.

Other recommendations in the report include:

  • Providing increased flexibility for market-making.
  • Reducing the burden of hedging business risks.
  • Focusing and simplifying covered funds restrictions.
  • Creating an off-ramp for highly capitalized banks.

Reuters is reporting that SEC Commissioner Michael Piwowar urged IPO companies to request relief from the SEC to include mandatory arbitration provisions for shareholder disputes. Commissioner Piwowar apparently made the comment in as yet unpublished remarks during an appearance at the Heritage Foundation.

In 2012, Carlyle reportedly dropped a mandatory arbitration provision from its IPO documents after pressure from the SEC.

Mandatory arbitration is seen as a means to stop frivolous shareholder class action law suits.

In remarks before the Economic Club of New York, new SEC Chairman Jay Clayton discussed eight guiding principles:

  • Principle #1: The SEC’s mission is our touchstone. Investors and capital markets will suffer if the SEC strays from its mission or emphasizes one principle over the others.
  • Principle #2: Our analysis starts and ends with the long-term interests of the Main Street investor.
  • Principle #3: The SEC’s historic approach to regulation is sound.
  • Principle #4: Regulatory actions drive change, and change can have lasting effects. The disclosure-based regime has worked so well that we — not just the SEC, but lawmakers and other regulators — have slowly but significantly expanded the scope of required disclosures beyond the core concept of materiality. Those actions have been justified by regulators and lawmakers alike, often based on discrete, direct and indirect benefits to specific shareholders or other constituencies. And it has often been concluded that these benefits outweigh the marginal costs that are spread over a broad shareholder base. But the roughly 50% decline in the total number of U.S.-listed public companies over the last two decades forces us to question whether our analysis should be cumulative as well as incremental.
  • Principle #5: As markets evolve, so must the SEC.
  • Principle #6: Effective rulemaking does not end with rule adoption. The Commission should review its rules retrospectively. We should listen to investors and others about where rules are, or are not, functioning as intended. We cannot be shy about being introspective and self-critical.
  • Principle #7: The costs of a rule now often include the cost of demonstrating compliance. Vaguely worded rules can too easily lead to subpar compliance solutions or an overinvestment in control systems. The Commission needs to make sure at the time of adoption that we have a realistic vision for how rules will be implemented as well as how we and others intend to examine for compliance.
  • Principle #8: Coordination is key. The SEC shares the financial services space with many other regulatory players. Coordination is key for over-the-counter derivatives and cybersecurity.

Mr. Clayton also outlined some areas where these principles can guide practice:

  • Public companies have a clear obligation to disclose material information about cyber risks and cyber events. I expect them to take this requirement seriously. I also recognize that the cyber space has many bad actors, including nation states that have resources far beyond anything a single company can muster. Being a victim of a cyber penetration is not, in itself, an excuse. But, I think we need to be cautious about punishing responsible companies who nevertheless are victims of sophisticated cyber penetrations.
  • There are circumstances in which the Commission’s reporting rules may require publicly traded companies to make disclosures that are burdensome to generate, but may not be material to the total mix of information available to investors. Under Rule 3-13 of Regulation S-X, issuers can request modifications to their financial reporting requirements in these situations. I want to encourage companies to consider whether such modifications may be helpful in connection with their capital raising activities and assure you that SEC staff is placing a high priority on responding with timely guidance.
  • With the Department of Labor’s Fiduciary Rule now partially in effect, it is important that the Commission make all reasonable efforts to bring clarity and consistency to this area. It is my hope that we can act in concert with our colleagues at the Department of Labor in a way that best serves the long-term interests of Mr. and Ms. 401(k). Any action will need to be carefully constructed, so it provides appropriate and meaningful protections but does not result in Main Street investors being deprived of affordable investment advice or products.

 

 

Reyher v. Grant Thornton, LLP analyzed whether an employee of a CPA firm is protected by the anti-retaliation provisions of the Dodd-Frank Act for lodging complaints with an employer about suspected illegal activity regarding non-public clients.

