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

The U.S. Commodity Futures Trading Commission has obtained a federal court Consent Order against Defendant Jon S. Corzine, former CEO of MF Global Inc., requiring him to pay a $5 million civil monetary penalty for his role in MF Global’s unlawful use of customer funds totaling nearly one billion dollars and for his failure to diligently supervise the handling of customer funds. Per the Corzine Order, Mr. Corzine cannot seek or accept, directly or indirectly, reimbursement or indemnification from any insurance policy with regard to the penalty amount.  The Corzine Order also requires Mr. Corzine to undertake that he will never act as a principal, agent, officer, director, or employee of a Futures Commission Merchant and that he will never register with the CFTC in any capacity.

According to the CFTC, during the last week of October 2011, in violation of U.S. commodity laws, MF Global unlawfully used nearly one billion dollars of customer segregated funds to support its own proprietary operations and the operations of its affiliates and to pay broker-dealer securities customers and pay FCM customers for withdrawals of secured customer funds. The CFTC said when the transfers occurred, Mr. Corzine controlled MF Global because he was CEO, which was experiencing a worsening liquidity crisis.  Because of this control and by his conduct, the CFTC stated Mr. Corzine is liable for MF Global’s violations as its controlling person.  Furthermore, from at least August 2011 through October 31, 2011, the CFTC stated Mr. Corzine failed to supervise diligently the activities of the officers, employees, and agents of MF Global in their handling of customer funds.

Mr. Corzine did not admit or deny the findings in the Corzine Order.

The SEC has published a white paper describing the types of Regulation A+ offerings to date. Facts published include:

  • As of October 31, 2016, prospective issuers have publicly filed offering statements for 147 Regulation A+ offerings, seeking up to approximately $2.6 billion in financing. Of those, approximately 81 offerings seeking up to approximately $1.5 billion have been qualified by the Commission.
  • Tier 2 offerings were on the margin more common among qualified offerings, accounting for 60% of qualified offerings.
  • The offer amount varied with issuer size, with the average issuer was seeking up to approximately $18 million.
  • The majority of offerings were conducted on a best-efforts, self-underwritten basis, consistent with the small offering size and the small size of a typical issuer.
  • Approximately 54% of all offerings and 65% of qualified offerings involved offerings on a delayed or continuous basis.
  • The majority (around 80%) of offerings did not involve testing-the-waters. However, Tier 2 offerings accounted for the majority of testing-the-waters solicitations.
  • Approximately 10% of all offerings involved sales by existing (affiliated or unaffiliated) securityholders.
  • Across qualified offerings, the median time from initial public filing to qualification was 78 days.
  • The median legal cost was reported to be approximately $40,000 ($50,000) based on all filings (qualified offerings).
  • The typical issuer had median assets of approximately $0.1 million across all filings and approximately $0.2 million across qualified filings.
  • Based on all filings with available data, the median issuer had no cash, property, plants and equipment (PP&E), long-term debt, revenue, or net income.
  • The finance, insurance, and real estate sector accounted for the largest number of offerings and total amount offered across issuers.

The Appointments Clause of the US Constitution requires that “inferior officers” be appointed by the President, department heads or courts of law. SEC administrative law judges, or ALJs, are not appointed by the SEC – they are hired by the SEC’s Office of Administrative Law Judges, with input from the Chief Administrative Law Judge, human resource functions and the Office of Personnel Management.

For those reasons, the 10th Circuit Court of Appeals found SEC administrative proceedings to be unconstitutional.  In Bandimere v. United States Securities and Exchange Commission, the Court found it is unclear where the appointment buck stops at the SEC. The current hiring system would suffice under the Constitution if SEC ALJs were employees, but under current precedent they are inferior officers who must be appointed as the Constitution commands.  The ALJ’s exercise significant discretion while performing “important functions” that are “more than ministerial tasks.”

Among other things, the Court noted ALJs have the authority to shape the administrative record by taking testimony, regulating document production and depositions, ruling on the admissibility of evidence, receiving evidence, ruling on dispositive and procedural motions, issuing subpoenas, and presiding over trial-like hearings. ALJs also have authority to issue initial decisions that declare respondents liable and impose sanctions.

The decision is contrary to an August 2016 decision by the U.S. Court of Appeals Court for the District of Columbia Circuit. That decision found ALJs were not inferior officers because their decisions were subject to Commission review and therefore not final.

In 2015, Section 115 was added to the Delaware General Corporation Law, or DGCL providing that Delaware corporations may adopt bylaws requiring that internal corporate claims be filed exclusively in Delaware. Section 109(b) of the DGCL was amended simultaneously to provide that the bylaws of Delaware corporations “may not contain any provision that would impose liability on a stockholder for the attorneys’ fees or expenses of the corporation or any other party in connection with an internal corporate claim.”

