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

The SEC announced that beginning on July 10, 2017 it will accept voluntary draft registration statement submissions from all issuers for nonpublic review. The SEC believes this will facilitate capital formation.

The catch is the SEC will limit its nonpublic review in these cases to the initial submission. An issuer responding to staff comments on a draft registration statement must do so with a public filing, not with a revised draft registration statement.

The SEC will not delay processing of a confidential registration statement if an issuer reasonably believes omitted financial information will not be required at the time the registration statement is publicly filed.

In Williams v. Ji et al, the Delaware Court of Chancery examined an alleged scheme in which the Directors of Sorrento Therapeutics, Inc. granted themselves options and warrants for the stock of five subsidiaries over which the corporation had voting control. Shortly before or after the options grants, the board transferred valuable assets and opportunities of the corporation to the subsidiaries.  The subsidiary option plans and grants were not approved by the stockholders of Sorrento.  The Plaintiff also claimed a voting agreement amounted to improper management vote buying.

By way of example, LA Cell, a Sorrento subsidiary, granted options to purchase 1,700,000 shares of LA Cell common stock to the Sorrento directors and a warrant to purchase 9,500,000 shares of LA Cell Class B stock with 10 to 1 voting rights to Sorrento Director Ji. The warrant and the options had an exercise price of $0.01 per share. The options and warrant gave Ji the right to purchase over 18% of the economic interest and 25% of the voting interest in LA Cell. Subsequently, LA Cell entered an exclusive licensing agreement with City of Hope, a medical research center, under which LA Cell licensed to City of Hope certain technology. Sorrento announced that the total deal value with City of Hope could be in excess of $170 million.

The Court rejected the Defendants’ characterization that these were typical compensation decisions subject to business judgment review noting that “self-interested compensation decisions made without independent protections are subject to the same entire fairness review as any other interested transaction.” Here, every member of the Board was interested in the grants.  Thus, entire fairness review applied so long as Plaintiff had pled some specific facts suggesting unfairness in the option and warrant grants.  Assuming the allegations were true, Plaintiff sufficiently alleged the grants were excessive given the size of the grants to Ji and the $170 million value of the City of Hope transaction.

The vote buying allegations involved a private placement where an investor purchased 2.75% of Sorrento’s outstanding common shares. The investor executed a voting agreement that required the investor to vote the shares as directed by the Board. The Court held management may not use corporate assets to buy votes unless it can be demonstrated that management’s vote-buying activity does not have a deleterious effect on the corporate franchise.”  Here, Sorrento’s Directors allegedly made the voting agreement a condition of a Sorrento capital raise and, thus, used corporate assets to buy the votes. As such, the Defendants must prove that the agreement is intrinsically fair and not designed to disenfranchise Sorrento’s stockholders.

As this was a motion to dismiss, the Court did not make any determination that any of the Defendants acted improperly.

In Chicago Bridge & Iron Co. N.V. v. Westinghouse Electric Co. LLC, the Delaware Supreme Court examined the interaction between a working capital true up and alleged breaches of financial statement representations and warranties in a purchase agreement for an acquisition of a subsidiary.  The purchase agreement was certainly unusual.  The expected purchase price at closing was expected to be zero, subject to a working capital true up.  The representations and warranties did not survive closing. Buyer Westinghouse’s sole remedy for breaches of representations and warranties was to refuse to close and seller Chicago Bridge would have no liability for monetary damages post-closing.  Chicago Bridge’s business of participating in the construction of nuclear power plants with Westinghouse had gone south, and it was seeking a clean exit.

After the closing, Westinghouse claimed that Chicago Bridge owed it nearly $2 billion for the working capital true up. Westinghouse admitted that the overwhelming percentage of its claims were based on the proposition that Chicago Bridge’s historical financial statements were not based on a proper application of GAAP.  In other words, the amount owed under the true up would have been far less if working capital were calculated in accordance with Chicago Bridge’s historical practices.  Westinghouse knew of these matters before closing, but closed anyway.