The Plaintiff discovered what she believed were accounting irregularities in tax matters for non-public clients and complained to administrators at Grant Thornton about the inaccurate information. The Plaintiff believed the irregularities “amounted to bank fraud, mail fraud, wire fraud and/or fraud against shareholders.”  By way of example, the alleged wrongful activities included “problematic deductions,” failure to file required returns, and failure to pay gift tax.

Grant Thornton terminated the Plaintiff and allegedly told the Plaintiff she was terminated because she had been disruptive, did not want to be at Grant Thornton and was not a good fit for Grant Thornton’s culture. The Plaintiff filed suit in the Eastern District of Pennsylvania, claiming her termination violated the anti-retaliation provisions of the Dodd-Frank Act because her whistleblower disclosures constituted protected activity under the Sarbanes-Oxley Act.  The thrust of Plaintiff’s complaint was she qualified as a protected whistleblower because Grant Thornton was a contractor to public companies, even though her claims related only to private companies.

The Court determined the applicable precedent was Lawson v. FMR LLC. Lawson involved employees of private contractors that provided day-to-day operational services for public mutual funds. The plaintiffs in Lawson alleged that they were terminated after raising concerns about accounting by the mutual funds in SEC registration statements.  In Lawson, the Supreme Court held the Sarbanes-Oxley Act protects employees of private contractors and subcontractors. Lawson did not directly address the types of claims made against Grant Thornton.  However, the Court found that Lawson contemplated that Sarbanes-Oxley protection would not extend to Plaintiff who engaged in whistleblowing unrelated to Grant Thornton’s work as a contractor to public companies.  Accordingly, the Court dismissed the Plaintiff’s claim for retaliation under the Dodd-Frank Act.

As previously reported here, on June 29, 2017, the Division of Corporation Finance announced that it would accept draft registration statements from all issuers for nonpublic review. The Division’s initial announcement noted that the newly available nonpublic review for issuers outside of Emerging Growth Companies (EGCs) and foreign private issuers would be limited to the initial submission and indicated that responses to staff comments on draft registration statements needed to be made in in a public filing, not with a revised draft registration statement. The Division has since released additional guidance in Q&A form addressing the new process for making confidential submissions. The FAQs include the following additional highlights:

  • Issuers should request confidential treatment under Rule 83 (17 CFR 200.83) for its draft registration statement and associated correspondence when seeking a nonpublic review.
    • Issuers should submit their Rule 83 requests electronically (using submission type DRSLTR) not separately to the Division or the SEC’s FOIA office.
    • Issuers should include a legend at the top of each page of the electronically submitted draft registration statement indicating a request for confidential treatment pursuant to Rule 83.
  • Issuers should submit a cover letter conveying agreement with the public filing guidelines in the Division’s June 29, 2017 announcement.
  • Issuers conducting an IPO (or an initial registration of a class of securities) must publicly file its registration statement, the initial nonpublic draft registration statement and all draft amendments thereto at least 15 days before it conducts its road show or, if there is no road show, at least 15 days before the effective date.
  • Registration statements related to follow-on offerings within 12-months of an initial Securities Act registration statement must be publicly filed no later than 48 hours prior to any requested effective date and time.
  • The staff will still process a draft registration statement that is substantially complete except for financial information the issuer reasonably believes will not be required at the time the registration statement is publicly filed.
  • Draft registration statements need not be signed by the registrant or by any of its officers or directors, nor is it required to include the consent of auditors and other experts, since it is not filed with the Commission.
  • The Securities Act registration filing fee for a draft registration statement is due when the registration statement is first filed publicly on EDGAR.
  • The staff will publicly release its comment letters and issuer responses to staff comment letters on EDGAR no earlier than 20 business days following the effective date of a registration statement.
  • Non-EGCs may not use test-the-waters communications with QIBs and institutional accredited investors pursuant to Securities Act Section 5(d).

The Divisions full FAQs are available here.

The NYSE has filed a proposed rule with the SEC which will require listed companies to provide notice to the Exchange at least 10 minutes before making any public announcement with respect to a dividend or stock distribution in all cases, including outside of the hours in which the Exchange’s immediate release policy is in operation. The principal change is requiring advance notice at any time, rather than just during the hours of operation of the immediate release policy as is currently the case. You can find the rule filing here and here.