About six months later, the board of Paylocity Holding Corporation adopted two new bylaws. The first was an exclusive forum bylaw that, absent the company’s consent, requires internal corporate claims to be filed in a state or federal court located in Delaware. The second bylaw purported to shift to a stockholder who files an internal corporate claim outside of Delaware without the company’s consent the attorneys’ fees and other expenses that the company incurs in connection with such a claim if the stockholder does not obtain a judgment on the merits that substantially achieves the full remedy sought (the “Fee-Shifting Bylaw”). In other words, to trigger the Fee-Shifting Bylaw, a stockholder must first violate the company’s exclusive forum bylaw.

Ruling on a motion to dismiss, the Delaware Court of Chancery agreed with the plaintiff that the plain text of the Fee-Shifting Bylaw violates Section 109(b) because the statute unambiguously prohibits the inclusion of “any provision” in a corporation’s bylaws that would shift to a stockholder the attorneys’ fees or expenses incurred by the corporation “in connection with an internal corporate claim,” irrespective of where such a claim is filed. Thus, even though the Fee-Shifting Bylaw is triggered only when an internal corporate claim has been filed outside of Delaware, it is invalid under the blanket prohibition on such bylaws contained in Section 109(b).

 

ISS has updated its equity compensation plan FAQs. New and materially updated questions include:

  • If a company grants performance-based awards, how will the shares be counted for the purposes of calculating burn rate?
  • How does ISS evaluate an equity plan proposal seeking approval of one or more plan amendments?
  • How does ISS evaluate an equity plan proposal seeking approval of one or more plan amendments?
  • How does ISS view a plan amendment to increase the tax withholding rate applicable upon award settlement?
  • What changes were made to the Equity Plan Score Card (EPSC) policy for 2017?
  • How will equity plan proposals at newly public companies be evaluated?
  • What factors are considered in the EPSC, and why?
  • Are the factors binary? Are they weighted equally?
  • How does ISS assess a plan’s minimum vesting requirement for EPSC purposes?

ISS has also updated its FAQs on executive compensation policies. New and materially updated FAQs include:

  • How is Total Compensation calculated?
  • What are the factors that ISS considers in conducting the qualitative review of the pay for performance analysis?
  • What is the Relative Pay and Financial Performance Assessment included in research reports?
  • How will ISS use the Relative Pay & Financial Performance Assessment in its analysis?
  • If a company has not been publicly traded for at least three or five years, does the relevant quantitative pay for performance evaluation still apply? Does this affect whether a company would be used as a peer?
  • What is ISS’ Problematic Pay Practices evaluation?
  • What is ISS’ policy on say-on-pay frequency?
  • In the event that a company does not present shareholders with a say-on-pay vote where one would otherwise be expected, what are the vote recommendation implications?
  • How does ISS evaluate the treatment of equity awards upon a change-in-control?
  • How does ISS evaluate management advisory proposals seeking shareholder approval of non-employee director pay?
  • How does ISS approach U.S.-listed companies with multiple executive compensation proposals on the ballot as a result of the company’s incorporation in a foreign country?

ISS also issued a publication on pay-for-performance mechanics.

An equity and debt based crowdfunding portal built on Blockchain technology is set to begin offering crowd-sourced financing opportunities to non-accredited investors under Minnesota’s MNvest crowdfunding legislation. Silicon Prairie Online is the second platform available for interstate crowdfunding under MNvest, following the approval of Venture Near’s crowd-funding portal by the Minnesota Department of Commerce in early November (as highlighted in this recent post).

Crowdfunding in Minnesota became legal as of June 2016 and provides a means for Minnesota-based companies to crowdfund up to $2 million in proceeds in exchange for equity and/or debt. Entities must also be organized under the laws of Minnesota, have principal offices in Minnesota, maintain at least 80% of assets in Minnesota, and ensure at least 80% of gross revenues are derived from business operations in Minnesota to meet the eligibility requirements under the MNvest regulation.

While the occurrence and frequency of actual crowdfunding offerings using approved MNvest platforms remains unknown (and we are not aware of any equity crowdfunding campaign launched to date), reports that Silicon Prairie Online will rely on Blockchain technology to facilitate payment and transfer of shares suggests a broadening embrace of the novel technology and may portend a broader move for future securities offerings in the crowdfunding space.