The Court rejected Westinghouse’s claims. According to the Court, the true up language emphasized that net working capital should be determined using the same accounting principles that were used in preparing the financial statements represented by Chicago Bridge to be GAAP compliant. The purchase agreement did so by stating that working capital was “to be determined in a manner consistent with GAAP, consistently applied by [Chicago Bridge] in preparation of the financial statements of the Business, as in effect on the Closing Date.”  A new assessment of Chicago Bridge’s GAAP compliance was not permitted.  Any other interpretation would render the limitations on liability meaningless.

The Court also noted the reasons for working capital true ups:

  • The true up was not meant to aid Westinghouse’s investigation of the business or to otherwise provide a historical picture of the purchased operations.
  • Buyers want protection against value depletion before they take over the business, and, at the same time, sellers want to ensure that they will be compensated for effectively running the business.
  • Purchase price adjustments account for the normal variation in business from signing until closing to assure the buyer and seller that the purchase price accurately reflects the target’s financial condition at the time of closing.

A percolating issue with respect to the SEC’s whistleblower regulations is whether the anti-retaliation protections apply only when suspected misconduct is reported to the SEC, or whether the protections also apply when the whistleblower reports the misconduct internally.

Two circuit courts have held internal reporting is protected under the Dodd-Frank Act, and one circuit court has found the protections apply only when misconduct is reported to the SEC.

The Supreme Court has agreed to review the Ninth Circuit opinion in Somers vs. Digital Realty Trust Inc. to resolve the issue.

Some have suggested that the FASB’s new revenue recognition standard will result in particularized representations in M&A, underwriting and loan documents. It’s easy to argue it’s not necessary and is covered by the standard representation such as “The Financial Statements have been prepared in accordance with GAAP applied on a consistent basis throughout the period involved … and fairly present in all material respects the financial condition of the Company as of the respective dates they were prepared and the results of the operations of the Company for the periods indicated.”

But financial statements are often the subject of multiple representations for accounts receivable, inventory and the like. So it’s entirely possible specific representations regarding the new standard will be required.

For public companies, any such specific representations will likely begin to appear later in 2017 and the first quarter of 2018 before a Company actually issues any financial statements reflecting the new revenue recognition standard. The representations for public companies could take the following form, although perhaps with more qualifiers if the issuance of financial statements is not imminent and work to adopt the standard is ongoing:

The Company has developed disclosure controls and procedures required by Rule 13a-15 or 15d-15 under the Exchange Act which the Company anticipates will be effective to ensure that information required to be disclosed by the Company pursuant to Topic 606 and Subtopic 340-40 of the FASB Accounting Standards Codification (the “Revenue Recognition Standard”) is recorded and reported on a timely basis to the individuals responsible for the preparation of the Company’s filings with the SEC and other public disclosure documents. The Company has developed internal controls over financial reporting (as defined in Rule 13a-15 or 15d-15, as applicable, under the Exchange Act) which the Company anticipates are sufficiently designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with the Revenue Recognition Standard. The Company’s disclosure of the impact of the adoption of the Revenue Recognition Standard set forth in [describe SEC filing] is true and correct in all material respects and is in accordance with Staff Accounting Bulletin No. 74 promulgated by the SEC.

Once financial statements have been issued which reflect the adoption of the new standard, the representations could take the following form:

The Financial Statements [describe financial statements] have been prepared reflecting the adoption of Topic 606 and Subtopic 340-40 of the FASB Accounting Standards Codification (the “Revenue Recognition Standard”). The Company elected to utilize the [modified retrospective] method of transition beginning [January 1, 2018].  Footnote [insert reference] to the Financial Statements accurately states in all material respects (i) the amount by which each Financial Statement line item is affected [describe reporting period] by the application of the Revenue Recognition Standard as compared to GAAP that was in effect before the change and (ii) the reasons for each significant change identified.  Footnote [insert reference] to the Financial Statements accurately states in all material respects the judgments, and changes in judgments, made in applying the Revenue Recognition Standard that significantly affect the determination of the amount and timing of revenue from contracts with customers.