The Exchange’s immediate release policy, set forth in Sections 202.05 and 202.06 of the Manual, already requires companies releasing material news between 7.00 AM ET and the NYSE close (generally 4.00 PM ET) to call the Exchange’s Market Watch team at least 10 minutes before issuing their announcement to discuss the content of the announcement and also email a copy of the proposed announcement to Market Watch at least 10 minutes before its release. Listed companies announcing dividends during these hours are required to comply with the immediate release policy in connection with such announcement.

Section 204.12 of the Manual requires listed companies to give prompt notice to the Exchange as to any dividend action or action relating to a stock distribution in respect of a listed stock (including the omission or postponement of a dividend action at the customary time as well as the declaration of a dividend). This notice must be given at least ten days in advance of the record date and is in addition to the requirement to publicly disclose the information pursuant to the immediate release policy. The dividend notice must be given to the Exchange in accordance with Section 204.00.4 Notice must be given as soon as possible after declaration and in any event, no later than simultaneously with the announcement to the news media.

In addition, Section 204.21 of the Manual requires listed companies to give prompt notice to the Exchange of the fixing of a date for the taking of a record of shareholders, or for the closing of transfer books (in respect of a listed security), for any purpose. The notice must state the purpose or purposes for which the record date has been fixed. This notice must be provided to the Exchange in accordance with Section 204.00.

The Exchange proposes to amend each of Sections 204.12 and 204.21 to specify that notice of any dividend or stock distribution required by Section 204.12 must be provided to the Exchange at least 10 minutes before any public announcement, including when such announcement is being made outside of Exchange trading hours. The principal effect of this amendment would be to require listed companies to provide 10 minutes advance notice to the Exchange with respect to a dividend announcement made at any time, rather than just during the hours of operation of the immediate release policy as is currently the case.

In a no-action letter issued earlier this week, the Staff of the Division of Corporation Finance granted relief to LA Fan Club, “a fan club for loyal fans of the Rams football team,” to offer fan memberships for sale and resale without triggering registration requirements under Section 5 of the Securities Act or Section 12(g) of the Exchange Act. The Office of Chief Counsel was swayed by LA Fan Club’s argument that such memberships would not constitute “securities” for purposes of the Securities Acts.

Echoing prior grants of no-action relief by the Staff involving similar fan membership programs or services to facilitate sale of seat licenses for sporting events, LA Fan Club successfully argued that its fan club membership program falls outside the scope of the term “security” as defined by the Section 2(a)(1) of the Securities Act and, by extension, Section 3(a)(10) of the Exchange Act because such memberships “will be purchased by Rams fans for recreational use and consumption and not acquired for investment purposes or with the expectation of profit.”

LA Fan Club also relied on the analyses described in the Supreme Court’s keystone securities law cases on the definition of “securities” (e.g., Forman, 421 U.S. 837 (1975), Landreth, 471 U.S. 681 (1985), Reves, 494 U.S. 56 (1990), and Howey, 328 U.S. 293 (1946)) and highlighted the following as additional indicia that the membership rights should not constitute “stock”; “notes,” “bonds,” “debentures,” or other “evidence of indebtedness”; “investment contracts”; or another form of securities:

  • The membership rights include no dividend rights, cannot be pledged or hypothecated, have no voting rights and have no ability to appreciate in value;
  • The membership rights include no resemblance to a debt instrument since there will be no return of funds to the purchaser; and
  • The membership rights involve no investment of money in a common enterprise where a person is led to expect profits arising from the efforts of others.

The incoming no-action request sought a prompt response from the Staff to ensure that the membership program was up and running prior to the commencement of the NFL season but did not provide an indication of the expected demand for participation in the membership program including whether the underwhelming performance of the Rams over the last decade would be expected to dampen sales of membership interests or if the Rams’ new headquarters in Los Angeles is expected to spur interest from an optimistic fanbase.