Blockchain, also known as distributed ledger technology and typically associated with the use of Bitcoin currency, relies on an algorithm to track the exchange of stocks, bonds and other financial securities without a centralized ledger. Blockchain technology is based on a distributed “open ledger” using consensus-based authentication methods that depart from the current methods of securities settlement process.  The technology works by storing information in blocks that record all transactions ever done through the network and allows for independent validation of both the existence of assets to be traded and ownership – eliminating the need to rely on an outside third-party institution to conduct this necessary step.

On December 10, the SEC Small Business Advocate Act was approved by the Senate, clearing the way for signature by the President. The measure, which creates an advocacy office for the interests of small businesses within the SEC, came out of the House, where it was first proposed back in October of 2015.  In February of 2016, the measure was approved by the House, but it met with delay in the Senate.   The text of the bill was then again included, along with five other financial measures previously approved by the House, in the Creating Financial Prosperity for Businesses and Investors Act, which was passed by the House on December 5, 2016.  You can find a full summary of this legislation and links to the full text by exploring our prior coverage.

The Senate approval is only to the specific SEC Small Business Advocate Act; it is not an approval of the entire six-measure package passed by the House on December 5, so the fate of those remaining measures remains unclear.

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.

The SEC’s Division of Corporation Finance staff released 35 new Compliance and Disclosure Interpretations (C&DIs) (available here) on December 8th. Among numerous interpretations focused on issues applicable to foreign private issuers and offshore offerings under Regulation S were several C&DIs providing new interpretations of the SEC’s rules for determining qualified institutional buyer (QIB) status for Rule 144A offerings.

Overview: Rule 144A and QIBS

Rule 144A is a safe harbor exemption from the registration requirements of Section 5 of the Securities Act for certain offers and sales of qualifying securities (not listed on a U.S. securities exchange or quoted on a U.S. quotation system). Public company offerings of debt or preferred securities and offerings by non-reporting issuers or foreign issuers are the most common Rule 144A offerings.

The exemption available under Rule 144A allows resales of securities to QIBs, which are institutions (not individuals), deemed to be an “accredited investor” as defined under Rule 501 of the SEC’s Regulation D. To qualify as a QIB under Rule 144A, an entity must own and invest a minimum of $100 million in securities on a discretionary basis.

New C&DIs

In new C&DI 138.05, the staff clarifies that securities purchased or are held on margin by an entity would still be considered owned by the entity (as long as they are not also subject to a repurchase agreement) for purposes of determining whether such entity meets the $100 million threshold to qualify as a QIB under Rule 144A(a)(1)(i).

Question 138.06 similarly provides that an entity’s loaning of securities does not preclude it from including such securities in calculating the $100 million requirement for QIBS.

In converse, Question 138.07 and Question 138.08 clarify that securities borrowed or sold short by entities may not be include in the Rule 144A(a)(1)(i) calculation.

In new C&DI 138.09, the staff expresses its view an investment company that is not registered under the 1940 Act may not aggregate investments by the other funds that are part of the family in the manner described under Rule 144A(a)(1)(iv) as such aggregation is only available to registered investment companies.

And in the staff’s final interpretation on QIB status under Rule 144A, Question 138.10, the staff provides additional clarification on the accommodation under Rule 144A(a)(1)(v) in which an entity may qualify as QIB if all of its equity owners are also QIBs. The C&DI notes that limited partners are considered the equity owners of a limited partnership for purposes of applying Rule 144A(a)(1)(v). As a result, the QIB status of a general partner need not be considered unless such general partner is also a limited partner.

The SEC announced that Equidate Inc. agreed to settle charges that it violated federal securities laws by failing to register security-based swaps that were offered and sold online to shareholders in pre-IPO companies. Equidate did not admit or deny the SEC’s findings.

The SEC instituted an order finding that Equidate sought to provide liquidity for employees of private, growth-stage companies in the Silicon Valley and others holding restricted shares of their stock, and its platform essentially matched these shareholders with investors seeking to invest in the potential economic return on those shares. Equidate conducted transactions through contracts that its subsidiary entered into with the shareholders and investors, and payment provisions were triggered by such events as a merger, acquisition, or IPO at the underlying company.  But Equidate never filed a registration statement for the swaps nor sold them through a national securities exchange as required.

In broad economic terms, Equidate designed its structure to allow investors to purchase the rights to the economic upside or downside of an equity security, similar to the operation of a total return swap. Typically, Equidate Holdings entered into separate contracts with both the shareholder and the investor. The contract with the shareholder was called a Shareholder Note (“SHN”). The contract with the investor was called a Payment-Dependent Note (“PDN”). The contracts were designed to work together to transfer the potential economic return in a set of reference shares from the shareholder to the investor through defendants, despite the payment obligations under both instruments being legally separate, and the investor not having a direct right to the shareholder’s payment. In exchange for providing the potential economic return to the investors, the shareholder received an up-front cash payment from the investors via a subsidiary known as Equidate Holdings based on an agreed-upon price for the shares.