The Company has implemented disclosure controls and procedures required by Rule 13a-15 or 15d-15 under the Exchange Act which are effective to ensure that information required to be disclosed by the Company pursuant to the Revenue Recognition Standard is recorded and reported on a timely basis to the individuals responsible for the preparation of the Company’s filings with the SEC and other public disclosure documents. The Company has implemented internal controls over financial reporting (as defined in Rule 13a-15 or 15d-15, as applicable, under the Exchange Act) which are designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with the Revenue Recognition Standard.

The Delaware Supreme Court upheld the Chancery Court decision in Chester County Retirement Systems v. Collins et al.  In so doing, it noted one troubling aspect of the record as follows:

The plaintiff’s complaint pointed out the failure of the target to the merger to disclose that the chairman of its special committee was considering joining the special committee’s outside counsel as a partner. That fact was disclosed within weeks after the merger’s closing by the law firm in a hiring announcement. Although we, like the Court of Chancery, conclude that this fact was not material, one can understand why it caught the attention of the plaintiff, and prudence would seem to have counseled for bringing it to light earlier, especially given that the chairman’s intention to become a partner at that firm was going to become public in any event. Given when the eventual disclosure was made, the special committee chair and the committee’s outside lawyers presumably knew that this potential relationship was at

Even though we agree that this development was not material, the failure to disclose it in these circumstances nevertheless raised needless questions, in a high-salience context in which both cynicism and costs tend to run high anyway. Both of those factors increased here simply because of the fact that the chairman’s new relationship with outside counsel was disclosed after, and not before, the votes were counted. That said, the Court of Chancery correctly analyzed this and the other alleged disclosure deficiencies and found that the vote was fully informed and as a result the business judgment rule applied.

 

The SEC recently brought charges against the CEO and CFO of UTi Worldwide Inc. in a settled enforcement proceeding.  The Company was engaged in multinational freight forwarding and logistics operations. In connection with its freight forwarding business, the Company provided cash outlays for transportation costs, customs, duties, taxes, and other expenses. These disbursements temporarily consumed cash as the Company typically paid them in advance, and then obtained reimbursement from its customers through invoicing.

In September 2013, the Company began its U.S. rollout of a proprietary freight forwarding operating system called 1View. A cash manager shortly notified the CFO that 1View was properly recording transactions in the system but that it was not printing out invoices.  Delayed invoices caused delays in payment.

The CEO and CFO were aware that the Company was taking steps to remediate the cash flow situation, including delaying payments to vendors. At one point a cash manager advised the Treasurer that US regional operations would run “out of cash tomorrow.”  The CFO later met with the Company’s lead lender to request an amendment to the Company’s loan covenants.  The lender agreed but advised there would be no further amendments.

In December 2013, the Company filed its third quarter 10-Q which disclosed material fluctuations in certain line items related to liquidity. The Company did not report any of the specific 1View billing problems that contributed to the changes.  The Company did note in its 10-Q that it considered 1View ready for its intended use.  The CEO and CFO signed the related Sarbanes-Oxley certifications included with the Form 10-Q.

Cash receipts improved in December and January but the improvement was not sufficient to meet debt covenants. The lead lender wanted to be paid off and refused to grant a waiver.

In February 2014, the Company filed a Form 8-K which disclosed for the first time details regarding the extent and causes of its liquidity problems. The Company also disclosed a planned offering of convertible notes and preference shares. In connection with the planned offering, the Company also noted its independent accountant had amended its audit opinion for the fiscal year ended January 31, 2013 to express doubt about the ability of the Company to continue as a going concern. The Company’s shares fell 30% from the prior days close.

The SEC found the CEO and CFO caused the issuer to violate Exchange Act requirements to file reports that contain such further information as maybe necessary to make the required statements not misleading. Additionally, Regulation S-K Item 303 requires registrants to disclose in the MD&A sections of required periodic filings “any known trends or uncertainties that will result in or that are reasonably likely to result in the registrant’s liquidity increasing or decreasing in any material way.”  The SEC also noted that the CEO and CFO certifications violated the Exchange Act.

The CEO and CFO did not admit or deny the SEC’s findings. The Company was not named in the action.

The SEC announced that John David Telfer, the former chief compliance officer and anti-money laundering (AML) officer of a registered broker-dealer, agreed to a securities industry bar to settle charges in a pending administrative and cease-and-desist proceeding related to gatekeeper failures.

The SEC instituted proceedings against Telfer and his former employer Meyers Associates, L.P. (now known as Windsor Street Capital, L.P.) on January 25, 2017. According to the SEC’s settled order as to Tefler, Meyers Associates failed to file Suspicious Activity Reports (SARs) for approximately $24.8 million in suspicious transactions. Collectively, these transactions were marked by numerous red flags suggesting that certain Meyers Associates’ customers may be involved in fraudulent “pump and dump” schemes.

According to the SEC, even in cases where one or more of these red flags was brought directly to Telfer’s attention—for example, through notification from Meyer Associates’ clearing firm—Telfer knowingly or recklessly failed to file the required SARs.

Without admitting or denying the findings in the SEC’s order, Tefler consented to an associational, industry, and penny stock bar and to pay a civil monetary penalty of $10,000.

The matter pertaining to Meyers Associates has been scheduled for a public hearing before an administrative law judge on June 26, 2017, who will prepare an initial decision stating what, if any, remedial actions are appropriate.

 

The U.S. Department of the Treasury today issued its first in a series of reports to President Donald J. Trump examining the United States’ financial regulatory system. Appendix B to the report includes 16 pages of detailed recommendations, noting which actions do not require further legislation. The action is not meant to displace the Financial Choice Act intended to roll back Dodd-Frank that was passed by the House.

This report was prepared in response to an Executive Order which enumerated certain core principles for financial regulation. The report notes that there are over 800 provisions in law, regulation, and agency guidance that impose obligations on bank Boards.  Treasury believes this volume crowds out time that should be allocated to oversight of the enterprise’s business risk and strategy. The report also notes there is a considerable volume of non-strategic regulatory matters requiring Board attention that has the impact of blurring the appropriate line between management and Board duties. Finally, the report asserts there is little coherence in the panoply of requirements imposed on Boards by various financial regulators, on top of federal and state statutory requirements.

According to the report this has resulted in significant overlap, a lack of thoughtful coordination of aggregate requirements and expectations, and a lack of periodic review or reassessment of the impact of aggregate requirements placed on Boards. This has a particularly negative impact on mid-size and smaller banking organizations. The Trump administration believes duties imposed on Boards are too voluminous, lack appropriate tailoring, and undermine the important distinction between the role of management and that of Boards of Directors. A significant shift in the nature and structure of Board involvement in regulatory matters could be made with little or no increase in risks posed to the financial system. In fact, allowing Boards to fulfill a clearer set of agreed duties, per an enterprise’s corporate governance model, would reduce risk by restoring their appropriate governance authority. Treasury recommends an inter-agency review of the collective requirements imposed on Boards in order to reassess and better tailor these aggregate expectations and restore balance in the relationship between regulators, Boards, and bank management.

On June 8, 2017, the U.S. House of Representatives passed the Financial CHOICE Act, a bill designed to replace many of the financial regulations imposed by Dodd-Frank.  Among other things, the Financial CHOICE Act would eliminate the Volcker Rule, ease regulations of community banks and credit unions, and the Department of Labor’s fiduciary rule.  The bill would also eliminate the FDIC’s Orderly Liquidation Fund, which allows that agency to unwind giant banks.

The bill faces a tough road ahead in the U.S. Senate and would require Democrat support to overcome a filibuster.

ABOUT STINSON LEONARD STREET

Stinson Leonard Street LLP provides sophisticated transactional and litigation legal services to clients ranging from individuals and privately held enterprises to national and international public companies. As one of the 100 largest firms in the U.S., Stinson Leonard Street has offices in 13 cities, including Minneapolis, Mankato and St. Cloud, MN; Kansas City, St. Louis and Jefferson City, MO; Phoenix, AZ.; Denver, CO; Washington, D.C.; Decatur, IL; Wichita, KS; Omaha, NE; and Bismarck, ND.

Drew Kuettel is a member of the firm’s corporate finance group.  Drew works in the firm’s Minneapolis office and can be reached at andrew.kuettel@stinson.com or 612.335.1743.