The Commodity Exchange Act contains a number of exclusions from the definition of “swap,” including for any note, bond, or evidence of indebtedness. Although the instruments bore the title of a “note,” as a matter of economic reality, the defendants conceded that they were not designed to operate as a note, bond, or evidence of indebtedness. There is also an exemption for security forward contracts.  The fact that the SHN contemplated the physical delivery of the underlying backup shares (or their equivalent) in certain limited circumstances did not render it a security forward or a purchase or sale of a security on a fixed or contingent basis.

Dodd-Frank and Section 5(e) of the Securities Act makes it unlawful for any person to offer to sell, offer to buy, or purchase or sell a security-based swap to any person who is not an eligible contract participant without an effective registration statement. An “eligible contract participant” includes several categories of persons and, in certain cases, monetary thresholds that vary depending on the particular type of person or entity involved. For example, individuals need at least $5 million and often $10 million invested on a discretionary basis to qualify as eligible contract participants.

Dodd-Frank also makes it unlawful:

  • for any person to offer to sell, offer to buy, or purchase or sell a security-based swap to any person who is not an eligible contract participant without an effective registration statement; and
  • for any person to effect a transaction in a security-based swap with or for a person that is not an eligible contract participant, unless such transaction is effected on a national securities exchange.

Many shareholders and investors who entered into defendants’ SHN and PDN contracts were not eligible contract participants. Therefore, according to the SEC, the defendants violated the Securities Act because the transactions were not executed with eligible contract participants, no registration statements were in effect and the contracts were not effected on a national securities exchange.

 

On Monday, the House of Representatives passed the Creating Financial Prosperity for Businesses and Investors Act (H.R. 6427) (the “Act”) by a vote of 398 to 2. The Act is actually a compilation of six measures that were previously considered and passed by the House in 2016, but that have thus far seen no action in the Senate.  Here is a summary of each piece of legislation, along with links to our prior coverage and to the actual text of each provision.

The Small Business Capital Formation Enhancement Act

Existing law requires the SEC to hold “an annual Government-business forum to review the current status of problems and programs relating to small business capital formation,” to invite other relevant federal agencies to participate, and to prepare summaries of the forum and any findings made by the forum for participants in the forum and appropriate committees of Congress. (15 U.S.C. 80c-1). The Small Business Capital Formation Enhancement Act would go a step further by requiring the SEC to review the findings and recommendations of the forum and, in the event that the forum submits a finding or recommendation to the SEC, to “promptly” respond by issuing a public statement evaluating the finding or recommendation and indicating what action, if any, the SEC intends to take in as a result.  Presumably, the SEC action could be to further study a particular matter, or to consider and propose a rule change, or to take no action at all.  The government-business forum has in the past recommended concepts that were included in the JOBS Act.   I’m not sure this bit of legislation, which adds all of 50 words to the end of an existing statute relating solely to SEC procedure, is quite worthy of its grand title.

Check out our prior coverage and the text of the measure.

The SEC Small Business Advocate Act

This piece of legislation would amend the Exchange Act to create a new Office of the Advocate for Small Business Capital Formation within the SEC. This new office would be charged with planning and executing the annual Government-Business Forum on Small Business Capital Formation and would also interface with small businesses to understand significant regulatory problems they may be having and advocate within the SEC for rule or policy changes to address those problems.  The office would also analyze the effect of newly proposed rules or regulations on small businesses.  The office would be headed by an individual appointed by the SEC (but not an employee of the SEC) and would produce an annual report on its activities that would be provided directly to various committees of Congress without any review or oversight by the SEC.  The SEC would also be required to adopt procedures ensuring an SEC response to any proposals from the office within three months of receipt.

The legislation would create the Small Business Capital Formation Advisory Committee, which would be tasked with providing the SEC with advice on the SEC’s rules, regulations, and policies relating to capital raising, trading in securities, and public reporting and corporate governance requirements, in each case with respect to privately held small businesses and public companies with a public float of less than $250 million. However, any advice regarding any aspect of the SEC’s enforcement program is expressly excluded from the scope of the committee’s mandate.  The SEC would be required to assess the recommendations from the committee and publicly disclose any action the agency takes as a result of those recommendations.  The committee would be made up primarily of persons representing small business interests who would be appointed by the SEC to four-year terms.  The legislation includes procedural rules for the working of the committee and provisions relating to salaries and reimbursement of travel expenses.

Check out our prior coverage and the text of the measure.

The Supporting America’s Innovators Act

There is currently an exemption from classification as an investment company for purposes of the Investment Company Act of 1940 for an issuer not involved in a public offering of its securities whose outstanding securities (other than short-term paper) are held by fewer than 100 persons.   The Supporting America’s Innovators Act would raise the number of holders to 250 for purposes of this exemption, but only for companies that meet the new definition of “qualifying venture capital fund.”  A qualifying venture capital fund would be defined as any venture fund (as defined under the Investment Advisers Act of 1940) with $10 million or less in invested capital, with that threshold amount subject to annual adjustment by the SEC to reflect changes in the Consumer Price Index.

Check out our prior coverage and the text of the measure.

The Fix Crowdfunding Act

The Fix Crowdfunding Act is designed to do two things: (1) provide a way for companies to receive the benefits of crowdfunding without having to deal with a large number of direct equity holders, and (2) change the conditional exemption from counting securities sold in a crowdfunded offering towards the Exchange Act registration thresholds.

The legislation would amend the Investment Company Act of 1940 to newly define “crowdfunding vehicle” to mean an entity whose purposes is limited by its charter documents to acquiring, holding, and disposing of the securities of a single issuer in one or more crowdfunding transactions conducted under Section 4(a)(6) of the Securities Act and Regulation Crowdfunding, and which meets the following requirements:

  • It must have only one class of securities;
  • Neither the crowdfunding vehicle itself nor any associated person of the crowdfunding vehicle may receive any compensation in connection with the purchase, holding, or sale of securities of the investment target;
  • The securities of the crowdfunding vehicle must have been issued in a crowdfunding transaction under Section 4(a)(6) and Regulation Crowdfunding in which the investment target was a co-issuer;
  • Both the crowdfunding vehicle and the investment target must be current in their respective disclosure obligations under Regulation Crowdfunding; and
  • The crowdfunding vehicle must be advised by an investment adviser registered under the Investment Advisers Act of 1940 or registered in its home state.

A crowdfunding vehicle would be exempt from the investment caps that apply to individual investors in crowdfunding offerings (the greater of $2,000 or 5% of the lesser of income or net worth if either income or net worth is below $100,000 OR 10% of income or net worth up to $100,000 if the lesser of income or net worth is equal to or greater than $100,000). In other words, the actual crowdfunding could occur in the crowdfunding vehicle, which could then make an investment into the target as a single investor.

The Exchange Act and related rules generally require an issuer to register its securities if it meets certain thresholds relating to its total assets or the number of its security holders. Section 12(g)(6) of the Exchange Act and Regulation Crowdfunding currently provide that security holders who acquired their securities in a crowdfunded offering don’t have to be counted for purposes of the registration threshold, PROVIDED, that the issuer is current on its required annual reports and it has engaged a transfer agent for its securities.  The Fix Crowdfunding Act would remove the conditional nature of the exemption (annual report and transfer agent) if the issuer had a public float for the last semi-annual period of at least $75 million, or (if the public float is $0 for such period) annual revenues of less than $50 million in the most recently completed fiscal year.

If you’re interested in the way this piece of legislation has evolved since its initial proposal and additional context, you should check out this article from Crowdfund Insider.

Check out our prior coverage and the text of the measure.

The Fair Investment Opportunities for Professional Experts Act

This legislation codifies the accredited investor definition (which is currently set forth in Rule 501 under the Securities Act) and adds two additional categories of accredited investors: (1) any person currently licensed or registered as a broker or investment adviser by the SEC, FINRA, an equivalent SRO, or state securities regulator, and (2) any person that is determined by SEC rule or regulation to have “demonstrable education or job experience to qualify such person as having professional knowledge of a subject related to a particular investment, and whose education or job experience is verified by the Financial Industry Regulatory Authority or an equivalent self-regulatory.” Of course, the scope of education-or-job-experience prong of the definition would be subject to rulemaking, which would likely be affected by numerous factors, including the political climate at the time of the rulemaking and the directive of the executive administration at the time.

Check out our prior coverage and the text of the measure.

The U.S. Territories Investor Protection Act

Section 6(a)(1) of the Investment Company Act of 1940 currently exempts any company organized or created under the laws of, and having its principal place of business in, Puerto Rico, the Virgin Islands, or any other possession of the U.S. The  U.S. Territories Investor Protection Act would remove this exemption, thus subjecting companies in U.S. territories to the Investment Company Act to the same extent as U.S. companies.  The legislation provides for a three year phase out period for companies that were covered by the exemption on the date it is enacted and allows the SEC to further delay application to such companies for an additional three-year period in its discretion.

Check out the text of the measure.

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.